Q1 2019 January 10
INSIDE THIS ISSUE:
Yield Curve Flattens on Renewed Worries
Outlook for Equities Improved After Selloff
DB Fitzpatrick 800 W. Main Street, Suite 1200 Boise, Idaho 83702 (208) 342-2280 www.dbfitzpatrick.com
YIELD CURVE FLATTENS ON RENEWED WORRIES Three principal issues, all ongoing
holding down the long end of the
outlook among investors and has
throughout 2018, came to a head in
curve. The lack of resolution to this
helped keep long-term Treasury yields
the last weeks of December to result
issue has many investors concerned
low. Home price appreciation has
in falling interest rates and a very flat
and has recently contributed to a
slowed in recent months, while
yield curve (the short end of the curve flight to high quality assets and falling inflation breakeven rates (what is inverted). First, the Federal Reserve Treasury yields. The cost of tariffs
investors are betting inflation will be
raised the fed funds rate four times
in the future) have plummeted.
has begun to show up in economic
last year and as recently as three weeks data in both China and the U.S., and ago promised two additional hikes in
corporate earnings are being impacted The result of all this was a roundtrip
2019. The Fed has also been allowing both directly by tariffs and indirectly
ride for long-term Treasury bond
$50 billion of Treasuries and agency
by the economic slowdown they cause yields in 2018 (up for the most of the
mortgage-backed securities to burn
(Apple is a prime example, with its
year before falling precipitously at the
off its balance sheet each month.
recent warning of a sharp slowdown
end), significant flattening of the yield
Monetary policy tightening through
of sales in China).
curve as the Fed has pushed the short
rate hikes has resulted in the short end
end higher, and widening corporate
of the yield curve rising significantly
Finally, there are signs that the U.S.
spreads toward the end of the year as
during the last 12 months, with bond
economy is weakening, most notably
investors repriced risky assets.
investors showing increasing
evidenced in the housing sector,
skepticism regarding the wisdom and
which has added to the pessimistic
durability of this policy. The long end of the curve refused to move
much higher even with the continued balance sheet wind-down. Fears of a continuation of the trade conflict between China and the U.S. have been another
We believe it is extremely unlikely that
ECONOMIC FORECAST | Q1 2019 the Federal Reserve will be able to raise the fed funds rate two times in 2019 as policymakers have guided, and view no hikes at all during
the year as the most likely outcome. This is already incorporated into market prices. Rate cuts could be on the table if the environment
continues to deteriorate, but we view it as more likely that the Fed will slow the pace of its balance sheet runoff. Fed chair Jerome Powell said on January 4 that the Fed “will be
We believe President Trump will choose this route as
prepared to adjust policy quickly and flexibly and to use
the 2020 presidential election cycle is already underway
all of our tools to support the economy.” Still, it’s safe
and economic growth is increasingly imperiled by the
to say that rate cuts will only occur as a last resort. New prolonged conflict. There is a precedent for this as dovishness from the Fed, which we expect, is likely to be President Trump, after railing against the North bearish for long-term Treasury bonds as investors’ fears
American Free Trade Agreement for years, eventually
of policy overshoot recede.
agreed to modest reforms and a change of the name of
The trade conflict between the U.S. and China is another real worry for investors, but this could be remedied in
the upcoming months if both sides decide to cut a deal.
the deal. It is likely that a resolution to the trade conflict between China and the U.S. would also be bearish for long-term Treasuries, as an important cause for investor worry would be removed.
With this outlook in mind we are shortening duration in our intermediate duration portfolios and anticipate adding additional credit exposure where appropriate. Pessimism is elevated today and we could see a dramatic swing higher announce a significant change of in long-term Treasury yields
policy. We are not making significant short end of the curve, which should
(combined with steepening) if a trade adjustments to our short duration deal is reached or if Fed leaders
likely to result in lower yields on the benefit these portfolios.
strategies, as a change in Fed policy is
OUTLOOK FOR EQUITIES IMPROVED AFTER SELLOFF The stock market ended 2018 on a volatile note with the
sentiment, we see reason to be optimistic as 2019 gets
same factors that caused long-term Treasury yields to fall
underway. First, it is very likely that Federal Reserve
and the yield curve to flatten (trade conflict, Federal
policymakers will embrace a more dovish monetary policy
Reserve overshoot, slowing economic growth) converging this year. Such a move is likely to be positive for stocks. to push equity investors to reassess their previous sanguine outlook. The MSCI All Country World Index
(which measures the global stock market) fell 12.7% in the fourth quarter, returning -9.0% for full-year 2018. The S&P 500, a measure of large cap domestic stocks, was down 13.5% in the fourth quarter and returned -4.4% for the full year. The MSCI EAFE Index, which tracks international developed (ex-U.S.) equities, fell 13.3% in 2018, while the MSCI Emerging Markets Index was down 14.5%.
A second reason for optimism is that President Trump
might decide to finally hammer out a trade deal with China. The prolonged trade conflict has certainly been a negative for stocks as so many companies rely on sales in China and logistical networks involving the country. Itâ€™s likely that a resolution to the conflict would be very positive for the broad equity market, and especially for companies with significant direct operations in China (there are many).
Despite the multiple issues currently weighing on investor Admittedly, trade negotiations with China are more
ECONOMIC FORECAST | Q1 2019
complicated than were negotiations with Canada and Mexico as many in the administration view China as a strategic foe and
trade as part of a larger conflict. Still, we think the odds today favor a deal and this has us optimistic regarding the outlook for stocks. The outlook for the domestic economy is admittedly somewhat dreary, but significant relief would be offered if the Fed does indeed alter its tightening policy and trade conflicts are brought to an end. In our view the gloom in investorsâ€™ minds today is already appropriately priced into stock prices, with the S&P 500 and MSCI All Country World Index trading at a roughly neutral 14.3 and 13.1 times expected 2019 earnings, respectively.
Europe, and Japan, and increased spending in the
emerging markets. We view this as a core long-term position. In recent days we have decreased an overweight to consumer staples and increased our exposure to financials, technology, and industrials, taking advantage of attractive relative valuations. After these moves our equity portfolios are no longer positioned as defensively as they were last quarter. Should the stock market fall further, we will look to further lower our positioning to defensive sectors, hoping to take advantage of cheaper
In our equity portfolios we are maintaining an overweight prices in more cyclical sectors of the stock market. position to U.S.-based stocks and to the healthcare sector, which benefits from aging demographics in the U.S.,
â€” Brandon Fitzpatrick
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DB Fitzpatrick 800 W. Main Street, Suite 1200 Boise, Idaho 83702 www.dbfitzpatrick.com | (208) 342-2280