PDF MARKET REVIEW April 2019

MARKET REVIEW

April 2019

`Running of the Bulls'

"Nobody ever lives their life all the way up except bullfighters." ? Ernest Hemmingway, The Sun Also Rises (1926)

Since 1592 the Running of the Bulls in Pamplona, Spain has typically occurred in July each year. That's right, this year will be the 427th annual occurrence making it among the longest standing traditions in the world. The fiesta began as an event to honor the patron saint, San Fermin, and was later popularized by Ernest Hemmingway's book The Sun Also Rises in 1926. While inherently risky, apparently, there are far more attendees that are incapacitated from alcohol consumption than from bull related accidents ? little consolation if you find yourself in a pack full of marathon runners.

This year, the market's Running of the Bulls got off to a head start on the above festivities. As can be seen in the chart below, as of the end of April the S&P 500 hit new record highs and recovered back all it lost during the fourth quarter selloff last year. In fact, it's been the best 4-month streak since 2010 and the best start of the year since 1987. This seemingly "V" shaped recovery has been influenced by a number of catalysts.

Reopening of the government following the shutdown at the end of last year Fed's dovish policy pivot that has led to a pause on rate hikes Stimulus efforts out of China that have helped stabilize growth Improved US-China trade discussions (notwithstanding the recent threat of additional tariffs) An extension on Brexit negotiations until October of this year

Additionally, there's been more evidence recently of lessening global growth fears. Various metrics (Markit PMI's, OECD Leading Economic Indicators, Yield Curve) have begun to point to early signs of stabilization. And first quarter US GDP growth was better than anticipated at 3.2%. While the sustainable rate of growth is not likely as high as the headline number suggests (due to some 1Q non-core growth drivers including inventories and government spending), it was still much better than originally expected in what is typically a seasonally soft first quarter. Probably most importantly, we're seeing signs of steadiness among earnings growth expectations ? confirmed by improving estimate revision trends and first quarter earnings that have largely come in better than feared.

So does this mean it's time to buy with fearless abandon? Not necessarily. As we'll discuss more in our outlook ? while a lot of the storm clouds have cleared, this is partly reflected in price, valuations and sentiment conditions ? all of which argue for some tempered enthusiasm. The bottom line is that while we think investors can participate in the Running of the Bulls, it's not recommended without first making sure your insurance policy is up to date.

As referenced earlier, it's been an exceptionally strong start to the year for risk assets ? especially stocks and real estate (REIT's). Commodity and bond returns have also been positive but lagged the double digit performance of those aforementioned risk assets. While stocks continued to perform strongly in April, the other assets classes were relatively flat.

Stocks

Year-to-date there's been broad participation within equity markets, which have led to double digit returns

across all major geographies. Domestic markets (S&P 500 and Russell 2000) outperformed ? helped by

a stronger dollar and

better than feared

first quarter earnings

reports as well as

higher

than

anticipated US GDP

growth to begin the

year. By S&P 500

sector, the market

maintained

a

cyclical, "risk on"

tone. Returns were

positive for all

sectors year-to-date

and all but two

sectors for the

month of April. A combination of cyclical growth (Tech, Discretionary, Communication Services) and

cylclical value sectors (Industrials, Financials) outperformed both for the month and the year. Meanwhile,

the more defensive, income oriented sectors (Staples, Utilities, Health Care) generally lagged.

Bonds

Bonds posted mixed returns for the month of April though still saw positive returns for the year. The market's "risk on" tone remained evident in fixed income where the more cyclical segments outperformed both in April and year-to-date. As a result, corporate credit (High Yield, Invt Grade) and emerging market debt (EMBI Global) remained at the top of the list ? both having higher correlations to the stock market. Dollar strength dulled international fixed income (Global Agg ex US) performance and the modest back up in yields in April dampened longer duration Treasury (Govt Tsy Long) returns. Also consistent with the "risk on" mantra in April was the re-steepening of the yield curve between the 10 year and 2 year ? a sign of moderating growth fears.

Alternatives

Alternatives posted positive returns for the year though relatively flat returns for the month. Returns were generally led by publicly traded real estate (REIT's) ? up double digits YTD ? benefiting from a combination of income and capital appreciation associated with this segment. Commodities posted positive returns year-to-date though results were more mixed. Energy and industrial metals pricing led for the year while declines in precious metals and agriculture were partial offsets. Finally, Treasury Inflation Protected Securities (TIPS) also provided positive (albeit more subdued) year-to-date returns. TIPS outperformed nominal Treasuries both for the year and for the month as inflation expectations have started to modestly rise.

Market Outlook

Our base case continues to be a moderating but still positive growth environment (i.e. slowdown) as long as the following four preconditions hold true.

Policy doesn't turn overly restrictive Changes in rates and inflation remain gradual Investor sentiment lacks euphoria Fundamentals remain constructive

The above doesn't suggest an ultra defensive posture, however, we think its important not to let risk asset exposures get too extended given where the market has taken us. Stocks have come an awfully long way year-to-date ? the best start in 32 years ? and we think more good news has gotten priced in. At the end of last year the market consensus was for a recession of some sort, however, the Fed's dovish policy pivot, progress on trade and better than feared 1Q earnings have shifted that consensus closer to our base case slowdown scenario. In short, investor fear of not getting their return of capital has shifted to investor fear of missing out on additional return on that capital. In sum, we think it pays to be nimble as market views will continue to oscillate.

We also think its interesting to compare market stats from the end of 3Q18 ? just prior to the market selloff ? to the end of April. As can be seen in the table at right, we thinks its notable that the S&P 500 price level, stock valuations and sentiment conditions are all very similar to where they were prior to the selloff and yet earnings growth is lower and financial conditions are tighter. To us, this argues having modestly lower risk exposure today than we had back at the end of the third quarter and we have taken profits accordingly.

From here, we think the market hinges on two critical factors ? earnings growth expectations and interest rates. Regarding the latter, we think yields having stayed low so far this year have been especially supportive for stocks. The risk, of course, is that higher rates provide a headwind for equities now that stock valuations have more fully recovered amid slowing earnings growth. As a result, its not surprising to see equity markets having had some trouble digesting recent Fed comments that suggest a rate cut is less likely. Conversely, earnings growth expectations are beginning to show signs of stabilization which is also being confirmed by improving estimate revision trends. We think its premature to suggest earnings re-accelerate but stabilizing growth expectations is important to eliminating the earnings recession scenario.

Separately, as US-China trade talks have approached what appeared to be the final round of discussions, sticking points remain as evident by the President's recent threat of additional tariffs as of the time of this writing. The off again ? on again ? off again trade backdrop remains a wildcard that suggests market sentiment can shift quickly.

The bottom line is that while we think its too early to hunker down for an imminent recession scenario, we're also not as optimistic on stocks as we were to begin the year. As a result, portfolio positioning has started to reflect more of a barbell posturing. We've maintained a cylical lean geographically within equities (by maintaining our overweight to emerging markets) ? though we've balanced that out by continuing to move up in quality within fixed income (by increasing our overweight to US Core bonds). A barbell posturing can also be seen in our US Large Cap sector exposure where we're overweight the more cyclical value sectors counterbalanced with an overweight to the more defensive and income oriented sectors.

More specifically from a positioning perspective, we maintain diversified portfolios for our clients. We incrementally "risked up" in early January following the 4Q selloff and "de-risked" some in early February and again in early April as sentiment caught up to fundamentals and equity markets got closer to fair value. Currently, we still maintain a modest preference for stocks over bonds and alternatives.

Within equities, we maintain broad diversification but with a tilt toward international markets mostly in the form of emerging market stocks. Meanwhile, we have retained our bias to quality and value risk factors given the late cycle backdrop. We think maintaining a value bias in our US large cap exposure will be important as US earnings growth continues to moderate. To that point, we continue to make adjustments within our stock portfolio with a bias to trim cyclical growth oriented stocks and add to attractively priced businesses and more defensive, stable growers.

Within fixed income, we remain positioned for less interest rate sensitivity and have been moving up in liquidity and up in quality. Beginning in the fourth quarter we have started to de-emphasize corporate credit incrementally by reducing our exposure to floating rate bank loans and adding exposure to shorter duration US Treasuries given attractive yields and favorable risk adjusted returns. We remain overweight US bonds relative to international fixed income given their yield advantage.

Within alternatives, we maintain an overweight to our volatility mitigating managers. We are underweight more interest rate exposed REIT's and are more modestly overweight commodities ? a typical late cycle inflation beneficiary.

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