“Don’t fight the Fed” is a common axiom among investors that has relevance in today’s market environment. After a brief trade related scare in May, markets continued to push higher during the second quarter. The major stock indices are trading at or near new highs, corporate credit has remained firm, and U.S. Treasuries have rallied on expectations of rate cuts in the second half of the year.
The seemingly insatiable appetite for U.S. Treasuries has resulted in a steep drop in yields as the market discounts Fed rate cuts. Yields on the 10-Year Treasury Note sank to 2.0%. At the June FOMC meeting, the Fed left interest rates unchanged but prepared the market for future rate cuts. The prospect of a policy error and rising trade tensions with China have gotten the Fed’s attention, and the Fed’s bias has turned dovish given the uncertainties surrounding the economic outlook and muted inflation pressures. The Fed is now expected to cut rates at the July FOMC meeting. It seems strange to cut rates with stocks trading at or near record highs, full employment, 3.1% real GDP in the first quarter, tight credit spreads, and the moral hazard of cutting rates.
The current economic expansion has been very resilient and at the end of June, it became the longest economic expansion on record, tying the expansion from 1991–2000. At 120 months, this expansion has more than doubled the median length of past expansions. Data we look at suggests continued economic growth through year-end, but there are some concerns given the late cycle nature of the advance. For example, global manufacturing has been in decline for over a year and the yield curve is inverted, signaling potential trouble for the economy down the road.
Second Quarter Attribution
The Fixed Income Total Return (FITR) portfolio was invested in high yield bonds from January 10th until June 3rd, when the portfolio moved into U.S. Treasuries. During the second quarter, trade tensions with China turned into a full-blown trade war between the world’s two largest economies. The escalation of the trade war, breakdown in negotiations, and trade tensions with Europe and Mexico resulted in fears of a deeper global economic slowdown.
These fears caused a correction in risk assets and a flight to safer asset classes with the models that guide the FITR strategy showing pronounced strength in U.S. Treasuries. This strength in U.S. Treasuries resulted in the strategy shifting its allocation away from high yield bonds and into U.S. Treasuries in early June.
De-risking added value in the portfolio both in terms of return and reduced risk during 2018. While it has reduced risk in the portfolio, unfortunately that same de-risking has also been a net detractor from return so far this year. For the quarter, the FITR portfolio underperformed both the Bloomberg Barclays Corporate High Yield Bond Index and the Bloomberg Barclays Aggregate Bond Index on a gross and net basis.
Credit spreads have remained tame most of this year and have come in substantially from their peak in the 4th quarter. Given that our economic outlook remains positive, we expect credit spreads to stay mostly contained until economic conditions worsen.
Since the Great Recession ended, there have been several bouts of credit weakness where spreads spiked higher, including those in 2011, 2015, and 2018. Each one of those weak periods was primarily due to growth scares that proved to be temporary. As we move deeper into the late stages of this economic expansion, we should anticipate similar episodes of volatility.
We came into the year with a bullish outlook and expected continuing, but slowing economic growth. The U.S. markets have delivered solid gains, and we expect further gains in the second half of the year. We believe the range of possible outcomes is wider than usual over the next six months given uncertainty on the trade front, Fed policy actions, and slowing U.S. economic activity.
Economic indicators suggest continued economic growth, but at a slower pace. In our opinion, the risk of recession remains low as Leading Indicators and labor market statistics are strong, but the yield curve is beginning to flash warning signs.
There are many risks to the outlook that could roil the markets. Top on the list is the trade war with China. Anything can happen, and even a tweet can send the market into a buying frenzy or selling panic. That adds a level of uncomfortable uncertainty into the equation. The Fed’s pivot to a more dovish bias is almost complete. As of quarter end, the market was discounting 100 basis points of rate cuts over the next 12 months. We expect the Fed to cut rates, but in our opinion, the market’s expectation is too aggressive.
High yield investors may need to downgrade their return expectations over the intermediate-term given the recent strength in credit and decline in yields. The yield on the Bloomberg Barclays Corporate High Yield Index dropped below 6.0% in June. Total returns for the index’s 6 and 12 month forward averaged just 1.19% and 2.4%, respectively.
|3 month||6 month||12 month||18 month|
There has been a deterioration in credit quality over the past couple of years. Over 50% of both the U.S. and European investment grade corporate bonds are trading at the bottom rung of investment grade ratings. The amount of debt rated BBB is currently larger than the entire high yield market.
As a result, many people are concerned about the spillover effect on the high yield market if a large share of these BBB bonds are downgraded to junk status. Our view is that this would present a tremendous opportunity should it occur, and we believe we are well positioned to capitalize on this opportunity with our active and tactical approaches to managing fixed income.
This is not a recommendation to buy or sell a particular security. Please see attached disclosures.
Gross returns will be reduced by investment advisory fees and other expenses that may be incurred in the management of the account. For example, a 0.50% annual fee deducted quarterly (.125%) from an account with a ten year annualized growth rate of 5% will produce a net result of 4.4%. Actual performance results will vary from this example. The Firm’s policies for valuing portfolios, calculating performance, and preparing compliant presentations are available upon request.
The opinions expressed are those of the Clark Capital Management Group Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. There is no guarantee of the future performance of any Clark Capital investment portfolio. Material presented has been derived from sources considered to be reliable, but the investment accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. For educational use only. This information is not intended to serve as investment advice. This material is not intended to be relied upon as a forecast or research. The investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Past performance does not guarantee future results. All investments involve risk, including loss of principal and there is no guarantee that investment objectives will be met.
This document may contain certain information that constitutes forward-looking statements which can be identified by the use of forward-looking terminology such as “may,” “expect,” “will,” “hope,” “forecast,” “intend,” “target,” “believe,” and/or comparable terminology (or the negative thereof). No assurance, representation, or warranty is made by any person that any of Clark Capital’s assumptions, expectations, objectives, and/or goals will be achieved. Nothing contained in this document may be relied upon as a guarantee, promise, assurance, or representation as to the future.
The S&P 500 measures the performance of the 500 leading companies in leading industries of the U.S. economy, capturing 75% of U.S. equities.
The Dow Jones Industrial Average is a stock market index that shows how 30 large publicly owned companies based in the U.S. have traded during a standard trading session in the stock market.
The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performers of developed markets outside the U.S. and Canada.
The MSCI Emerging Markets Index is a free float adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
The Russell 2000 Index measures the performance of the bottom 2,000 stocks in the Russell 3000 Index which is made up of 3,000 of the largest U.S. companies.
The Russell 3000 Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.
The CBOE Volatility Index (VIX) is a forward looking index of market risk which shows expectation of volatility over the coming 30 days.
The volatility (beta) of a client’s portfolio may be greater or less than its respective benchmark. It is not possible to invest in these indices.
Bloomberg Barclays U.S. Government and Credit Bond Index measures the performance of U.S. dollar denominated U.S. Treasuries, government-related and investment grade U.S. corporate securities that have a remaining maturity of greater than one year.
The Bloomberg Barclays U.S. Aggregate Bond Index covers the U.S. investment-grade fixed-rate bond market, including government and credit securities, agency mortgage pass-through securities, asset-backed securities and commercial mortgage-based securities. To qualify for inclusion, a bond or security must have at least one year to final maturity and be rated investment grade Baa3 or better, dollar denominated, non-convertible, fixed rate and publicly issued.
The BofA Merrill Lynch U.S. High Yield Index tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
The Bloomberg Barclays 7-10 Year Treasury Index tracks the investment results of an index comprised of the U.S. Treasury bonds with remaining maturities between seven and ten years.
The Bloomberg Barclays 20+ Year Treasury Index tracks the investment results of an index comprised of the U.S. Treasury bonds with remaining maturities greater than twenty years.
The Bloomberg Barclays Long-Term Treasury Index tracks the performance of the long-term U.S. government bond market.
The Bloomberg Barclays U.S. Corporate High-Yield Index covers the U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
The Bloomberg Barclays U.S. Treasury Bond Index is an issuances-weighted index measuring the performance of the U.S. Treasury bond market, one of the largest and most liquid government bond markets in the world.
Bloomberg Barclays U.S. Aggregate Bond Index: The index is unmanaged and measures the performance of the investment grade, U.S. dollar denominated, fixed-rate taxable bond market, including Treasuries and government-related and corporate securities that have a remaining maturity of at least one year.
MSCI All Country World Index is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world. The MSCI ACWI is maintained by Morgan Stanley and is comprised of stocks from both developed and emerging markets.
Index returns include the reinvestment of income and dividends. The returns for these unmanaged indexes do not include any transaction costs, management fees or other costs. It is not possible to make an investment directly in any index.
Gross performance shown is presented gross of investment advisory fees and includes the reinvestment of all income. Gross returns will be reduced by investment advisory fees and other expenses that may be incurred in the management of the account. Net performance includes the deduction of a 3.0% annual wrap fee, which is the highest anticipated wrap fee charged by any sponsor. Management and performance of individual accounts will vary due to differences such as the availability of securities, trading implementation or client objectives, and market conditions. For a fee schedule, please contact your financial advisor. If you enter into an agreement directly with Clark Capital, refer to Clark Capital’s Form ADV Part 2A.
Clark Capital Management Group, Inc. is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Clark Capital’s advisory services and fees can be found in its Form ADV which is available upon request.
The relative strength measure is based on historical information and should not be considered a guaranteed prediction of market activity. It is one of many indicators that may be used to analyze market data for investing purposes. The relative strength measure has certain limitations such as the calculation results being impacted by an extreme change in a security price. Clark Capital Management Group, Inc. reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. It should not be assumed that any of the securities transactions, holdings or sectors discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.
CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.