Back in January, after the painful market downturn in the fourth quarter, we saw scenarios that could make markets rise or fall in the near term and that the best approach was to take a middle path taking both into account. And both is what we got during the first half of 2019. However, the sharp downturn in May was short, and following a strong June most asset classes posted nice gains for the six months ended June 30, 2019.
All asset classes rose during the second quarter, as progress in U.S.-China trade negotiations and a newly dovish (accommodative) Federal Reserve buoyed investors. The S&P 500 hit a new high near the end of June. Fixed income also gained, as the 10-year Treasury yield fell below 2.0% on the heels of the Fed’s willingness to cut, rather than raise rates at their June meeting. When bond yields fall, their prices rise.
A Mix of Risks Persists
Could the second half of 2019 also deliver such positive returns? We don’t say “never,” just as we don’t rely on short-term predictions to drive our investing. However, risks to global markets have increased somewhat – including the potential escalation of a trade war and conflict with Iran – and with valuations even higher than they were, similarly robust second-half 2019 returns seem less probable, meaning we likely “front-ended” gains for the whole year in the first half.
The Fed’s changing stance and a shift toward loosening by other central banks, including the European Central Bank and stimulus by the People’s Bank of China, were a plus and this typically lifts global markets and asset prices. However, the market now generally anticipates at least one Fed rate cut during 2019. It’s possible that stock prices already fully reflect the impact of potential Fed rate cuts, so an actual rate cut may not have the power to lift prices further. And if the Fed fails to cut rates that could potentially hurt stock prices as it rattles markets that were expecting more.
Another concern is the length of the U.S. economic cycle. The U.S. is now experiencing one of the longest runs of economic growth in our history. Each quarter brings this economic cycle closer to its end. Of course, there’s no way to know how long an economic cycle can run. However, quite a few leading economic indicators have turned negative. It seems likely that the U.S. will experience a recession at some point during the next few years. And it’s certainly possible that we could see a recession in the next 12 months, which is why making modest adjustments to our portfolios to provide more explicit protection against that possibility is something we have already begun.
The increasingly stretched valuations of many riskier assets like stocks are a related concern. This is less true in Europe and emerging markets, where stock prices reflect expectations that may be overly pessimistic. That’s why we’re slightly underweight U.S. stocks, and will be adding to our international stock positions.
If global economies and markets turn negative, our core bond holdings, other fixed income, and alternative investments will provide cushioning against broader stock market declines.
This has been an extraordinarily long U.S. economic and market cycle. But we firmly believe it is still a cycle, so our patience and our emphasis on fundamental valuation will eventually be well-rewarded again, as it has throughout our history.