There was little follow-through into the first quarter after late-2018’s risk-off market environment, with strong returns generated across nearly every major asset class in the first three months of 2019. Underpinning the sharp performance reversal were expectations for Chinese-related tailwinds, including fresh rounds of fiscal stimulus and a potential easing of trade tensions with the United States, as well as an increasingly more accommodative global central bank policy path. While some measures of U.S. economic fundamentals moderated from cyclically elevated levels—due in large part to diminishing fiscal support—the ongoing economic expansion pressed on in the first quarter, approaching the longest on record.
Global equity returns ranged from strong to stellar during the quarter, with notably impressive performance witnessed in domestic equity sectors, particularly small cap, which bore the brunt of the move lower across the global equity marketplace in late-2018. Despite lagging domestic markets, international developed and emerging market equity returns were also solid, each posting essentially a 10% quarterly total return. Stylistically, growth continued its run of outperformance versus value, as the financial sector significantly lagged both the broader market and the technology sector amid sharply declining Treasury rates and a flattening yield curve.
Given the impressive returns across global equities, participation in the rally by credit and interest-rate-sensitive fixed income sectors alike came as a surprise. The Bloomberg Barclays U.S. Aggregate Bond Index, a common proxy for domestic rate-sensitive bonds, generated a 2.9% total return in the first quarter, the strongest quarterly return in 3 years. A nearly 30 basis point decline in interest rates helped support the outsized performance. Structurally, a number of inversions that took place along the Treasury curve during the quarter stoked recessionary fears, which have ebbed slightly to begin the second quarter.
Real assets produced handsome returns, as a more than 30% increase in the spot price of crude oil and generally elevated investor sentiment drove outsized returns among energy-related sectors such as pipelines and MLPs. A broader rally across commodity prices and global industrial companies were a welcomed development for those managers and strategies that remained positioned for a continuation of global economic growth.
Key Market Themes and Developments
CENTRAL BANKS STOKE MARKET RALLY WITH DOVISH MOVES
The Throughout 2018, U.S. economic activity appeared robust, with strength emanating from nearly every corner of the economy—particularly the labor market. Annual U.S. nominal GDP growth, for example, accelerated to 5.5% through the third quarter, a 12-year high. With incoming data supported by fiscal stimulus tailwinds, strong capital flows, and generally-elevated animal spirits, the U.S. economy’s fortune may have come at the expense of key trading partners, such as China, Europe, and Japan. Illustrating this relative strength is the U.S.’s real GDP growth rate through the third quarter—the strongest since second quarter 2015—contrasted against steadily declining growth rates for many of the world’s largest economies.
A predominant driver behind the rebound included a concerted effort by both the Federal Reserve (Fed) and European Central Bank (ECB) to stem market volatility and increase market participants’ expectations for the level of near-term monetary accommodation.
In the United States, the Fed has invoked substantial dovish sentiment into the market since last November, despite a domestic economy that appears sound in absolute terms and particularly strong relative to the downward growth trajectories plaguing many of the U.S.’s key trading partners such as Europe, Japan, and China, among others.
Since last October, the Fed’s guidance on policy rates has shifted dramatically. In early October, Fed Chairman Powell described rates as “a long way from neutral,” but described them as “just below” neutral a little more than a month later at the end of November. In the first quarter, the Fed took an even more accommodative stance, laying out through the Dot Plot an expected policy path that includes zero rate hikes in the coming year.
The Fed appears to be taking cues from the “market,” as market-implied measures of the expected policy path in 2019 were already pointing to a shallower expected path than previously laid out by the Fed in the final 2 months of 2018, the disparity of which continued in the first quarter. In fact, at the end of the quarter, prices on Fed funds futures pointed to a 50% probability the Fed may actually cut interest rates at their October meeting, representing a pivotal reversal from the tightening efforts of the past three years.
Across the euro zone, economic conditions have not been as favorable as in the U.S., weakening considerably year-over-year. Real GDP growth slowed to a half-decade low rate of 1.2% through 2018, and the region’s manufacturing sector tipped into outright contraction in February, the first occurrence since 2013.
Numerous headwinds have weighed on the euro zone economy over the past year, including continued uncertainty related to Great Britain’s withdrawal from the European Union, a growth slowdown in China—the region’s largest trading partner—and elevated global trade tensions.
In early March, the ECB responded by announcing several policy changes, most notably the extension of additional lending capacity to the regional banking system and an extended pledge of the current ultra-low rate policy regime through at least the end of the year. Additionally, the central bank downgraded their growth forecast for 2019 from December’s estimate of 1.7% to an expected pace of just 1.1%.
With a balance sheet 40% of the size of the euro zone economy, the ECB already exhibits one of the most forward-leaning policy stances among developed market central banks, the most recent actions of which should increase this level of accommodation even further.
Outright dovish ECB policy actions and a Fed seemingly on indefinite hold were both significant tailwinds behind market performance across the major asset classes in the first quarter. Investors have now re-focused their sights on the timing of the Fed’s potential interest rate cut, with pockets of turbulence expected along the way.
WHY REVERSE COURSE NOW?
Logically, investors may be asking themselves, why is the Fed now reversing course? Three years into the Fed’s policy normalization campaign and the federal funds rate sits at only 2.50% and the balance sheet—while some $500 billion smaller than peak levels—remains historically large, at just shy of $4.0 trillion at the end of the quarter. The balance sheet may not shrink materially further anytime soon either; in March the Fed communicated a planned end to the winddown process set to take place in September and looming cuts to policy rates may pave the path for an eventual re-igniting of the QE engine.
One potential reason the Fed appears to be gradually taking their foot off the monetary brake pedal relates to ongoing economic weakness abroad, which has pressured certain central banks to turn more dovish. Thus, even if the Fed stayed the course, on a relative basis their policies would be viewed as increasingly more hawkish, the disparity of which could result in disruptive international capital flows. Compounding this risk is the U.S. dollar’s title as the world’s reserve currency, which helps amplify the Fed’s policy actions when viewed in a global context.
Another potential driving force are the recent developments on the fiscal front. The latest tax stimulus package has helped drive the Treasury’s budget balance deeper into deficit territory; to fund the growing deficit, the Treasury has watched their financing needs increase, leading to a spike in Treasury issuance. Net Treasury issuance, which compares the notional value of Treasuries issued versus Treasuries retired, rocketed higher in 2018 to $1.1 trillion, the largest calendar year issuance since 2012.
Someone must purchase these newly-minted Treasury securities, with “natural” buyers including individual and institutional investors, money managers, and pension and sovereign wealth funds, among others. These traditional sources of demand presumably require a higher risk premium, or yield, than competing bidders which, by mandate, are price—and yield—agnostic, such as the Fed.
Beginning in September, the Fed will no longer allow the balance sheet to naturally run-off, and instead will replace maturing securities with newly auctioned Treasury and mortgage-backed securities. Stated otherwise, the Fed’s demand for these securities is set to increase from current levels, perhaps coincidentally, as Treasury issuance has sharply increased and is expected to continue expanding.
Serendipitously arrives Modern Monetary Theory (MMT), which calls upon the Fed to utilize its balance sheet in order to sop up, or “monetize,” the debt issued to finance expansionary fiscal programs, a potential benefit bestowed on those countries that enjoy the luxury of a printing press. Opponents of this proposed policy framework point to a potential disorderly un-anchoring of inflationary expectations, as well as a possible loss of faith in the dollar as a reserve currency.
Proponents marginalize this risk. They argue that following the Global Financial Crisis, the central bank embarked on an ultra-accommodative policy journey that resulted in neither above-trend inflation nor concerns of sovereign creditworthiness—outside of a credit downgrade by S&P in 2011. Under this proposed regime, both monetary and fiscal policy would be deemed simultaneously expansionary.
The growing popularity of MMT has garnered attention in the press. FEG remains skeptical of the efficacy of such a program due primarily to an unfavorable set of initial conditions—specifically, an already wide budget deficit and historically large Fed balance sheet.
ESTIMATING OUR POINT IN THE BUSINESS CYCLE
As the current business cycle expansion approaches the longest duration on record—set to officially take place this summer—and certain recessionary warning signs have recently surfaced, many financial media news outlets have fueled fears of a looming recession. Specifically, these sources accurately point to a number of inversions that have taken place along the Treasury yield curve, the most recent of which included 10-year Treasury note yields sliding below yields on 3-month Treasury bills. This particular slope, which, according to the Federal Reserve Bank of San Francisco, has the most predictive power of all term spreads at forecasting recessionary episodes, inverted for the first time in the current cycle in March, before nudging back into positive territory by quarter’s end.
FEG firmly believes that no single economic or market factor, model, or pundit has the ability to accurately forecast recessionary episodes; however, attempting to ascertain our point in the cycle through an approach that leverages a mosaic of inputs is a worthwhile and prudent endeavor in the asset allocation process.
Importantly, having a rough estimate as to whether the economy is early, mid, or late-cycle has wide-ranging implications on portfolio risk posturing, the number and size of opportunistic positions, investment manager preferences, and overall return expectations.
Despite the worrisome trends emanating from the Treasury market, a broader set of business cycle aggregates shows the U.S. economy still exhibiting an expansionary bias, the trajectory of which has flattened in recent months as fiscal tailwinds have dissipated and ongoing weakness abroad has persisted.
It has become increasingly tough to argue that the economy is anything other than late-cycle, as demonstrated by Fed policy tightening which has exhibited signs of excessiveness, numerous inversions along the Treasury term structure, a more-than-closed output gap—i.e., an over-utilization of resources—and a slowdown in the pace of labor market improvement.
Counterbalancing these later-business cycle dynamics is growth in leading economic indicators, solid corporate profitability, tight credit spreads, inflation that remains subdued, and broad gauges of economic activity that remain in expansion—but not overheated—territory.
The key takeaway is that while some business cycle measures have recently moved in a recessionary direction, numerous others point in the opposite direction, the disparity of which has narrowed. Monetary authorities have responded to mounting global growth headwinds by relaxing their policy stances, sparking a confused market response that has benefited both risky and traditionally high-quality sectors alike.
Strong downward pressure on risky assets at the end of 2018 reversed in the first quarter, due in large part to expectations and guidance for an easier near-term monetary policy backdrop in both the euro zone and United States. The ECB added to their level of policy accommodation, while the Fed laid the groundwork for a “pause” on their normalization voyage.
Policy responses by the ECB appear intuitive, given the region’s apparent heightened vulnerability to global trade tensions and moderation in economic activity that may be running the risk of completely stalling. It is not completely evident, however, if the policy reversal in the United States is as fundamentally grounded, as the actions taken by the Fed over the past 6 months appear more reactionary. Perhaps the Fed’s newfound “patience” is a defensive mechanism aimed at preventing a similar policy-induced slowdown that has plagued the heavily-indebted, trade-sensitive euro area.
As many news headlines communicated throughout the quarter, portions of the Treasury yield curve inverted for the first time in the current cycle, pressuring recessionary risks higher; however, a broader scope of cyclical data points does not necessarily confirm these perceived risks.
Due to a balanced set of risks, FEG continues to emphasize a skillful set of active managers that are have the potential to flourish in an anticipated period of dispersion and diverging fundamental trends. This focus, combined with select opportunistic positions that offer attractive risk-return profiles, can provide a favorable stance as global policy makers mount a historic attempt at returning to more “normal” levels of accommodation.
This report was prepared by Fund Evaluation Group, LLC (FEG), a federally registered investment adviser under the Investment Advisers Act of 1940, as amended, providing non-discretionary and discretionary investment advice to its clients on an individual basis. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Fund Evaluation Group, LLC, Form ADV Part 2A & 2B can be obtained by written request directed to: Fund Evaluation Group, LLC, 201 East Fifth Street, Suite 1600, Cincinnati, OH 45202 Attention: Compliance Department.
The information herein was obtained from various sources. FEG does not guarantee the accuracy or completeness of such information provided by third parties. The information in this report is given as of the date indicated and believed to be reliable. FEG assumes no obligation to update this information, or to advise on further developments relating to it. FEG, its affiliates, directors, officers, employees, employee benefit programs and client accounts may have a long position in any securities of issuers discussed in this report.
Diversification or Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment loss.
Index performance results do not represent any managed portfolio returns. An investor cannot invest directly in a presented index, as an investment vehicle replicating an index would be required. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown.
Neither the information nor any opinion expressed in this report constitutes an offer, or an invitation to make an offer, to buy or sell any securities.
Any return expectations provided are not intended as, and must not be regarded as, a representation, warranty or predication that the investment will achieve any particular rate of return over any particular time period or that investors will not incur losses.
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This report is intended for informational purposes only. It does not address specific investment objectives, or the financial situation and the particular needs of any person who may receive this report.
Published January 2019
The Alerian MLP Index is a composite of the 50 most prominent energy Master Limited Partnerships that provides investors with an unbiased, comprehensive benchmark for this emerging asset class.
The Bloomberg Barclays Capital Aggregate Bond Index is a benchmark index made up of the Barclays Capital Government/Corporate Bond Index, Mortgage‐Backed Securities Index, and Asset‐Backed Securities Index, including securities that are of investment‐grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $100 million.
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