- These risks are not gone for good. We believe it is prudent to maintain a defensive stance given the current phase of the market cycle.
This year has shown that markets love when risks diminish. Avid readers of the PFP Monthly will remember that we highlighted three key sources of risk facing the global economy last year: (1) a U.S.-China trade war, (2) slowing Chinese growth and (3) the possibility of a U.S. recession brought on by tighter monetary policy. Below, we explain how policymakers have pacified the market on each of these areas in 2019. We highlight the fact that none of these risks have actually gone away. For this reason, and given the current phase in the market cycle, we are maintaining a defensive tilt in client portfolios.
U.S. and China friendly (for now)
The market has loved the optimism coming out of U.S.-China trade negotiations. Both countries’ leaders have made a concerted effort to highlight the “constructive” nature of trade talks as they aim for a formal agreement in May. Both have strong incentives to make a deal happen: Trump craves a political win before his 2020 campaign begins in earnest, while Xi continues to depend on economic stability for social stability. The market correction late last year appears to have convinced both parties to move away from the combative stances they adopted in 2018.
We would caution against being too optimistic about the results of current negotiations. As we highlighted in earlier Monthlies, the major grievances brought up by the U.S. strike at the core of Chinese economic policy and are unlikely to be resolved in the near future. The underlying issue is more “big picture” than tariffs or quotas; it is the result of one global superpower (the U.S.) confronting the rise of another (China). For now, however, tension between the countries looks like it will wane in the short term. This should continue to please markets as long as it lasts.
Chinese growth looks set for soft landing (for now)
The outlook for Chinese growth has also improved as of late. Before last year, investors worried about the prospect of a dramatic slowdown in China (or a so called “hard landing” from the period of rapid economic expansion the country experienced over the last few decades). Chinese policymakers were faced with a dilemma: prop up the economy and let high debt levels continue to threaten financial stability, or clamp down on credit and watch growth slow. They chose the latter and the Chinese stock market proceeded to fall by over 20%.
As above, market turbulence was enough to convince policymakers to change direction. They cut taxes, ordered banks to lend more freely to businesses and ramped up infrastructure spending. These moves began to pay off in early 2019, with the most recent GDP growth number tracking a healthy 6.4%.
We note that the debt problem has not gone away and in some ways has gotten worse. Policymakers will eventually have to address these concerns or deal with the consequences to financial stability. However, with October marking the 70th anniversary of the Chinese communist party, we believe China’s leaders have a strong incentive to keep up the perception of a soft landing. Again, this should placate markets for the time being.
Central banks change course (for now)
Politics aside, the greatest source of market strength in 2019 has arguably been the shift in global monetary policy. The world’s most influential central banks all shifted towards more growth-friendly stances in the first few months of the year. In the U.S., market rates now imply a higher likelihood of rate cuts than increases – a stark contrast to the outlook six months ago. Regardless of whether this happens, markets see recent policy as an extension of the current phase of the economic cycle. In other words, the Fed has apparently bought the U.S. economy a little more time until the onset of the next recession. Again, the underlying risk has not gone away. Central banks will eventually be forced to raise rates once inflation pressures rise. For now, however, it looks like the party will go on.
So why are we still defensive?
Despite the positive news on each of the topics above, we maintain a tilt towards defensiveness. This means we are keeping equity exposure low (about 10% below our long-term targets), maintaining an emphasis on dividends and income over growth, and focusing on companies that will do relatively well regardless of economic conditions (think consumer staples and health care).
Our reasoning is simple. Despite the above, we continue to believe we are in the final innings of the economic cycle. In the current phase, we see more value in positioning ourselves for an inevitable slowdown than taking excessive risks. This is consistent with needs of our clients, who trust us to remain vigilant when the markets move up in order to capitalize when the markets move down.
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