Quarterly Client Letter – Q2 2019
- July 19, 2019
- Investment Insight
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Dear O’Brien Wealth Partners Investor,
As we enter the second half of 2019 the same political uncertainties that have been haunting the market since mid-2018 continue to cast a shadow over business and investor confidence. A U.S. economic recession appears unlikely in the near term; however, business investment is slowing and global growth is showing signs of suffering from tariffs and restrictions of unresolved trade disputes. That said, on average, current equity valuations are only slightly above historical levels, inflation remains low and global central banks seem committed to supporting this record-long expansion. In times when there is no clear direction, the best move is to maintain a diversified and disciplined approach, remaining invested despite the currents of volatility that the daily news headlines may bring.
Despite an uptick in market volatility that delivered uncomfortable inter- and intra-day stock market swings, nearly all asset classes showed positive returns for the second quarter. The risks that have concerned investors for the better part of the past year – trade tensions, unknown Federal Reserve actions, and slowing global growth – still loom large. At the same time, the U.S. economy continues to exhibit solid economic growth, with first quarter GDP of 3.1% (nearly identical to last year), historically low inflation, and the lowest unemployment rate in 50 years. While business investment is moderating, consumer spending remains solid. However, the escalation in the cross currents caused by global trade policy uncertainty, weakening economic momentum in certain countries, and the potential impact of Brexit were sufficiently strong to cause waves throughout the quarter.
Geopolitical events seem to be the key driver of the market right now, with global trade having the tightest grip on the wheel. While the U.S. and China have shifted from their extreme initial positions, reaching a mutually acceptable trade resolution has proven difficult and has taken longer than most anticipated. As a result, global manufacturing has slowed down considerably, casting pallor over global growth. Unfortunately, the tension may continue until the Presidential election in 18 months, as any decisive move could be used as ammunition in a presidential campaign. A lack of clarity around Brexit, and its impact on the Eurozone, persists. Citing these “greater uncertainties,” the Federal Reserve is now forecasting one or two rate cuts by the end of 2019. Although recession risk is rising as a result of the manufacturing slowdown, most economists predict continued slow growth throughout the rest of 2019 and into 2020.
In the equity markets, the U.S. built on its strong performance from the first quarter despite the looming geopolitical risks. The Russell 1000 (large cap), Russell Mid Cap, and the Russell 2000 (small cap) returned 4.2%, 4.1%, and 2.1%, respectively in the second quarter, as investors continued to modestly broaden their stock exposure. Defensive sectors, such as healthcare, utilities, and consumer staples once again underperformed their more volatile peers, including financials and technology; however, the gap in performance narrowed materially when compared to the first quarter given the increase in market fluctuation.
Outside of the U.S., the MSCI EAFE and the MSCI EM, broad measures of the developed and emerging markets on a dollar adjusted basis, were up 3.7% and 0.6%, respectively. Uncertainties around Brexit hurt European equities and increased trade tensions negatively impacted countries that are export-oriented, which is where most emerging market countries fall. While many analysts believe the global manufacturing slowdown to be temporary, we continue to monitor world trade volume and trade talk developments.
In the fixed income markets, the yield curve remained relatively flat with an inversion in very short-term bonds propelled by the Fed’s rate increases in 2018. Rates have since paused as the Fed continues to wait on changes in inflation before deciding on the next movement. With over half of the Fed’s voting members expecting two rate cuts this year, short-term interest rates are expected to fall. In fact, we are already seeing the yields start to drop as investors buy into higher rate bonds. Because the difference between interest rates and inflation is historically low, we believe fixed income is a better source of insurance than income when complementing equities. As far as cash management, we continually monitor and compare savings rates against inflation. With short-term interest rates expected to fall, we may see cash returns fall below inflation once again, which further solidifies our stance of remaining invested in the markets to maintain purchasing power.
What does this mean for your portfolio?
As the economic expansion continues, we stand by our belief that your stocks are your growth engine and your bonds are your source of protection. Over the past year and a half, we have been positioning your portfolios to weather market volatility by adding diversification in your stocks and safety in your bonds. We continue to see opportunity outside the U.S. market. Given slowing growth and rate cut expectations, we expect the dollar to weaken in the near future. That belief combined with relatively high U.S. equity valuations points to potential outperformance in the international equity space. Accordingly, we are adding a growth-oriented active international fund to our global line up. Additionally, we will also be making changes to our emerging markets allocation to ensure our selected managers meet our long-term views on the opportunity in the emerging consumer classes in this area. Furthermore, with corporate bonds currently valued more expensively than equities, we continue to favor investing in high quality debt, including treasury- and mortgage-backed securities.
We believe that the second half of the year does offer positive growth momentum; however, now is not the time to turn overly aggressive or conservative with portfolio positioning. Rather, it is a good time for our clients to reassess and ensure that their investment allocations are aligned with their long-term goals. The top level decision of how much of the portfolio to allocate to stocks versus bonds guides us in how we manage your assets, and is probably the most critical in allowing our clients to feel comfortable staying the course in times of market volatility.
If you have any questions or would like to discuss the specifics of your portfolio, please contact your O’Brien Advisor.
Your O’Brien Wealth Partners LLC Investment Team