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Volatile markets require a strong investment process
Equity prices ultimately reflect fundamentals
Global economy shows early signs of bottoming
The past two quarters have been a study of sharp contrasts in investor sentiment. After ending 2018 by posting its worst monthly performance since 1931, the S&P 500 bounced back with its biggest quarterly gain in a decade, rising 13.7%, with bond markets also rallying strongly. Last year’s historic sell-off was driven by concerns over rising trade tensions and fears that higher interest rates could hurt the U.S. economy, along with broader worries about a slowdown in the global economy and corporate profits. So what has changed?
For one thing, we think investor sentiment likely overshot to the downside when markets teetered on the edge of bear territory back in December. Investors’ expectations simply fell faster than the economic backdrop suggested. But the new year has also brought with it a new wave of optimism. Recent developments in U.S.-Chinese negotiations have raised confidence that a more damaging trade war will be avoided. Meanwhile, early signs of a bottoming in the global economy have helped investors look through the current weak patch in corporate earnings growth.
Perhaps most importantly, though, has been the shot of adrenaline delivered to markets by the Fed’s pause in monetary policy normalization. Despite essentially full employment, with inflation remaining stubbornly below target, policymakers have signaled they are now focused on the risk of overtightening and ending the expansion prematurely. Higher interest rates are feared by equity investors because they raise borrowing costs, reduce profits and make fixed income more attractive relative to stocks. They also draw capital into the U.S., strengthening the dollar, which makes it tougher for U.S. exporters to compete and for emerging market companies to repay dollar-denominated debts.
We’re not surprised by the recovery in markets. For us, the rally has been an appropriate rebound in sentiment from December’s overly pessimistic outlook. As we have seen several times before in this cycle, markets eventually reconnect to positive fundamentals. But we doubt the pace of recent gains will be sustained. Risks and tailwinds have grown more balanced, but expectations on monetary policy have now been priced into the market, which could be a source of further volatility ahead.
Will the Fed be as dovish as expected, even if the tight labor market causes a sudden, unexpected flare-up in inflation? Much of the rally this year has been built on market expectations that policymakers are done raising interest rates over the next few years. In fact, the next move now expected by the bond market is a rate cut. Likewise, while President Trump has signaled that he is generally pleased with the progress of trade negotiations with China, little tangible evidence of an impending deal has emerged. And even if a lasting truce can be reached, there is no guarantee that the U.S. administration won’t turn more confrontational with other trade partners in areas such as autos or border security.
The first quarter was a good reminder of the importance of having a rigorous investment process that can protect client portfolios and prevent overreacting when markets grow turbulent. Good periods often follow bad, when underlying fundamentals remain positive. With late business cycle conditions of slower growth and higher volatility in mind, our equity and fixed income research teams have worked proactively to fortify client portfolios against periods when uncertainty dominates, as was the case in December, while also leaving them well positioned to take advantage of an improving investment environment, as has been the case recently.
We continue to favor high-quality U.S. growth and dividend equities over other developed markets such as Europe, which has weaker growth prospects and high political risk. We also like emerging market Asia equities. Policy across the region is turning more supportive this year through fiscal and monetary stimulus, and valuations — even after this year’s rally — are still attractive, both on a historical basis and relative to other regions (see chart). Longer term, the investment case remains particularly compelling (see article: “When It Comes to Diversification, Don’t Be Naïve”). In fixed income, we also continue to see opportunities in a number of select global credit sectors, including U.S. Muni HY, emerging market debt (see article: “Emerging Market Corporate Credit: An Overlooked Opportunity”), and senior bank loans and their CLO cousins. These sectors will likely lead fixed income returns in 2019 and serve as a valuable diversifier to other risk assets.
As investors celebrate the 10-year anniversary of the bull market, we seem set to return to the defining backdrop of this cycle: low rates, slow growth and an occasional bout of volatility. The long-running expansion is now in its later stages, and uncertainty tied to Fed actions, politics, trade and sluggish global demand will likely keep markets susceptible to swings in sentiment. However, economic fundamentals remain healthy and growth, while moderating, looks sustainable. Since the Second World War, all but two bear markets have been accompanied by a recession. We think corporate profits and stock prices can continue to rise higher in such an environment, but we also believe clients should prepare for a slower, bumpier climb.