Still Invested, Perhaps More Vigilant
At the start of the year, it was easy to upgrade equities. The pace and scale of global equity market declines in Q4 departed significantly from the underlying economic data. Investors were overly bearish. We believed that these fears about a global slowdown were overdone.
Since then, global equity markets staged strong rebounds. The rally thus far has simply been an expected reversal in investor sentiment further supported by positive policy developments. Trade tensions eased, and the once-hawkish Fed has staged a 180-degree pivot in its communication with markets. With these market concerns clearing, the fog of uncertain economic policy should soon lift.
New York Life Investments’ Multi-Asset Solutions team published our 2019 Outlook update to share our detailed macroeconomic and asset class views. In this post, we focus on our high-level market takeaways for the remainder of the year.
Can equities continue to outperform?
Making a high conviction call is more difficult now than it was at start of the year. Valuations are about average, investor sentiment is mixed, and leading indicators of a growth pickup in the second half of the year need further confirmation. This leaves the risk-reward prospects for equities less clear.
In the near term, we expect that the late-cycle environment, lower liquidity, and higher volatility will give us more attractive entry points to add risk. Investors should focus on careful value plays – companies that trade at a discount and exhibit strong balance sheets, stable sales, or high return on investment. Free cash flow generation is likely to be one of the strongest drivers of equity performance.
Fixed income, on the other hand, remains less attractive.
Fixed income fared better than we expected in Q1. A few bad data releases, lower growth forecasts, and Fed dovishness pushed some investors into safer government bonds. In Q1 the aggregate bond index increased 2.9%.
Looking ahead, the risk for bond investors is elevated. Markets are pricing a Federal Funds rate below the Fed’s own expectations. If growth accelerates in the second half of the year as we expect, and inflation expectations start to grind higher, the risk that interest rates and bond yields further out the curve rise is elevated.
The risk/return tradeoff in credit is also less than attractive. Healthy corporate profits and limited refinancing risk will keep defaults low by historical standards, but higher overall interest rates and profit margin pressure could cause defaults to rise modestly not too far down the road. As such, we don’t see investors in speculative grade debt as being particularly well rewarded for the risk they bear.
That said, fixed income is an important diversifier in investor portfolios. We believe investors should give up some yield in exchange for flexibility and safety. For example, we hold slightly shorter-term debt instruments and higher quality bonds than are contained in our benchmarks, and we look to generate income across a broad range of sources. Timing an impending credit cycle is extremely difficult, but we can prepare our portfolios to take advantage of the inevitable.
Equities are attractively valued relative to fixed income
Sources: New York Life Investments, S&P, Thomson Reuters DataStream, as of 4/22/19.
Our strategy for the remainder of 2019
Equity and fixed income investors appear to be pricing in different levels of risk. What are we to think? At least through 2019, we are inclined to side with other equity investors. Real rates are still quite low, consumer confidence is rebounding, household income continues to expand, and businesses continue to invest in themselves through capital expenditures and share buybacks.
Nevertheless, the late cycle environment raises stakes for investors who must be vigilant for signs the economic engine is finally running out of fuel. Tighter monetary policy, trade concerns, and the government shutdown have contributed to softer data readings. Slower economic growth – compounded by one-off effects of the anniversary of the new tax law – is likely to produce some weakness in the next few months, but conditions thereafter look favorable. Investors will need to be more precise about their risk budgeting and work harder for risk-adjusted returns than they have for most of the post-financial crisis period.
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
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