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Brian Herscovici, CFA Chief Investment Officer, USAA Managed Portfolios






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U.S. equities thrived in April, cratered in May and bounced back strong in June — the S&P 500 marked a new all-time high in the final days of the quarter. The market’s mood swings corresponded to a pair of fluid factors: the outlook on global economic growth and the likelihood of settling the U.S.-China trade dispute.


Other asset classes also fared well despite the uncertain conditions.


Expectations of U.S. interest rate cuts escalated in the quarter as worries grew about a trade-triggered global economic slowdown. The Federal Reserve and other central banks signaled that they are prepared to ease monetary policy to push back against recessionary pressures. The Treasury yield curve inverted in late May as some investors sought safety in bonds even as others leaned into risk.



At some point in time, the Federal Reserve will not be the dominant factor driving global asset markets. That time, however, is not 2019.


This is not to say that there aren’t other forces affecting markets — trade turmoil certainly continues to exert an impact, as do rising geopolitical tensions in the Persian Gulf and East Asia, and the professional-grade fiasco that is Brexit. But it seems that nothing has more influence on market buoyancy than the closely scrutinized decisions handed down by Washington’s central banker.


Over the three years ending last December, the Fed was in tightening mode, raising short-term interest rates from essentially zero to nearly 2.5%. Coming into 2019, the consensus called for more hikes this year and next, but that forecast is toast — now the smart money is on rates reversing course and investors are positioning themselves accordingly. “Lower for longer” looks to be back in control.


Does the U.S. economy really need cheaper money right now? It’s a legitimate question, but one largely rendered moot by President Trump’s relentless Twitter campaign demanding cuts, the Fed’s default tendency toward protecting the economy, and the market’s fast and total buy-in. Current expectations in the futures market are running at 100% that the first cut will come at the next Fed meeting in late July, and that maybe two more will follow by year-end (Figure 2)




The latest data can be tailored to support either side of the rate debate. On one hand, the macro picture looks good.


U.S. real GDP growth — albeit modest — continues for a record 10th straight year. Unemployment is at its lowest since those rose-tinted days of Woodstock, Apollo 11 and the Miracle Mets, with job openings far outnumbering job seekers. Consumers are spending freely as their wages and home prices climb higher. Investors don’t seem to be running away from risk, given the new all-time high for the S&P 500 set in late June.


But on the other hand, there are signs of stress. Global growth is waning, manufacturing activity is slowing and there’s less demand for oil and other industrial commodities — as a result inflation is stuck below the Fed’s target. Earnings growth for U.S. companies is weakening — second- and third-quarter profits are expected to be negative compared to a year ago. Many investors are rotating into defensive sectors and Treasuries to try to protect this year’s stellar stock gains (+18.5% for the S&P 500 through June).


The trade issue touches all of those stress points. Tariffs of up to 25% are already in place on hundreds of billions of dollars of U.S. imports, mostly from China, and the White House is threatening to spread them to even more goods. U.S. businesses, from huge multinational corporations to family farms, say they are feeling financial pain from disrupted supply chains and reduced profits. China is also suffering, as are Europe and some emerging markets.


So if the U.S. and China can make a deal on trade that removes tariffs, there’s a good chance of relieving at least some of the downward pressure facing markets and companies. With the 2020 election season now under way, we think the president has a strong incentive to take actions that would boost the economy — stripping away trade barriers would fall into that category. Another economy-lifting lever within the White House’s reach is fiscal stimulus, the most obvious of which would be a huge spending program to upgrade the nation’s infrastructure.


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A trade deal and a fiscal spending program would take some time to put together — the Fed, however, can move fast. The central bank hasn’t committed to rate cuts in 2019, but the pressure to do so is building, not only from the president but also from the bond market. The Treasury yield curve has been inverted since late May. The inversion is the bond market telling us that rates are too high — if they’re right, growth will be repressed until rates come down.


While we question whether rate cuts are necessary at this point, the Fed faces little near-term economic risk if it takes such an action because inflation is so tame. Over the longer term, cutting now could hamper the Fed’s ability to respond to deteriorating growth or a recession — over the past half-century’s loosening cycles, the Fed has reduced interest rates by an average of 3% (Figure 3). But we don’t see a recession coming any time soon, which tempers this risk.


For now, we believe a greater threat is faced by the stock market if the Fed doesn’t cut, since the market’s June surge reflects expectations of lower rates ahead.


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Tactical positioning in USAA Managed Portfolios at the end of the second quarter favored fixed income

assets over equities to reflect our cautious stance given heightened market uncertainties, particularly those related to global economic growth. We believe markets may be somewhat overextended, with the 100% expectation of a rate hike in July already priced in.


We shifted away from tactical positions in U.S. small cap and high yield bonds at the end of June, and during the quarter we added a tactical allocation to


U.S. large cap. We believe U.S. large caps reflect the relative stability the U.S. economy enjoys compared to overseas markets where growth has been slower. We also added emerging market bonds to our tactical allocation — these bonds are high-rated government debt, which we believe gives us the opportunity to pick up extra yield without stepping down in quality.


Our key themes heading into the second half of the year:



As we discussed above, U.S. economic data is a mixed bag — some metrics are hanging tough, while others are losing traction. That said, we believe the U.S. market may be the only major global economy insulated from a potential recession. If multiple Fed rate cuts materialize before year-end, the easier liquidity would likely provide fuel for a continuing rally. More tailwind could come if earnings growth in 2Q and beyond tops weak expectations.



We are overweight fixed income and moving up in quality due to short-term economic and market uncertainty. We are particularly focused on the yield and relative safety offered by longer-dated Treasuries, investment-grade corporates and emerging market sovereign debt. A less attractive risk-reward profile led us to dial back our tactical exposure to high-yield bonds — they can be sensitive to economic trends, and tight credit spreads over Treasuries stand to limit their return potential.


As always, our guidance to members is to remain focused on the long-term investment plan that you have put so much thought into. For those USAA Managed Portfolio shareholders who may be uneasy about market risk in general or have concerns about current asset-class allocations, we suggest consulting with a USAA advisor.


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Investment Philosophy

We believe in constructing global, actively-managed portfolios that aim to capitalize on market opportunities utilizing multiple asset classes, institutional managers, and investment factors including value, momentum, and corporate credit. We adhere to our disciplined research and portfolio construction process, even if it causes us to deviate from the crowd.


What We Do

  • Build broadly diversified model portfolios to help you achieve your financial goals
  • Set long-term allocations to help reduce risk and volatility along with a short-term allocation to maximize timely opportunities
  • Monitor how investments and managers complement each other
  • Rebalance to keep risk in-line
  • Employ tax minimization strategies when warranted

We continually focus on global markets, economies and the geopolitical environment so you can focus on your life goals.


* As of 12/31/18


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Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income. Past performance is no guarantee of future results.

Asset allocation does not protect against a loss or guarantee that an investor’s goal will be met.

Fixed income securities are subject to price volatility and a number of risks, including interest rate risk. Interest rates and bond prices move in opposite directions so that as interest rates rise, bond prices usually fall and vice versa. Interest rates are currently at historically low levels. Fixed income securities also carry other risks, such as inflation risk, liquidity risk, call risk, and credit and default risks. Lower-quality fixed income securities involve greater risk of default or price changes. Securities of non-U.S. issuers generally involve greater risks than U.S. investments and can decline significantly in response to adverse issuer, political, regulatory, market and economic risks. Fixed income securities sold or redeemed prior to maturity may be subject to loss. • Investments in foreign securities are subject to additional and more diverse risks, including but not limited to currency fluctuations, market illiquidity, and political and economic instability. Foreign investing may result in more rapid and extreme changes in value than investments made exclusively in the securities of U.S. companies. There may be less publicly available information relating to foreign companies than those in the U.S. Foreign securities may also be subject to foreign taxes. Investments made in emerging market countries may be particularly volatile. Economies of emerging market countries are generally less diverse and mature than more developed countries and may have less stable political systems.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. • The MSCI EAFE Index covers 21 developed markets outside of North America: Europe, Australasia and the Far East. It aims to include in its international indices 85% of the free float-adjusted market capitalization in each industry group within each country. • The MSCI USA Index is designed to measure the performance of the large- and mid-cap segments of the U.S. equity market. The index covers approximately 85% of the free float-adjusted market capitalization in the U.S. • The MSCI World ex USA Index measure large- and mid-cap stock performance in 22 developed markets (U.S. excluded). The index covers approximately 85% of the free float-adjusted market capitalization in each country. • The Bloomberg Barclays U.S. Municipal Index covers the U.S. dollar-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and pre-refunded bonds. • The Bloomberg Barclays US Corporate High Yield Bond Index measures the U.S. dollar-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded. • The Standard & Poor’s 500 Index is an unmanaged index of 500 stocks representing the large cap segment of the market, covering 75% of the U.S. equities market. • The S&P SmallCap 600 Index measures the small-cap segment of the U.S. equity market. The index is designed to track companies that meet specific inclusion criteria to ensure that they are liquid and financially viable. • The Russell 2000 Index is an unmanaged index that consists of the 2,000 smallest companies in the Russell 3000 Index. It is a widely recognized small cap index. • The Bloomberg Barclays U.S. Aggregate Bond Index is a widely recognized index used to track the performance of investment grade bonds in the U.S. • The Bloomberg Barclays U.S. Credit Index measures the performance of the investment- grade, taxable corporate and government-related bond market. It is composed of the Bloomberg Barclays U.S. Corporate Index and a non-corporate component that includes non-U.S. agency, sovereign, supranational and local authority bonds. • The JP Morgan Emerging Markets Bond Index Plus (EMBI+) tracks total returns for foreign currency-denominated, fixed-income securities issued in emerging markets.

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