As of the close of June 21st the S&P 500 is +7.7% MTD and +14% YTD, and the MSCI World is +6.7% and +15.6% YTD.
- The month of May finished with a gloomy prospects, caused by the negative headlines ignited by the decision of the Trump administration to impose higher tariffs to Chinese imports. The month of June has seen the opposite, with a strong bounce in the equity markets created by more conciliatory news between China and the US, and the prospects of an expected “extended meeting” between Xi Jinping and Trump, in the G-20 meeting this week in Osaka, Japan.
- The S&P 500 touched an all time-high of $2,964, June 21st., in part as a result of improved trade related news, suggesting that equities are likely to head higher in the short term, and a dovish message from the Fed.
- The Fed delivered a dovish message. Although It kept rates steady last week, the Fed also stressed that there were global “uncertainties”. This has driven real rates 10bps lower, the dollar went down 1% and the yield curve of 2 versus 10 year rates steepened and is now positive by 28bps (2 year 1.74% and 10 year 2.02). The Fed now appears on track to deliver a July rate cut of 50bps, along with “flexible language”, and to stay on hold for the foreseeable future.
- Gold has also made a significant advance this month, reaching $1433 today, while equity markets have charged back reaching near all-time highs—a dynamic that we don’t see too often.
- Ahead of the much anticipated G20 this week, the following outcomes can be envisioned:
1) working towards a deal, delays economics risks;
2) uncertain pause which helps near term but later disappoints; and
3) escalation (further tariffs) which leads to growth decline and recession.
- In outcome #1, which appears more likely following headlines this week, one could expect the S&P 500 to trade upwards (even eventually to the 3,000 level). The market will focus on domestic issues and eventually focus again on a potentially trade escalation, and would start discount mounting earnings risks, and then trade lower.. This would indicate that one should remain invested in equities for now.
- Liquidity (FOMC, ECB, BOJ) coupled with easing trade tensions have given global markets a boost while the patient, that is the global economy, is looking weaker. Recent global PMIs have largely disappointed, the Morgan Stanley Business conditions index just printed the largest 1-month decline and last Thursday the Philly Fed became the 3rd business survey this month to post a significant sequential decline (-16.3pts) — the largest since February 2019 and before that August 2011. The market appears to be taking this in stride but for how long?
- More broadly, if US-China trade tensions were to go away, investors would still be left with a troubling set of late-cycle warnings signs (expensive valuations, slowing EPS growth, falling margins, high leverage, etc). Morgan Stanley’s US Equity Strategist Mike Wilson’s model, who we follow closely, already points to ~0%Y/Y growth for 2019, but trade impacting economic activity in the back half of 2019 would create further downside risk to his forecasts.
- With the FOMC meeting behind us, we have one major macro/political event; the G-20 meeting, before we get to refocus on 2Q earnings. We expect dispersion of 2Q earnings, as companies have the opportunity to separate themselves on an idiosyncratic basis against the more challenging backdrop. Remember we saw a generally healthy number of beats in 1Q against a significantly lowered bar after 4Q18, and it appears as though corporates have taken the opportunity to keep this bar low for 2Q. Bulls argue that this is simply another opportunity for companies to clear the hurdle, while Bears believe that companies are already seeing the writing on the wall for weak prints. Unfortunately, only time will tell which side wins out.
- With regard to broader sectors, we have spoken about semiconductors (semis) in several occasions. Semis have been firmly in the debate around the US / China trade war along with other global secular drivers including AI, autonomous cars, factory automation and the Internet of Things (IoT). These drivers have been set against an unusually volatile cyclical picture with too much inventory in most markets, a pretty weak macro picture, and huge swings in sentiment driven by the trade tensions.
- The global view of semis remains cautious, however opportunities are starting to emerge. For example, there are a number of near-term challenges for the European semi industry, including weak end-markets, global supply chain inventory 25% above the long term median (at all-time highs in Europe) and industry margins having peaked in 4Q18. That being said, the current shares prices might capture a number of these concerns.
Sources: Global Reflections, by Nick Savone, Morgan Stanley, June 22, 2019
As of the close of June 21st the Eurostoxx is +5.7% MTD and +15.5% YTD, and the MSCI Europe is +5.8% and +13.6% YTD.
- Keeping our eye on Europe, valuations no longer look excessively cheap as they did in December, they are only in-line with historical averages and are lower versus history than other regions.
- Stepping away from the Brexit related headlines and the tough sentiment in Europe, there are many single name opportunities across EU Equity Markets. Capital expenditure intentions in Europe have fallen sharply since 2018 and the risk of potential auto-tariffs remains a cause for concern in the region.
- However, even though the economic numbers in Europe are not rosy, our view remains that one should not to get too bearish as equity valuations are not expensive, sentiment is muted, and economists project a (moderate) improvement in growth going forward.
- Finally the ECB remains vigilant and has announced further quantitative easing if necessary.
ASIA AND EMERGING MARKETS
As of the close of June 21st the MSCI Asia ex-Japan is +5.8% MTD and +8.9% YTD, and the MSCI Emerging Markets is +5.6% MTD and +9% YTD.
Both indices are still down -7.5% and -9.0% respectively since the end of 2017.
- Looking at China, the CSI 300 has made +5.8% in June, and continues to be up +27.5% YTD. Strength this month has been largely driven by the possibility of an improvement in the trade conflict with the US.
- Our views on the “rest of the world” EMs have not changed since last month’s decision to slightly reduce our weighting to EMs. Our reasoning remains that even though EMs wills probably benefit from the looser monetary policy in the DMs, the current trade conflict could extend longer than expected causing a bearish outlook and sentiment for growth in the EMs.
CURRENCIES, FIXED INCOME AND COMMODITIES
- In currencies - The USD weakened to around 1.14 against the EUR. Even with the tariff turmoil the currency markets have remained extremely stable. However, better growth indicators in the US, and continued interest rate differential in favor of the USD favor the US currency which turns out to be more resilient.
- However, as stated last month two opposing US domestic forces support the view of —fiscal policy tightening (balance sheet normalization) and monetary policy getting looser— leading to a reversal in net US inflows. A weaker USD opens the door for investors to start paying attention as EM starts to outperform on the back of a weaker dollar
- In US Fixed income - The yield curve has continued to change shape. The spread between 3-month treasuries and the 10-year is now inverted. With Fed Fund rates at 2.5%, 3 month T-Bills at 2.1% and 6 month at 2.04%, current 2 year rates are at 1.74%, 5 year rates at 1.75% and 10 year at 2.02%. But the yield curve is not anymore inverted in the 2-10 year maturities and in fact has a positive spread of 28 bps. The 30 year bond is now yielding 2.54%, resulting in a +52 bps spread between the 10 year and 30 year. This spread was around 33 bps at the end of December and 15bps one year ago. Thus the bond market has been re-pricing a steeper yield curve as monetary stimulus has changed direction, from rate hikes last year to potential rates cuts this year.
- In European Fixed income - Also, outside the US, the yield on Germany’s benchmark 10-year, is now negative -0.30%, following comments from Draghi speaking at the ECB’s annual symposium in Sintra, Portugal, last week. The ECB could launch a fresh expansion of its €2.6tn quantitative easing program if the inflation outlook failed to improve. Weak German growth data, low inflation numbers and the continued belief that China weakness is bad for German growth, remain the main drivers for negative interest rates in Europe.
- In commodities - Markets have strongly reversed last months risk-off repositioning. In the oil markets, both WTI and Brent are +8.2% and +1.3% in June (they do remain +27.5% and +21.4%, respectively). Partly the Iran – US skirmishes have led oil prices higher. Other markets like Copper (+2.4% in June) and Gold (strongly positive of +8% in June, and now +10% YTD) have also gained. In the case of Copper it is understandable that the fears of lower growth in China and a correction in cyclical stock would affect the metal. Gold, on the other hand, has recently jumped, as a result of the belief that lower interest rates will eventually result in higher inflation, as well as a hedge to the Iran-US potential conflict.
Sources: Global Reflections, by Nick Savone, Morgan Stanley, May 24, 2019
- Sustained equity rally – Global equity performance is now facing different outcomes based on the following: (i) global GDP growth rising back to trend, (ii) a lasting de-escalation of U.S.-China trade tensions and (iii) policy rate cuts by the Fed. While some combination of these factors will mitigate at least a portion of the downside risk to our growth and market outlook this year, their interdependencies create stumbling blocks for a sustained equity rally.
- Recession risk remains low – Companies have adopted a more prudent behavior, and one can expect sluggishness in business capital spending and, by extension, that the global industrial cycle will persist in the coming quarters. Many economists have revised their forecasts down to slightly below-trend global real GDP growth through the middle of 2020, roughly 2.5%–2.6%, on average.
- Trade war -- The key source of risk for the global economy and markets is the trajectory of the trade war and its feedback into economic growth. Trade tensions could improve, as tariffs are not broadly popular in the US and thus are not a clear political win as the 2020 presidential election draws nearer. Furthermore, multiple circuit breakers could potentially mitigate the economic damage of trade policy uncertainty and a more sheltered U.S. international trade stance. There are incentives of all parties to find common ground or, at a minimum, reduce the pace of tariff escalation and retaliation. Of note, the trade war has switched between periods of escalation and de-escalation, the global economy has cooled and the Fed has moved persistently more dovish in response.
- Monetary policy will actively lean against downside risks – The market pricing suggests certainty that the Federal Open Market Committee (FOMC) will cut its policy rate in July, followed by potentially another two 25 basis point cuts by the end of 2019. The forward-looking implications of last week’s FOMC meeting were clearly dovish.
- Asset class implications – Swings in sentiment expressed in the news are becoming quite sharp; they have retreated from the optimism of the IC at the end of April, when the S&P 500 made new highs, to a much more pessimistic tone in May, to another optimistic scenario now in June. The dovish tenor of the June FOMC meeting underscores the support that monetary policy will provide to the economy and markets this year. The countervailing pricing of growth and policy is a recipe for continued volatility around a muted equity market trend in the coming months. In contrast, sources of carry, like credit, make more sense on a risk adjusted basis. We continue to overweight U.S. equities over the rest of the world, with the idea that the S&P absorbs a lot of the good news on trade if and when it occurs, while Europe, Japan and emerging markets are still in the shadow of potential future trade disputes. We remain negative on duration – prefer short duration fixed income instruments. We are skeptical that the Fed will follow through on the three rate cuts priced into markets for 2019, and thus long duration can be extremely painful if the curve moves higher and steeper, as the sensitivity of longer duration fixed income assets will be extremely high. We do not want to make any fixed income duration bets when now over $12 trillion of sovereign credit is negative yielding. Bonds may be telling a more gloomy story than the equity markets. So who should we believe ? We would acknowledge that it is becoming harder to balance the marginally more positive tone being set by economic data and stabilizing earnings against the clear tail risks arising from trade tensions and geopolitics in general. Harder still is filtering out the more extreme expressions of optimism or pessimism that nowadays seem to accompany relatively small shifts in price action. Absent a full scale tit-for-tat escalation in trade tensions, the backdrop of stable, trend-like growth will eventually regain primacy. And with it, the volume of those voices suggesting a “melt up” in asset prices may well rise again. But looking beyond the fear and greed that tends to fuel sentiment, the fact is that the global economy remains in late cycle.
- This leaves investors with an unsatisfactory combination of economic data that looks like it may be starting to improve, assets that are already discounting such an outcome and the unsavory reminder that all is still not well on the trade front.
- So what should we do? Will trade fears pass and the market quickly resume its pricing of an ever-stronger surge in growth? Or should we be accepting this is the end of the goldilocks phase in this already extended cycle and be reducing risk ? We have treated the rebound in global stocks with some caution thus far, having reduced the equity weighting already last year. We have preferred to acknowledge the easing of monetary policy and shift in the market’s direction through carry assets, like corporate credit and high yield. Should trade tensions ease and the tentative stabilization in growth gain some momentum, there is a case for a modestly more positive view on stocks. But we would still caution against the idea of going “all in” this late in the cycle. Those voices suggesting a “melt up” can sound compelling when growth data are picking up and tail risks appear to be abating. But in a late-cycle environment, there is little room for maneuver if news flow were to lurch negatively once again. And even assuming positive returns, it’s unlikely the Sharpe ratios for equities will be particularly strong.
- Over the longer run, our base case remains that there will be some de-escalation of trade rhetoric, sufficient to calm markets.. As a result, we expect the second half of 2019 to be characterized by trend-like growth, easy policy, muted inflation and limited near-term risk of recession. And as the 2020 election campaign draws nearer, we would also anticipate a rather more reassuring tone for the economy and markets from the administration. In this environment, we continue to believe that credit can perform well. A diversified exposure to credit, like we have, should be maintained. We do see a better outlook for equities at the margin, with earnings revisions trending a little better and expectations for the rest of 2019 now quite achievable. Nevertheless, the level of headline risk associated with the prevailing trade rhetoric leaves us in no hurry to rush into a large equity position. But as this risk clears, we see scope for equities — particularly U.S. stocks — to trade modestly higher in the back half of the year.