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ECONOMIC FLASH – All Eyes on the Fed

The Fed cut interest rates for the first time in ten years despite many positive economic indicators, such as strong earnings and low unemployment. Uncertainty of trade war impacts and slow business investment seemed to drive the Fed’s decision. Fortunately, the inflationary consequences often associated with rate cuts feel unlikely.

August 2019

US Economy: Things aren’t that bad.

US GDP growth in Q2 (+2.1%) slowed by 1.0% as a surge of consumer spending was somewhat offset by weaker business investment. Unemployment is steady at historical lows (3.7%), consumer balance sheets are healthy and wage growth (+4.0%) has accelerated.

US Stocks: Earnings ahead of expectations.

Both large and small cap US stocks rose as corporate earnings have generally beat expectations. According to FactSet, nearly 80% of S&P 500 companies that have reported outperformed analyst estimates.

Foreign Stocks: Non-US stocks languish.

Non-US stocks struggled with a resurgent US dollar creating headwinds and ongoing geopolitical disruption, including a new British PM overseeing a no-deal Brexit, adding to trade war uncertainty. Europe (-1.9%) lagged the more economically stable Far East (-0.4%).

Fixed Income: Fed follows through but…

Interest rates continued to fall as the Fed followed through on indications of an interest rate cut. Market reaction wasn’t initially positive as investors viewed Fed Chair Jerome Powell’s comments as indicating the Fed was not committed to an ongoing program of rate cutting as they had hoped.

Real Assets: Infrastructure equities pullback.

Infrastructure assets lagged the greater equity markets with a decline in many energy related names a contributing factor. We deemphasized energy exposure when we initially made our allocation to the space.

Alternatives: Illiquid investments add value at the right price.

Private equity strategies have made headlines by accumulating “dry powder” while maintaining strong fundraising efforts. We believe a private equity program is an important source of return for investors, but we are conscious of high valuations and this build up of capital.

Equities Total Return

U.S. Large Cap 1.4% 20.2% 8.0%
U.S. Small Cap 0.6% 17.6% (4.5%)
U.S. Growth 2.2% 24.0% 9.9%
U.S. Value 0.8% 17.0% 4.2%
Int’l Developed (1.3%) 12.6% (2.6%)
Emerging Markets (1.2%) 9.2% (2.2%)

Fixed Income Total Return

U.S. Agg. Bond 0.2% 6.3% 8.1%
TIPS 0.4% 6.5% 5.7%
U.S. High Yield 0.5% 10.7% 6.9%
Int’l Developed (0.7%) 4.3% 4.5%
Emerging Markets 1.1% 6.4% 8.2%
Intermediate Munis 0.9% 4.6% 5.8%
Munis Broad Mkt 0.8% 6.2% 7.3%

Non-Traditional Assets Total Return

Commodities (0.7%) 4.4% (5.4%)
REITs 1.5% 21.1% 14.1%
Infrastructure (2.0%) 17.8% 8.0%
Hedge Funds
Absolute Return 0.2% 1.8% 0.4%
Overall HF Market 0.8% 5.1% (1.0%)
Managed Futures 3.2% 8.1% 7.6%

Economic Indicators

JUL-19 JAN-18 JUL-18
Equity Volatility 16.1 16.6 12.8
Implied Inflation 1.8% 1.9% 2.1%
Gold Spot $/OZ $1414 $1321 $1224
Oil ($/BBL) $65 $62 $74
U.S. Dollar Index 91.6 92.0 89.7

Glossary of Indices

Our Take

Last month we said we thought the Fed was in a balancing act of expectations more than anything else when it came to monetary policy. Based on how markets immediately responded to the 0.25% rate cut, it was clear that investors were hoping for a larger one and/or an indication of more. Futures markets continue to price in additional cuts through the end of the year. That said, we remain unconvinced that the economy needed substantial stimulus, acknowledging the consumer and labor market data above. The Fed’s case for cutting appears to be grounded in the uncertainty of the trade war, which has been some measure of a headwind to business investment, but this seems counter to the Fed’s stated “data dependent” approach.

What is the risk of an unnecessary cut? Theoretically, we would see an increase in inflation, but inflation has been so muted (1.6% by the Core PCE Index) that this seems unlikely to approach an uncomfortable level for the Fed. So, while the cut may not be necessary to support the economy, it won’t likely have inflationary consequences either. If the Fed continues to make cuts or resumes asset purchases this question will be worth asking again.

In terms of positioning, we continue to believe in alternatives in portfolios for both return generation and diversification, and we are pleased with some of the recent changes we have made to our alternative lineup which have added value in the last few months. We have also made a change to the opportunistic portion of our fixed income portfolios by selecting a manager we believe will have a greater advantage relative to core fixed income investments should rates remain low as anticipated.