Unusual Market Conditions Call for Innovative Portfolio Strategy


The first quarter of 2019 witnessed an extremely rare combination of a powerful stock market rally accompanied by a sharp drop in interest rates. US financial markets are essentially forecasting that the US economy will be strong enough in 2019 to validate current earnings expectations, yet weak enough to require the Federal Reserve to lower interest rates.

The improbability of such a Goldilocks outcome helps explain why the market movements seen in the first quarter of 2019 (the red dots in the chart below) sit almost entirely by themselves in a chart of historical equity and bond market moves.

We believe that both equity and bond market expectations are likely to be disappointed in 2019. We expect the US economy to remain resilient enough to preclude a Fed easing, but the lingering impact of trade disputes could weigh on corporate earnings more than is currently anticipated.

As a result, the majority of US equity returns for 2019 were likely garnered in the first quarter. Assuming the US and China resolve their current trade disputes, we expect US markets to remain volatile but produce returns of between 0% to 5% over the final 9 months of 2019. Without a trade war bond yields are likely to rise from their first quarter lows, with rates in the intermediate section of the curve (2 to 10-year maturities) potentially rising back towards 3.0%.

Economic & Market Outlook

Two major factors hammered global equity markets in 2018—tariffs and Fed moves.

President Trump’s imposition of tariffs on China and almost every other major US trading partner, along with the Fed’s hasty and potentially premature moves to normalize interest rates and the size of its balance sheet, put a serious damper on stock prices throughout the year. Equity markets rallied in the first quarter of 2019 as investors gained confidence that the policy missteps of 2018 will be corrected

in 2019, The Fed has joined central banks around the world in signaling that it will postpone indefinitely further tightening moves, and trade talks between the US and China appear to be making progress.

Our outlook for the rest of 2019 is shaped by our expectation of an improved policy environment going forward, balanced by continued drag from the mistakes made in 2018. Specifically, we believe:

  • The US economy will remain robust enough to forestall a Fed easing anytime in the near future. US growth is likely to be supported by a strong job market, relatively low consumer debt burdens, an improved housing market spurred by lower interest rates and over $1 trillion in fiscal stimulus coming from the Federal budget deficit.
  • China has lost the trade war and will not fully recover its economic momentum—despite extraordinary stimulus efforts and potential resolution of its trade disputes with the US. US tariff policy has exposed the risk companies face when relying on China as their sole location for product production. Companies have responded to this newly perceived risk by diversifying production to other locales, and we believe this headwind to private investment and private job creation will weigh on the Chinese economy for several more years.
  • Europe and Japan depend on Chinese demand to accelerate their growth above an anemic 1.0% to 1.5%. Resolution of trade disputes and Chinese stimulus will likely make the next 12 months better than the past year, but the lingering impact of trade disputes will likely preclude the kind of acceleration seen in 2017.
  • Emerging economies will see improved growth across 2019 thanks to China’s massive stimulus program and a less restrictive Federal Reserve.
  • With more than 40% of S&P 500 earnings coming from overseas, US companies could struggle to meet the optimistic profit outlook built into equity prices as a result of the powerful Q1 market rally.

Portfolio Strategy

US equity and fixed income markets are priced for ideal and somewhat conflicting outcomes, while most other global equity markets remain well below their 2018 highs.

In this market environment, we believe investors should move away from index hugging strategies and embrace a series of less conventional strategies that we believe offer superior risk and return characteristics.

Barbell the Bond Portfolio

We maintain that the biggest risk facing global investors is that the current optimistic consensus proves wrong, and the US/China trade dispute devolves into an outright trade war.

Despite our view that rates are likely to rise, the consequences of failed trade negotiations are so severe that we believe investors must at least partially hedge against such an outcome.

Investors can hedge against this risk by significantly overweighting 30-year treasuries in their bond portfolio and offsetting the increased duration risk by selling intermediate maturity 2-year through 10-year treasury notes. The bond market rally significantly steepened the yield curve between intermediate and 30-year treasuries, as intermediate bonds fell to around 2.2% to 2.4% while 30-year bonds remained above 3.0%.

If a trade war erupts, 30-year yields might fall back towards 2.0%—producing sufficient price gains to help offset likely price declines in equity portfolios.

A trade truce will likely push rates back up, but we would expect the intermediate rates that fell the most to experience the biggest rate increases. The current yield curve inversion between cash and intermediate treasuries means that the barbell strategy actually improves portfolio yield, allowing the barbell strategy to outperform if yields remain unchanged.

Swap US Equities for High Yield

Moving to a barbell fixed income strategy will raise cash in the portfolio. We believe that a portion of this cash should be invested in US high yield bonds. The increased portfolio risk can be partially offset by selling approximately $1 in US equities for every $2 in high yield bonds that are added to the portfolio.

We expect the US economy to continue growing in 2019. We also believe that Fed’s recent moves to defer further rate increases and stop shrinking its balance sheet will support credit market liquidity for the balance of 2019.

Continued growth and improved liquidity conditions should create a supportive backdrop for high yield bonds. Replacing equity exposure at a ratio of 2 to 1 provides reasonable downside protection and should allow the superior income of high yield bonds to outperform in the modest equity return environment that we anticipate.

Underweight Emerging Markets to Fund an Overweight to Japan

China’s current stimulus efforts include a range of the usual infrastructure and real estate incentives. These efforts will help increase demand for raw materials in emerging economies and machine tools in Japan.

These economies should see improving growth as we move through 2019. However, for the first time Chinese stimulus efforts include provisions to increase consumer spending through tax cuts. Japan has become a preferred destination for vacationing Chinese consumers seeking better deals on high end consumer goods and is therefore better positioned relative to most emerging economies to benefit from China’s stimulus efforts.

Since Japan is likely to get more of a lift from China, we recommend investors move to an underweight position in emerging markets and use the proceeds to fund an overweight to Japan. Both emerging market and Japanese equity markets offer attractive valuation levels along with extremely high volatility. A swap from emerging markets to Japan keeps the portfolio positioned in undervalued markets and should keep overall portfolio risk approximately unchanged. Since the yen has fairly consistently rallied in the event of market turmoil, the yen exposure could provide some protection in the event that current negotiations fail, and a US/China trade war erupts.

Buy Currency Hedged European Exporters

Negative interest rates and relatively flat yield curves in most euro bloc economies could keep European bank and insurance stocks under pressure. That will limit the gains of finance heavy European market indices.

By contrast, European exporters and consumer products companies enjoy a dominate position among high end Chinese consumers and those high-end consumers are likely to be the most responsive to China’s current tax cut stimulus.

We recommend buying export oriented European companies but doing so on a currency hedged basis. We like a currency hedged strategy because if we are wrong and a trade war erupts, a falling euro is likely to exacerbate the pain of falling European equity prices.


US equity and bond market prices experienced an unusual simultaneous rally over the past quarter. The unusual market conditions present an opportunity for investors willing to be more creative than the typical index-oriented strategies.

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