July 02, 2019

“We simply attempt to be fearful when others are
greedy and to be greedy when others are fearful.”
– Warren Buffet

 

With U.S. stocks near all-time highs, economic momentum slowing, and geopolitical risk on the rise, we recently downgraded our view on U.S. and emerging market equities to neutral from overweight. We also recommended using the proceeds to increase allocations to both alternative strategies (i.e., those with lower correlation to public equities) and cash. Although we are not forecasting an impending recession, we do believe these shifts more closely align with the current environment and possible distribution of future returns. Recent indicators for U.S. and global growth have been pointing toward a slowdown, including the July 1 release of the U.S. Manufacturing Purchasing Managers’ Index (PMI) whose “new orders” sub-component flatlined to a non-expansionary reading of 50 for the first time in a few years (Exhibit #1). In China, where marginal demand has a large impact on many international economies, the most recent industrial output figure showed growth slowing to a 17-year low, highlighting the need for ongoing stimulus. The trade war between the world’s two largest economies remains in place, and while President Trump may be striking a more conciliatory tone (see “Déjà vu: U.S. & China negotiations restart”), the uncertainty associated with tariff policy will likely be a headwind for business sentiment and spending.

As the 3-month T-bill yield remains above that of the 10-year Treasury note (Exhibit #2), and also above core inflation levels, cash has become more attractive on a relative basis than at any time since the financial crisis. Though we concede that the Federal Reserve is likely to cut rates later in 2019, the good times for cash may not last. But even if rates move lower, cash offers a nice cushion for portfolios should market volatility rise, and may be redeployed opportunistically as conditions change. In addition to the small cash position, we also believe that certain alternative strategies can offer a favorable risk-adjusted return profile in today’s environment. As (Exhibit #3) shows, even in the recent historical period of modest absolute returns, the risk-adjusted performance (e.g., Sharpe ratio) of “hedged equity” alternative strategies has still proven attractive. These type of investments can also provide relative downside protection, while certain strategies can even benefit from a spike in market volatility. In the current environment of slowing global growth, disruptions from trade uncertainty and an inverted yield curve, the potential for downside protection is particularly attractive.

Democratic primaries: A lot of candidates, a few big themes

The first Democratic presidential debate spanned two days – June 26 and 27 – and according to NBC, the second day was the most - watched Democratic primary debate ever, with TV viewership topping 18 million and online streaming adding another 9 million viewers.1  A significant portion of the debates centered around overhauling the health care system, and the political cloud over health care stocks is reflected in the valuation multiple compression the group has witnessed over the last few years (Exhibit #4). Other major topics of discussion included curbing the power of large corporations, reversing President Trump’s corporate tax cut, addressing income inequality, and overhauling immigration policy. While too early to make any predictions on the potential nominee (on 7/1/19 Politico suggested the race has indeed broken wide open), there is no doubt these themes will get more airtime in the coming months. If we fast forward into 2020, the potential market impact from leading candidates’ positions will increase as the election comes into focus.

 

Perhaps more relevant to present concerns were debate questions and comments on day two relating to China. While the Chinese threat was acknowledged, there was no endorsement for President Trump’s enactment of tariffs. “Tariffs are taxes,” proclaimed candidate Pete Buttigieg. Of course, these views will likely evolve in the coming months (polls suggest a tough stance on China is favored by most voters), but Chinese leaders surely took note of the decreased tariff appetite coming from the democratic field. This lack of tariff support will not help President Trump’s ability to make a deal, and further illustrates that trade negotiations can break down due to many different considerations – including the possibility that China stalls for the next 18 months in the hope of reengaging with a new administration after the presidential election.

 

1 https://www.nbcnews.com/news/all/second-night-democratic-debate-draws-record-audience-n1024796.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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