Heritage Investment Review, Second Quarter 2019


Global stocks and bonds compensated investors quite well over the first half of 2019.  The 12.17%1 global stock market rebound in the first quarter after the late 2018 rout accounted for the majority of the year-to-date return. However, the second quarter saw healthy, normal levels of returns accruing 2.85%1 for a first half-year total of 15.37%1.

Investment grade bonds have also produced strong total returns on the back of the Fed’s change in the direction of monetary policy.  Over the course of 2019, market expectations for lower interest rates were absorbed into bond prices, resulting in some capital appreciation.  The investment grade bond market outpaced global stocks in the second quarter, producing a 3.01%1 return, bringing the first half-year total to 6.04%1.

The two major financial headlines in the first half of 2019 were the ongoing trade negotiations between the U.S. and other nations (particularly China) and the Fed’s about-face position from a contractionary to an expansionary monetary policy.  The latter helps explain the inverted yield curve, another topic much discussed in the financial media.

We view the current trade negotiations as a relatively minor threat to global financial markets, especially over a longer period of time as the effects on sentiment dissipate.  When there are new trade rigidities between two nations, there’s a spillover effect through which other nations may benefit from trade being redistributed.  We believe a globally well-diversified stock allocation is the best protection against the uncertain outcomes of the current trade negotiations.

Of greater significance for financial markets is the directional change in the Fed’s monetary policy and the inverted yield curve.  Both of these occurrences signal higher-than-average recession risk, which typically goes hand-in-hand with a stock market decline.  Stock market declines during economic recessions are more probable and severe when prices are already high compared to fundamentals.  In a recession, earnings fall and required rates of return tend to increase, exacerbating the decline.

Despite somewhat concerning short-term economic indicators, we believe there are excellent investment opportunities over the next 5 to 10 years.  The unbalanced returns over the past decade in growth and value stocks has left a historically wide opportunity for value investors.  Likewise, the gap in performance since the end of the Financial Crisis of 2007-2009 between U.S. stocks and international stocks has opened an attractive opportunity for global investors.



A Strong First Half for Investors

Asset Class Returns

While a majority of asset class returns through the first half of 2019 came during the first quarter, the second quarter was still a rewarding period for investors.

Financial markets’ returns come in anything but a straight line.  Volatility is psychologically difficult to absorb, recently seen in the near-panic at the end of 2018—during which time U.S. stocks fell precipitously with a 20% pullback—to then quickly recover to new highs just 6 months later.  We believe volatility is best coped with broad diversification and aim to experience portfolio returns near the middle all the time instead of experiencing the lowest lows and highest highs to end up in a similar place over time.



Trade, Tariffs & Trump

The Risks of a Decrease in Global Trade

We understand the headline appeal of the drama surrounding trade negotiations between the U.S. and other nations, particularly China.  Global trade is very important to overall production and consumption.  However, we believe it’s not particularly productive to speculate on the outcome of the trade negotiations and then infer the outcome’s impact on security prices.

Perspective must be kept in mind when apolitically evaluating the current trade negotiations.  U.S. imports are approximately 15%2 of the economy’s annual output.  U.S. exports are around 12%2 of the economy’s annual output.  Therefore, net imports—the trade imbalance—is around 3% of gross domestic product (GDP).  U.S. GDP in 2018 was $20.5 trillion3.  The U.S. total trade deficit is approximately $650 billion4. The U.S. trade deficit with China in 2018 was $419 billion5.  If the U.S. wants to come closer to balancing trade, the necessary clear place to start is with China.

In a stressed scenario, tariffs are imposed by the U.S. on Chinese goods and retaliatory tariffs are imposed by China on U.S. goods (this is a “trade war”). The result would be a slight decline in trade between the two nations in the short-term.  The economic consequences won’t be seismic.

Tariffs collected by governments are still economic revenue.  If the volume of trade declines between the two nations, much of it spills over—either with other trading partners or to domestic producers.  The redistribution of net exports (not a loss) gained by other nations from re-allocated U.S. consumption may be around $60 billion6.

The small real economic loss in output from the loss of the “most efficient” allocation of productive resources is a fraction of the total trade between China and the U.S.  The lost output may be on the order of magnitude of $20 billion —that’s less than 0.10% of U.S. GDP.  For reference, Bitcoin has a market capitalization of approximately $200 billion7 and last year fell from $300 billion to $100, a loss of over 10 times the magnitude.

With all that said, the current trade tensions between the U.S. and China once again highlight the benefit of broad, global diversification.  Regardless of what happens between the primary players in the trade saga, it’s business as usual in many other countries.  In fact, if trade migrates away from China as it’s no longer the low-cost producer of certain goods for U.S. consumers, there are bound to be collateral beneficiaries (who’s stocks will benefit a globally-diversified investor).



Change in Direction of Monetary Policy

Why a Yield Curve May Invert

In its March meeting the Fed revised its 2019 interest rate projection from two increases of 0.25% to no further expected increases.  Shortly thereafter, the three-month to ten-year portion of the yield curve inverted (the short-term rate exceeded the long-term rate).

If no interest rate changes are expected, the yield curve should be flat.  When the yield curve inverted, the bond market signaled that it believed there would be upcoming rate cuts, not just no more rate increases.

The bond market appears to have been right.  The Fed has since become more “dovish,” talking about how it may cut rates multiple times this year.  Why does this matter?

Shortly after prior inversions of the 3-month to 10-year segment of the U.S. Treasury yield curve, a recession set in.  During recessions, global stocks have experienced losses.

The yield curve inverts when the Fed is expected to cut interest rates. The Fed cuts interest rates because it’s worried about the poor economic results in the most recent data. Poor economic results show up in lower earnings for companies, which typically weigh on stock prices.  Additionally, lower earnings result in layoffs and higher unemployment.  Higher unemployment and frozen wages makes individuals’ required rates of return to invest higher, which further weighs on stock prices.

The U.S. recently experienced a yield curve inversion and the Fed has changed course in its monetary policy to start stimulating the economy.  While a host of economic indicators have turned negative, stock prices in the U.S. are still at all-time highs and a recession has not been experienced.  However, we believe this is a time for caution in risk-taking.



Mean Reversion & Investment Opportunities

Value Stocks

Over the decade-long recovery from the Financial Crisis of 2007-2009, growth stocks have significantly outperformed value stocks.  But, value investing over the long run has outperformed growth investing.  We believe that when there’s a major divergence in one strategy versus another, it tends to be an opportunity to be positioned for a reversal.

Charles Schwab’s Chief Global Investment Strategist, Jeffrey Kleintop, echoes our views about the major opportunities for mean reversion.

We believe value outperforms over time and should be the dominant strategic overweight.  However, slightly over a decade ago, there was an opportunity to be tactically growth-oriented.  Today, there’s an opportunity to be tactically value-oriented.

International Stocks

The other glaring opportunity from a relative-returns standpoint is international stocks over U.S. stocks.  Once again, Jeffrey Kleintop’s illustration of the opportunity for mean reversion is in agreement with our view.

We believe a globally diversified portfolio provides a better risk-return tradeoff than concentrating in any one market, and a market cap-weighted stock allocation should be the dominant strategic allocation.  However, at the beginning of the 1990s, there was an opportunity to be tactically U.S.-oriented.  Today, there’s an opportunity to be tactically internationally-oriented.




The first half of 2019 has been a good time for investors, both in the first quarter and second quarter.

While returns year-to-date are strong, there are some concerning signs in the economy that the U.S. may be nearing the end of a long stretch without a recession.  When there’s a recession, stock prices generally recede, especially when they’re priced somewhat expensively to start with (expressing optimism).

We don’t believe the trade negotiations, while taking up a lot of air-time, will be the cause of a recession (although people may blame it for a recession if it happens by coincidence).  We believe the Fed’s reversal from contractionary to expansionary monetary policy and the inverted yield curve are important indicators that the economy may slow down in the near-term.

Even in an environment with above average risk, there are significant opportunities available to investors.  We believe value stocks are attractive relative to growth stocks.  We also believe international stocks are attractive relative to U.S. stocks.

We appreciate your business and trust in our process.  It takes patience to see a strategy through and to enjoy its success.  We believe well-reasoned positioning rewards those willing to wait for its payoff.

Disclosures: This newsletter has been prepared solely for informational purposes, and is not an offer to buy or sell, or a solicitation of an offer to buy or sell, any security, product, service or investment. The opinions expressed herein are solely the opinions of Heritage Financial Services and do not constitute investment advice and are subject to change without notice.  Heritage customizes client portfolios based on individuals’ financial situations.  Various components of this commentary may not be relevant to each client’s personal portfolio due to, without limitation, portfolio legacy securities, portfolio size, accounts with limited investment options, tax considerations, investment accreditation and personal preferences.  Past performance may not be indicative of future results.

All data contained herein are believed to be accurate as of the date of publication.  Data sources include Morningstar, Inc., Yahoo! Finance, Charles Schwab, and various cited publications.  Certain third-party sources are relied upon for historical statements and performance information.  Heritage is under no obligation to update this document as additional information becomes available or if any revisions are made to information herein contained.

  1. 1 Morningstar, Inc.
  2. 2 Statista.
  3. 3 Bureau of Economic Analysis.
  4. 4 Federal Reserve Bank of St. Louis.
  5. 5 Office of the United States Trade Representative.
  6. 6 The United Nations Conference on Trade and Development.
  7. 7 CoinMarketCap.