Midyear Outlook: Fed’s About-Face Breathes Life into Economic Cycle. | Capital Group

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Midyear Outlook: Fed’s About-Face Breathes Life into Economic Cycle.

With the S&P 500 Index mere basis points away from bear-market territory, the U.S. Federal Reserve delivered a timely gift shortly after New Year’s Day. In a monumental policy shift, Fed officials made it abundantly clear that their plan to raise interest rates this year is on hold.

That move, coupled with mixed signals on the progress of U.S.-China trade talks, fundamentally changed the outlook for financial markets and the global economy. While the investment landscape looked dark and foreboding near the end of 2018, it brightened considerably in the first quarter of this year, and market gains since then have generally held up well.

What a difference six months makes.

On a year-to-date basis through mid-June, most markets are solidly in positive territory and appear poised to stay there for a while — thanks to low interest rates and a healthy U.S. economy. GDP growth in the first quarter came in at a surprisingly strong 3.1%, the highest first-quarter rate since 2015.

That said, there are reasons why the Fed and other major central banks around the world don’t want to raise interest rates at the moment and may even be looking to cut in the months ahead. Economic growth abroad is slowing as Europe and China struggle with a deteriorating trade environment. With punishing tariffs imposed by multiple countries and trade wars ongoing, it is difficult to confidently assess the global outlook.

“Events are changing rapidly, and that's why we are seeing higher levels of market volatility almost on a daily basis,” says Darrell Spence, an economist with Capital Group. “If you could put aside the trade disputes for a moment and just look at the fundamentals, you'd see a U.S. economy that actually looks pretty well supported and generally slowing growth abroad — but nothing that suggests a sharp downturn in the months ahead.”

Macro perspectives: Lower-for-longer rates extend the cycle.

As Mark Twain might have put it: Rumors about the death of low interest rates were greatly exaggerated. Even after the Fed hiked short-term rates four times last year, they remain low by historical standards. And, if anything, the Fed appears ready to cut rates as a counterbalance to late-cycle conditions in the U.S. and worsening global trade tensions. Lower rates are generally supportive of corporate earnings growth, suggesting stocks could appreciate in the second half of the year.

A low unemployment rate and rising wages should continue to support U.S. consumer spending. On the flip side, those same conditions can eventually hurt corporate profitability and trigger greater stock market volatility. Given these circumstances, it makes sense to prepare for a tougher environment in 2020 and beyond by taking a closer look at dividend-paying stocks and avoiding excessive credit risk in the bond market.

Equity opportunities: International equities deserve a place in well-diversified portfolios.

Outsized gains in U.S. equities over the past decade have left international markets relatively unloved and underexposed in many portfolios. That could prove to be a mistake down the road.

Non-U.S. stocks offer a number of potentially attractive traits, including diversification, higher dividend yields, the chance to benefit from currency tailwinds if a strong U.S. dollar starts to weaken and, perhaps the most compelling attribute, substantially lower valuations.

Beyond that, the highest returning stocks each year are often located outside the United States. Since 2009, the top 50 companies with the best annual returns overwhelmingly had a non-U.S. address. Had you decided to ignore international equities, you would have missed a shot at many of the best opportunities.

Fixed income opportunities: It's time to revisit your bond allocation.

Years of ultra-low yields have pushed many investors into areas of the bond market that may not hold up particularly well during an economic downturn or a sharp decline in equity markets. Lower rated corporate bonds, in particular, have been a popular choice as investors engage in the “hunt for yield.” Problem is, those types of bonds have had a higher correlation to equities, meaning they are less likely to provide protection when stocks decline.

Given lofty valuations in the high-yield bond market, investors are not being sufficiently compensated for taking on this higher risk at a time when the U.S. economy is exhibiting classic, late-cycle conditions.

“A core bond portfolio should serve four primary roles,” affirms Mike Gitlin, Capital Group’s head of fixed income. “It should provide diversification from equities, income, inflation protection and capital preservation. What it should not do is replicate equity risk.”

Increasing exposure to high-yield bonds or emerging markets debt should be an independent decision, separate from a primary core bond strategy, Gitlin notes. When stocks come under pressure, bonds should provide stability. Investors should ensure they own enough core in their fixed income allocation to provide that stability. Fixed income strategies that are more total-return and income-seeking may not provide ballast when it’s most needed.

Posted June 27, 2019.

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