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By Charles Tan - April 2019
After the first quarter’s sharp rally from December’s selloff, markets are breezy with late credit cycle headwinds and tailwinds. What’s caused this whirlwind of change? In three words: The Federal Reserve.
When the Fed was calm, the market panicked. When the Fed started to panic, the market rallied. The Fed’s 180-degree change on interest rate policy has rescued the market from a sharp sell-off. The question now: after the rally, can Fed policy rescue the slowing economy?
More important, what’s an investor to do about it? Watch my video below to find out what headwinds and tailwinds may affect markets through 2019, and why I believe it’s time for investors to be cautious.
There is a time to play offense, and there is a time to play defense. When risk is not worth taking and turning points of the economic cycle, it's probably best to play some defense in your portfolio.
In the first quarter of this year, we have witnessed a broad-based, sharp rally across all the risk markets: equity, high yield, bank loans, and EM (emerging markets). It's almost the complete reversal of what happened in the fourth quarter of the last year, which was a panic sell-off across the board. So, what triggered a sharp turnaround? In three words: The Federal Reserve.
The Fed, in its March meeting, predicted no rate hikes in 2019 and the possibility of one in 2020. But the Fed has also significantly raised the bar for further rate hikes. They have shifted from a framework of overshooting on inflation.
This is a classic example of when the Fed was calm, the market panicked. When the Fed starts to panic, the market rallied. So, the Fed’s 180 has rescued the market from a sharp sell-off. The question now is, after the rally, can the Fed’s policy rescue the slowing economy?
There are a couple headwinds we see over the horizon. The first is a synchronized global slowdown. Growth has been very sluggish out of Europe, out of China, and here as well in the U.S. That is likely to continue through, most likely, the first half of 2019. The other big headwind is the fact that we have rallied so much since the selloff in December. Valuation has gotten tighter, so the tension now is between are there going to be more issues sprouting around the world, and what will we do with the tighter valuation?
Another significant tailwind that we can see is a very aggressive fiscal stimulus policy implemented by the Chinese government. They've been very aggressive in cutting their taxes and subsidizing their economies and companies—so hopefully that will also generate some growth from that very important part of the world economy.
Another very important factor is the U.S.-China trade deal. If both sides can come to some kind of agreement, that will take the downside risk—tail risk—away from the market, and it will go a long way to stabilize both global trade, global economy, as well as market sentiment.
Now having said that, we do believe the U.S.-China relationship, over the long run, is going change significantly from a strategic cooperation in the past to strategic rivalries.
The market is very obsessed with the yield curve inverting at this point, and for good reason. If you look at the past 50 years, the six recessions we've had, were all preceded by yield curve inversion. But then there were also a few times inversion did not lead to recession. I think what history suggests here is that the inversion is to be at least the 15 basis points for at least 10 weeks long. So, whether the current inversion will lead to a recession, time will tell. What it does indicate is that the market has very significant concerns about lack of growth or lack of inflation—or both.
We are probably seeing a little more off-side lift in the credit markets, but it’s important to keep in mind that we’re at a very late credit cycle, and the default rates are expected to pick up over the next 12- to 18-month time horizon. It's probably a good time to think about your portfolio and to start to put some hedges and caution into your portfolio.
Right now, we are overweighting sectors that are more steady and will be less vulnerable to economic slowdown—such as the banking sector, the municipal sector, the TMT (technology, media and telecom), and also in energy space midstream pipelines.
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