Being an auspicious (rei) month in early spring, the weather was pleasant and the wind was peaceful (wa).
– Preamble to the Manyoshu (“Collection of Ten Thousand Leaves”), an anthology of Japanese poetry from the 8th century
On April 1, much of Japan came to a standstill – quite literally. Broadcasting live on NHK from the prime minister’s official residence in Tokyo, Japan’s chief cabinet secretary, Suga Yoshihide, made a major announcement: Japan would be officially entering a new era. This was a historic event. The transition from one era to another is of huge significance in Japan. This is such a rare occurrence that one might have imagined this was an April Fools’ joke (yes, April Fools’ Day is celebrated in Japan). But this was no joke. This would be the 248th new era since the system of designating eras began in 645 AD. The announcement related to Emperor Akihito’s upcoming abdication from the throne on April 30. What made this event even more significant than usual was that no emperor had abdicated since 1817. Akihito’s eldest son, 39-year-old Crown Prince Naruhito, would officially ascend to the throne, thereby signifying the beginning of the new era. This was a Japanese version of Game of Thrones, playing itself out in real life, with a change of monarchical control – though instead of the Iron Throne, this was the Chrysanthemum Throne.
During the announcement, Yoshihide revealed that the name of the new era was “Reiwa.” He unveiled a calligraphy of the two Chinese characters (“rei” and “wa”) signifying the name. An era’s name is chosen to embody the hopes of the nation for the new emperor’s reign. When the new name was unveiled, the reaction among the Japanese naturally was, what does it mean? Chinese characters can often have multiple meanings, and so the Japanese were left a bit puzzled at first as to exactly what was meant by the term “Reiwa.” Prime Minister Shinzo Abe, appearing later on the broadcast, explained that the term was derived from the Manyoshu, an epic collection of Japanese poetry from the 8th century that comprises some 4,500 poems overall, but that includes a group of 32 poems on the theme of plum blossoms. As used in the context of these poems, the term “rei” means “auspicious” or “good.” “Wa” means “peaceful” or “harmonious.” As Abe further explained, the name has connotations of “spring” and “renewal” – and “a wish for a Japan where everyone and their hopes for the future can bloom.” The timing of the announcement certainly was auspicious as the cherry and plum blossoms in Japan began to open in late March and reached their peak bloom in early April.
Peak bloom or new era?
After a tough winter, during which investors were surprised by a sudden and sharp bear market in the fourth quarter of 2018 (chronicled in our previous commentary, “Winter Is Here”), followed by a strong recovery in the early part of this year, the themes of spring, renewal, and “a wish where everyone’s hopes for the future can bloom” seem to be an apt metaphor for the financial markets. But what’s behind this “early bloom” in the markets? Is it as ephemeral as the two-week peak bloom of the cherry and plum blossoms, or are we in an entirely new era – an era of genuine renewal, a sustainable upturn in which everyone’s “hopes for the future” can continue to bloom?
We think the recovery in the financial markets is sustainable (with some important caveats, which we will note later). However, we wouldn’t characterize this as an entirely new era. Rather, we think what we’re witnessing is merely a return to the previous era – before the acceleration in economic growth that occurred in the middle of last year, and the subsequent slowdown and bear market in the fourth quarter. We think the fourth quarter was an anomaly, and thus the recovery this year reflects a continuation of the existing era (albeit with a brief, and somewhat painful, interruption), not an entirely new era. In short, we think this is the continuation of the bull market, not merely a bear market rally as some have suggested.
Why the interruption?
The tax cuts caused U.S. GDP growth to accelerate last year from 2.2% in the first quarter to 4.2% in the second quarter. As the impact of the tax cuts began to fade, though, growth began to slow to 3.4% in the third quarter and 2.2% in the fourth quarter. The government shutdown exacerbated this slowdown. When investors saw growth in the U.S. slowing, combined with slowing global growth (including, especially, in Europe and China), the Federal Reserve raising interest rates in the face of this slowdown, and what appeared to be a protracted trade war with little evidence of a resolution in sight, they became worried. Many assumed this confluence of events meant we were headed inexorably for a recession, and thus they hit the panic button – selling stocks and triggering the sudden bear market. For our part, while we acknowledged that the economy was slowing, and that there were many global macro issues to be aware of, we nevertheless felt the economy was strong enough to avoid recession. We wrote about this at length in our “Winter Is Here” commentary. And, since we expected to avoid a recession, we believed the downturn in the stock market would prove to be temporary and would be followed in short order by a recovery. Though our predictions are not always right, of course, in this case, that’s exactly what happened.
What changed? What gave us confidence that we were likely to avoid a long, harsh winter?
Three key events occurred late last year that served to rebuild investor confidence. The Fed indicated it would be patient, watching and waiting carefully before hiking interest rates, essentially signaling that it was on pause. The trade negotiations began to pick up some momentum. We went from what looked like a long and intractable trade war to the suddenly real possibility of a trade agreement in the very near future. Finally, favorable economic data, including especially a better-than-expected employment report, signaled to investors that what we were experiencing was, in fact, merely a slowdown, rather the beginning of a recession. Investors breathed a collective sigh of relief, and the market took off, with the Dow, S&P 500, and Nasdaq all posting strong double-digit gains so far this year. International and emerging markets stocks posted strong gains too. Bonds and real estate also recovered. As a result, our diversified asset allocation strategies followed suit. Winter had passed. The cherry and plum trees began to bloom. The birds began to sing. Spring arrived.
The move in the stock market has been mostly upward this year, with only a few brief pauses and slight pullbacks along the way as investors occasionally reacted to soft economic data, questioned the outlook for a trade agreement, or became concerned about a sudden inversion of the yield curve. An inverted yield curve (where the 10-year Treasury note is yielding less than the 3-month Treasury bill) has traditionally been viewed as an indicator of a looming recession. Indeed, inverted yield curves have preceded the last seven recessions. However, as my colleague Brett Dulyea pointed out in a recent The Week Ahead blog post (“Inversion Diversion”), an inverted yield curve is not always a reliable indicator. There’s an old joke among economists that the inverted yield curve has predicted nine of the last seven recessions. That is, it’s notoriously susceptible to false positives. Moreover, as Brett noted in his post, this particular inversion was extremely shallow and short-lived. The yield curve was inverted for just six days, and by only a few basis points (0.03%, to be exact). We would need to see the inversion last at least three months for this indicator to be historically significant. Thus, we have dubbed this event the “Inversion Diversion.” However, while we’re not particularly concerned about the recent inversion, rest assured we will be monitoring this indicator carefully.
Base case in place
In “Winter Is Here,” we outlined our base case scenario for the economy, which called for a slowdown in growth but the avoidance of a recession, at least for the foreseeable future. That continues to be our view, and this scenario seems to be exactly what’s unfolding this year. We expect U.S. GDP growth of about 2% in the first quarter, a further slowing to around 1% in the second quarter, but a pickup during the balance of the year such that full-year growth should be around the 2% level. We would note that the continued slowdown, especially the tepid growth in the second quarter, could rattle investors again, and thus we could see a pullback in the stock market, especially after the strong gains we’ve had already this year. Many investors remain on edge, worried that a recession might be just around the corner. They note that the expansion is getting long in the tooth. After all, this is the longest expansion on record. By July, it will be in its 11th year. While there has been a lot of talk about a “maturing economy” and the “late cycle” (with many observers using the baseball metaphor of “late innings”), we would point out that the length of the expansion is not necessarily an indication that the expansion is about to end. Those investors who were predicting a recession, but have finally conceded that one is unlikely to occur this year, nevertheless think we’ve merely extended the day of reckoning until 2020. We would counter this view by noting that there’s nothing special about 2020 that suggests a recession is inevitable. The baseball metaphor is not relevant since nine innings is a fixed and arbitrary number, and there’s nothing fixed about the length of an economic recovery. It’s quite possible that the expansion could go on for some time beyond 2020. As the old adage goes, expansions don’t die of old age. Most expansions are cut short by the Fed tightening too aggressively (either too quickly or too much, or both). While that was a concern at one point, when the Fed seemed determined to raise rates in the face of a slowdown, at the moment at least, this condition no longer seems to apply. Since this has been an unusual expansion, characterized by below-average growth compared with past recoveries, there’s no reason why a recession should show up with conventional timing. One school of thought is that an unconventional expansion is likely to have an unconventional recession (late, shallow, and short-lived). Accordingly, while we remain on watch for signs of recession, we are also mindful that this expansion could go on longer than many investors expect, and thus we want to be positioned for both potential scenarios.
U.S. stocks – average valuations, but still room to run
Domestic large cap stocks are neither especially cheap nor egregiously expensive. After strong year-to-date gains, the S&P 500 is trading at a forward price-earnings ratio of about 17x, which is roughly in line with its 25-year average. On other valuation measures, U.S. stocks look a bit more expensive, but with continued growth in earnings (albeit slowing growth) and an environment of continued low interest rates, we think they have more room to run. However, given the strong gains already achieved so far this year, we think they have only modest room for further gains by year-end.
A strong recovery for international stocks
We have written in the past about the attractiveness of international and emerging market stocks, even when they were out of favor, as was the case last year. We stuck with them when many investors were abandoning them. We noted that they were cheap compared with U.S. stocks, and we felt they had a longer runway of growth ahead of them given that, unlike U.S. stocks, profits (and share prices) remain below their 2007 peak – more than a decade after the Great Financial Crisis. There’s no question that global growth is slowing too. Europe is experiencing a particular slowdown. We suspect that much of the slowdown is due to the trade issue, which weighs more heavily on many European economies given their export orientation. The uncertainty associated with Brexit doesn’t help either. Emerging markets were suffering from rising interest rates, a rising dollar, concerns about global growth, and a slowdown in China, and the U.S.-China trade war. But we felt these issues were transitory, and we expected that a recovery would eventually unfold. We added to our emerging market exposure in our asset allocation strategies, in part by trimming a portion of our existing weighting in international developed stocks, but also from cash. Once again, in the international arena, our base case scenario appears to be playing out. With the Fed on pause, the dollar plateauing, the recognition among investors that we’re merely experiencing a slowdown and not a recession, and finally a resolution of the U.S.-China trade war in sight, international and emerging market stocks have also posted a strong recovery this year. Both the MSCI EAFE Index, an index of international developed stocks, and the MSCI Emerging Markets Index, are up double digits year-to-date. The Shanghai index, for example, after having suffered a punishing bear market last year, has rebounded sharply, gaining 31% already this year.
Even with the strong gains already this year, international and emerging market stocks still look attractive, trading at a discount to their historical discount relative to U.S. stocks. Moreover, U.S. investors remain under-allocated to them, with only 22% of their overall equity allocation in international stocks compared with a 45% weighting in the MSCI All-Country World Index and a representation of approximately 75% of global GDP.
Headwind removed: The outlook for fixed income
The environment for fixed income – indeed, all income-oriented assets – has improved markedly since the Fed hit the pause button earlier this year on its program of hiking interest rates. We expect inflation to remain at the 2% level, which will allow the Fed to maintain a neutral stance. Wage growth is creeping up, but only at a modest pace. We don’t expect the Fed to raise interest rates this year, but unlike some investors, we also don’t expect the Fed to cut rates either. If it did, that would likely send a negative signal to the markets, causing investors to suddenly worry that something must be seriously wrong with the global economy. As a result of this neutral Fed policy, bonds, which previously faced a headwind from rising rates, are slightly more attractive now than previously, though not all that attractive given their still relatively low yields. Nevertheless, we think bonds should still be a part of most investors’ portfolios. In this new environment, we think investors can be more confident about earning their coupon income without any offsetting decrement in price from rising rates, but we don’t expect much, if any, price appreciation. Despite the somewhat more favorable environment, we remain relatively defensively positioned with our fixed income allocation, with a relatively short duration and an emphasis on quality. With credit spreads relatively tight, and credit metrics generally unfavorable (e.g., rising debt levels, covenant-light loans, EBITDA adjustments), we have chosen to stay cautious. We favor high-quality municipal bonds for their tax benefits, relatively short Treasury securities (e.g., 2-year Treasury notes), investment-grade corporate bonds, residential mortgage-backed securities (both agency and non-agency), and commercial mortgage-backed securities. We have relatively limited exposure to high yield corporate bonds, floating rate bank loans, emerging market bonds, and other credit-oriented securities. We continue to wait patiently for opportunities to boost our position in these areas should they become attractive again.
MLPs – the oil and gas “toll road”
Earlier this year, we identified what we believed to be an attractive opportunity in MLPs (master limited partnerships). Midstream MLPs own the pipelines that transport oil and gas across the country. In a sense, they’re like a toll road, collecting revenue on the volume traversing through their pipelines (with little direct commodity-price exposure, as is the case with upstream oil and gas exploration and production companies, for example). In particular, we observed that some of the MLP closed-end funds were selling at discounts to their NAVs (net asset values). We took advantage of this opportunity by buying a select group of MLP closed-end funds in some of our more appreciation-oriented asset allocation strategies. (Note: We deliberately did not purchase these in the asset allocation strategies at the more conservative end of the spectrum since these assets can be volatile at times and thus we felt they were inappropriate for those strategies.) We think these assets remain attractive, and we continue to own them for the time being.
Positive, but cautious
As we sit here today, we remain positive about the outlook for both the economy and the financial markets for the balance of the year, even with the strong gains already achieved year-to-date. Our base case scenario is playing out nicely. We think economic growth will remain solid, even as it slows back to its earlier 2% trend line, with no sign of recession in sight (but, again, we’re watching things carefully). Fed activity appears to be on hold for the time being. We don’t expect a rate hike or a rate cut this year. All of this sets a favorable backdrop for the financial markets going forward. Of course, lots of things can happen throughout the year that can rattle investors, and thus we could see a pullback at any time. We’re prepared for whatever might crop up, with a diversified portfolio, some cash holdings, exposure to short duration, high-quality bonds, and other less-correlated assets (e.g., real estate, merger arbitrage funds, balanced funds). The biggest risk is probably a failure to achieve a trade agreement between the U.S. and China. Signs of a further slowdown in global growth (beyond the already expected slowdown) would most certainly be bad for the markets. And, as is always the case, there are plenty of things to worry about – including Brexit, the political divide in Washington, the rise of populism, geopolitical risks (e.g., North Korea, the Middle East, Syria, Russia). However, if we were to get a pullback, we expect that it would likely be shallow and short-lived and may even present us with attractive opportunities.
Put away your fleece jacket, beanie, and boots. It’s time for short sleeves, shorts, and flip-flops. The sun is out. The birds are singing. And the blossoms are blooming. Spring has arrived! The financial markets have recovered. We think the rest of the year will continue to be good, although as always, we remain vigilant about the risks, which are ever-present. We remain diversified, playing both offense and defense simultaneously. Yet now’s the time to enjoy life. If you get the chance to visit Japan – or Washington, D.C., or Portland, Boston, or Philly – revel in the beauty of the blooming sakura and ume. Engage in the Japanese tradition of hanami (“watching blossoms”) – gathering under these magnificent trees to picnic, drink, barbeque, and spend time with family and friends. May this era be characterized by “reiwa” (auspicious harmony and peace). May your hopes for the future bloom.
As always, we appreciate your confidence and trust in us. Should you have any questions, please don’t hesitate to reach out to your Wealth Advisor.