RCM Managed Asset Portfolio - Q2
Current Market Environment
Since the end of difficult end of 2018, we continue to closely monitor market conditions. From our perspective, the largest drivers of equity markets are evolving. Last year we wrote that:
We think that the reasons for owning stocks still outweigh the reasons for selling them. (1) The economy continues to grow; (2) the yield curve has not yet inverted; (3) credit conditions remain good. And until these change convincingly, we continue to want to own equities.
We continue to review these three conditions. As it now stands, we are more cautious than we were last year.
First, while the economy still continues to grow, the Fed forecasts it to grow at a somewhat slower pace than last year. From what we have seen, when GDP growth decelerates, the performance of the equity markets tends to significantly lag the periods when GDP growth accelerates. Nevertheless, the economy grew at a surprising 3.1% rate in the first quarter, driven by government spending and increases in productivity. We will certainly be interested in seeing the 2nd qtr GDP growth rate when it is reported in July.
Second, normally the 10-year Treasury yield sits above the 2-year Treasury yield. While this still remains the case, the difference between them is very close. This condition has persisted for so long that one believes it inevitable that an inversion will occur. During the first two quarters, the shortest part of the yield curve, the 3-month Treasury, has inverted against the 10-year Treasury. The 3mo-10 year yield curve, however, is a poor predictor of imminent recessions. Its inversion does indicate that the 2 and 10 year inversion may happen soon.
On average, a yield curve inversion has occurred 6-8 months prior to a recession. This is but an average; it doesn’t mean a yield curve inversion will always provide adequate warning. From our recent study of yield curve inversions, in the year 2000, the yield curve inversion occurred simultaneously with the decline of equities, meaning it gave no forewarning to equity investors that a major decline was coming.
Third, while credit conditions were fair in the first quarter, they have not improved significantly since the end of 2018. We look especially at the high yield market. While high yields peaked to end Q4 2018, they have not narrowed as much as equities have rebounded. Other alternative forms of credit such as the leveraged loan market continue to have demand and issuance remains robust.
A number of potentially negative catalysts continue to be in the forefront, including:
- Lowering rates. While there has been some divergence in central bank policies, there is no longer a consensus among the major central banks that tightening is warranted. In fact a loosening of US monetary policy may be taken as a negative sign for markets as it would signal that the economy has weakened to the point that a looser monetary policy is warranted.
- Tariffs. The current administration continues to negotiate trade terms with China. The expectation that a trade war will affect global growth has been one of the causes of the market declines during the last few months.
- Global growth. On the global front, growth in Western Europe (esp. in Germany) has slowed and parts of the emerging world now contend with weaker currencies versus the strengthening dollar. The threat of still lower growth has likely been the cause of the market declines during the last few months.
- Government. Domestically and abroad national politics continues to demand attention from equity markets. We see sensitivity to national politics as an enduring feature of equity markets globally, given the fiscal balance sheets of developed and emerging economies.
- Domestic Industrial Production. This indicator has been very telling as a precursor to economic slowdowns and some major market sell-offs. Note how industrial production tends to be in a downtrend whenever the economy enters recessionary periods. There has been a slight but noticeable downtrend in industrial production since the start of the year. The question is whether this is simply momentary or the start of a significant decline, certainly something market participants are paying attention to.
Gov’t, High Credit Corporates
The Fed has signaled a halt to the raising of the Fed funds rate with the strong possibility of lowering rates from 2.50%. As a result of this signaling, bond prices, especially longer dated issues, have begun to rise after declines earlier in the year. We have reallocated to longer-dated corporate holdings in the mutual fund program and exited our allocation to floating rate bonds.
Among corporate bonds, high yield performed well, as equity prices rebounded. Credit conditions still remain fair. With defaults currently below 4% in the US, it seems that this credit cycle may yet continue, However, the high yield default rate has been forecast to rise, according to Moody’s, from 2.8% in December 2018 to 3.4% by December 2019.Globally, the high yield default rate is now above 4%, according to S&P.
Investments in the high yield market represent riskier investments along the risk spectrum. We expect this sector to be among the most vulnerable to any increased risk and volatility whenever the downturn comes. But, it will also be among the fastest to recover in any recovery of credit markets. We anticipate making a return to this allocation after prices have declined significantly at the end of this credit cycle.
Recent developments in Large Caps and Strategic Knight
Equity markets began the quarter on a upswing only to stall in May and begin a decline that lasted throughout the month. They began to rebound in June on the hopes of the Fed easing and this rebound continued through to the end of the quarter.
We are currently near or at all-time highs and are waiting for another catalyst to the market, whether it be an end to the trade war or a continuation of robust domestic growth. In the absence of these catalysts we have or are looking to reduce some of our over-weighted positions.
Small and Mid-Caps
During the past quarter small and mid-caps which had underperformed during the final quarter of 2018 had a significant rebound.
In the mutual fund portfolio, we continue to maintain an equal weight exposure to small and mid-caps. Unlike large caps, which have a large portion of their sales to international markets, small and mid-caps sell almost exclusively to domestic markets. While some of the catalysts that propel smaller caps may no longer persist into the future (such as a strong dollar), so long as equity markets do well, small and mid caps should do well also.
Drawbacks to investments in the small and mids include the higher levels of debt to capital when compared to historical norms.