By: Guy Adami, Director, Advisor Advocacy
Published July 24, 2019
On the July Market Update call, Guy Adami hosted three accomplished economists to get their input on the risks facing the financial markets, and what they anticipate for the rest of 2019. He was joined by Terri Spath, Chief Investment Officer and Portfolio Manager at Sierra Investment Management, Ed Kerschner, Chief Portfolio Strategist at Columbia Threadneedle Investments, and Andrew Patterson, Vanguard Investments Senior Economist.
Risks Affecting the Market Over the Next Six Months
Guy kicked off the call by asking about potential risks affecting the market over the rest of 2019. Terri responded that the biggest risk she sees right now is the complete state of confusion going on in the financial markets. The stock market is hitting all-time highs, and it does seem to be anticipating that there will be a soft landing engineered by the Fed. However, bonds are indicating the need for much more concern. When there is this type of confusion in the market, one of the biggest risks is the lack of direction and volatility. From the viewpoint of Sierra Investment Management, muting that volatility is what matters looking forward. Andrew responded that his biggest concern was around global monetary policy, which seems kind of counterintuitive today, but his team is concerned with policy tightening too much and too quickly. They changed expectations a few times to more of a dovish stance—and he thinks the biggest risk now in the Fed is current trade tensions.
Was the Fed on the wrong path, perhaps with policy errors, back in September and October of 2018 and are they trying to make up for it now? Andrew thinks yes. In December, the Fed tried to mix a hike with some dovish language (it didn’t go over well), but they have now reversed course and made it seem as though a steady rate environment in 2019 was the base case. What happened since with the deterioration in international conditions has caused Andrew’s team at Vanguard to revise down expectations to two cuts. He references President William’s recent comments and says it is likely one of those cuts will come about in the upcoming meeting in July.
When posed the same question about risks over the next six months, Ed responded that the biggest risk right now is valuation. No market is cheap, at least by historical standards; they’re all overvalued at this time although admittedly it’s being supported by low bond rates. This time the bond market led the Fed; it didn’t follow the Fed. Trade confrontation could be the cause; it’s not going to go away. The biggest risk is the so-called nuclear option. Right now, the U.S. is fighting trade in China with conventional methods, i.e., tariffs – but remember China owns 10% of U.S. debt, and China tends to take a long-term view of things. If it ever gets painful for China… what if they sell? What if rates go back up? That could pose a lot of problems for the market.
Lower Bond Yields
Although the U.S. market seems to be about 15% overvalued given historical levels, where bond yields are, it’s not quite as scary. Guy asked the panel, “At what point do lower bond yields actually prove to be a headwind OR are lower bond yields signifying something else?” Ed says that 2% is probably as good as good gets. Nobody is happy with negative yields in Germany and Japan. It means they cannot get growth going, and it means the outlook for the economy is abysmal. If yields were at 1 or 1.5%, it would mean earnings are disappearing. We don’t want to go down the rabbit hole that Japan went, and Germany may be going.
Along the same lines, Andrew said when we start seeing rates around 1.5% on the ten-year, this is a perceived low growth environment for the foreseeable future with inflation expectations around 1%. That is a concerning environment, particularly from a monetary policy standpoint.
Opportunity in the Market
Moving on from risk to where there could be opportunity in the market, Terri gave her insights on interest rate hikes. She doesn’t think we need to see a cut by the Fed but thinks we can expect it based on the public remarks. She doesn’t see that the data supports a cut, but the central banks are tilted towards monetary easing. It’s a “lower for longer” environment, and maximizing that income component within fixed income is about as challenging as it gets right now. She says, “I agree with Ed’s comments about EM, but EMD is an area where we do see opportunity. The yield in that particular asset class is attractive relative to other opportunities out there with similar risk.” It gives a decent return and cushions some of the risks.
As far as income opportunities go, Ed’s advice is to stop thinking traditionally. What about stocks? What about dividends? Look at dividends in value, not just the highest yields. Dividends carry a lot more of the load in his opinion, and he says a dividend opportunity strategy can be quite successful in the current environment. But also beware; sometimes, dividend yield is going higher for the wrong reasons. At a certain point, it becomes concerning.
Guy mentioned that 24% of sovereign bonds globally have negative yields. Yet the U.S. stock market doesn’t seem to care, but at what point should we care? The numbers seem to increase each month. In Terri’s opinion, it is a mistake, going back to her point that she doesn’t think the Fed has the data to support reversing what they did in December. Central banks are globally pulling down rates, and it’s messing up the curve here. Almost 25% of global debt, something like 13 trillion dollars, is in a negative yield situation. It doesn’t make any sense, and when you keep interest rates so low; it’s having a strange effect. The U.S. consumer, for example, has taken down their debt levels since the crisis but corporations and the government have not. These low yields are encouraging some excessive borrowing by corporations and the U.S. government, and it will add pressure to wanting to keep interest rates low.
How Did the First Half of 2019 Play Out?
From a fundamental standpoint talking about growth and inflation, Andrew says the picture has evolved very much as expected. The Fed doesn’t have much justification for cutting interest rates. There are trade tensions and uncertainty creating slowdown globally to consider. Then there is the inversion of the yield curve, which is very concerning. If this inversion continues, recession in 2020 to start looking more like base case. He says, “In terms of playing out how we expected heading into the year, fundamentals look much like we anticipated. We weren’t expecting equity returns this strong, and certainly weren’t expecting yields to fall down to where they are, but fundamentals are strong…”
In mixed interest rate environments, with seemingly no perceivable end in sight in terms of how low yields can go, what do bond market investors do for income? Ed says to remember that there is more to a bond market than interest rates and duration… there’s credit, there’s inflation, etc. He thinks the consumer is in good shape and he sees opportunity in credit – specifically in revenue bonds and active credit research. He encourages investors to be selective, but look beyond treasury and duration.
Referencing Ed’s comment about the consumer being in good shape, Guy says, “One thing I’ve learned in 13 years is to never underestimate the U.S. consumer’s want to spend…I do believe the one metric the U.S. consumers look at, regardless of if they own a stock or not, is effectively the stock market. If they see it going higher every day they feel richer, whether that is justified or not, and they’re prone to spend money. We saw how quickly spending ground to a halt November/October, and that coincided with a market sell-off. In a lot of ways, that consumer you talk about is all predicated on the market, and that’s concerning to me…”
All of that to say, what role does diversification have in today’s market environment? Can you BE diversified? Terri says her firm values being broadly diversified. She says what is important in a period of volatility and confusion is making sure to defend gains. “We’ll diversify across any asset class that follows our rules, is in a buy trend, but we are quick to defend those profits if we start to see a turn in trends.”
Ending Commentary from Economists
Andrew Patterson: In terms of the economic cycle, Andrew thinks we are close to the middle, not quite late stage yet. If anything, monetary policy is looking to be more accommodative, at least not more restrictive, over the course of the next year. The risk of a recession over the next 6-12 months, unless the yield curve inversion persists, is pretty low.
Ed Kerschner: According to the New York Fed model, there is only a 30% probability of a recession, so he doesn’t think one is likely either. His team actually quantifies the value of diversification, and he mentions there have been only five times since 1998 where diversification hasn’t worked – being diversified does help. There is a little bit of valuation risk in the market, but there is opportunity in dividend growth and opportunity in some of the credit areas within the fixed income market.
Terri Spath: Defend your gains. Generating income is a challenge now in this type of environment, so take a broad view of what’s available in the fixed income market and look at ALL the opportunities. She says to diversify broadly on the fixed income side to make sure you’re generating income.