Q3 2019 Market Outlook:
A Descent into the Maelstrom
Off the Lofoten Islands on the Norwegian coast, the sea regularly forms massive open-water whirlpools called maelstroms. From the summit of Mt. Helseggen an observer can see the inky sea coalesce into a vortex fully one mile in diameter and hear the emanating roar like a waterfall shrieking in agony. The tidal force is powerful enough to swallow whales that venture past the event horizon — they impotently bellow and thrash as the void takes them in. The locals know to stay far away.
In Edgar Allen Poe’s “A Descent into the Maelstrom,” a fisherman gets caught in the Lofoten whirlpool. There is no escape. Knowing resistance is futile, the fisherman resigns himself to his fate. As the jet-black walls of the funnel close in, he notices that certain objects fall at different speeds according to their shape. He uses this flash of insight to escape the vortex.
Investors are caught in a Fed-induced maelstrom, as equity markets are now driven by monetary policy expectations. Witness the 20% S&P decline in Q4 2018 resulting from the Fed’s tampering. If the Fed fails to meet market expectations for multiple rate cuts in the second half of 2019, the likely results will be equity market decline and a volatility spike. Investors are just along for the ride.
How should investors navigate the Fed maelstrom? Like the fisherman of Lofoten, with a detached, scientific mind.
But first, what happened in Q2?
2019 Q2 Market Summary
The US Economy: Still number one with a bullet.
With unemployment at 49-year lows and strong GDP growth, the US economy continues to top the economic charts and maintain its positive growth momentum. Investors have few concerns about a recession in the short-term. Markets are focused on trade disputes and Fed policy as drivers of the economy.
US Equity markets sell in May, swoon in June, and end up 18% YTD. Gold hits 6-year highs.
After an April lull, the S&P dipped 5.9% in May then rose to new all-time highs in June. The Fed’s anticipated rate cuts and possible resolution of trade disputes could provide momentum for further equity gains in H2. But look out if rates and trade go the other way. New market highs were accompanied by successful IPOs of Beyond Meat, Chewy, and Crowd Strike, each with much-hyped first day pops.
US credit markets have strong H1 returns and sovereign debt yields hit new lows.
Low defaults and high total returns continued through Q2. H1 returns in Investment Grade (9.9%), High Yield (9.9%), and Leveraged Loan (5.7%) indices defied bearish expectations of late 20181. Returns may be tempered through the remainder of the year with gains already front-loaded.
Sovereign 10-year bond yields are at new lows as negative rates continue in Germany, Japan, and Switzerland2. The US 10-year is a comparable high-yielder tossing off 2.0%.
Central Bank Update: The Federal Reserve is now likely to slash rates in 2019. Major central banks are stuck with low rates.
What a difference six months makes! In was only in December that 2019 was destined to be a year of interest rate hikes and balance sheet normalization. Alas, it was not to be. The Fed has completed a full 180 and rates are now expected to be cut this year. Consider these cuts a pre-emptive strike against a recession.
The ECB, as expected, held rates steady in Q2.
Global Equity Markets steady as she goes with a great H1.
After double digit declines in 2018, global equity markets roared back in 2019. Whatever woes are facing the world, they haven’t shown up in stock prices. Equity markets in Australia, Argentina, Russia, Switzerland are all near all-time highs. Slow economic growth and rising populism may increase market risk in Europe. Market volatility remains below 2018 levels.
A look to Q3 – Three Lessons from the Maelstrom
The Fed has set expectations for lower rates in 2019. Already a gap has developed between the Fed’s statements and market expectations. The Fed has messaged a one-off rate cut, while the futures market has priced in several. This source of friction will drive equity returns for the remainder of the year. Here is how to navigate the maelstrom and remain sane while doing so.
1. Managing risk is about accepting risk, not avoiding it
The Lofoten fisherman works in a dangerous location. By venturing near the whirlpool, he is able catch more fish in one day than most can haul up in a week. Eventually, his speculation results in disaster. The potential (and almost realized) downside was complete catastrophe. No investor would accept that potential risk.
Equity investors risk portfolio decline and a volatility spike if the Fed ignores the market’s desire for multiple rate cuts. So how can an investor manage risk? By realizing that investment returns come with trade-offs that aren’t only about loss. An investor with low tolerance for investment losses, for example, will hold only T-bills (and accept the certainty of negative real returns). Risks can be managed by allocating to investments that are less correlated with the broader market and to sectors more resilient to recession. By accepting other trade-offs, such as lower liquidity, less frequent reporting, etc., investors can receive non-correlated returns and volatility mitigation simultaneously.
The S&P will go where the Fed takes it. An investment portfolio focused on safety will be less linked to monetary policy whims. Consider the boring, safe option as a way to sleep easy as the storm rages.
2. When the market changes, adjust your portfolio balance accordingly
To a fisherman, the ship is safety. As long as it remains afloat, there is no better place to be; not so with the physics of the whirlpool. The weight of the ship makes it certain to sink. To save himself, the fisherman straps himself to a barrel and jumps overboard. The light barrel provides the buoyancy to ride out the whirlpool and survive.
Investors have enjoyed over a decade of positive equity market returns. Few investors would have predicted a record bull market after the crisis of 2008. Index funds have performed well in times of easy equity gains and record low volatility… so why change what has worked for so long? Because late in the cycle, a shift is inevitably coming.
Besides monetary policy, other macro events contribute to market turmoil. Escalating trade disputes, yield curve inversions, tensions in the Middle East, and worldwide rising populism each have the ability to catalyze market declines into chaos. Investors should consider what a smart portfolio allocation would look like if multiple macro events were to occur.
A well-balanced portfolio can help investors survive market uncertainty. If the Fed’s monetary bullets fail to stop a recession, then underperformance will be a new reality for investors. In the maelstrom, smart allocations focused on active management, diversification, alternative strategies, or income producing holdings can provide a way to stay afloat in a volatile market.
3. Investors should not be satisfied with mere survival
The whirlpool trapped the fisherman for six hours and cost him two brothers and the ship. He survives, but is broken in body and spirit. His hair turns from raven-black to white. The fisherman never sets foot in the ocean again. He was undone by the maelstrom.
Investors who grew up during the financial crisis 2008 have lingering scars. A recent survey by Capital One showed that 93% of millennials distrust the market and that they hold over 40% of their wealth in cash. Once bitten, twice shy and all wrong.
Their perception of the market was indelibly tainted. An over-allocation to cash may help them sleep, but it costs them dearly. Investors cannot avoid the maelstrom, but they can and should control their reaction to it. Creating an investment plan is a good first step. As is avoiding excess cash drag, which invisibly reduces gains and doesn’t allow for the miracle of compounding. Further, seeking the help of a third-party, like a financial advisor, can provide the perspective necessary to make unbiased decisions in any weather.
Edgar Allen Poe frequently explores the idea that people confronted with overwhelming experiences can either lose their mind or use their mind to save themselves. Investors can take advantage of the current market calm to position themselves for choppy waters. “You can’t fight the Fed” says that old chestnut… True, but you can cooperate with it. The Fed is driving the market, but if you use your mind it doesn’t have to be an unpleasant ride.