Equity markets finished a challenging third quarter of 2019 with positive returns. While the last three months have been held back by worries about trade relations and slowing economic growth, the quarter’s other dominating force of Central Bank (CB) easing won out in September, especially in Europe. International stocks, as measured by MSCI EAFE Net(1), increased 2.9% last month given a massive, open-ended stimulus plan by the European Central Bank and various easings by other foreign CBs. Meanwhile, the S&P 500 Index(2) and the MSCI Emerging Markets Net(1) were both up 1.9%. For the quarter, many equity markets were down(1).
Volatility in the bond market continued in September. Following another rate cut by the Federal Reserve last month, short rates fell but longer term rates increased by 0.16 – 0.18%(2). This small change caused the Barclays U.S. Aggregate Total Return Index (3) to lose -0.5%. As mentioned last month, when interest rates are excessively low, any increase in rates will cause a higher percentage decline in bond prices. In corporate credit, investors’ appetites for risk offset higher interest rates and the Barclays U.S. High Yield Index(3) increased +0.4%. For the quarter, significantly lower bond yields delivered strong returns to longer term bond investors.
Under the placid surface of September’s equity markets, several undercurrents are concerning us. First, “momentum” had been driving equity markets for some time. Momentum-driven markets feature investors seeming to be simply buying what has been making money (high growth names and consumer staples stocks) and selling what hasn’t (banks and energy). The problem is that it leads to crowding into the same stocks. As soon as those stocks stop making money, these investors rush for the exits and the stocks fall significantly, which is what happened in the first two weeks of September. Second, you may have heard that the New York Federal Reserve injected reserves into the banking system to keep some short-term rates from rising. This system, the so-called overnight repo market, is where the interest rates that central banks SET meet the interest rates that real economic actors USE. The recent unrest in money markets, which briefly caused short-term interest rates to get out of the Federal Reserve’s control, could signal that something’s potentially wrong with the financial system, especially as it relates to banks and liquidity. Lastly, this month, WeWork pulled its Initial Public Offering (IPO) after a series of revelations about this “profitless-growth-forever” real estate company. It brings to mind whether investors will question pursing “greater fool strategies” in relation to the WeWorks and future unicorn IPOs. What does it say about investors’ view generally that stocks as an asset class ALWAYS go up over time?
In consideration of these undercurrents and trade war uncertainty, along with weakening global growth, we continued our transition to “a later cycle approach” in portfolios during the quarterly rebalance. Overall, equity holdings were decreased and fixed income increased slightly. Some of the areas where equity exposure decreased were: consumer discretionary, technology, and small-cap stocks. Equity exposure was increased in investments that are typically perceived to be more defensive in nature: healthcare, consumer staples, and stocks emphasizing balance-sheet strength and dividends. In fixed income, a position dedicated to high yield bonds was eliminated and exposure to short and medium duration bonds and treasury inflation-protected securities was increased. Finally, in alternatives, “value-additive” holdings in a volatility-tracking position decreased and gold and long-short equities increased.
The accumulating tension between the hopes of a U.S.-China trade deal and efforts to combat slowing growth increases the uncertainty for the global economy and markets and threatens the trading range that equities have been in for some time. We will look to shift into a further defensive posture, if conditions warrant.