2019 Mid-Year Update

The first half of the year saw strong market performance across all asset classes as client multi-asset portfolios have enjoyed positive returns. While gains posted across the board, the equities market stole the spotlight. Representing large blend domestic equities, the Standard &Poor’s 500 Index returned 7% in June despite a difficult May, resulting in second-quarter gains of 4.2%. The Index posted an 18.5% year-to-date return, despite modest inflation, significant trade uncertainty, and a 3-month vs 10-year US Treasury inverted yield curve, often considered a predictor of recession. Year-to-date domestic equity market returns have not been this strong since 1977; June’s domestic equity market performance was the best since 1955.

International equities also joined the party with second quarter 2019 returns for the MSCI All-Country World ex-US Index of 3.0%; up 14% year-to-date. Commodities were one of the few sectors sitting out the rally. The Bloomberg Commodity Index posted a negative return of -1.2% in the second quarter but maintained a positive year-to-date return of 5.1%. Natural gas and cotton were the worst performers during the quarter, but the precious metals funds held by most clients flourished, as gold achieved a 8.4% second-quarter return, bringing its year-to-date gain to 10%.

Risk assets have rallied in 2019 across the globe as central banks are desperately trying to extend the business cycle and are thereby distorting markets. US GDP in the second quarter was 2.1% and estimated to be 1.2% for the third quarter (NY Fed Nowcast). In addition to slowing US GDP growth, earnings per share (EPS) of large domestic companies (as represented by the S&P 500 Index) declined 0.3% during the first quarter of 2019; second and third quarter estimates are -2.6% and -0.4%, respectively. Although forecasters expect earnings per share to rebound 6.7% during the fourth quarter, predictions have usually been premature and overly optimistic. Corporate earnings per share grew 20% during 2018, reflecting both ongoing economic growth, corporate tax cuts and hastiness to buy back shares. This trifecta of conditions are not replicable any time in the near future. Given the multiple inflection points in today’s environment, it’s impossible to ascertain how much longer an accommodative Fed (and/or global central banks) can keep this cycle and stock market on a positive course. But if the actions like rate cuts and more QE follow Fedspeak, risky assets could continue providing excess returns and uncertainty across asset classes despite the suggestions of valuation analytics.

Domestic bond yields have been declining for the last three quarters, while Eurozone yields have been consistently negative, with an estimate of $13 Trillion in global negative-yielding debt floating about. Our US Treasury yields this quarter:

These outsized downward moves in yield have boosted fixed income returns. Representing the broad US Bond market, the Bloomberg Barclays US Aggregate Index returned 3.1% during the second quarter and 6.1% year-to-date. Of course, most of these interest rate moves have been reinforced by preemptive expectations that the Fed will cut the federal funds rate this year. Most recent forecasters expect a total rate reduction of 75 bps in 2019.

Thoughts from Towneley

Since we last rebalanced most client portfolios 16 months ago, domestic equity indexes have continued to reach new highs, with cumulative gains for the Standard & Poor’s 500 Index of 17%. As the markets have become more volatile and expensive, in July we rebalanced portfolios back to their target objectives by trimming domestic equity positions and adding to fixed income and international equity positions. These moves brought portfolios back to their target Exposure and, in doing so, took some gains off the table and reduced some equity risk.

In addition to the total rebalance, we strategically repositioned assets. For example, we lowered duration and high-yield exposure in the taxable bond segment. As longer-term interest rates have declined, and the yield curve has become inverted, shorter-term bonds now offer similar yields but with much lower risk. With the intention of reducing the interest rate risk in your portfolio, we increased short-term bond exposure and decreased intermediate (longer duration) taxable bond exposure. The resulting shorter average duration should help reduce interest rate risk in the fixed income portion of your portfolio as interest rates rise. High yield has been one of the best performing segments in the portfolio and was up 10% year-to-date through June 30. As the yield spread between lower and higher quality corporate bonds has narrowed, and as risk increases in the leveraged loan market, we took gains and reduced exposure to the high-yield segment.

Within the domestic equity portion, we frequently run a regression analysis to monitor how much the segment has in value/growth and large/mid/small-cap stocks. Over time, the allocation has drifted away from our desired balance between value and growth. We took this opportunity to realign the segment, so it is closer to a more equal weighting of 50% value and 50% growth.

Within international equity, we recently decreased the index exposure and purchased a new fund from MFS. The managed segment of the portfolio has consistently generated positive alpha over rolling three-year periods and we expect it to continue to do well in this volatile environment. The MFS international fund we added to the portfolio scored high in our proprietary scoring system. Historically, the fund has delivered above average returns compared to its peers, has performed better in down markets compared to its peers, and has a consistent strategy and a strong management team.