HFG Market Update

August 5, 2019
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The Song Remains the Same…

If you are a fan of Led Zeppelin, this must be running through your head.  The 6% market decline over the past 5 days has prompted speculation from the TV talking heads as to whether or not this is a signal that the U.S. is headed into a recession and if this is the start of something bigger.  Does this sound familiar?  It should – because they are the same talking points that were made during the 4th quarter, and earlier this summer.  As we pointed out then in our May update, the market reaction regarding the trade dispute was too severe given the impact on the U.S. relative to China, and the fact that the Fed had shifted its policy stance significantly.

Last week, the Fed cut short-term interest rates by 25 basis points, moving the range for the federal funds rate down to 2.00 – 2.25%. It also announced it will stop reducing its balance sheet in August, two months earlier than previously planned, which is an intellectually consistent move as there is no need to ease through rate cuts and tighten through balance sheet reductions.  Interestingly, these moves came against a backdrop of better-than-expected economic data since the last meeting in June.  Chairman Powell’s press conference confirmed the view that our economic performance is “reasonably good” and the outlook is “good,” as well.

From a purely economic view, it does not seem that a rate cut was needed.  Nominal GDP (inflation adjusted) is 4.0% over the past year, and still stands well above the Federal Reserve’s target for short-term rates.   As we spoke about in our summer Insights  , the 25 basis point cut may actually create unintended consequences on corporate spending.  By cutting rates only 25 basis points and leaving alive expectations of further gradual cuts at future meetings, the Fed has possibly created an incentive to postpone economic activity.  If there was a clear economic reason to cut rates, a larger 50 basis point cut would have told businesses and consumers considering big-ticket purchases the Fed is ahead of the curve and the issue would have been resolved.

Our most recent portfolio adjustment made in June reduced overall portfolio risk by shifting exposure into large value from growth and reducing international exposure in favor of the U.S.  These risk adjustments have helped during the most recent decline, as growth exposures have been much more affected by the trade issue.  The tactical portion of our portfolios have also been defensively positioned in treasuries since February, which has also provided a cushion for the recent market volatility.  We are closely monitoring the recent market decline risk / reward metrics to see if a change in our tactical exposure will be warranted.

The market’s negative response since the cut shows why inserting politics into monetary policy is dangerous – it’s almost impossible to surprise on the upside when expectations are all on one side.  The increased trade tariffs and rhetoric between the U.S and China has only added fuel to the fire, and is the primary cause of the most recent weakness.   However, it is important to view the short-term market reaction as just that – a short-term move in response to negative news.  Certainly, we are not discounting the fact that a “trade war” will have negative repercussions on global trade, but the impact will be minimized by the dominant position of the U.S. economy and the accommodative Fed stance.

Historical Context for “Mid-Cycle” Rate Cut

One of the most important investment skills is to be able to put events in historical context.  While this doesn’t mean that the future will follow the past, it does provide a sense of how expectations can be shaped.

The chart shows the historical market performance for a Fed “mid-cycle” adjustment.  The average annualized return is more than 20% from the first cut to the next hike.  While that is the number that many will focus on, the more important numbers are found in the instances of negative returns.  The average annualized loss is about 5.5%  – just about where we are over the past five days.  (Discount the 20% annualized number from 1986 because it was only 1.6% nominally and lasted just a month.

The second point to be made can be seen in the chart below.  There is an element of seasonality to equity performance. Historically, positive equity market performance over the first three quarters has led to positive equity performance in the fourth quarter.  From an expectation perspective, there is a higher probability of positive performance over the next five months than not.

Given that we view the current market (over)reaction as temporary, we remain positive on equities as long as the Fed stays in accommodative mode.  With the recent, flight to quality in 10 year treasuries, we  see more risk in fixed income, as equities still appear more attractively priced from a risk perspective, and we remain positively positioned in the asset class.

It is also important to understand that just because you believe, that does not make it so.  That worked for Peter Pan, but in the investment world, we don’t base decisions on predictions or forecasts for the simple reason that it is incredibly difficult to do that well consistently.  One only has to look at Wall Street market predictions to see how poorly that exercise has fared.  What we are able to do is to implement a process that evaluates risk and return on an ongoing basis and create a framework to monitor and adjust portfolios according to the most probable scenarios.  If those scenarios change, then our investment decisions are adjusted accordingly.  While there may be short-term dislocations as we are seeing currently, over the long-term, these decisions will ensure that your portfolios remain on track, your financial goals are met, and most importantly – you can sleep well at night.

If you would like to further discuss this or other investment issues, please contact our office.

Henry Pizzutello

Chief Investment Officer

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Copyright © 2019. HFG Wealth Management, LLC. Investment advisory services offered through HFG Wealth Management, LLC – An independent Registered Investment Advisory firm registered with the SEC. Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Therefore, any information presented here should only be relied upon when coordinated with individual professional advice. [ more disclosures ]