CIO Newsletter [Q1 2019]

Current Environment

2019 has started with strong performance for return-seeking assets, especially stock markets, continuing the rebound that began in the last week of December. The global stock market index1  rose almost 13% in Q1 2019. While not yet regaining the peak levels of 2018, this rebound has recovered most of the sharp losses of Q4 2018. The primary catalyst for the rebound has been the abrupt pivot by the Federal Open Market Committee (FOMC) on monetary policy. At its meeting in mid-December, the FOMC raised the federal funds rate and reaffirmed its hawkish path of further rate hikes and balance sheet shrinking in 2019. However, in late December, after the stock market turmoil, informal remarks from FOMC Chairman Jerome Powell shifted to a more accommodative tone.

We are relieved by the FOMC pause but also slightly concerned by how enthusiastically it has been embraced in the stock market.

This was reinforced by FOMC members during Q1 2019 and then was formalized in a policy change at the FOMC March 2019 meeting in new guidance that no rate hikes are now expected in 2019, and that the Fed balance sheet unwind shall cease by September 2019 with a projected $3.5 trillion remaining on the balance sheet. The FOMC’s pivot was (gratefully?) echoed by other central banks, especially the European Central Bank and the Bank of Japan, for whom continuing to follow the FOMC in monetary tightening would risk a full recession in Germany and Japan. After complaining throughout 2018 that the FOMC was tightening faster than conditions warranted, we are relieved by the FOMC pause but also slightly concerned by how enthusiastically it has been embraced in the stock market.

This easing of monetary policy has been greeted by stock investors as a “Powell put” similar to the “Greenspan put” of the 1990s, whereby any large decline in the stock market would be quickly mitigated by monetary stimulus. The inference is that a Goldilocks scenario for the economy is bullish for the stock market; if growth and inflation are not so hot as to spur monetary tightening by the FOMC, but neither too cool that they cause corporate earnings to fall, then a just-right level of slow growth would be enough to keep corporate earnings high and keep monetary policy loose enough to maintain high valuation multiples on those earnings. And so stock prices have rebounded vigorously since Dec. 26th despite no improvement in underlying fundamentals in that time: GDP growth is slowing in the U.S. but not facing an imminent contraction; global GDP growth has been slowing; political uncertainties like Brexit and trade wars remain unresolved; and corporate earnings will not repeat the tax-cut-fueled growth rate of 2018, but on the other hand don’t seem to be dropping yet. If this seems like a slightly precarious path to tread, it is. We could easily see a renewed sell-off in return-seeking assets if GDP growth continues to slow globally, but in the meantime the bearish sentiment of Q4 has been quickly reversed. Also, the stock market rebound has been very much assisted by a resurgence of stock buybacks by corporations in Q1, which had slowed in Q4 after very high levels of buybacks in Q2 and Q3 of 2018, when corporations deployed their tax cuts and cash repatriations.

As a large and integral part of the global economy, and the primary source of economic stimulus since the Global Financial Crisis, a lot depends on the health of the Chinese economy.

We have described for more than a year how we are in a late cycle transition market. That is still the situation, and this welcome pause by the FOMC has not significantly changed the possibility that the slowdown in global GDP will coalesce into a shallow recession sometime soon, even if no immediate catalyst is apparent. A lot will depend on whether China’s GDP growth is reinvigorated by their announced expansion in lending. The GDP contractions in Germany and Japan in 2018 – both large exporters to China – hinted at the possibility that Chinese growth was slowing more than indicated in the official figures. As a large and integral part of the global economy, and the primary source of economic stimulus since the Global Financial Crisis, a lot depends on the health of the Chinese economy. The Chinese announcements of monetary easing in recent months have been almost as helpful as the FOMC in spurring the rebound in stock markets, and a strong Chinese PMI report in early April was a significant boost for global stock markets.

The bond market, typically the gloomier cousin of the stock market, has dissented with the rebound.

While stocks have almost regained their prior peak, long-dated U.S. Treasury bond yields have remained stubbornly lower. Following the FOMC March meeting, we even saw an inverted yield curve as measured between three-month Treasury bills and 10-year Treasury bonds. As we discussed in this newsletter in 2018, an inverted yield curve has been the most reliable past predictor of approaching recessions. Through much of 2018, the yield curve had flattened and moved to within touching distance of inversion. So while this new inversion does not yet apply to the bellwether two-year to 10-year measurement, and has not yet persisted for very long, it reaffirms that bond investors are wary of future growth prospects and see a large potential for the FOMC to need to cut interest rates within the next year.

Longer-Term Outlook

Modern monetary theory (MMT) has been a topic of some debate in recent months, particularly among economists involved in public policy. Without delving into arcane details debated by economists, this is a topic that investors will hear more of ahead of the 2020 election campaign because of its potential impact on fiscal policy. To simplify the issue at stake — albeit a disservice to the greater complexity of the theory — the bottom line is that proponents of MMT propose that the U.S. government should print money to finance increased government spending, only constrained by concerns about near-term inflation and economic dislocation.

Most economists disagree that deficits via currency printing press are not a problem just because the government has a monopoly on the sovereign currency.

The FOMC, no longer independent, would facilitate this creation of money supply and would keep interest rates extremely low. If/ when inflation subsequently increased because of the massive monetary stimulus, the government could then raise taxes to stifle consumption and thereby lower inflation again. Of course, a system that deliberately enables increased government spending and can only be offset by increased taxation would lead to a rapid expansion of the government as a share of the economy, which would crowd out private enterprise. It would also lead to predictable secondary problems of misallocation of capital and porkbarrel politics. Most economists disagree that deficits via currency printing press are not a problem just because the government has a monopoly on the sovereign currency2.

So why is this receiving so much attention now? First, it is a politically expedient way to get around the fiscal limitation of needing unpopular taxes or deficits in order to fulfill spending promises. Printing more money does not impose an immediate direct harm on any particular constituency, so there would be less political resistance. For this reason MMT is often cited as a way to allow large, expensive spending policies on the populist left. Second, the experience of quantitative easing (QE) by central banks in the aftermath of the Global Financial Crisis has created a plausible precedent. We saw that monetary stimulus via the printing press will not necessarily lead to immediate hyperinflation and a Weimar Republic-type collapse, although Zimbabwe’s plight does offer a current counter-narrative of what happens when a government abuses the currency printing press.

Hyperinflation and ruinous devaluation of the dollar only become possible if the monetary stimulus is very large relative to existing money supply.

So what is the realistic eventuality for investors? Even if MMT is very convenient to political campaign promises, it would be politically difficult to completely end central bank independence and turn the FOMC into a compliant printing press. However, if MMT were embraced and practiced in some form, the U.S. would have a lot of leeway before any Zimbabwe-like consequences manifested. With the dollar as the global reserve currency and the U.S. economy not close to overheating (but much closer than when QE first started), a limited application of MMT would be no more damaging than any other fiscal stimulus fueled by deficits – which we already have after the 2018 tax cuts and budget expansion – though some political proposals would further increase the magnitude of deficit spending and its ramifications. Hyperinflation and ruinous devaluation of the dollar only become possible if the monetary stimulus is very large relative to existing money supply. But on the other hand, the end of central bank independence that is needed to facilitate MMT … well, that could be extremely disruptive to capital markets as the future of the global reserve currency comes into question and investors must scramble to redefine safe haven assets.

Current Positioning

As the rebound in January persisted and demonstrated a return to positive sentiment, we returned to a neutral stance on U.S. equity.

We ended 2018 on underweight returnseeking assets, particularly equity and returnseeking credit. As the rebound in January persisted and demonstrated a return to positive sentiment, we returned to a neutral stance on U.S. equity. We are not yet ready to go overweight on U.S. equity, as we are still concerned that there is potential for another sell-off unless/until economic fundamentals grow stronger. Positive momentum has been strong so far, but there are definitely downside risks. For developed non-U.S. equity markets, we eventually returned to a neutral stance there too, but that took longer because the fundamentals continue to look shakier; however, we eventually acceded to the strong momentum. We are cautious here too.

We have had a positive view on emerging market equity for several months because the decline in emerging market currencies relative to the dollar in 2018 has made valuations attractive. So we ended Q1 2019 with a neutral stance in U.S. and developed non-U.S. equities, and an overweight to emerging market equity.

We continue to hold a positive view of diversifying 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. High yield bonds and floating rate bank loans both saw strong rebounds from their December losses, although now high yield bonds are once again trading at yields so low as to weaken their appeal, even if defaults remain very low so far.

We continue to hold a positive view of diversifying asset classes like real estate, returnseeking credit, and liquid alternatives.

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.


1 MSCI World Index

2 Wall Street Journal, “Can the U.S. Afford Democrats’ Bold Promises? Why One Economist Says Yes,” Updated March 31, 2019.


Legal Disclosures and Disclaimers

Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. (“AHIC”). The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto.

The information contained herein is for informational purposes only. Nothing contained herein should be construed as legal or investment advice; please consult your investment professional for any such advice. This information has been obtained from sources believed to be reliable, but is not necessarily complete and its accuracy cannot be guaranteed. Any opinions expressed are subject to change without notice. This document is not intended to provide, and shall not be relied upon for, accounting, legal, or tax advice or investment recommendations. Any accounting, legal, or taxation position described in this presentation is a general statement and shall only be used as a guide. It does not constitute accounting, legal, and tax advice and is based on AHIC’s understanding of current laws and interpretation.

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