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Bogue Asset Management’s Quarterly Investment Letter      

In this commentary, I discuss how I still see a high degree of uncertainty and a wide range of plausible outcomes looking out over the next 12 months (and beyond). But at the margin I think the macro risks have increased. Trade uncertainty has damaged global business confidence in what by many measures is an already weak global economy..........[See More]

    

How your advisor is compensated does matter.  Lately there has been a blurring of the lines with the use of the term “Fee-Based” to describe how one is compensated.  I’ll tell you why Fee-Based is not Fee-Only and the difference can be substantial: [See More]

 

    

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Second Quarter 2019 Key Takeaways

 

The first half of 2019 saw robust gains across most asset classes, but it certainly wasn’t a smooth ride. Global stock markets got a jump start on the year thanks to progress in US-China trade negotiations and a newly “patient” Fed, but an abrupt breakdown in the trade talks (announced via Presidential tweet) spurred a sharp market sell-off in May. Stock markets subsequently shook off their swoon in June, rebounding on expectations of Fed rate cuts later in the year and (tentative) signs of re-engagement on the US-China trade front. 


The S&P 500 hit a new high near the end of June. Large-cap U.S. stocks shot up 7.0% for the month – their best June since 1955. They were up 4.3% for the second quarter, and a remarkable 18.5% for the first six months of the year—their best first half since 1997.


Foreign stocks also notched double-digit gains through the first half of the year. Developed international stocks gained 5.9% in June, 3.2% for the second quarter, and 14.2% for the year to date. European stocks have done a bit better, gaining 15.6% on the year so far. In April, the “Brexit can” was kicked down the road at least until October 31, but the risk of a disruptive “no-deal” exit remains. Emerging-market stocks also rebounded in June, gaining 5.4%. Although emerging-market stocks were only up 0.8% for the second quarter, their first-half gains stand at 12.6%. 


Moving on to the fixed-income markets, the 10-year Treasury yield continued to plunge from its multi-year high of 3.2% last October, dipping below 2% following the Federal Reserve’s June meeting. This was a near three-year low, and among its lowest levels ever. The 10-year yield ended the month at 2.0%. Bond prices rise as yields fall, driving the core bond index to a 3.0% gain for the quarter and an impressive 6.1% return so far this year. Floating-rate loans gained 1.7% for the quarter and are up 5.7% for the year. 


Alternative investments also gained. The trend-following managed futures funds I use remained in positive territory, building on a positive first quarter. 


Looking ahead, I still see a high degree of uncertainty and a wide range of plausible outcomes looking out over the next 12 months (and beyond). But at the margin I think the macro risks have increased. Trade uncertainty has damaged global business confidence in what by many measures is an already weak global economy. While this is for now being offset by easier monetary conditions, the inevitable impact of any additional central bank rate easing is certainly muted. 


I believe portfolios are positioned to both generate attractive returns over the next five to 10 years, and to be resilient across this wide range of potential shorter-term risk scenarios. If central banks are successful with their renewed stimulus efforts, my analysis indicates that will favor my positions in global equities, flexible income funds, and floating-rate loan funds.  


On the other hand, should markets turn south, portfolios will benefit from my “ballast” positions in core bonds, lower-risk hybrid and alternative strategies, and trend-following managed futures. These lower-risk, “insurance” positions have been a drag on my returns over the past several years as U.S. stocks have been in a record-long raging bull market. But I’ve seen their benefits during the occasional market corrections, including in last year’s fourth quarter. They also present me with potential capital to re-allocate back into U.S. stocks at lower prices and much higher expected returns if and when the opportunity should arise.


Second Quarter 2019 Investment Letter

 

Market and Portfolio Recap

In my year-end 2018 commentary, I emphasized the wide range of plausible macroeconomic scenarios and financial market outcomes for the year ahead with the potential for either a positive or negative shorter-term path. Through the first half of 2019 we’ve gotten a little bit of everything—signs of both scenarios, though so far the ups have outpaced the downs.

 

The first half of 2019 saw robust gains across nearly every asset class—including both core bonds and equities—but it certainly wasn’t a smooth ride. Among the primary drivers of the market sell-offs and their subsequent rebounds were on-again/off-again U.S.-China trade negotiations and two major shifts in central bank policy.

  

Large-cap U.S. stocks gained 4.3% for the second quarter, and a remarkable 18.5% for

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 the first six months of the year—largely earning back what was lost in the fourth quarter of 2018. Developed international stocks also experienced a healthy rebound from 2018’s losses, up 3.2% for the second quarter, and 14.2% for the year to date. European stocks have done a bit better, gaining 15.6% on the year so far. In April, the “Brexit can” was kicked down the road at least until October 31, but the risk of a disruptive “no-deal” exit remains. 

 

Emerging-market stocks, up just 0.8% for the second quarter, absorbed more of the uncertainty surrounding global trade tensions. But for the year so far, they have gained 12.6%.

 

In fixed-income markets, the 10-year Treasury yield dipped below 2% following the Federal Reserve’s June meeting. This was a near three-year low, and among its lowest levels ever, reflecting promises of further easing later this year. These falling yields drove the core bond index to a 3.1% gain for the quarter and an impressive 6.1% return so far this year. Floating-rate loans gained 1.7% for the quarter and are up 5.7% for the year. 

 

The portfolios I manage have experienced strong gains in the second quarter with many netting low double-digit returns for the year so far.

 

Market and Portfolio Outlook

Not surprisingly, I still see a high degree of uncertainty and a wide range of plausible outcomes looking out over the next 12 months (and beyond). But at the margin I think the macro risks have increased. Trade uncertainty has damaged global business confidence in what by many measures is an already weak global economy. While this is for now being offset by easier monetary conditions, the inevitable impact of any additional central bank rate easing is certainly muted.

 

The risk of a geopolitical shock on financial markets is also ever-present. Most recently, there is heightened potential for a military conflict with Iran. But there are many other potential geopolitical flashpoints and unknowns: Brexit remains unresolved. The tug of war between democracy, populism, nationalism, and autocracy continues around the globe. The U.S. presidential election next year will likely create additional market uncertainty. China’s rise and challenge of the United States as a global superpower goes well beyond just the current trade conflict. The Middle East (beyond Iran) remains a potential flashpoint, as does North Korea.

 

To what extent stock markets are already pricing in these fears and risks is also an unknown. On the heels of yet another strong quarter for U.S. stocks, their valuations are looking more stretched than ever. My analysis of U.S. stock market valuations and expected returns implies the market consensus is discounting an overly optimistic outlook. And it can certainly be said that any investors chasing stocks higher simply because of the tailwind of more monetary stimulus face potential dangers. My analysis—informed by history and applying forward-looking judgment—leads me to a base-case scenario where the expected annualized return from U.S. stocks over the next 5 to 10 years is in the very low single digits. This is well below the upper single-digit expected return I require to compensate for the full risk of owning stocks. As such, I remain underweight to U.S. stocks across my portfolios until the risk/reward trade-off improves.

 

On the other hand, I continue to have modestly overweight positions to international and emerging-market stocks. My analysis indicates their valuations are very attractive relative to the U.S. In my assessment, these markets are implicitly discounting a lot of bad macro news and poor sustained corporate earnings growth. My base case generates high single-digit expected returns for international and emerging-market stocks over the medium-term horizon.

 

Over the shorter-term, if the global economy starts recovering from current depressed

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 levels—with China’s fiscal and monetary stimulus being a key to that outcome—and the United States avoids recession, I would not be surprised to see strong absolute returns from stocks, with outperformance from foreign stocks versus U.S. stocks. Further, if the growth differential between the United States and the rest of the world narrows, the U.S. dollar will likely depreciate, providing an additional tailwind to foreign stock returns for dollar-based investors.  

 

A solid global economy would also be beneficial for my flexible fixed-income and floating-rate loan investments relative to core investment-grade bonds, which have much lower yields and would be hurt by rising interest rates.

 

On the other hand, if the global economy continues to weaken and the United States falls into a recession and bear market, my balanced (stock/bond) portfolios have “ballast” in the form of core bonds as well as lower-risk fixed income and alternative strategies that should hold up much better than stocks on the downside. These lower-risk, alternative positions have been a drag on my overall returns over the past several years as U.S. stocks have been in a raging bull market. But I’ve seen their benefits during the occasional market corrections, including in last year’s fourth quarter.

 

In Closing 

As we experienced this past quarter, uncertainty is a constant presence and volatility can return to markets at the drop of a pin (or a tweet, it seems, these days). Regardless of my tactical diversification efforts, those of us who own stocks need to be prepared to ride through the inevitable down periods. It’s the shorter-term price we pay to earn their higher expected returns over the longer term.

 

This has been an unusually long U.S. economic and market cycle. But I firmly believe it is still a cycle, and that my patience and fundamental valuation discipline will be well-rewarded as it turns again. As always, I appreciate your continued confidence and trust, and I work hard every day to continue to earn it.



Jeff (7/10/2019)

 

 

 

 

 

 

 

Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by Bogue Asset Management LLC with permission.  Reproduction or distribution of this material is prohibited and all rights are reserved.