The S & P 500 ended the quarter up 18.5% year to date.

This has been the best first half of the year in terms of investment returns in over 20 years. How can this be? We all see the seemingly daily headlines about the trade war with China and the slowing down of Economic Data and the risk of recession not only in the U.S. but globally.

Things are seemingly boiling down to a couple of themes one of which has become more dominant. First there is optimism that the China trade war will in fact be solved at some point in time. In our estimation the final resolution is still a ways out but as long as there is hope of a favorable outcome the market will likely continue to react positively. The second theme that really kicked in the second quarter and has become the dominant theme at the moment was optimism that turned to the likelihood of the Federal Reserve cutting interest rates. As of June 21st, the futures markets were anticipating a 100% chance of an interest rate cut in July with a 78% chance of .25% cut and a 22% chance of a .50% cut.

Clearly the stock market is anticipating this event and historically the market reacts well in times of declining interest rates (at least initially.) It is important to keep in mind that the Federal Reserve does not cut interest rates when things are good, and the economy is firing on all cylinders. We are at a very late stage in this economic cycle and the ability to avoid a recession at this stage should the data weaken further would be difficult to say the least. The Federal Reserve’s Yield Spread Model which we follow currently estimates a 34% chance of a recession in the next 12 months.

Only once has this model hit 34% chance without a recession hitting in the following 12 months, so this certainly bears watching. However, at the present time, the economic data is still very mixed which makes recession a tough call. (Recessions are extraordinarily difficult to call anyway.) Manufacturing has slowed tremendously but employment is still very robust. The Leading Economic Index which typically declines 6 months or so before a recession starts has not shown significant signs of weakness as of yet. It’s a some good news, some bad news scenario. Given the risks that are present we are comfortable with the reduced risk positioning we are currently carrying. We believe risks are much higher than the market is pricing in and the media is talking about and are prepared to react.

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