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Did Asset Allocation Just Get More Difficult in 2019?

By Richard "Crit" Thomas, CFA, CAIA
Economy & Markets
Asset Allocation charts and light bulb
  • In the first half of 2019 seemingly everything rallied, both asset classes that are considered more risky and those considered less risky (stocks, bonds and gold) which means the price of everything just went up. Now what?

While it is not unheard of to see assets with dramatically different risk profiles rally together, it is certainly unusual; especially considering the extent of this recent rally.

  • The first half rally of 18.5% for the S&P 500 in 2019 was the best first half rally seen in over 20 years.
  • The Bloomberg Barclays US High Yield index returned the best first half performance since 2009, +10%.
  • The Bloomberg Barclays US Aggregate index returned 6.1%, the best first half performance in over 20 years.

The S&P 500

Admittedly the strong stock returns so far in 2019 would not have occurred without the near 20% swoon in late 2018. Like a flying trapeze artist the market has simply swung down and then back up from one platform to another of similar height.

The ring leader behind this aerial feat was none other than the Federal Reserve (“Fed”). A more hawkish tone by the Fed leading into the fourth quarter 2018 amidst signs of slowing economic growth raised fears that the economy would make a hard landing sometime in 2020.

These fears abated as the Fed’s stance moved from one of tightening to potential easing, reducing those recessionary fears and allowing the stock market to rebound.

Treasury Bonds

While stocks were falling in late 2018, Treasury bonds rallied and their yields fell (yields move opposite of price). Treasury bonds were responding to the same concerns as stocks surrounding the Fed and economic indicators.

Yet in 2019 Treasury yields did not rebound with the stock market, they continued to fall.  Have bond investors gotten too pessimistic or are stock investors getting too optimistic?

Probably a little of both.

In 2019 bond yields have come down partly in response to weaker than expected economic data and a slowing rate of inflation. As compiled by Citigroup Global Markets, US economic releases have been coming in below expectations for the last four months.

Global Demand for US Treasuries

This economic weakness has not been isolated to the US alone, there have also been signs of weaker economic conditions in most developed economies. This economic weakness has led to a decline in bond yields across the globe.

The amount of negative yielding debt outstanding hit a record high of $13 trillion in June 2019. Think of that, $13 trillion dollars of fixed income securities priced to lose money.

This large amount of negative yielding debt has likely funneled new foreign buyers into US Treasuries, also putting downward pressure on yields.

Bloomberg Barclays Global Negative Yielding Debt Outstanding from January 2010 to May 2019

Source: Bloomberg

Another significant buyer has been US individual investors fearful of an impending equity bear market.  Mutual fund purchases (a proxy for retail investors) of newly issued Treasuries represented over 50% through May 31, 2019, the highest proportion ever seen for mutual funds.

The Stock Market Needs Earnings Growth

Turning to stocks, missing from the first half 2019 rally was underlying earnings growth.  First quarter earnings for the S&P 500 were down 0.3% and according to FactSet are expected to decline in the second quarter and then again in the third.

While we agree that the Fed may be in a position to buy this economic expansion more time, we question how much earnings growth US companies can deliver through the remainder of this cycle.

Ultimately it is earnings that determine where the stock market goes. Generally earnings growth is more robust early in the cycle when profit margins are cyclically low and rising. Expanding profit margins amplifies sales growth.

Later in the cycle profit growth becomes more dependent upon sales growth as profit margin expansion becomes more difficult. Profit margins reached an all-time high in the fourth quarter of 2018.

With a backdrop of slowing economic growth we believe that future profit growth for the overall market will be much more moderate.

S&P 500 Profit Margin Quarterly data from March 1991 through December 2020

*Based on analysts’ annual estimates for revenue and EPS. Source: Bloomberg, S&P Dow Jones Indexes

Tactical Asset Allocation Thoughts

Outperformance of both risk assets and safe assets creates a dilemma. If one wanted to take some profits, where would they go?

Asset Allocation from a tactical standpoint has become more complex, though we do believe that there are still pockets of opportunity with relative sources of value.

US Stocks

For US equities slowing profits growth does not necessitate a bear market; more likely rotation within the market.

Many have suggested to us that slower growth would favor a Growth style tilt, though we would point out that the Technology sector is taking the brunt of the earnings swoon due to more global exposure and greater supply chain integration within China.

The Technology sector is also one of the most expensive sectors on a P/E basis. We suggest a more targeted Active approach to concentrate on individual stocks as opposed to style or sector biases.

We also continue to see opportunities within the mid cap space due to relative valuation and better earnings growth prospects.

Emerging Markets

Looking outside the U.S. if one were to consider valuation and easing monetary policy across the globe, then Emerging Markets would be at the top of the list.

The forward earnings multiple for the MSCI Emerging Market Index is below 13x and earnings growth estimates over the next two years are better than projected for the U.S. or other developed markets.

Given the less developed nature of the countries in the emerging markets, they are greatly impacted by global liquidity and money flows. Monetary authorities for most all of the major developed nations have indicated a bias to easing monetary policy.

Easier monetary policy has historically benefited emerging markets.

Fixed Income

Given the rally in both higher risk corporate bonds and risk-free Treasuries the risk/reward profile for fixed income looks less appealing.

Still fixed income plays an important role in one’s strategic allocation, in offsetting more volatile equity exposure and providing income (albeit modest today).

While higher risk corporate bonds can provide more yield, given a slowing economic backdrop and high correlation with equities we find this asset class less appealing for purposes of capital protection.

We suggest that investors consider moving up in quality and look for non-correlating assets that may provide a yield benefit and/or reduce risk (interest rate or credit).

The expressed views and opinions contained in this material are those of Touchstone's Global Market Strategist based on current market conditions and are subject to change without prior notice. There are no assurances that the opinions contained in this material will occur, this information is offered as a representation of a broad range of possible outcomes. This information does not take into account the specific investment objectives, restrictions, tax and financial situation of any individual client. Performance statements are historical. None of the information contained herein should be construed as an offer to buy or sell securities or as investment recommendations. This material is not intended to serve as the primary or sole basis for any investment decision. This information represents general market activity or broad based economic, market or political conditions and should not be construed as research or investment advice.

Investing in Equities, including International, Emerging and Frontier Market equities are subject to market volatility and loss. They also carry the associated risks of economic and political instability, market liquidity, currency volatility and differences in accounting standards. The risks associated with investing in international markets are magnified in emerging markets and frontier markets.

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crit thomas global market strategist

Richard "Crit" Thomas, CFA, CAIA

Global Market Strategist
Crit is responsible for examining and evaluating economic conditions, generating insights and providing a sharpened perspective on investment strategies for enriched portfolio construction.

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