2019 Midyear Market Outlook

Cautious Optimism for Equities

Is the U.S. economy experiencing a soft patch, or is a recession on the horizon?
Regardless of the outcome, history suggests that equities will continue to move
higher in the coming months with an uptick in volatility.

Scott Glasser, Co-Chief Investment Officer; Jeffrey Schulze, CFA, Investment Strategist

U.S. equities, as measured by the S&P 500, finished the first six months of 2019 up 18.5%, their best performance since 1997.  While we still expect higher returns in the second half, several of the perceived positives that have driven equities to all-time highs may be less supportive going forward. Despite the U.S.-China trade détente that emerged from the G-20 summit in Japan, if an agreement can’t be forged in the coming months and tensions re-escalate, it could push equities lower like previous episodes when stocks sold off swiftly due to trade war fears. In our view, the recent trade “truce” could be a “sell the news” type of event due to the lack of substance and tangible progress (Exhibit 1).
Exhibit 1: Trade Escalations Have Come at Market Highs
S&P 500 price index: 12/30/16 – 6/28/19
Source: Factset, as of 6/28/19. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
The second perceived positive for stocks that could warrant a more cautious stance is the expected easing of Federal Reserve (Fed) policy. The markets are currently pricing in at least two interest rate cuts this year. Historically, Fed cuts are bearish for equities and the economy. Ten of the last 13 interest-rate hike cycles have ended with a recession because the Fed acted too late and lower rates couldn’t prevent the economy from rolling over.

Importantly, the current yield curve inversion has not persisted for a long time and it's relatively shallow, meaning there is still a chance the Fed can reverse course and manage a “soft landing” à la 1995 or 1998. Bull and bear markets are primarily a function of liquidity in the system. We think there's ample liquidity right now, and that should continue as rates head marginally lower and inflation remains contained.  For now, we would view expected rate cuts as limited and more of an “insurance policy” to sustain growth.   

Finally, the overall signal for the ClearBridge Recession Risk Dashboard has recently turned yellow from green, signaling caution. It’s important to note that a yellow signal does not mean that the market or economic cycle is over just quite yet. On average, the ClearBridge Recession Risk dashboard would be expected to turn yellow before both a recession and a market top.  Additionally, the dashboard would have shown three yellow signals in the past that never worsened to red: 1995, 1998 and 2015.Although the economy avoided a recession in each of these instances, economic activity slowed substantially before quickly reversing course. Should the dashboard continue to erode and turn red, we would become much more cautious, given its much stronger recessionary track record. As a result, the U.S. economy is at a crossroads: soft patch versus recession on the horizon. Regardless of the outcome, history would suggest that equities will continue to move higher in the coming months, accompanied by an uptick in volatility.

In terms of positioning in this environment, we want to tread lightly in areas most at risk from both a trade perspective and a slowdown in global growth. Take technology, for example. The hardware side has a lot of exposure in China, and areas like semiconductors have been badly hit. Software, meanwhile, is much less affected by what's going on in China. Though the market may come down or tech may come under pressure, software is an area to maintain or even expand through volatility.

In the 10th year of a bull market, there are not a lot of stocks that offer both reasonable valuations and solid fundamentals. What does look attractive is a little controversial, like the pharmaceutical and biotechnology sub-sectors of health care, which continue to deal with pricing pressure and rhetoric over changes to the overall health care system.

Another sector where we see opportunity is energy pipelines. Energy companies are dealing with questions about global demand and how that will impact commodity prices. But as long as prices stay within a certain range, pipeline companies can thrive. After suffering through a multi-year bear market, in our view they offer attractive yields at moderate valuations.  
1 The ClearBridge Recession Risk Dashboard was created in January 2016. References to the signals it would have sent in the years prior to January 2016 are based on how the underlying data was reflected in the component indicators at the time.
2019 Midyear Outlooks
Brandywine Global
Growth: Turning a Corner
Clarion Partners
The Momentum Continues
ClearBridge
Cautious Optimism for Equities
EnTrust Global
Realistic About Risk
Martin Currie
Looking Beyond the U.S.
QS Investors
Where Do We Go from Here?
RARE Infrastructure
U.S.-China: Fallout from Trade Tensions?
Royce & Associates
Cyclical Thinking
Western Asset
Resilient Growth, Despite Uncertainty

Investment risks:

Yields and dividends represent past performance and there is no guarantee they will continue to be paid.

Definitions:

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The Group of Twenty (also known as the G-20 or G20) is an international forum for the governments and central bank governors from 20 major economies. The members include 19 individual countries—Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom and the United States—along with the European Union (EU). The EU is represented by the European Commission and by the European Central Bank.

The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.

Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.

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