The US economy has been sending mixed signals, even as the start of July marks the longest economic expansion in US history, surpassing 120 months. The final estimate for real GDP growth in the 1st Quarter (Q1) came in at a surprising 3.1% thanks to a boost from shrinking net imports and rising inventories. Estimates for Q2 have come down but are not signaling disaster, such as the most recent Federal Reserve Bank of Atlanta’s GDPNow estimate of 1.5% GDP growth. Survey-driven economic data, such as Purchasing Managers’ Indexes (PMIs), have begun to weaken. Other indicators including the Treasury yield curve, vehicle sales, durable goods orders, and softness in loan demand and the housing market are leaning towards an economic slowdown. Surely, the China/US trade war and Federal Reserve (Fed) monetary policy have affected these measures, but there may also be structural shifts at play as well.
Layoffs have increased in the auto industry, for instance, as sales have been slumping. Home prices have outpaced broader inflation for years, but price increases have started to slow despite incredibly low interest rates and generationally low unemployment. Investment in new residential construction has been disappointing despite friction caused by a demographic shift of baby boomers downsizing while potential first-time home buyers are less willing or able to pay up for their larger homes. An uptick in renovations has helped bridge the divide of generational wants in places where location is all that matters, yet housing supply may continue to cause issues in certain markets.
The Federal Reserve has moved from a patient stance in the 1st quarter to outright dovishness by signaling lower rates in the release of its latest dot plot expectations of future interest rates. The Fed median forecasts (green line) are not as dovish as those predicted by the market (black line), which is pricing in multiple rates cuts this year and next from the current 2.38% and is causing the Treasury yield curve to invert at intermediate maturities. The inversion usually signals a recession, albeit on a significant lag. However, the Fed seems ready to change policy as necessary to avert a slowdown. The dovishness should help alleviate some of the structural issues mentioned above, but the dislocation of expectations for the Fed versus those of the market present risks to prices of all types of investments.
The initial tariffs from the US trade war with China turned a year old on July 6th, and they have been increasing the drag on global growth with consequences that may prove to be permanent. The two sides settled on a truce during a meeting at the recent G20 conference, agreeing to no new tariffs as they continue to work towards an agreeable solution, but the ongoing saga has taken its toll. It has caused China to reverse their deleveraging initiatives and even increased measures to keep the economy afloat. Some were expecting even more easing from China, but an overly aggressive easing policy would undermine China’s goal of increasing the global use its currency.
China is very reliant on imports of oil, computer chips and the US dollar, which is used in trade, even with non-US partners. They are also increasingly relying on other Asian nations for computer chips, becoming less-reliant, thereby, less captive by the movement and supply of the US dollar. US corporations have also started to adjust plans considering a protracted stand-off, rearranging supply chains to circumvent China by moving operations to places like India and Vietnam. This is a welcome side-effect for President Trump, so, no matter the outcome of the trade war, shifting supply chains are re-designing the future of global cooperation or lack thereof.
Falling interest rates in Q2 contributed to strong quarterly performance from bond indices, which resulted in similar total return performance as those from broad equity indices, in the 2-3% range. The parity alone does not reflect the different paths taken to achieve those returns, as broad risk assets such as equities experienced significant drawdowns during the month of May before recovering strongly in June. Investment grade corporate and government bonds were mostly steady in their price ascent, as the yield on the 10-year US Treasury Note slipped below 2% for the first time since 2016, thanks to the Fed indicating a switch to an easing bias from their on-hold stance in Q1. Interest rate cuts are expected soon.
Small-cap equities, which led large cap during Q1 due to large outperformance in January and February, continued March’s relative underperformance throughout Q2. Small-caps started to show signs of life in late June but will need to continue the strength into Q3 and beyond if the broader market is expected to continue to make and sustain new highs.
Despite underperforming in Q2, emerging market equities have outperformed developed markets since the May lows, as expectations for easier US monetary policy has reduced US dollar pressure on foreign companies, many of whom borrow and transact in US dollars. Markets ETF (EEM), representing emerging markets equities is shown in the chart below (black line) versus the S&P 500 Index (blue line). The weakening dollar also fueled a strong recovery in local currency denominated emerging market bonds, represented below by the VanEck JPM EM Local Currency Bond ETF (EMLC, green line) that have relatively attractive yields in this environment of $13 trillion of negative-yielding debt outstanding globally.
The Financial sector led the major S&P 500 sectors, passing Materials and Technology with a late-quarter surge when the Federal Reserve announced positive results from its annual stress tests which will allow for some of the nation’s largest banks to return more capital to shareholders. The Financial Select Sector SPDR Fund (XLF) returned 7.90% during Q2 after lagging in March. The Energy sector trailed the major S&P sectors, as the only sector with a negative return for the quarter due to effects on oil prices associated with the cuts on global growth projections.
Hanlon Tactical Portfolio Commentary
The large cap equity portion of our Hanlon Tactical Models finished the 2nd quarter exactly how it had entered, invested at market weight in all 11 economic sectors except Q2’s sector laggard, Energy. The defensively characterized Consumer Staples sector was the only sector not sold during the May swoon. The allocations to US small-cap, US mid-cap, and emerging markets were also jettisoned due to the weakness in May, however, the domestically focused small/mid-cap allocations were re-added prior to the end of Q2. Emerging market equities were added back just as Q3 began.
The Managed Income portion of our Hanlon Tactical Models were almost fully invested to begin Q2, with the majority allocated to high yield bond positions. Positions in local currency emerging market bonds, long-term US Treasuries, and convertible bonds rounded out the larger allocations. Smaller positions included US and International REITs, option writing and low volatility equity strategy funds, and bank loans. During the quarter, convertible and local currency emerging market bond positions were replaced with long term corporate bond and high yield municipal bond funds. High yield corporate bonds were scaled back to avoid drawdown during the quarter, but like the equity portion, were added back prior to the quarter close.
Hanlon Strategic & All-Weather Portfolio Commentary
Parity amongst asset classes is evident when discussing the returns of the Strategic positions during the 2nd quarter, as those that are less susceptible to bouts of volatility were able to ultimately perform like broader equity markets without the late quarter comeback. The Invesco S&P 500 Low Volatility ETF (SPLV) outperformed the other Strategic equity allocations, returning 5.1% in Q2, thanks to the reduced volatility in the middle of the quarter. The US total market allocations, by comparison, used the best June month for large cap indices since the middle of last century to return just north of 4% for Q2. A more severe drawdown weighed on allocations to emerging market equities, with quarterly returns near 1%, while developed international stocks returned just above 3%.
Both US dollar and local currency denominated emerging market bonds were among the top performing holdings from the fixed income portion of the strategic allocations. The SPDR DoubleLine Emerging Markets Fixed Income ETF (EMTL) returned 4.10% and the First Trust Emerging Markets Local Currency Bond ETF (FEMB) returned 3.66% in Q2. For Q2, High yield bonds performed well despite a negative month in May, as the SPDR Bloomberg Barclays High Yield Bond ETF (JNK) gained 3.37% during the quarter.
The “Alternatives” portion of the Hanlon Strategic and All-Weather models were positive contributors, however, the JPMorgan Alerian MLP ETN (AMJ) had a minimal .06% gain in Q2 after leading all holdings during Q1. The positions invested in natural resources stocks (commodities) and Real Estate (REITs) had returns of around 1%.
As always, we will do what’s in the best interest of our clients consistent with our principles of Passion, Integrity, Vision, and Care. We will continue to monitor for opportunities, look ahead for market strength and weakness and make corresponding moves in our Tactical Models. For investors seeking a complete portfolio asset allocation solution, our Strategic Models or All-Weather Models that combine buy-and-hold strategy with tactical allocations could be the solution.
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