Looking back on the past six months, one of the more striking shifts we have encountered is an increased willingness on the part of market participants to opine on where we are in the business cycle. Where there was a seemingly divergent set of views not too long ago, there now seems to be a more solidified consensus that we are decidedly in the later stage of this economic expansion. As such, debates now seem to rage over just when the cycle will end, and what will cause it. While we have expressed concerns over this environment for some time now, we feel that such discussions, though at times interesting, wholly miss the point. Recognizing that “timing” the market is more or less a fool’s errand, we have felt, especially recently, that we are best served taking a step back, and earnestly reassessing all our existing positions in light of their investment theses. Though our views are cognizant of the increased risks that exist to both the upside and downside, they remain, as always, firmly grounded in more long-term views of the assets we own, and how those assets are valued.
Early in the year, it appeared as though U.S. equities were due to continue the impressive performance seen in 2017. Solid corporate results and economic data, further bolstered by fiscal stimulus, brought market indices to new highs. However, this environment reversed quickly, with a spike in volatility in February quickly driving markets into correction territory for the first time in two years. Amidst this market rout, many pointed to the massive losses incurred by investors who had bet that volatility would remain, or in many cases decline from, its already muted levels versus the historical norm. While such bets certainly represented an unsettling level of complacency in markets, perhaps what was more disconcerting was the proliferation of products offering such exposure, and the extent to which market participants had been trading in them.
Though U.S. markets recovered somewhat as we moved into the spring, volatility has remained somewhat elevated from its pre-February lows. This stands to reason, given positive economic developments, especially in labor data, and a generally strong set of first quarter earnings. At the same time, CPI numbers suggested that inflation may well finally be coming in line with (or even slightly above) the Federal Reserve’s 2% target. While it will certainly take time to see whether this trend will sustain (especially since meeting this target for any length of time has proven an elusive goal for the Fed), it has certainly paved the way for future rate hikes this year and beyond. So far, the Federal Reserve has raised rates twice this year, once in March and once in June, with another two rates expected by the end of 2018. Given such an environment, it is unsurprising that fixed income markets have represented a difficult place to be in the first half of the year, regardless of positioning, and this may remain the case for some time, especially as other central banks seek to normalize monetary policy in Europe. For example, the European Central Bank, though emphatically gradual in its actions, has begun to reduce its bond buying programs, and is signaling that the groundwork is in place for its first set of post-crisis rate hikes as soon as next year.
...Amidst Concerns Old and New
While a lot can happen in that time, the fact remains that Mario Draghi, the current President of the European Central Bank, has sought now for some time to get investors used to the notion of monetary tightening within the Eurozone. From a shorter-term perspective, European equity markets have generally posted negative returns year to date, driven by internal political drama, namely in Italy and Germany, the appearance of softening economic data and, of course, concerns about global trade.
Fears about the future of global trade have weighed on markets around the world for a better part of this year but have intensified recently as months of rhetoric and threats from Washington have now led to some initial action, and it now seems that the U.S. will indeed be pursuing further protectionist policies going forward. Such policies would undoubtedly lead to retaliatory measures by the likes of Beijing and Brussels, ultimately creating severe headwinds for global growth. While this would certainly be an unsettling outcome, we recognize that the situation remains extremely fluid, and likely very far from any resolution one way or another. However, having already seen the power headlines regarding trade can have on market sentiment, we feel developments on this front are likely to be top of mind throughout the second half of the year.
In light of this environment, our team took significant time at the end of last month to consider portfolio positioning, the ongoing validity of our investment theses, and our views on how to allocate capital going forward. On the most general level, the situation remains quite the same as it has for some time: valuations still appear somewhat stretched, not only in equities but other asset classes as well. This is in many ways unsurprising, given the continued signs of exuberance we see within markets today whether in the form of M&A mega-deals, loose credit conditions or, in a more recent development, a reinvigorated IPO market. While we do not discount the fact that the late stages of an economic cycle offer plenty of “upside risk”, where positive economic developments can drive markets higher than expected, they too tend to represent periods in which investors engage in riskier behaviors despite grave consequences. It can be quite easy to extrapolate current trends far out into the future, justifying such behavior despite its risks. However, amidst an economic expansion that is now the second-longest ever, despite looming headwinds to growth, we feel it is likely best to maintain our discipline, acting only when we feel we are being adequately compensated for the risks we are taking.
As discussed, this has meant that our opportunity set continues to remain rather narrow, but it does not mean we have remained static in our positioning. A careful look at our holdings has allowed us to make some tactical portfolio decisions, trimming positions where we feel valuations are stretched and adding to those names which have seen recent weakness despite our constructive long-term views. At the same time, we feel that strategically speaking, it makes sense for us to add to certain, less efficient asset classes at this point in time, especially given our longer-term orientation.
With that being said, we do feel that there remains plenty of reason to be cautious in this environment. Overall, we continue to believe it prudent to maintain a healthy allocation to less risky assets to retain our ability to act nimbly as a wider range of opportunities presents itself. The volatility we have seen so far this year certainly has the potential to persist, especially if the outlook for growth becomes more uncertain or even if improving economic circumstances lead to further normalization of monetary policy.
On another note, we would like to make you aware of some additional work we have been doing to widen the breadth of our client offering. Over the years, we have made note of the compelling opportunities that exist in developed markets outside of the U.S., and continue to feel that long-term, this is an area where many investors are underexposed. To that end, we are seeking to launch a stand-alone strategy that can more efficiently take advantage of these opportunities, acting as a valuable complement to your current allocations. If you wish to learn more about the work we have done in this area, we encourage you to reach out.
At the same time, we also wish to remind you that in general, we welcome any thoughts and feedback you may have, especially as we seek to further improve upon our experience for clients. We hope that you enjoy the rest of your summer and as always, greatly appreciate your support and trust.
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