Third Quarter 2019

For many in the U.S., the closing of the third quarter marks the end of summer and the beginning of the new school year. However, for many investors, class started a few months early. Volatility did not go on vacation and actually picked up considerably in the third quarter. We believe episodic spikes in volatility will persist for the remainder of the year. Economic growth forecasts have fallen over the year as it appears the structural impediments to growth are still largely unresolved. The consumer sector is critical in maintaining a positive growth environment. However, government spending and business investment which have been weak, are also needed to generate above trend sustainable growth. We maintain our outlook for a slow growth and low inflationary environment.

Pugh Capital expects the economy to slow to potential GDP levels of 1.75-2.00% in the near term. The strength of the labor market remains intact and we are starting to see signs of higher wages. Home sales have picked up and we expect the housing sector to have a positive impact on the economy. On a more negative note, business optimism is trending lower and the weakening global macro picture may continue to suppress capital expenditure. Fiscally, the deepening divide within Congress and the President has the potential to create further gridlock, instability, and uncertainty. The Fed stands ready to help support the economy through preemptive interventions.

Trade war uncertainty, BREXIT, global economic weakness and its potential spillover effects, are in contrast to the more stable domestic U.S. consumer growth story. Currently, the market is discounting more rate cuts as it worries about a significant economic slowdown and that the Fed may be behind the curve. Political actors have also expressed their desire for lower rates, but the juxtaposition of a fairly resilient domestic economy and tight labor markets provides little reason for further rate cuts. The mixed economic picture and increasing amounts of dissention within the Fed has led to uncertainty around the future path of monetary policy.

With regard to interest rates, we have moved our trading range outlook for the 10-year U.S. Treasury to 1.25-2.00% for the fourth quarter. With the divergent outcomes of low but orderly growth and idiosyncratic risks, rates volatility has increased. From a geopolitical standpoint, U.S. and China tensions continue to increase anxiety and a possible flare-up with Iran creates further risk. Lastly, inflation has continued to surprise to the downside and may remain low for longer than forecasts suggest. Given the crosscurrents and uncertainty with rates, duration will be managed closely to the Index with a modest long bias. Our longer term outlook is for lower rates.

Currently, the VIX Index is signaling a more tolerant view for risk assets, perhaps based on expectations of continued accommodative monetary policy from the Fed. We are concerned about the potential of spikes in volatility associated with tail risks. But we also recognize that accommodative monetary policy and a slow growth environment is supportive of risk assets. Fundamentals for corporations are also stretched. They continue to exhibit late-cycle characteristics such as higher leverage and lowered earnings growth expectations. In a slowing growth environment these conditions signal, a cautionary stance is appropriate. Valuations have cheapened modestly and we believe credit spreads largely do not reflect longer term deteriorating fundamentals.

We remain overweight ABS and CMBS as they are high-quality sectors with attractive risk profiles given our defensive posture. The MBS sector is a tougher call, given its negative convexity and our expectations of higher rates volatility and longer term a lower rates call. We are currently neutral the sector, but will rely on bottom-up security analysis to navigate a higher prepayment environment. Specified pools provide some shelter from this risk.

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.