This blog post originally ran as a State of the Markets commentary by Darrell Cronk, CFA, President, Wells Fargo Investment Institute and Chief Investment Officer, Wealth and Investment Management.
The first half of 2019 has delivered the strongest and broadest cross-asset rally in a decade, with almost every major asset class beating its long-term annual average in just six months. The last time gains were so broad was in 2009-10, when the global economy was recovering from the financial crisis, the Federal Reserve (Fed) was implementing quantitative easing, and valuations were considerably cheaper across asset classes.
It appears the Fed has all but confirmed a July 31 rate cut and a dovish pulse is emanating from central banks around the globe. U.S. equity markets are posting record highs, and the economy is clocking its longest expansion in post-World War II history; yet investor exuberance remains absent as narrow equity market breadth, weak fund flows, and negative earnings revisions persist. As we approach the Fed’s July meeting, investors don’t seem to be demonstrating the vigor to chase equites much higher as economic surprises have been rare and second-half risks remain. All of this has investors asking this important question: “Is it time for a thoughtful pause?”
It is important to remember that the markets’ fixation on interest-rate cuts is a double-edged sword. On the one hand, they are undeniably stimulative and the age old expression “Don’t fight the Fed” rings clearly and loudly in our ears. On the other hand, there are valid reasons why the Fed and global central banks believe they need to act. Global data continue to weaken in manufacturing, trade, sentiment and investment, all while inflation remains stubbornly below central banks’ targets. This is most currently evidenced by the fact that 16 of the world’s 20 largest countries have their Purchasing Managers’ Index (PMI), a proxy for manufacturing growth, currently in contraction, a phenomenon not seen since 2012.
As we peer into the second half of 2019, we would expect most asset-class returns to be in the low single digits, barring a disregard for valuations and an ensuing melt-up scenario. Excess levels of cash are omnipresent, and this additional liquidity always presents a risk that it could get aggressively reallocated into capital markets. That said, we don’t see tangible evidence of this today. Rather, we believe the second half could be a grind with periods of elevated volatility and at least four potential speed bumps that will need either clarification or resolution.
- Trade: Certainly a U.S.-China trade truce and a nice G20 family photo have eased tensions temporarily. The “glass half empty” view is that any scenario resulting in either higher tariffs or technology restrictions isn’t priced into today’s markets. The “glass half full” view is that neither is the more constructive scenario of a materially successful trade deal. We believe a U.S.-China deal eventually will get done, but negotiations could stretch into 2020 and the substance of the deal is what will matter in the end.
- Rate Cuts: Markets are currently pricing in as much as 100 basis points of rate cuts by the Fed over the next 12 months1. The rationale explaining why these cuts may occur is expected to be critical to the market’s path. If rates cuts are less than expected because of positive reaccelerating economic growth, then this shallower easing cycle should prove welcome and positive. Concurrently, if rate cuts are delivered and growth does not reaccelerate, consistent with past easing prior to economic slowdowns, then we expect markets to find a more difficult path forward.
- S. Debt Ceiling/Budget Cap: Obscured by the focus on trade have been the Congressional negotiations to lift the U.S. debt ceiling and renew higher federal spending limits originally approved in 2018. Both must be approved by September, according to the U.S. Treasury, to avoid a potential repeat of the August 2011 U.S. debt rating downgrade. Congressional leadership reportedly has no interest in creating political theatre this time around—with memories of the longest federal government shutdown still fresh and a contentious election season ahead—but it remains a risk that needs to be watched. It is possible this issue could get resolved prior to the Congressional August recess, which looms very close on the calendar.
- Brexit: The latest pending deadline for resolution falls at the end of October. While another delayed outcome is always possible, the recent exit of former Prime Minister Theresa May’s steady hand; a new, yet untested, Prime Minister with potentially different agendas and views; and markets believing “No-Deal” rhetoric is increasing, alters the risk calculus of the negotiations this time around. If a No-Deal scenario actually moves closer to reality, global markets are likely to react negatively on the consequences.
To be clear, what does a “thoughtful pause” entail? It is not a signal to exit current or existing portfolio positions or turn materially defensive. Rather, investors should look opportunistically to trim strong first-half profits where allocations have become extended and shift back to strategic targets, tactically bend portfolio exposure to areas where we remain favorable and valuations prove reasonable (as outlined in our asset allocation guidance), and understand that maintaining slightly higher levels of cash can prove prudent and provide optionality if the second-half speed bumps become more prevalent.
1 100 basis points equals 1%.
Darrell L. Cronk, CFA
President of Wells Fargo Investment Institute Chief Investment Officer for Wealth and Investment Management, Wells Fargo & Company
Darrell L. Cronk is the president of Wells Fargo Investment Institute, which is focused on delivering the highest quality investment expertise and advice to help investors manage risk and succeed financially. Mr. Cronk leads global investment strategy and research including equity, fixed income, real assets, and alternative investments. He also serves as chief investment officer for Wealth and Investment Management, a division of Wells Fargo & Company that includes Wells Fargo Private Bank, Wells Fargo Advisors, Wells Fargo Institutional Retirement & Trust, and Abbot Downing.
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