Will the Real Market Please Stand Up

Strategic Income Outlook
January 2019

The markets have not been kind to investors lately. There were precious few bright spots in the recent quarter, and it seems there was nowhere to hide, except cash. Our instincts, however, tell us that cash is not a long-term solution. After almost 10 years of positive returns in equity markets, the decline from recent peaks came very close to bear market territory before reversing course, with most major domestic markets ending the year down between low and mid-single digits – not a major catastrophe, but not a great finish to the year either. Declines have been far worse in some emerging markets, like China, which has been selling off for most of the year and is decidedly in a bear market. This should be no surprise as they are much more dependent on trade.

The optimists, including some in the economic profession, would say the glass is half full, citing very low unemployment, accelerating wage growth, steady retail sales, slowing inflation, dubious yield curve signaling, healthy corporate profits and positive small business sentiment. The pessimists, which include most financial writers and some economists, would say that the glass is half empty, citing the possible deleterious effects of a prolonged trade war, political disfunction, slowing economic growth, a possible “BBB” bubble, a sagging leveraged loan market and lower oil prices. Pragmatists, like us, would say neither full nor empty matters, as the glass can be refilled, citing fiscal stimulus here, in China, Italy and most recently in France.

It seems the world has switched from synchronized growth at the start of the year to a slower growth regime, and the concurrent flight from risk that comes from deteriorating sentiment has resulted in record outflows from equities and credit funds and massive inflows to cash-like funds. Our biggest challenge as investors is determining which path will be correct; will negative changes in sentiment spill over into the real economy, or can we stabilize at a slightly lower level of economic growth and improve from here once the economic outlook appears more steady?

Clearly some of the “negatives” cited by investors are in fact positive for the health of consumers, particularly declining energy prices and lower inflation. Although weakness in the energy sector accounted for a preponderance of the negative returns among non-investment grade bonds in 2018, lower oil prices benefit almost everyone except the producers of energy, as we have written about in previous letters. It is very important to understand why oil prices are weak, and today most agree that it is not due to a lack of demand, but rather an excess of supply. The Organization of the Petroleum Exporting Countries (OPEC), especially Saudi Arabia, and Russia acknowledge this and have recently announced production cuts. The U.S., however, continues to forge ahead with increased production and will only respond with cuts when either funding is cut to producers, as it was a few years ago, or prices decline to where it is uneconomical to drill. We are not there yet, but most commodity-related imbalances do correct themselves over time, and then we would expect investors who now view weak oil prices as a precursor to an economic slowdown may change their minds.