Q3 capital market returns were modest with elevated volatility. US equities continued to mostly outpace other markets around the globe as several key issues continue to worry investors. Examples include:
- The ongoing US/China trade war
- Uncertainty around Brexit
- Recent attacks on Saudi oil facilities
- Continued evidence of slowing global economic growth
- Two consecutive quarters of negative earnings growth for S&P 500 companies
- Uncertainty associated with the Presidential impeachment investigations
The result has been a swift and fairly steep drop in bond yields around the globe, so much so that there is now an estimated $15-16 trillion of sovereign debt with negative interest rates2. Despite better (though still sluggish) economic growth in the US, supported by the US consumer, domestic bond markets were not immune to concerns over slowing growth and the potential for recession as bonds outpaced equities in the US during the quarter as noted in the table above. September ended with an inverted US Treasury yield curve as 3 Month T-Bills yielded more than 10 Year Treasury Notes. US 10 Year Treasury Notes declined 32 bps in Q31, ending the quarter at 1.68% (actually fell below 1.50% during August)2.
Fundamentum Tactical strategies were well-positioned for this environment in Q3, as they were broadly overweight US bonds vs global equities (relative to our neutral benchmark weights). Within equities, we were markedly underweight emerging markets equities and overweight US equities, with an emphasis on US large-cap growth stocks and US large-cap dividend growers. During the quarter, we reduced equities further below the neutral points in favor of high-quality, fixed income securities (see the 8/7/19 Market Update). Our message over the last two quarters has largely been the same - we remain concerned enough over global economic growth and corporate earnings pressures to have a cautious stock/bond allocation. We do not currently expect a US recession during the next 6 months, so we still favor US large-cap equities over US small-cap and international equities tactically as we move into Q4. However, we are closely monitoring developments in Europe for any signs of willingness to embrace broad fiscal stimulus, especially in Germany. Should we see such stimulus, we would likely increase our allocations to both developed and emerging international equities, as they generally exhibit more attractive valuations relative to US equities in our opinion. It is becoming difficult to expect the US economy to remain supported by the US consumer should corporate profits, trade and manufacturing trends continue sliding, as we would expect the labor market to soften at some point. Recent data from the manufacturing sector indicates that trade battles and lack of growth outside our borders has significantly cut into activity, leaving the domestic economy largely supported by the consumer. Even the US services sector, comprising over 70% of domestic economic activity, has turned decidedly lower in recent months, though still above levels consistent with recession2.
Over the last couple quarters, investors appear to have been placing more faith in the Federal Reserve than actual fundamentals. Despite economic activity (outside of labor markets) and earnings being sluggish most of the year, risk-assets have mostly enjoyed sizable gains year to date. We are aware (and respect) the “Don’t fight the Fed” mantra, but we are increasingly concerned that monetary stimulus has largely supported economic activity as much as can be expected. Already historically low interest rates aren’t likely to provide much of a boost to the economy should the Fed move even lower from our view. As evidenced with the negative interest rates and very slow economic growth in much of Europe, some economists argue lower rates may actually do more harm than good. The two most identifiable catalysts that could break the logjam of slow global growth are:
- A truce or agreement in trade discussions between the US and China
- Efforts to boost economies in Europe (i.e. Germany) through fiscal stimulus.
Our sense is that either of these could benefit non-US equities more than US equities, though all risk-assets are likely to rally should those occur.
An additional concern on our radar is inflation, where the thought for some time has been fear of deflation, not rising inflation. Yet, there are forces in play that could put upward pressure on inflation (limiting what the Fed might do) with the impacts of tariffs, rising wages and rising cost of housing/rent working their way into inflation numbers in 2020. This would be a worst-case outcome (slow growth AND inflation). This is NOT presently our base case, but it is an issue we are monitoring closely.
For now, Fundamentum Tactical portfolios (compared to their neutral benchmarks) are geared towards high quality US fixed income securities and US stocks, with meaningful underweights in Emerging Market and most non-US equity classes. We remain more concerned about downside risks versus keeping pace with risk-assets that may have already discounted much of what can be expected from easy global monetary policies. We will continue to monitor these issues closely and adjust as necessary with new information.
As always, thank you for your confidence in our team.
Fundamentum Investment Committee
Chad Roope, CFA® Portfolio Manager
Paul Danes, CFA® - Investment Committee
Trevor Forbes - Investment Committee
Matt Dunn, CFA® - Chief Compliance Officer
1-Morningstar Direct 10/1/19
Investment advice offered through Fundamentum LLC a registered investment advisor. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the investment objective of any investment strategy will be attained. Investing involves risk including loss of principal. Past performance is no guarantee of future performance. All indices are unmanaged and may not be invested into directly.