U.S. – China Trade negotiations continue to dominate pricing.
U.S.-China Trade negotiations continue to dominate pricing. Until these negotiations are settled, market participants will focus on little else.
Fed Funds futures are calling for a rate cut by year-end. We see this as a low probability event, though one with the potential of inflating the everything bubble even more than it already is.
Risk sentiment seems balanced on a dime. With trade war at one extreme and a fed cut at the other, now is not the time to be betting on risk appetite. We see little information in the markets and highly binary events that will push us in either direction.
Figure 1: Market Performance as of April 30, 2019
Market Review: Hope and Fear
U.S. equities experienced a steady upward trend in the first half of the month driven by repeated hopes of a China-U.S. trade deal, FOMO (fear of missing out) based momentum and poor performance in other regions pushing investors to reallocate capital into the U.S. equity space. Hope, fear and no better options drive a 4% return for U.S. equities for the month.
While investors were focused squarely on China, trade tensions with the EU reemerged as the World Trade Organization ruled that EU subsidies to Airbus had caused $11 billion worth of damage in adverse effects to the United States. As a result, U.S. Trade Representative Robert Lighthizer proposed a list of products from the EU to hit with tariffs as a means of retaliation. This, coupled with concerns about corporate earnings on the 7th, caused treasuries to tick down for a period of slightly less than a week but quickly rebounded. Investment grade and high-yield bonds followed similarly.
Bond yields in the UK and Britain followed a similar pattern as the regions grappled with the international trade issue related to the U.S. and Europe.
International equities jumped at the beginning of the month on positive Brexit news and economic promise from Australian political leaders. Theresa May showed signs of lessening her convictions for a strict Brexit by coming to the leader of her opposition, Jeremy Corbyn, in an effort to end the deadlock that potentially could boot the United Kingdom out of the European Union without ever coming to an agreed-upon deal. By coming to Corbyn, Prime Minister May created the possibility of a softer form of Brexit and potentially even allowing the UK to stay within the European Union, in turn, compromising many of May’s demands. The Prime Minister has shown a willingness to allow a second referendum vote in the U.K. only as a last resort if negotiations with the Labour Party fail. Across the water in Australia, the Australian government promised major tax cuts and reported the region’s first surplus in over 10 years. Investors were excited by this news buying up EAFE equities. The rest of the month appeared to be just noise as EAFE equities remained fairly stable with limited volatility.
European Central Bank President, Mario Draghi, announced in a conference earlier this month that recent data has shown slower growth momentum in the Eurozone. This caused German 10-year bond yields to quickly dip into negative territory before rebounding. However, yields rose back up into positive territory again after data showed a rebound in Chinese exports. UK 10-year bond yields jumped at the beginning of the month on Theresa May’s Brexit move and moved in accord with those of Germany for the remainder of the month.
Optimism over global growth stemming from indicators of the Chinese economy rebounding, a prospective end to the trade war, and a less impactful Brexit deal help to create heightened investor risk appetite pushing emerging market equities forward for the first half of the month. The asset class stabilized and moved with fairly minimal noise throughout the rest of April.
Oil prices continued the upward trend they have been on as demand remains strong and supply remains weak. Demand has been resilient throughout the year and emerging markets have surprised with much higher demand than expected. OPEC and its allied nations have been reducing production while simultaneously sanctions from the U.S. have been cutting off exports from Iran and Venezuela. Quality issues with Russian oil also added to supply constraints. In other commodities, copper prices swayed back and forth relative to investor’s perspectives on a U.S.-China trade deal and Chinese growth. A weaker dollar lifted gold prices in the period from the 5th to the 12th; however, prices fell sharply on a rebounding dollar and investor’s moving their money out of safe haven gold assets and into equities eased concerns over global growth.
Going Forward: Volatility is Back
Take a dash of hope that all will work out, add a pinch of fear of missing out, and throw in one Trump tweet and you get volatility. With that volatility, comes a lot of noise and mixed signals that each require analysis. At the base of this entire pyramid of assumptions is the grand idea that the economy is slowing and will likely bottom out toward the end of 2019 or early 2020. Next, it assumes that the bottom will still be positive, rather than a recession, and earnings will recover alongside the economy. If you buy that, then the next assumption, which is that the Fed is at least on pause for the rest of the year and could even cut rates before the year is out, could come true if inflation remains muted. So far, muted wage growth has helped. However, the pickup in oil prices and agriculture generally presents a challenge to consumers and could support a rate cut to spur consumption. Now, assuming muted inflation and a continuation of Fed accommodation, financial repression could continue to drive mispricing of risk assets. However, the piece that could bring down the whole pyramid of assumptions, in our opinion, is how much growth is already priced into the market versus how much growth you can actually expect from muted wages (perhaps permanently muted as a result of structural changes to the labor market) and commodity price rises acting as a further tax to consumption. Add to that the idea that Congress will remain in gridlock for another year and a half, so a deteriorating fiscal outlook and no other support to consumers. Throw on top the idea that trade could come to a grinding halt if we do see a trade war and we have a massive repricing of risk. So, given what we know and what we don’t know, we can commence the game of what if.
What if U.S.-China Trade Negotiations Fail?
We consider this the most dangerous of the set of assumptions because so much hope has been ascribed to it. Arguably the boost in valuations from December until now has largely been on the back of this notion. Continued reasonably strong earnings could help, but cannot fully shield against the 15% rise in multiples for large cap equities since the shift in sentiment around the U.S.-China trade negotiations. The dramatic fall in credit spreads, particularly in high-yield, is even more exposed to this shift in risk sentiment. High quality and low risk would argue for continued exposure to Treasuries to guard against this outcome.
What if the Recovery in the Economy and Growth Start to Look Lackluster?
Here, we would see a repricing of equities with some ripple effects into high-yield. However, assuming that the bottom is still in positive territory, the Goldilocks story could continue, favoring higher-quality equities and credits. In addition, rotation into EAFE and emerging markets could start to look more attractive as the U.S. picture starts to lose its luster.
What if the Fed cuts rates?
This is a low probability event this year, but stranger things have happened. This could help the real assets and real estate asset classes perhaps the most and reinvigorate equity risk appetite. This could also push money into emerging market debt and high-yield debt. If this is coupled with short-term bond buying, the markets could become even more risk-loving than they already are.
–Your investment team at Lido Advisors