First Quarter 2019

Our outlook for the economy is for slower growth, with 2018 representing the peak in this cycle.  This post-recession recovery has been characterized by low actual and potential GDP.  However, if it is sustained into the summer it will become the longest recovery on record.  Wage inflation may drift higher with employment at full capacity, but it too is close to peaking for this cycle.  With the combination of elevated geopolitical risks and an economy exhibiting late cycle characteristics, we foresee higher market volatility and more idiosyncratic events.  Therefore, we expect that the market’s current “risk-on” sentiment will reverse course later in the year. 

First quarter GDP is currently tracking below 2%.  Housing appears to be weakening, along with consumer spending.  The brief “sugar high” provided by the 2018 tax cuts seems to be fading and leaves in its wake a federal budget deficit that is more bloated than the last.  We view the increasing fiscal debt to GDP as a red flag that may limit the effectiveness of future fiscal stimulus during the next recession.  While the economy should rebound from its first quarter lethargy, we believe 2019 GDP will slow down and track more closely to potential GDP projections of 1.8% to 2.0%. 

In light of this unremarkable growth path, we believe the Fed’s move to a “wait and see” approach is the right one.  The Fed Funds futures market is forecasting that the next policy action will be a rate cut.  With the current dot plot indicating a much lower rate trajectory, we believe that we have seen the cyclical high in long-term interest rates.  Long-term inflationary expectations are well anchored, allowing the Fed additional flexibility.  The Fed announcement that they will stop their balance sheet reduction by September adds to their accommodative stance. 

While the Fed’s dovish actions may extend the market’s recent “risk-on” behavior, there are several factors that cause us to maintain a defensive outlook.  Corporate valuations are tight on a historical basis and don’t compensate for higher leverage and larger concentrations in BBB-rated bonds.  Market volatility is too low for a late cycle environment.  Rates have moved sharply lower and the short end of the treasury curve has inverted, indicating growing concerns about the global economy.  Finally, many geopolitical factors such as an adverse Brexit outcome, weaker growth abroad, or the political turmoil surrounding the White House, could easily undermine market sentiment. 

We maintain a modest underweight to credit relative to the Index and have focused on up-in-quality trades in that sector.  Late credit cycle characteristics, including higher leverage and shareholder friendly initiatives, are not priced into spreads.  Market liquidity is also somewhat fragile and it is likely that credit liquidity premiums may re-price higher given trading volumes are down sharply as a percent of debt outstanding.  In the post-Volcker Rule era, dealers are also more sensitive to balance sheet risk management.  Idiosyncratic risks also typically increase at this point in the cycle. 

We remain comfortable with overweight positions in high quality CMBS and ABS.  We are moving to a slight underweight in Agency MBS versus the Index as tight valuations and the risk of higher volatility offset the sector’s attractive liquidity and credit characteristics.  We believe that economic softness and a return to risk-off sentiment will act as a cap on interest rates and possibly cause them to fall further.  We foresee a 10-year Treasury trading range this year of 2.25-3.00%.  Therefore, the portfolio is currently positioned with a modestly longer duration than the Index.  While we are defensive, we view this as a “tail-risk” environment which should allow active managers opportunities to use bottom-up security selection as a strong driver of performance.

Disclosure – As of March 31, 2020. 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.