The third quarter showcased similar volatility to that seen in the 2nd quarter with significant swings in equities. Going into the quarter we saw risk assets sell off over the summer months only to recoup those losses and more during September. A few of the key headlines we have been following:
- The market continues to monitor the Fed closely as a rate cutting cycle began in Q2 with the first cut since 2008 on July 31 followed by an additional cut in mid-September.
- In late October, the Fed cut rates for the third time this cycle, taking the Fed funds rate to 1.75% and indicated a pause is likely and the market quickly priced that in.
- The potential for volatility remains elevated and we anticipate rate expectations will change quickly if that volatility comes to fruition.
- As of July, we are now in the longest economic expansion in US history as shown below.
While we remain cognizant of the potential for the expansion to continue, we are balanced in our risk assessment and looking for opportunities to manage risk while still maintaining an appropriate level of exposure to growth assets. While the yield curve has recently steepened with much of the inversion that has characterized the fixed income market in 2019 fading, we continue to believe the risk of a near to medium term slowdown is possible and we are investing accordingly. At the beginning of Q3, The International Monetary Fund cut its global growth forecast for 2019 for the second time in as many quarters as the weight of global trade tensions dampens the prospect of enhanced growth. The chart below represents a model of the probability of a recession 12 months ahead. It is now near its highest reading since the Great Recession. Note, while it is only ~30%, it rarely exceeds 40-50% prior to the onset of a recession. The actual inception point of an economic recession is generally only able to be determined after the fact, therefore the indicator never approaches 100%.
We remain focused on managing risk in client portfolios wherever prudent while continuing to meet each client’s overall objectives. While equity valuations appear stretched and yields are decreasing, we are still finding opportunities in some sectors of the market. See our details model commentary below.
This income generating portfolio continued to provide solid returns in Q2, generating much of the return through distributions as designed. After reducing equity exposure in the fund during Q2, we continued to look for opportunities to reduce risk again in Q3 in order to maintain principal when volatility increases while continuing to produce steady income. We reduced our high yield bond exposure as spreads compressed to medium term lows. We moved most of this exposure to investment grade credit, largely high-grade corporate bonds and mortgages. This reduced the portfolio yield by less than 15 basis points while allowing us to move significantly up in quality. We will continue to look for similar opportunities until a dislocation in the market present opportunities to once again increase risk.
We maintained the portfolio this quarter after we took advantage in Q2 of a sell- off in risk assets to add some value stock and preferred equity exposure. We continue to maintain the portfolio in a risk-off stance with a significant allocation to short term bonds. However, the changes in Q2 have allowed us to take advantage of the continued increase in risk assets that began late in the quarter and has continued into the fourth quarter. These equity exposures give us a lever to reduce risk further if we see financial conditions tighten as we approach the end of 2019.
Large Cap US stocks outperformed other equity sectors in Q3, returning 1.7%, as international and small cap lagged. This gave the Par 4 portfolio a boost as it is largely comprised of large cap domestic firms. After going up in quality by moving into Amgen and CVS over the summer, we maintained the portfolio during Q3. We continue to look for value opportunities but as the market continues to rise, these are becoming increasingly difficult to come by.
Preferred Equity & Fixed Income
Fixed income performed well in Q2 with all sectors including government, investment grade, high yield, and mortgages all positive. Longer term bonds were the best performer with 10-year treasuries entering Q3 near 2.00% and closing the quarter at 1.66% as fixed income investors continue to signal fears of an economic slowdown. Preferred equity benefitted from the lower yields and stable credit spreads by increasing in price. Preferred equity portfolios that were created in Q2 and early in Q3 near 5% yields are now trading closer to 4-4.5%.
Large cap US growth stocks led the way once again during Q3 as the outperformance versus value continued. The US also outperformed international developed and emerging markets as both were negative for the quarter. We believe that the long running underperformance of value and international will eventually end as we approach the latter stages of this economic cycle. It is not possible to time the market turn but we are positioning to take advantage of depressed valuations in both value stocks as well as international equities. The chart below shows the 20-year average of emerging markets versus the S&P 500 may indicate emerging markets are ~30% undervalued at the moment.
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