2019 began with strong—albeit very mixed—signals about the health of the U.S. economy:
- The ISM Manufacturing index in December grew at the slowest pace in two years as demand for manufactured products softened. The slowdown surprised investors, sparking nervousness that the economy may be decelerating more than expected.
- On the plus side, hiring in December (U.S. nonfarm payrolls) surged by a much-better-than-predicted amount—a sign suggesting the U.S. economic expansion remains strong. Average hourly earnings also accelerated faster than expected.
European economic data was also mixed:
- A key gauge of Europe’s overall business activity—IHS Markit’s Euro Zone Composite Final Purchasing Managers’ Index (PMI)—missed estimates slightly, falling from the previous month’s reading.
- At the country-specific level, manufacturing PMIs in the UK and Italy topped expectations, while German and French manufacturing PMIs met expectations. UK services PMI topped estimates, but Germany’s disappointed.
- Construction data in the UK was slightly softer than estimated.
In Asia, all eyes were on China’s manufacturing PMI—which fell below consensus and actually contracted for the first time in 19 months. However, other measures of the Chinese economy—such as China’s non-manufacturing PMI—exceeded estimates and still indicate expansion.
The U.S. equity market enjoyed its second consecutive week of positive returns—a welcome change from results during much of December—with the energy and communications services sectors leading the pack.
- Energy benefited from a recovery in crude oil prices, driven by strong U.S. economic data and oil production cutbacks from key OPEC countries.
- Communication services was buoyed by positive comments from industry analysts suggesting that some quasi-technology stocks within the sector may offer a better risk/reward profile than other mega-cap/FAANG stocks. In addition, telecom and cable shares benefited as investors took a more optimistic view that these companies can continue to increase revenues despite a declining subscriber base.
In contrast, defensive sectors like real estate lagged as investors showed more willingness to take on risk. Technology also lagged after Apple’s disappointing earnings guidance adjustment—a negative development that rippled through the sector.
European equity markets also rallied at week’s end on improving macro sentiment, after a volatile few days following downbeat economic signals from the U.S. and China. Cyclicals such as energy shares were positive standouts after a weak ending to 2018 (the energy sector posted its worst quarterly return in four years during the fourth quarter). Financials also outperformed. The technology and consumer staples sectors lagged, however.
Asian markets lagged the U.S. and Europe for the week. However, timing likely played a bigger role than usual: The Japanese stock market was open only on Friday last week, due to an extended New Year’s break in trading, and closed before the improvement in investor sentiment following the strong U.S. jobs report. Emerging markets continued their recent outperformance, with large emerging markets countries such as Brazil benefiting from optimism that its recently elected president will implement business- and economic enhancing reforms.
In the fixed-income markets, longer-duration securities tended to outperform shorter-duration debt. Riskier credits like high-yield bonds benefited from the shift to a risk-on market view at the end of the week. The bounce in oil prices also helped the high-yield sector, as a large percentage of high-yield issuance comes from the energy sector. Emerging markets sovereign credit delivered another week of positive performance, boosted by many appreciating emerging markets currencies. Emerging markets corporate bonds underperformed sovereign debt, but also gained ground for the week.
GAIN: Active Asset Allocation
The new year has gotten off to a rocky but positive start. Over the past five years, the market has tended to rebound quickly from dips, as investors piled in and limited market losses. Last quarter, however, institutions de-risked and were not willing to buy on dips. With a new year, hedge funds and banks are likely to be ready to make new investments.
The price action during the past five to ten days has shown support for the market segments that got hit the hardest during much of the fourth quarter—a good sign. The economy remains strong, if not spectacular—and as long as it doesn’t deteriorate rapidly (which we do not expect) investors should find reasons to buy stocks.
We enter 2019 with a 20% allocation to emerging markets.
Bonds were relatively flat last week, although credit markets rebounded nicely on Friday following the strong jobs report and comments by Fed Chairman Powell. Investors shifted back into both high-yield bonds and senior loans. The lack of liquidity we saw in stock in stocks during the last quarter was also present in those areas of the bond market. However, unlike in 2015 and 2016, the companies issuing that debt are financially strong with solid balance sheets.
PROTECT: Risk Assist
Our volatility forecasts came in substantially higher this month than last, which will impact how quickly the models may de-risk or re-risk to avoid being whipsawed by rapid price movements. This period is similar to early 2016, when many Risk Assist models were 60% – 70% de-risked. Investing in partially de-risked models can be beneficial: if markets fall, the models have the ability to de-risk further; if markets rise, investing in a model that is re-risking over time can be similar to the concept known as “dollar-cost averaging,” but with the added benefit of volatility forecasting to guide re-exposure to the market.
SPEND: Real Spend
The stock market’s rally late last week helped boost the year-to-date spread between global equities and investment-grade bonds to 1.5%, in favor of stocks. The one-year spread currently has stocks trailing bonds by 9%.
Returns among yield-focused assets were particularly strong last week. Master limited partnerships were up 9% as oil and high-dividend financial stocks rose along with equity markets. Preferred stock was up 3% and high-yield gained more than 1.6%. Higher-quality fixed-income securities, such as Treasuries and mortgages, lagged.
All Real Spend Models were recently de-risked due to elevated levels of volatility. Additionally, Real Spend models currently hold 11 quarters of Spend—one quarter less than the maximum allocation.
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