After the tumultuous winter of 2018, when virtually every asset class declined and stocks suffered a bear market in the fourth quarter, the spring recovery (chronicled in our previous commentary, Early Bloom) has continued into the summer months of this year. The S&P 500 rose 3.8% in the second quarter and has gained 17% year to date, posting its best performance in 22 years. However, it hasn’t been an entirely smooth ride in 2019. As our Early Bloom piece forecasted might happen, the stock market experienced a bout of volatility in May as investors grappled with the seemingly endless and worsening trade war. The breakdown in negotiations with the Chinese and President Trump’s threat to impose tariffs on Mexico rattled investors. The volatility was short-lived, however, and the market resumed its upward path in June, defying gravity yet again. Despite the favorable trend, we caution investors against becoming complacent. Underlying investors’ cheerful mood and the rising stock market is an ongoing battle for supremacy between two warring camps: the “hawks” and the “doves.” These two camps are battling it out across three key economic and geopolitical fronts: global central bank policy, geopolitical tensions, and the trade war. How this “war” plays out over the next few months will be critical for determining where the economy and the financial markets go from here.
So far, the doves are winning most of the battles. They may look soft compared to the hawks, but they’ve been able to prevail nonetheless. Their ascendency, however, is a recent phenomenon, and it’s been punctuated by periods when the hawks have gained the upper hand, at least temporarily, before losing out to the doves once again. In this issue, we explore this unfolding drama and what it means for investors. If the hawks, which are known for their keen intelligence, sharp vision, and hunting skills, regain dominance over the doves in any of these key areas, we could be in for trouble. On the other hand, if the doves, which are known for sociability, loyalty, consistency, affability, and a placid, peaceful demeanor, maintain their dominance, we would expect the favorable investment environment to continue. Hawks versus doves is likely to be the defining feature of the financial markets at this critical juncture. Whether you’re engaged in the battle or merely watching from the sidelines, get ready for an epic aviary fight.
The Fed Pivot: From Normalization Back to Easy Money
“Whiplash” might be a good word to describe the impact of recent Federal Reserve policy. We recently witnessed a truly remarkable occurrence, where the Fed has gone from raising rates four times in 2018 – with the expectation of further rate hikes in 2019, as it set out on a path of “normalization” – to suddenly pausing its planned rate hike policy to now signaling its intention to cut rates! And all of this has occurred in the span of six months. Fed Chairman Jerome Powell, who is normally viewed as a dove – the successor of a long line of former Fed chairs, including Janet Yellen, Ben Bernanke, and Alan Greenspan, who were also viewed as doves – suddenly turned hawkish late last year as he embarked on the process of normalization (returning monetary policy to a “normal” stance after the unprecedented accommodative policies put in place to spur a recovery from the financial crisis and the Great Recession). Powell’s and the Fed’s insistence on raising rates in the face of an obviously slowing global economy – made worse by the prospects of a lengthy trade war – is what caused alarm among investors, helping trigger the sharp sell-off in the stock market in the fourth quarter. Powell’s use of the word “autopilot” really spooked investors. He seemed hell-bent on raising rates, no matter the data, no matter the cost. In investors’ minds, this meant the risk of recession had now gone way up. The economy was not just headed for a slowdown but rather a possible contraction – hence, the bear market in stocks in the span of a single quarter! The normally dovish Powell, who had suddenly turned hawkish, was now at odds with the dovish camp, which included two key constituents – none other than President Donald Trump and the majority of investors. Not that all investors are on board with Trump politically, of course, but they share a common objective: They want the economy to remain sound and the stock market to continue to climb.
Trump’s tweet on May 5 indicating that he planned to slap new tariffs on Chinese goods seemed to be the turning point for Fed policy. The tweet came just four days after the Fed meeting when policymakers had agreed to hold interest rates steady but indicated that they were merely pausing their plan to raise rates. However, as the economic data softened, trade tensions escalated, and inflation remained below target, the Fed suddenly signaled it was likely to cut rates. Trump’s threat to impose tariffs on Mexico likely added to the Fed’s decision to pivot. As many as seven Fed governors forecast a half a percentage point cut in the federal funds rate for this year. Powell’s and the Fed’s pivot from dove to hawk and back to dove again – in a span of less than a year – is really quite remarkable. It’s probably the single biggest reason for the bear market last winter and the subsequent strong rebound so far this year. Even Mario Draghi, the chairman of the European Central Bank, has gotten in on the act, signaling a likely shift in ECB policy from normalization to accommodation.
As usual, the outlook going forward will depend on the economic data, but what’s most critical is whether the hawks or the doves will prevail in reacting to the data. With a slowing global economy, exacerbated by the trade war, the doves are in control for now – effectively forcing the Fed and the ECB to adopt an easy-money stance. But if the trade war is resolved, growth reaccelerates, and inflation begins to pick up, we could see the hawks suddenly enforce monetary discipline and call for a resumption of normalization. The shift from cutting rates to suddenly hiking rates – a pivot in the opposite direction of the one we just experienced – could catch investors off guard.
The Axis of Evil
Apart from the geopolitical threat posed by China and the trade war, which will be addressed later, a number of other emerging geopolitical tensions around the world bear watching very carefully, as they threaten to derail the bullish run in the markets (to say nothing of the much more important threats they pose beyond those simply to investors’ wallets). The most pressing of these are probably two of the members of what former President George W. Bush referred to in his State of the Union speech in 2002 as the “Axis of Evil”: North Korea and Iran. (The third member of the Axis of Evil named by Bush was Iraq. Although Iraq has been ravaged by cycles of warfare and the country continues to face enormous challenges, including political, sectarian and tribal conflict, corruption, and a displaced population, the three-year military effort to remove ISIS has brought at least some stability, even if at the cost of spreading extremism elsewhere. As a result, in this piece we have chosen to exclude Iraq as a key geopolitical threat at this point).
A Love Letter From Little Rocket Man
North Korea remains an ever-present threat to geopolitical stability. Although Trump has made an effort to negotiate the denuclearization of North Korea by engaging Kim Jong-un at two summits, the first in Singapore and then another in Hanoi, those efforts have failed, so far at least. The recent handshake between the two leaders at the demilitarized zone, which resulted in an agreement to restart talks, is a positive development. But many longtime experts on North Korea remain skeptical about whether Kim Jong-un is serious about striking a deal involving full denuclearization in return for sanctions relief and, even if he is, whether he will live up to a deal, given his failure to honor past agreements.
In this drama, it’s not always easy to say exactly who the hawks and doves are, since for certain actors, the roles often switch at any given moment. South Korean President Moon Jae-in is clearly a dove. He has worked tirelessly to get the U.S. and North Korea together in an effort to try to strike a deal. Trump at times has seemed quite hawkish, with a series of tweets where he has called Kim “Little Rocket Man” and a “madman, who doesn’t mind starving or killing his people”; implied that Kim is short and fat; and threatened him by saying“North Korea will be tested like never before”, “They will be met with fire and fury like the world has never seen.”, and “Military solutions are now locked and loaded.” Yet, at other times, Trump has sounded quite dovish, fawning over the North Korean leader, saying he received a “warm letter” from Kim and “He wrote me beautiful letters and we fell in love.” His sudden and last-minute tweeted invitation to Kim to meet at the DMZ in late June immediately after the G20 meeting, which was politically risky given that Kim might not have accepted the invitation, was yet another example of Trump’s dovish stance.
Two members of the Trump administration who are clearly hawks are National Security Advisor John Bolton and Secretary of State Mike Pompeo. During the Hanoi summit, when it became clear that Kim had rejected Trump’s proposal to remove sanctions in return for complete denuclearization, in favor of a gradual reduction in nuclear weapons, Trump was reportedly tempted to take a more modest offer from Kim, the dismantling of the Yongbyon nuclear facility. Pompeo vigorously opposed Kim’s proposal. In the end, Trump rejected the proposal and walked away from the summit in Hanoi without a deal. As Trump departed the French colonial Metropole Hotel, it became clear that the hawks had prevailed. But fast-forward to the end of June, when Trump crossed into North Korean territory, the first sitting U.S. president ever to do so, and then he and Kim crossed back into South Korea, where they joined South Korean President Moon for an hourlong meeting at the Inter-Korean House of Freedom; it was clear that the doves were back in ascendency, at least temporarily. History was made, but as one expert on North Korea commented, “Will it lead to an actual agreement, or was it merely theater?”
Marching Toward War: The Twitter Tiger
Perhaps the most pressing geopolitical threat is a possible military conflict between Iran and the United States. The roots of the conflict perhaps can be traced to Trump’s decision to pull the U.S. out of the Iran nuclear agreement and the reinstatement of former and introduction of new sanctions against the Iranian regime. Many viewed this as a hawkish move. It’s widely believed that U.S. policy toward Iran is being driven by the two principal foreign policy hawks in the administration, John Bolton and Mike Pompeo. Bolton, who is considered one of the key architects of the war in Iraq, has been an outspoken advocate of military conflict with Iran for some time, even before the current tensions. In a 2015 op-ed piece in the New York Times titled “To Stop Iran’s Bomb, Bomb Iran,” he argued that only military action could prevent Iran from acquiring a bomb. Trump has issued a number of hawkish tweets during the recent crisis, including one saying, “If Iran wants to fight, that will be the official end to Iran. Never threaten the United States again!” With foreign policy hawks in both the U.S. and Iran in control, with each passing day it seems the two sides have moved closer to a potential conflict. Iran allegedly attacked two oil tankers in the Gulf of Oman and shot down a U.S. drone in the Persian Gulf. In the wake of the attack on the tankers, many assumed the U.S. would escalate tensions, including with a possible military response, but instead, the Trump administration called for a dialogue, a decidedly dovish move, suggesting that perhaps the hawks had been kept in check by the doves, at least temporarily. However, after the downing of the U.S. drone, Trump ordered a military strike against Iran – and thus the hawks were back in control – at least until Trump suddenly changed his mind and called off the strike at the last minute, citing concern over Iranian casualties. Trump had suddenly shifted from hawk to dove. The hawks criticized Trump for calling off the strike. Given that he announced the move using his preferred form of communication – Twitter – he was dubbed a “Twitter tiger,” someone whose threats cannot be taken seriously.
Trade War or Cold War
One of the most significant battles between the hawks and doves is the trade war. Leading the hawks is Trump’s Director of the Office of Trade and Manufacturing Policy, Peter Navarro, a longtime, outspoken critic of China. Navarro has authored books with titles such as The Coming China Wars and Death by China (the latter of which has been made into a documentary film). He has also been an opponent of the North American Free Trade Agreement (NAFTA) and the Trans-Pacific Partnership (TPP). Navarro has been a supporter of Trump’s threat to impose tariffs on Mexico unless Mexico takes more aggressive steps to stop illegal immigration to the U.S. Another trade hawk, promoting the administration’s tough stance on China (and other trading partners), is Robert Lighthizer, the U.S. Trade Representative. Lighthizer has been the lead negotiator for the U.S. in the trade talks with the Chinese. In the dove camp, we have administration officials including Treasury Secretary Steven Mnuchin and the Director of the National Economic Council, Larry Kudlow.
Many advisors behind the scenes fall into one or the other camp. For example, longtime China expert Michael Pillsbury, who authored the book The Hundred Year Marathon and serves as a consultant to the Trump administration, explains in his book that like most orthodox China experts in the U.S., he was a dove for many years, until he spent time interviewing numerous Chinese hawks (in China) who gradually revealed China’s strategy for economic ascendency, which caused him to become a hawk. (Pillsbury might not characterize it in exactly that way, but that’s my take based on my reading of the book and having watched and read numerous interviews with him.)
At various points during the trade dispute, the hawks have prevailed over the doves, while at other times, the doves have gained the upper hand. With the breakdown in negotiations between the two sides and the failure to reach an agreement in May, various sources with insider access to the talks suggest that the Chinese hawks, unhappy with what lead negotiator Liu He had apparently agreed to, altered the agreement at the last minute, which caused the Trump team to walk away from a deal. Liu, who has studied in the U.S. at Seton Hall and holds a master’s degree from Harvard, is viewed as a reformer (i.e., a dove). Although he has been appointed the lead trade negotiator by President Xi Jinping, that doesn’t mean he has free reign in all matters. Apparently, so the story goes, Xi gave Liu a broad outline of the terms he would be willing to accept in an agreement, but without the details. The agreement was 90% done, but when the Chinese translated it from English back into Chinese, it contained language and demands that were too stringent and unacceptable to the hawks, and thus the hawks redlined much of the agreement. When the U.S. negotiators received the redlined agreement, they felt the Chinese had gone back on already agreed-upon terms, which in turn caused Trump to walk away from the bargaining table and threaten to raise tariffs. In this round of the trade talks, the hawks – both the Chinese and the U.S. hawks – had won. However, with Trump’s meeting with Xi at the recent G20 meeting in Osaka and the agreement to restart talks again, perhaps the doves are now back in control. A successful agreement seems to come down to whether the hawks and the doves can find common ground. Strangely, Xi and Trump often seem caught in the middle – siding with the two different camps at different times.
Can Liu, the reformer dove, prevail over the hardline hawks in China? Will Navarro and Lighthizer convince Trump to hold out for a robust agreement, covering important issues such as not only the trade imbalance but also intellectual property theft, forced technology transfer, government-sponsored spying, government support of state-owned enterprises, dumping, etc. – or will Trump settle for a less-than-robust agreement just to get a deal done and “win” in an effort to declare a victory before the 2020 election and keep the global economy and stock market afloat? For our part, we think there will be an agreement that is somewhere between these two extremes. We doubt it will be a “light” agreement, involving the Chinese simply buying more Boeing aircraft and soybeans, which would likely be disappointing to the markets, but we also don’t think it will be a final, comprehensive agreement settling all issues once and for all (like a big gift box all wrapped up with a neat bow on it!).
Based on the examples outlined above, perhaps a pattern is emerging. Trump, who is surrounded by many advisors who are hawks (e.g., Bolton, Pompeo, Lighthizer, Navarro), often talks tough initially, sounding very much like a hawk, but then he often goes against the hawks (perhaps listening to the doves or his own instincts) and ultimately backs down, exhibiting dovish behavior. Is Trump a hawk or a dove? Some would say he talks like a hawk but acts like a dove.
Hawks and doves mean different things in different contexts. And we should be abundantly clear here – we’re not saying one or the other is right. We’re not saying doves are right and hawks are wrong or vice versa. What we’re saying is each is called for at different times and in different contexts. For example, if the global economy is weakening and the Fed seems determined to maintain a hawkish stance by raising rates in the face of the global slowdown (on autopilot), then the situation calls for a pivot from hawk to dove. Conversely, if the economy is accelerating and inflation is picking up steam, perhaps a more hawkish framework (a normalization of monetary policy through a reduction of the Fed’s balance sheet and rate hikes) is appropriate. Foreign policy is much more complex, and reasonable people can differ on the appropriate response to any given situation, but if we’re attacked by an adversary, perhaps a military response is appropriate. On the other hand, provoking a conflict unnecessarily or allowing the country to be drawn into a conflict that could lead to a lengthy and devastating war without assessing other options first is probably not the appropriate response.
Portfolio Positioning in an Era of Hawks Versus Doves
With the battle between hawks and doves across three key fronts – central bank policy, geopolitical tensions, and the trade war – how are we positioning our clients’ portfolios? We have a base case scenario that suggests the economy is sound, even if slowing; a recession is unlikely for the foreseeable future; inflation remains in check; the Fed will likely lower interest rates; a trade agreement will eventually be struck; we’ll avoid war with North Korea and Iran; and over time, the markets will move gradually higher from these levels. That is, the doves will largely prevail over the hawks.
However, we recognize that an alternative scenario may play out instead. The hawks might prevail on one or more of these fronts – e.g., the trade war worsens, the Fed makes a policy mistake, or we end up in a military conflict of some sort. To account for both our base case scenario, which is the more likely option, and also the possibility of an alternative, less-favorable scenario, first and foremost we rely on the time-tested strategy of diversification. Many of our clients have balanced portfolios, which are diversified across multiple asset classes, including stocks, bonds, real estate, and alternative strategies (and various sub-asset classes within each major asset class). We also rely on our tactical asset allocation process – overweighting attractive asset classes and underweighting (or outright avoiding) less attractive asset classes – which is driven by a valuation-oriented framework. Finally, in an environment right now where either hawks or doves could prevail, we think it’s important to play both offense and defense simultaneously.
Offense and Defense
What do we mean by playing offense and defense simultaneously? Here are some concrete examples.
- We are overweight stocks versus bonds generally.
- While the majority of our equity allocation is in high-quality, U.S. large-cap stocks, we have meaningful exposure to both international developed and emerging market stocks.
- We own publicly-listed real estate investment trusts (REITs), which have characteristics of equities.
- We own some master limited partnership (MLP) closed-end funds in the energy pipeline space.
- We have some modest credit exposure in our bond allocation, including corporate bonds, mortgage-backed securities, leveraged bank loans, and a small weighting in high yield bonds.
- We hold some cash in our standard asset allocation strategies (note that this may not hold true for certain specific client portfolios given their unique liquidity needs).
- Although we are broadly overweight stocks versus bonds, we purposely do not have a dedicated allocation to more volatile small- and mid-cap U.S. stocks.
- In general, our bond allocation remains defensively positioned, with a shorter duration than standard bond benchmarks and an emphasis on high-quality bonds (e.g., U.S. Treasury notes, short duration bond funds, investment-grade corporate bonds, mortgage-backed securities).
- We have no dedicated exposure to high-yield bonds.
- We own certain income-oriented assets that have favorable characteristics in a declining interest rate environment (e.g., REITs, MLP closed-end funds, infrastructure stocks).
- We own several less correlated alternative strategies and strategies with favorable downside capture (e.g., REITs, merger arbitrage, balanced funds, infrastructure stock funds).
So Far So Good, but Remain Vigilant
We believe we’re in a favorable environment for financial assets, with a sound economy, no recession in sight, inflation in check, declining interest rates, the expectation of a trade agreement, and geopolitical tensions that fortunately have not escalated. Therefore, with the current environment playing out essentially in line with our base case scenario set forth at the beginning of the year (except for, perhaps, the extension of the trade war), we remain constructive on the outlook for the balance of the year. However, we know that this environment can change at any time. The hawks and doves continue to battle it out across multiple fronts. Which side prevails will determine the future. Accordingly, we remain vigilant.
We’re looking for signs of a possible further weakening of the global economy and a recession. We’re watching geopolitical tensions – such as the brewing conflict with Iran and the ever-present threat of North Korea – like a hawk (no pun intended). All eyes are on the Fed and the trade war. Should our base case scenario change – or an alternative scenario begin to unfold – rest assured that we will endeavor to move swiftly to make the necessary changes to protect capital (and look for opportunities as well). In the epic aviary battle between the hawks and the doves, may the players exhibit the best qualities of both – the keen intelligence, vision, and skill of the hawks and the sociability, loyalty, and peaceful behavior of the doves.
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.