Global Asset Allocation Views – Q3 2018
Markets have continued their wild ride in 2018 with U.S. markets gaining steam with the help of small caps. Meanwhile, international markets have been damaged by political issues, the strengthening dollar, and the U.S. fed’s outlook on rate increases. A populist government has been allowed in Italy where the far-right Lega, promising a lower flat tax, and the far-left 5-Star party, promising a universal basic income, will increase the budget without the required structural reforms needed. In Spain, a minority government was formed by the center-left after ousting the prime minister and the troubles over secession by Catalonia continues. Brexit negotiations continue to go nowhere as the March 29, 2019 deadline looms. On top of this, European manufacturing has moderated while the ECB has stated they will end their QE (quantitative easing) program this December.
On this side of the Atlantic, the U.S. economy continues to show signs of strength. Recent tax cuts have begun to show up in consumer spending and companies are increasing their capital expenditures and buybacks at a record pace. Smaller cap companies have had a strong second quarter boosted by deregulation, tax cuts, and a strengthening dollar. On the other hand, the strengthening of the dollar has been an issue overseas, especially in emerging markets where countries as diverse as Argentina, South Africa, and Turkey have had significant problems dealing with inflation and currency controls. After a weak dollar in 2017, this strengthening was not unexpected and though we expect the short-term effects to continue, the longer-term view is for a somewhat weaker dollar.
A potential recession, based on models we follow, could occur late-2019 to early-2021, this will most likely be caused by an overeager Fed tightening too quickly to stay ahead of inflation, which though heading higher is still somewhat benign. Tariffs have been slapped on Chinese products, particularly in technology, with China responding in kind targeting U.S. products sensitive to states President Trump won in 2016. Tariffs are a bogeyman to markets and they have reacted negatively each time these make the headlines. The hope is this will lead to some concessions from China regarding theft of U.S. intellectual property and that it will not spiral out of control.
KEY THEMES
We continue to like equities over fixed income, though by a smaller margin then we liked near the end of last year. With rates creeping up, the gap between bond yields and the Earnings yield of the S&P 500 continues to narrow.
We still favor international equities over the long-term but are aware that during the short-term there will be some volatility.
KEY RISKS
As mentioned above, the Fed tightening too quickly in the later stages of the business cycle has historically led to a recession.
Continued protectionist trade policy, not just in the U.S., can be a headwind for growth and impact the interconnected supply chains used throughout the globe.
Dollar strengthening further from this point would impact emerging market monetary policy regarding rates, capital flows, and their ability to service debt. Here in the U.S., a stronger dollar would also make our exports more expensive before any tariffs are even levied.
KEY CHANGES
We will being using sectors in our Large Cap sleeve as this gives us more autonomy to shift positions to more favorable sectors to better utilize our research capabilities.
Upgrades
- Small Cap – will benefit in the late cycle of the U.S. expansion and in the short to mid-term from a stronger dollar
- Agency MBS – there is less risk, at this point, to having exposure to consumer balance sheets and provides an attractive spread over similar risk treasuries
Downgrades
- Europe – as we mentioned above, geopolitical issues in Italian markets, the impact of trade, and Brexit are all reasons to move Europe to neutral
- Investment-Grade Corporates – spreads are at very tight levels making valuations weak and business balance sheets are riskier than the individual consumer
Written by: Antonio Belmonte, CFA, Chief Investment Officer
These are the opinions of Antonio Belmonte and not necessarily those of Cambridge, are for information purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. The strategies discussed herein are not designed based on the individual needs of any one specific client or investor. In other words, it is not a customized strategy designed on the specific financial circumstances of the client. However, prior to opening an account, Cambridge will consult with you to determine if your financial objectives are appropriate for investing in the model. You are also provided the opportunity to place reasonable restrictions on the securities held in your account.