David Lebovitz: This is David Lebovitz, host of the Center for Investment Excellence. Welcome back to another episode. Today, we want to talk a little bit about what's been going on with economic growth, we want to talk a little bit about what's been going with the Fed, and then I want to talk about who’s right: the stock market or the bond market and what we think that that means for asset allocation. 

So taking stock of where we are broadly, the economic data has not been great. Global manufacturing activity based on the PMIs has slipped below the key 50 level indicating contraction. Meanwhile, services are holding in there a little bit better but the combination of a disappointing jobs report in May, a deceleration in services activity according to the PMIs, you know, it basically feels like you're seeing the global economy come under a bit of pressure due to what's gone on over the past couple of months with respect to trade and uncertainty more broadly. 

And given where we sit at the current juncture, you know, the big risk remains that the weakness in manufacturing and investment spending begins to manifest itself on the other side of the ledger; it begins to show up in weaker labor report numbers, it begins to show up in weaker services activity, a deceleration in things like retail sales. And while we're not seeing that quite yet, you know, that is what we're keeping an eye on from an investment standpoint. 

And the June payroll report obviously provided some relief with 224,000 jobs added last month. Generally speaking that gives us a little bit more confidence that things aren't slip-sliding away perhaps as much as they may have felt like they were back in May, but we are very cautious at the current juncture because of the uncertainty that’s been created by lack of resolution on trade, lack of - but we've been focused on this uncertainty driven by lack of resolution trade, you know, a tough outlook for nominal demand, it’s really difficult to gauge where the economy is headed going forward. 

And all of this has come together and led the Federal Reserve to make a pretty dovish pivot over the past couple of months. You know, it started at the beginning of this year and then the forecasts were revised at both the March and the June meeting. It does feel like there's a rate hike coming between now and the end of the year, possibly even two rate hikes. And we're really thinking about these as insurance cuts. 

Now, I’ve been having a lot of conversations with investors about what the Fed will do versus what the Fed should do. And I think that that’s an important distinction for us to make. You know, everybody has an opinion on what the Fed should do, my taxi driver this morning was telling me what he thought Jay Powell should do when the Fed convenes at the end of this month. But frankly, you know, what I think, what my taxi driver thinks, it’s irrelevant. 

You know, should the Fed cut rates? I don't really think they need to. I think potentially they could bring forward balance sheet reduction, halt that process, start reinvesting at the end of this month. That buys them a little bit more time to determine whether it’s really prudent to cut rates. But as Chairman Powell shared in his testimony to Congress this past week, you know, it does feel like there's a rate cut in the cards and it feels like that first rate cut is likely coming at the end of this month. 

So with all of that being said, you know, you look at capital markets today, you’ve got the S&P which touched 3000 earlier this week in intraday trading, you’ve got a 10-year treasury yield sitting just above 2%, and the question that we deal with in that environment is okay so who’s right? The stock market or the bond market? 

You know, 2% treasury yield don't instill a lot of confidence about the economic outlook, meanwhile investors that are willing to pay 17 times forward earnings and a busy S&P 500 up to a level of nearly 3000, you know, those are very different outlooks from where we sit. 

And, you know, on this one I frankly think the stock market has got it right. I started my career focusing on fixed income and I’m usually a bond market leads, equity market follows kind of guy. But I think the bond market’s got this one wrong. You know, I’m not expecting terribly robust economic growth, I’m not expecting inflation to accelerate unexpectedly, but what I am expecting is that the consumer is going to continue to provide support. You know, the weakness in manufacturing should lead this global expansion to bend and not break. 

And as a result, you know, we do think that we'll see moderate growth here over the next 12 months. So while the stock market from a valuation standpoint certainly makes me feel a bit uncomfortable, and I think that if the Fed doesn’t follow through on the three rate hikes that are currently priced into the market you could see some wind come out of the sails and perhaps, you know, a bit of a correction in equity crisis alongside a re-rating in interest rates which would need to go higher if the Fed in fact does not cut three times. 

You know, despite the risk that we see on the horizon for a short term pullback in risk assets, and a re-rating in treasury yields, you know, we're not terribly concerned that the end of the cycle is lurking right around the corner but rather are focused on what all this means for portfolios. 

So when we think about what it means for portfolios, again, three rate hikes priced into the market, 10 year treasury yield sitting around 2%, you know, the question for investors is do you really want to add duration? Do you really want to add high quality long-term fixed income at current levels? 

You know, the answer may be yes and it really depends on your Fed view. You know, if you think the Fed is going to cut three times this year and perhaps continue that process into 2020, buying bonds at 2% on the 10 year makes sense. But if you don't think that the Fed is going to go three or more times and you think that they may pause after a couple insurance cuts later this year, then you're looking at a market that is frankly a bit expensive relative to what will end up materializing. 

In that type of world given how flat the yield curve is I think that you can own high quality assets of a shorter duration, clip a similar type of coupon and not take on that interest rate risk that you would in longer duration fixed income instruments. 

On the equity side, you know, we expect volatility this year. I wouldn’t be surprised to see a 10% correction in the next couple of months as markets price in a somewhat uncertain and weaker earnings outlook than they’ve had to deal with in quite some time. But again, we see this expansion continuing, we think that there's room for stocks to continue to rise but we want to have a little bit more insulation, we want to pad our portfolios to an extent by focusing more on income. 

That’s led us to sectors like financials in particular where you get a pretty healthy dividend yield, the potential for capital appreciation and while financials tend to be more cyclical assets, if interest rates do rate higher on the back of a Fed that doesn’t cut three or more times, we think you’ll see some benefit among the banks as well. 

Thinking about parts of the equity market that we want to avoid, similar to our view of long duration fixed income, when you look at what's gone on in the utilities and consumer staple sector valuations are rich, these areas have rallied hard as rate expectations have built over the course of this year. Again, we don't want to be in that purely defensive camp of the equity market, but we also don't want to be on the highly cyclical side owning things that don't provide us with much income and have returns streams that have historically been driven by capital appreciation. 

So that leads us to a more balanced approach within equities focusing on what we like to call cyclical value. You know, you're maintaining some exposure to the upside but you're providing a bit of protection if the markets should get choppy through that healthy dividend yield that some of the more cyclical value sectors are able to provide. 

And then finally I would be remiss to not mention alternatives, things like infrastructure, and other real asset strategies can help diversify portfolios during periods of uncertainty and market stress. And while there are risks building in the private equity and the private credit universe, and I would implore you all to listen to our next episode where I interview Brad Demong, one of the private credit portfolio managers here at JP Morgan, you know, we do see opportunities in those spaces. 

We're gravitating away from direct lending, we're not terribly focused on mega-buyout strategies in the PE space, but those smaller middle market deals still do look appealing on the private credit side you're obviously getting a healthier coupon and on the private equity side you stand to potentially benefit and derive a return which is above and beyond what's available in the public markets so lots to chew on at the current juncture. 

The question for us is what will the Fed do, not what should the Fed do. And it looks like there are rates coming so we think portfolios should be positioned accordingly. And thanks again for joining me on another episode of Center for Investment Excellence. 

David Lebovitz: Welcome to the Center for Investment Excellence, a production of JP Morgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is on private credit and has been recorded for institutional and professional investors. I’m David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence. With me today is Brad Demong, Co-Chief Investment Officer and Portfolio Manager with the Global Special Situations Team. 

Thank you for joining us today on JP Morgan’s Center for Investment Excellence. CFA Institute members are encouraged to self-document their continuing professional development activities in their online CE tracker. Recorded on July 11, 2019.