MARKET OUTLOOK / STRATEGY
Fourth Quarter 2018
In 2018, the euphoria reflected in the markets reached new heights before weakening late in the year. Our 2019 outlook foresees a more turbulent and negative environment, driven by tighter monetary policy, geopolitical challenges, and greater uncertainty about the future. Meanwhile, the U.S. economy continues to grow above its long-term trend, even as the global economy slows. U.S. employment is also signaling an economy operating at full capacity. Late-cycle fiscal stimulus provided a boost to growth that should begin to fade in 2019. If this economic recovery persists through July, it will become the longest in history. We expect late-cycle economic and credit challenges to weigh on the markets and over time to evolve toward slower growth and higher volatility.
Inflation has moved higher and is now near the Fed’s target of 2.0%. Meanwhile, the Congressional Budget Office estimates the U.S. economy will operate above full capacity in 2019 for the first time since 2007 while unemployment remains well below the Fed’s long term target. Forecasts for median GDP for 2019 are above potential estimates of 1.75-2.00%. These conditions diverge from earlier stages of the recovery when growth was weaker, which warrants a different response from the Fed.
The FOMC raised the Fed Funds rate nine times in the past four years, making this the longest tightening cycle on record. The dot plot indicates the Fed will raise rates another 50-75 bps before this cycle ends. Market expectations are currently indicating some doubt as to whether the Fed will be able to raise rates to their projected level. We expect the Fed to be data dependent, but they will need to see slowing economic results to move away from their dot plot. Their goal will be to slow the economy down toward potential, while engineering a soft landing. However, the risks for policy missteps and market pain are higher as rates approach neutral and the Fed withdraws liquidity from the system.
In our risk assessment, the credit sector is a likely area of continued stress. We are late in the credit cycle, and many issuers have embraced debt leverage to fund shareholder friendly initiatives and mergers and acquisition activity. The amount of investment grade credit outstanding has almost tripled over the past decade, boosted by abundant cheap access to credit. In our view, current debt spread levels do not compensate investors for late cycle conditions and will likely reprice wider as the Fed continues to tighten. Even as corporate debt has expanded, dealers are committing less capital to fixed income market making. As a result, bond market liquidity will likely become more challenged in 2019. The combination of greater supply and less liquidity magnifies the possibility of contagion driven by idiosyncratic credit events and/or macro trends.
Pugh Capital shifted to a more defensive posture during 2018 to position for late-cycle challenges. We have reduced credit exposure via an underweight to longer dated maturities and through a reduction of higher beta issuers. We have an overweight to high quality sectors such as ABS and CMBS to provide income while reducing exposure to spread volatility. We are currently neutral MBS as the sector has cheapened. As we look forward to 2019, we expect higher volatility and more idiosyncratic challenges. We expect 2019 to be a “risk-off” year, which will provide a period of higher tail risks, but should also ultimately translate to greater opportunities for us in managing your portfolio.
Disclosure – As of September 30, 2019. Source: Pugh Capital, Bloomberg, and Bloomberg Barclays Indices. This market outlook and succeeding pages contains Pugh Capital’s opinions based on the information available at the time of the analysis. Opinions are subject to change without notice. Investors should evaluate their own risk tolerance, time horizon and other restrictions for their investment decisions. Statements concerning financial market trends are based on information available and current market conditions which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and investors should evaluate their ability to invest for the long-term, especially during periods of volatility in the market. Please do not redistribute. Refer to the Legal & Disclosures section for additional disclaimers, disclosures, forecast, outlook and other information.