The US economy has held up well thanks to historically low unemployment fueling consumer confidence enough to sustain this record expansion. The final estimation for 2nd quarter real GDP of 2% had been at the higher end of economist estimates and the envy of other developed market economies. There have been signs of stress, however, and the Federal Reserve has taken notice by twice deciding to cut its benchmark Federal Funds interest rate in order to thwart a slowdown being signaled by surveyed data as the China/US trade dispute headwinds blow stronger against global economic activity. The all-important services sector PMI readings have joined the slumping manufacturing sector readings near the break-even between expansion and contraction reading of 50 (chart below).
The low-inflation environment has given the Fed leeway to begin easing for the first time since 2008, having cut rates twice in Q3 – at the beginning of August and in mid-September. Inflation has recently started to move closer to the 2% target, though the Fed has expressed a willingness to let inflation run above its target to symmetrically offset prolonged running below target. However, this contradicts Fed insistence to-date that this is a mid-cycle adjustment and not the beginning of a cutting cycle, leaving uncertainty surrounding policy at the final two meetings of 2019 and beyond. The futures market is pricing in a better than 85% chance of another interest rate cut at the next Fed meeting on October 29th-30th, and there are even odds for another cut at the December Fed meeting. We believe the Fed will cut at least once more in 2019. The Fed has also started to engage in another round of quantitative easing via balance sheet expansion to help ease stress on lending markets that are starting to run short on liquidity, due to the deficit-funding record issuance of Treasury securities.
The X-factor for the global economy has been the trade war between the China and the US. The uncertainty has done damage to growth estimates due to supply chain disruption, and the longer it drags on, the more contingency plans turn into permanent solutions due to the long-term nature of capital expenditure budgeting. Plans for the two sides to return to the negotiating table on October 10th have restored some optimism that had been lost earlier in Q3. China and the US have been engaged in gamesmanship, using the other’s domestic economic or political woes to apply pressure for favorable terms. An impeachment inquiry into President Trump’s handling of foreign aid to Ukraine is the newest development that China will likely use to leverage a positive outcome, applying pressure in the run-up to the 2020 election. Signs of continued slowing in the Chinese economy provide a logical motivation for China to make a deal, as well as the social unrest in Hong Kong, and China has displayed a willingness to make small good-faith concessions in order to keep discussions cordial. A deal lacking substance or deterrents for subsequent violations can’t be ruled out due to both sides seeking political wins, however, such a toothless agreement would likely be itself insufficient to quell global economic and market concerns.
A quiet summer in terms of trading volume and volatility extended into July as 2nd quarter earnings season got underway and most companies were able to beat previously-lowered targets. Market participants were sure that the Fed would begin to cut its benchmark Federal Funds rate at its July 31st announcement, while assuming no news was good news on progress for a China/US trade deal. However, a breakdown in those negotiations triggered volatility’s return as major US equity indices dropped sharply from new all-time highs despite confirmation of the expected 0.25% Fed interest rate cut. Markets suffered their largest single-day drop of the year in August during a sustained inversion of the yield spread between the 10-year and 2-year Treasury bonds, a historically ominous signal for an upcoming recession. Exactly half of the trading days in August for the S&P 500 Index had intra-day moves of greater than +/-1%, though the large-cap bellwether would not revisit its low made on August 5th.
The August unease surrounding equities caused a flight to safety as longer-dated Treasuries and investment grade bonds continued their incredible run-up year-to-date, peaking in late-August as the yield on the 10-year Treasury fell near 1.45%, while the yield on the 10-year German Bund reached a record low, near -.70% (Chart below). As US inflation data started to perk up, economic data gave credence to the Fed narrative that the dovish pivot was a mid-cycle adjustment and not the beginning of an economic downturn necessitating a full-blown easing cycle. This coincided with generally overbought conditions in bonds, which precipitated an early-September correction in bonds (interest rates jumped up for a short stint).
This led to a reversal in the worst performing equity sector in August, Financials, which rebounded to be the best performing sector in September, due to the wild swing in interest rates affecting the expected profitability for banks. The move in Financials also coincided with heightened tensions and attacks in the Middle-East affecting a significant percentage of global oil supply, triggering a run up in beaten-down Energy stocks. The two sectors combine to make up much of the stocks that are considered to have “value” qualities, highlighting a rotation out of growth and momentum names and into Value, a prior laggard. The move up in energy stocks however was un-sustained. The more defensive sectors ended up leading for Q3, as Utilities and the Utilities Select Sector SPDR Fund (XLU) edged out Real Estate and Consumer Staples with a 9.41% return.
International equities underperformed their US counterparts in the 3rd quarter due to a more severe August drawdown. The iShares Emerging Markets ETF (EEM), representing emerging markets equities, experienced a larger bounce off the quarter lows due to positive news of the China/US negotiation, though remained under pressure due to the strengthening US dollar and the apprehension of the Fed members to commit fully to an easing cycle. Developed international equities have been hampered by a slowdown in the manufacturing heart of Europe, Germany. While another round of traditional as well as more creative quantitative easing policies from the European Central Bank are attempting to thwart further slowing, the policies have hurt valuations of financial sector stocks which is the largest sector in developed market ex-US equity indices.
Hanlon Tactical Portfolio Commentary
The US large cap equity portion of our Hanlon Tactical Models entered the 3rd quarter invested in 10 out of 11 sectors, with the struggling Energy sector excluded for the duration of the period. By August 2nd, US large cap equity was nearly 70% cash as volatility triggered sells on all sectors except Healthcare, Consumer Staples, and Communication Services. Those sectors, too, would be liquidated within a week as market choppiness raised the probability of breaking long-term support. The signals for US small-cap and mid-cap equities also flipped to sell at the beginning of August. As markets found their footing, and the expectation of interest rate cuts and a trade truce appeared, the US small, mid, and large-cap positions, excluding energy, were re-entered during the September rebound.
The Managed Income portion of our Hanlon Tactical Models were almost fully invested to begin Q3, with the majority allocated to high yield bond funds. Much of the high yield allocation was removed during August as the disruption in equity markets affected below investment grade bonds. Positions in long-term US Treasuries and long-term investment grade corporate bonds were maintained for the entirety of Q3, while local currency emerging market bonds were swapped for US intermediate-term investment grade corporate bonds driven by a relative strength signal. Smaller positions to US and International REITs, option writing, and bank loan funds rounded out the income positions.
Hanlon Strategic & All-Weather Portfolio Commentary
The August volatility and risk-asset drawdown led to another quarter of parity between fixed income and equity returns. Allocations to different styles of the US small-cap equity markets were mixed, as the allocation to small-cap value stocks helped offset the negative return from the broader small-cap blend position. The Invesco S&P 500 Low Volatility ETF (SPLV) outperformed the other Strategic equity allocations for a second consecutive quarter, returning 5.81% in Q3. International assets underperformed as investors sought the relative safety of US securities. The emerging market equity allocation fell 4% in Q3 after failing to recover from the mid-quarter drawdown.
Emerging market bonds, the fixed income standouts from Q2, were among the worst performing fixed income allocations in Hanlon Strategic allocations, underperforming all except the -0.75% from the iShares International Treasury Bond ETF (IGOV), consisting of international developed market government bonds. Conversely, international developed market corporate bonds were the best performing fixed income allocation, returning over 3%, benefitting from the relaunch of quantitative easing from the European Central Bank which also engages in open market purchases of corporate bonds. The largest holding in the Income allocation, the PIMCO Active Bond ETF (BOND) returned a solid 2.18% for the 3rd quarter.
The “Alternatives” portion of the Hanlon Strategic and All-Weather were mixed during the quarter, with a wide disparity of returns. The REIT positions had solid performance, returning nearly 7% and leading all the Strategic positions for the quarter. The allocation to Master Limited Partnerships (MLPs) and investments in natural resources stocks (commodities) were unable to rebound after sharper August drawdowns than broader equity indices.
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