The newsletter above is the Quarterly Investment Review and Outlook - Aon's Chief Investment Officer Insights for Q2 2019. Continue reading below to learn more.
The second quarter of 2019 repeated an up-and-down pattern we have seen lately. April saw the continuation of the V-shaped recovery in return-seeking assets as the stock market – as represented by the S&P 500 — returned to peak levels, driven by a dovish Federal Open Market Committee (FOMC), while the bond market remained cautious on the outlook for growth and inflation. May saw a selloff in return-seeking assets, especially stocks and credit, as the rhetoric on trade and tariffs escalated once again and global economic growth slowed again. Then June saw a positive rebound back to peak levels of the stock market after Jerome Powell and Mario Draghi, chairs of the FOMC and European Central Bank (ECB), provided dovish reassurance that monetary policy intervention would be available if needed. At the end of June, the G-20 summit of political leaders produced a cooling-off period for the trade war, but no tangible progress on the issues.
“The stock market returned to prior peaks but struggled to exceed them by much.”
There were some discernible patterns playing out over this period:
When stocks and credit sold off, the FOMC was quick to offer reassurance, and offered it much sooner this time than last. The dovish monetary policy dragged down bond yields, with the US 10 year Treasury bond yield even falling below 2% for several days in June. And the implied expectations for the FOMC to cut interest rates grew stronger and stronger.
The new phrasing used by the FOMC is that they wish to avoid any tightening of financial conditions which could drag on economic activity, but that implies protecting return-seeking assets from any significant decline in value, which sounds close to enshrining the “Powell Put” in current Fed policy.
“The inference by the bond market is that the FOMC stands ready to cut interest rates, beginning in July.”
This expected monetary stimulus is pushing up stock prices and pushing down bond yields, but as the expectations grow, there is increasing potential for the markets to be disappointed by any FOMC action that falls short of these expectations. The table on the next page shows the implied expectations for rate cuts at the upcoming FOMC meetings. For example, at least some rate cut is fully priced in for the July 2019 meeting, with a 29% implied probability of that rate cut being 0.50% rather than just 0.25%. Looking further out, there is an implied probability of 80% that the Fed Funds rate will be cut by 0.75% or more by March 2020. Of course, these implied probabilities reflect the expectations of bond traders and can change quickly with economic data or with comments from FOMC members.
For the moment, capital markets are heavily dependent on monetary policy. The fundamentals of
the economy and corporate profits remain in a low growth phase as trade war uncertainty drags on activity and decisions in and around the global supply chains. Consumer spending and sentiment are more robust than the declining sentiment from CEOs and CFOs, but it’s not yet clear whether that is because labor will finally start to benefit at the expense of capital, i.e. some positive wage inflation eats into profit margins, or because the CEOs and CFOs just have better visibility on the challenges ahead. The chart to the right shows how corporate earnings growth has dropped to zero, but with some recovery forecast for later in the year.
The net effect is that financial asset values have once again been buoyed by expectations of monetary stimulus. In just the first half of 2019, we have seen stock market returns of approximately 18% (S&P 500), while long-dated credit bonds have returned approximately 15%. These are very high returns over just six months, but for the stock market it just represents a restoration of value lost since October 2018. We are in a pattern where volatility is much larger than the directional trend.
The longer-term implication is our continued dependence on monetary policy to manage economic cycles. In earlier decades, fiscal policy was the primary source of economic stimulus to combat recessions. The rise of monetarism, notably with Paul Volcker’s appointment in 1979 to chair the FOMC, marked a change in paradigm after the stagflation of the 1970s. This new era of monetarism continued through the Greenspan era and arguably peaked in the global financial crisis as unconventional monetary policy was added to the usual approach of cutting interest rates. Unconventional monetary policy included quantitative easing via huge direct bond purchases by central banks, which proved necessary because cutting interest rates even to zero was insufficient monetary stimulus at the time. While fiscal policy is politicized and therefore convoluted, monetary policy has relative freedom to be the primary response to an economic recession.
And now we are embedded in a paradigm where monetary policy is the presumed remedy to any economic slowdown, with greatly expanded precedents for use. But what does this actually mean for the economy and for investors? We have seen in recent years that even extraordinary levels of monetary policy did not produce much consumer price inflation, especially not against the background disinflation from globalization and automation. It also did not produce a very large or particularly rapid rebound in economic activity. Instead, large doses of monetary stimulus helped debtors avoid default, prompted investors to shift from relatively safe assets to relatively risky assets, inflated the value of most assets relative to cash, and eventually produced a wealth-effect of greater spending to help boost economic activity.
“Asset inflation was far more pronounced than consumer inflation, wage inflation, or economic activity.”
The primary beneficiaries of monetary stimulus are the owners of assets and the deeply indebted. The rest of the economy gradually benefits because the indebted do not become bankrupt and curtail their spending, and because investors are more willing to provide capital to new ventures.
This reliance on monetary stimulus brings some unintended consequences. The first is that asset values remain buoyed, or at least recover relatively quickly from any large declines. This helps preserve the portfolios of current asset holders but makes it more difficult for new investors (a generational inequality), and it reduces prospective returns for all. This also means that the price mechanism for capital becomes distorted such that inefficient uses of capital may be protracted for longer than otherwise, e.g. “zombie” companies. The second unintended consequence is that debt becomes cheaper and less risky, and therefore used more expansively. Debtors can become complacent about their leverage and eventually risk a “Minsky Moment”—when too much leverage drives a sharp collapse.
“Operating within this paradigm seems simple on the surface: just don’t fight the Fed. ”
If you align with monetary policy then it should be fine. Add to return-seeking assets during monetary easing, and then reverse during monetary tightening. The problem emerges if and when monetary policy loses efficacy or paints itself into a corner. Just as fiscal stimulus fell out of favor when it led to stagflation, and could no longer reduce unemployment without further increasing inflation, there is a limiting point for monetary stimulus too, e.g. it relies on trickle-down effects rather than delivering income directly to those who would spend it, it increases the number of “zombie” companies in the economy, it addresses a tightness in liquidity rather than misallocation of capital, etc.
“It is not easy to predict when monetarism will experience its own loss of invincibility, but it will be a significant event for investors when that occurs. ”
We have maintained our neutral stance on equity exposure. This is consistent with balancing our concerns that a reversal could lie ahead as global economic growth softens, but it would be expensive to sit out of the stock market while the FOMC is sending dovish signals. Within equity, we have had a slight preference for US large cap stocks relative to small cap stocks and non-US developed stocks. We also have a slight preference for emerging market equity over the medium term (1-3 years), but we are cautious in the near term in case there is further evidence of slowing growth in China from the trade war. We continue to look for any early warning signs that a global economic slowdown is taking hold, and now we also will be watching for any disappointment of lofty market expectations for the FOMC. The Goldilocks scenario remains a difficult needle to thread but, in the meantime, investors have been rewarded with a quick recovery of recent declines.
“This is an environment where most market participants are reacting to any new information or indications.”
If our crystal ball is cloudy, or at least no clearer than most, then we will retain a neutral weighting for the near term, but over the medium term we are cautious about a possible decline in equity.
We continue to hold a positive view of diversifying1 asset classes like real estate, return-seeking credit, and liquid alternatives, ahead of possible further volatility in stocks, and while bond yields are already very low. REITs have performed very well as bond yields dropped, although we would prefer now to shift from them toward core real estate as liquidity permits as we expect both flavors of real estate to eventually converge again.
“ We have a slightly negative view of high yield bonds and bank loans, despite extremely low rates of default, because their yields are very low.”
They are exposed to the same potential risks as the stock market, but no longer offer substantial upside.
Within high quality fixed income, low yields offer very limited returns over the next several years. It is difficult to predict the path of interest rates in the short term, and so we have moved our duration positioning back very close to target levels. Investment grade credit spreads have tightened significantly again and are approaching the point where we would start to go underweight credit relative to government bonds.
1 Diversification does not ensure a profit nor does it protect against loss of principal. Diversification among investment options and asset classes may help to reduce overall volatility.
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