When we were preparing our investment outlook for 2019 in the fall of last year, Fed Chairman Jerome Powell said that interest rates were “a long way from neutral.” This implied that the Fed had a long way to go in its rate-hiking cycle, and that seemed like a risk to markets and the economy. Sectors that are sensitive to interest rates (like housing) were already suffering, and the rest of the world failed to take the baton from the United States as an engine of growth. It seemed like the conditions we thought necessary for recession (restrictive interest rates, slowing global growth and the imbalance of an indebted corporate sector) would all be in place by the first half of 2020.
The stock market recognized the risks we had identified much earlier than we expected, and declined by 20% from September to Christmas Eve. After the sell-off, the Fed changed its tune. Instead of saying rates were “a long way from neutral,” Chairman Powell said he was “listening sensitively to markets.” Investors took this to mean that the rate-hiking cycle would pause, and risk assets (like stocks and high yield bonds) rallied in relief. Their hunch was correct: Last fall, the median FOMC member expected the Fed to raise rates twice in 2019 and again in 2020. Now, the median FOMC member doesn’t foresee any moves in 2019 and a rate cut in 2020. This changes things.
Threat of overtightening seems off the table
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There is still a chance that the Fed may have already tightened monetary policy to a level that could cause a recession, but we think it is more likely that rates are low enough to accommodate further growth. Valuations across asset classes are now close to or above long-term averages, which seems appropriate for the current environment, but we don't think the coast is clear. Despite the Fed’s pause, the U.S. economy is still late in the cycle, and growth looks set to slow. Last year, the U.S. economy was being driven by three engines: business investment, fiscal spending and the consumer. The first two supports are now fading. While the consumer should be able to keep the economy growing, it won’t be enough to match the pace of the recent past.
Globally, the manufacturing sector is still working its way through a rough patch, and trade is weak amid tariff tensions between the United States and its trading partners. However, modest stimulus from Chinese policymakers and relatively healthy domestic conditions should act as a ballast against these headwinds. In short, our base case calls for growth rates to continue to slow, but not to recessionary levels that would cause the Fed to cut rates significantly. However, a downside surprise seems more likely than one to the upside at this point.
To be clear, our view of “no recession” in the near term is not sufficient for us to take outsized risk in portfolios. So what are investors to do? We are focused on three key themes.
Participation with protection
After 10 years of strong returns, we believe it is time to add more protection to portfolios—and there is a range of ways to do so. We think a focus on quality, both in stocks and bonds, is prudent. Higher-quality securities tend to outperform lower-quality ones in times of market stress. We also suggest adding duration in fixed income. This can support portfolios should markets take a turn for the worse. Other non-correlated asset classes could further cushion portfolios from equity losses. Finally, begin to rotate from stocks to bonds. It is too early to do this in a wholesale fashion, but we believe it is time to gradually change the composition of multi-asset portfolios.
We are sharpening our focus on generating returns from yield rather than from capital appreciation. There are multiple yield-harvesting tools to use across asset classes. Diversifying fixed income remains a core strategy, especially in a world of low default rates. Municipal bonds may make sense, particularly for investors in high-tax states. Further, structured products may provide the opportunity to exchange upside participation for protection and coupon payments.
Finding growth in a low-growth world
We believe the global economy will continue to slow. With growth scarce, sectors that are demonstrating the ability to grow should demand a premium. Technology and Healthcare are benefiting from secular trends (not dependent on seasonality or economic trends), and there are also several specific industries and themes that could provide above-market growth, such as cloud computing and software, 5G, data privacy and gene therapy.
RISKS TO OUR VIEW
No outlook is without its risks. We are watching the following areas:
- Trade war: If tariffs remain in place on Chinese imports, it could reduce consumption, hamper business confidence and spending, and hurt asset valuations. Further escalation (through mechanisms like export controls, boycotts, cyber attacks, etc.) would also hurt confidence.
- Global manufacturing slowdown: Even without the trade war, manufacturing is still slowing worldwide. If growth slides further than we expect, it could lead to job cuts in the United States.
- Corporate sector debt levels: While corporate debt levels are high, corporate debt service metrics still look healthy, but those can change if growth slows materially.
- Market structure and liquidity: The equity market selloffs at the beginning and end of 2018 showed the risks of modern market structure. Liquidity in fixed income markets is also more limited than it has been in the past.
- Election 2020: Whether we like it or not, the next election cycle will kick off soon. Popular talking points among candidates, including “Medicaid for All” and the breakup of “Big Tech,” have already made an impact on markets. Uncertainty around the outcome and headlines around specific policies could result in volatility for the next year and a half.
The Fed’s decision to pause breathed new life into markets and likely extended the cycle. But the cycle has not been reset, so investors should take a prudent approach to risk. While we see the potential for more upside, the risks are greater. Adding protection and focusing on yield are important, while the timeless strategy of diversification is all the more critical.
None of this caution precludes us from finding growth trends of the future. Technology and Healthcare are two key areas where we see substantial growth potential that is not currently factored into markets.
Finally, by shifting portfolios toward quality, liquidity, yield and secular growth, we can be prepared for greater uncertainty ahead. In portfolios that we manage, we have been making changes like this to ensure that we can be more comfortable staying invested and helping clients move toward achieving their goals.
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