Client Letter 2019 Q2

Q-1 2019 Market Results

What a difference a quarter makes. The first quarter of 2019 was an almost complete reversal of what we saw in the fourth quarter of 2018. The U.S. S&P 500 index was up +13.65%. The international market index was up +9.98% and emerging markets were up +9.93%. Global ex-U.S. fared slightly better at +10.32%. Bonds showed a nice recovery as well, with the aggregate index up +2.94% for the quarter. Short-term treasuries did reasonably well given their low level of risk at +0.99%.

After reaching a bottom on December 24 that brought the S&P 500 down over 20% from the previous peak, the market started a V-shaped recovery through the first quarter. I’m sticking with my view from last quarter that the market correction that started in early October 2018 was very similar to the correction we saw in late January 2018. The deeper correction that started in mid-December 2018 looked like a complete anomaly to me. The markets were reactionary and over-emotional and the recovery in January and February, to me, is proof. I suggested a three to nine-month stabilization for the market after the correction and it’s happened in just over three months.

Portfolio Thoughts

The first quarter of 2019 provided strong portfolio results for virtually everyone. Momentum portfolios with very limited buffering got hit hard last quarter. Tactical and Strategic portfolios were hit slightly less hard due to their inherent diversification buffering. But all portfolios had strong recoveries helped by rebalancing trades made in mid-January. For the coming quarter, I will be reducing exposure to U.S. large growth and adding to large value. International remains underweight while emerging markets remains overweight. I’m adding to hi-yield bonds and underweighting inflation protected bonds.

Q-1 2019 Notes

The Federal Reserve (Fed) did not raise rates in March as I expected last quarter. The Fed has gotten more dovish (meaning: a lower interest rate bias) since their last rate increase in December. It is currently looking as if we won’t see more than one rate increase in 2019, if we even see that. We might even see a rate decrease, but that’s not my expectation. This more dovish attitude is good for markets and risk-taking, but it also signals that a slowdown or recession is coming. I don’t feel it is time to get defensive in our investments, but I am paying close attention and expect to get more defensive sometime in 2019.

Politically, the first quarter saw the end of the Russia investigation spearheaded by Robert Mueller. Details are limited, but the current President will not face indictment. This doesn’t necessarily mean nothing happened or that President Trump is fully exonerated. It means that either 1) nothing happened, there is no evidence, and he is exonerated or 2) something happened, but there is insufficient evidence to indict. While the political hand-wringing over those two options will take time to play out, this no-indictment conclusion might mean that the President and Congress can move on from the investigation and spend time on actual governance. Though, given the rhetoric from both sides, I’m not banking on it.

Moving on to global topics, I want to come back to one I covered a couple of quarters ago--China. This topic generated a surprising number of questions and comments from clients, so I thought it worthwhile to spend a bit more time on the subject. In my last writing, I commented on how China has become the world’s second largest economy, built on a mercantile strategy of low-cost labor and inexpensive exports,
not domestic consumption. This process started in 1978 when then President Deng Xiaoping opened China to the global economy. I also mentioned in my previous writing that China’s aspirations go much further than economics. This can be seen in two public Chinese documents that outline exactly where China intends to go as a nation; “Made in China 2025” and “Vision 2050”. The former illustrates how China will pursue becoming the leading supplier of hi-tech products such as semiconductors, robotics, aerospace and artificial intelligence by 2025. This policy is essentially the roadmap for securing the needed technical capabilities, including intellectual property theft. The latter policy is less focused on specific capabilities, but much larger in scope. Vision 2050 is the open affirmation that China intends to be the leading global superpower by 2050. President Xi Jinping doesn’t flaunt this objective, but he and the Communist Party of China (CPC) are clearly maneuvering toward this goal. This is the essence of the oft-mentioned “power struggle” unfolding between the U.S. and China. The current global superpower will likely be tested by an upcoming would-be superpower.

In my opinion, we are indeed in a power struggle. The struggle comes down to two main areas, economics and military. From an economic view, the U.S. is more resilient than China because it is not export driven. China needs the U.S. market to sell its goods to, and it cannot afford the social consequences of higher unemployment resulting if the U.S. stops buying. Social stability is of paramount importance in China. Militarily, China is often thought of as a peer, or near-peer, which is far from true. China does have a large 2 million-man army, compared to only 1.3 million for the U.S. But the world is dominated militarily by controlling the oceans. The U.S. today has eleven fully operational aircraft carrier strike groups plus an additional nine amphibious ready groups (a smaller naval team with a main aircraft carrier designed for short take-off aircraft and Marine landing battalion). Since the end of World War II, the U.S. can keep open, or shut-down any sea-lane it chooses, including those in the Pacific Ocean China calls home. For comparison, China has two aircraft carriers. The first is a Soviet leftover updated with Chinese communications technology. The second is a Chinese built carrier based on a Soviet platform; nowhere near the size or capability of the latest U.S. carrier fleet.

China is developing its military at a rapid pace, which may eventually lead to something more like a Soviet-style Cold War. It was “mutually assured destruction” (an understanding that a nuclear war would utterly destroy both countries) that prevented the U.S. and the Soviet Union from determining who really was the global superpower during the Cold War. For now, the U.S. is the leading global economic and military superpower. China my very well challenge that in the coming decades, but I suspect the challenge will be met with the same mutually assured destruction mentality. The U.S will have friends in this stand-off. Given a choice between a U.S. global hegemon or a Chinese hegemon, the answer has been clear. Countries have aligned with the U.S. against China’s rise and I believe that will continue.

As always, I will watch and research the global economy and make investment choices to the best of my ability for each and every client portfolio. If you have questions about your portfolio, my views expressed in this letter, or anything else financial, please do not hesitate to call.

Best Regards,

Jim

Barron Financial Group, LLP is a fee-only Registered Investment Advisor regulated by the Connecticut Department of Banking.

This newsletter is for general information only and should not be considered investment advice.  Investors should consult with a trained investment professional to discuss their particular situation.