RCM Managed Asset Portfolio - Q3
Current Market Environment
We continue to review conditions driving the market. As it now stands, we are more cautious than we were last year. While the economy still continues to grow (2.0% last quarter), 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. Growth remains fair, however, bolstered by increases in productivity.
Another reason for caution is the yield curve. An inversion of the yield curve generally signals a coming recession. In August, the 2-10 yr Treasury yields finally inverted. On average, a yield curve inversion has occurred 20 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 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.
We have also looked closely at credit conditions to determine whether a decline in the equity markets is imminent. Credit conditions often speak to business health and confidence, specifically the ability of businesses to meet their debt obligations. While credit conditions were fair in the first quarter, they have not improved greatly in the weakest part of the credit market. Looking specifically at the poorest high yield credit, spreads have not narrowed as much as equities have rebounded. But in the better credit grades of high yield, spreads have narrowed. In other words, those bonds were in demand. This would indicate that the bond market is taking a dim view of the least creditworthy corporate borrowers but that the other parts of the bond market remain robust.
A number of potentially negative catalysts continue to be in the forefront, however, including:
- Lowering rates. There is a consensus among the major central banks that lowering of rates is warranted. 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 is affecting 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. 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. Brexit may actually come to a head in October, as a hard U.K. exit from the European Union would likely be seen as a negative for the equity markets.
- 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 lowered the Fed funds target rate to a range of 1.75-2.00%. As a result, bond prices, especially longer dated issues, have risen significantly after declines last year. Last year we had reallocated to longer-dated corporate holdings in the mutual fund program and exited our allocation to floating rate bonds. Our bond portfolios have therefore done well. We knew that a halt of rate raises would be positive for bonds. But the performance of bonds this year has been historically good, perhaps better than anyone might have expected.
We will continue to hold this position until either (1) there is definite break down of credit conditions, which would signal an onset of a recession, or (2) there are signs of inflation, in which case the Fed would be compelled to raise rates.
Credit conditions still remain fair in most sectors of the high yield market, with those bonds rated CCC performing the worst. This may reflect future weakness in the overall high yield market. It should also be noted that about half of the investment grade bond market is BBB- rated, that is, barely investment grade and on the verge of being high yield. Some of this would surely be downgraded to high yield status in a recession.
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 volatility whenever the downturn comes. We therefore hold little to no direct investments in the high yield market. But this market 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
Similar to last quarter we are currently near or at all-time highs and are waiting for another catalyst to the market. Equity markets had dipped in August and rebounded in September on the hopes of more Fed easing. Also growth stock such as Visa and Adobe, which we hold in the Strategic Knight, had some declines during the month of September. This was offset by gains in value orientated stocks, like JP Morgan Chase and Chevron. This shift from growth to value occurred during September and did not have a material impact on the major indices or the Strategic Knight portfolio overall. In the meantime we continue to wait for an overall catalyst that would carry both growth and value higher. Whether that catalyst will be an end to the trade war or more 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 rebounded during the last month of the quarter September 2019.
In the mutual fund portfolio, we moved to underweight our 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. Drawbacks to investments in the small and mids include the higher levels of debt to capital when compared to historical norms.