Last year was characterized by central banks raising interest rates and tightening liquidity which caused essentially all asset classes to decline. As promises of rate increases have dramatically shifted to expectations of rate cuts this year, virtually all asset classes have reversed course. Stocks, bonds, and commodities have all rallied, making this year the opposite of 2018 (chart of past year’s asset class performance above) as central banks again take center stage, but this time to provide lower rates which has caused risk-on assets (like stocks) and risk-off assets (like gold and bonds) to rally simultaneously.
With earnings expected to decline year over year as second quarter corporate results are reported in July, the underpinnings of the equity market rally are far more a response to accommodative central bank policies versus higher growth expectations. Worldwide growth expectations have continued to decline led by a downturn in manufacturing. Global manufacturing indices like the purchasing managers index are now in contraction in aggregate and falling in a majority of countries. The May increase in tariffs on $200 billion of Chinese goods from 10% to 25% is just beginning to show up in economic data with a strong likelihood that growth will continue to dampen.
We do have some concerns that the central bank-fueled rally can continue without signs of noticeable economic improvement. Leading indicators of such improvement continue to be hard to find, and while large cap indices have made new highs, small cap stocks along with most international indices are lower than where they traded a year ago. Growth concerns and divergences amongst indices have led to us continue to be underweight stocks, as has been the case since last summer/early fall.
At present, our base case is the global economic downturn will not lead to a U.S. recession. Typically bear markets are limited to 20% declines when a global slowdown occurs that is not accompanied by a U.S. recession, as experienced during the fourth quarter of 2018. Concerns for a larger pullback would occur if U.S. economic data begins to point toward recession, as simultaneous global and U.S. recessions typically see a median stock market pullback in excess of 30%. As a result, we have remained underweight stocks for about a year on concerns of slower growth but do not feel as if a major bear market is imminent. We continue to closely monitor the U.S. economic picture to see if it follows the global economic trend which has been deteriorating since last summer.
Slower growth has provided the underpinnings for a strong rally in bond prices. Interest rates on a 10-year Treasury bond peaked last September at 3.2% and have fallen to 2.1% currently. Instead of leading, central banks have been following the action in bond markets to dictate policy moves. With a current Fed funds target of 2.3% and 2-year and 5-year Treasury notes both yielding under 1.9%, we expect the Fed to move its short-term targeted rate toward the lower yielding Treasury notes in the coming months.
Both risk-on and risk-off assets have been rallying to begin the year, yet slower growth and central bank expectations of easier monetary policy appear to be the catalysts for both the rallies in stocks and bonds. With limited signs of economic improvement, we have concerns about how long the equity market rally can continue. As long as this continues, we will likely remain overweight bonds at the expense of stocks in asset allocation strategies at JNBA.
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