Market Update August 2018- Not even a trade war can stand in the way of continued market strength
As economic momentum pushes ahead at a strong clip, it seems that not even a trade war can stand in the way of continued market strength. However, the momentum is now waning, and the underlying current is turning decidedly defensive.
Higher energy and tariff-related metals prices are creeping into inflation readings. The markets are looking to the Fed to contain inflation, but not overshoot, a fine line to walk.
U.S. markets are discounting burgeoning risks of global trade war, mid-term elections, potential for a government shutdown and Fed policy missteps. All invite short term volatility to U.S. equity markets that bear monitoring. Far more attractively priced EAFE and EM markets emerge as a potentially better option to watch however, a strong dollar could mute returns from overseas investments, so this must be monitored securely.
Figure 1: Market Performance as of July 30, 2018
Market Review: Fast Pace of Growth Ahead of Trade War
The U.S. economy grew at the fastest pace in nearly four years in the second quarter as households boosted spending and net exports surprised positively. Gross domestic product rose 4.1%, with consumer spending rising 4% and revealing solid green shoots by contributing 2.7% to the growth rate. Net exports contributed 1.1% and a 7.3% increase in business investment contributed 1% to overall output. Growth was strong despite inventory depletion over the quarter, which reduced Q2 GDP by ~1%. The depletion bodes well for Q3 GDP; however, since inventories are too low, they need to be replenished. Output expanded 3.1% in the first half of 2018, putting the economy on track to hit the Trump administration’s target of 3% annual growth.
More jobs were created in June than expected, but steady wage gains pointed to moderate inflation pressures that should keep the Federal Reserve on a path of gradual interest rate increases this year. An increase in consumer spending and tighter labor market were key topics at last month’s FOMC meeting, which produced a 25-basis-point rate hike and a rise in quarterly forecasts from one to two more hikes this year. The Fed also removed language indicating that rates would remain low for some time.
U.S. stocks rose early in July, giving the Dow and S&P 500 their biggest gains in more than a month. Bank shares jumped ahead of earnings reports, while industrial, energy and consumer discretionary shares rose sharply and S&P utilities and telecommunications – among the market’s recent outperformers – led percentage declines. Overall, U.S. equity markets followed the strong economic results, despite a trade war brewing between the United States and China, which analysts warned could slow hiring, especially in the manufacturing sector. The U.S. and China slapped tit-for-tat duties on $34 billion worth of the other’s imports. Wall Street responded positively late in the month as President Trump secured concessions from the European Union on trade, despite a disappointing quarterly report from Facebook that slammed its stock and threatened to put the brakes on a tech rally. Trump said that the United States and the European Union had agreed to work toward eliminating tariffs on industrial goods and increasing U.S. exports of liquefied natural gas and soybeans to Europe.
The International Monetary Fund left its global economic growth forecast unchanged at 3.9% for both 2018 and 2019. IMF projections take into account only tariffs currently in force, so larger actions are not included. Forecasts for the United States and China were both unchanged, with U.S. growth pegged at 2.9% in 2018 and 2.7% in 2019. China’s growth was forecast at 6.6% in 2018 and 6.4% in 2019. The IMF warned world economic leaders on July 21 that the recent wave of trade tariffs being discussed would significantly harm global growth, a day after U.S. President Donald Trump threatened a major escalation in a dispute with China. Further, the IMF declared in late July that the U.S. dollar is over-valued, while China’s yuan is in line with fundamentals. Nearly half of global current account balances are now excessive, adding to growth risks and trade tensions. The IMF also said excessive current account surpluses and deficits are increasingly concentrated in advanced economies.
The euro fell late in the month as the European Central Bank clung to its easy money policy and signaled no change to its timetable to move away from ultra-low rates or end its bond purchase program. The Pound sterling, already pressured by a strong dollar, fell on the European Union’s rejection of key elements of Britain’s new trade proposals after it leaves the EU. ECB President Mario Draghi indicated he was confident regional inflation would reach the ECB’s 2% target; however, rising tariffs and trade barriers would hurt Euro growth.
China’s economic expansion slowed in line with expectations, signaling broadly stable output as trade conflict with the U.S. intensifies. Gross domestic product increased 6.7% in the second quarter, which was the slowest pace since 2016, and in line with the 6.8% pace in the previous quarter. While investment growth and industrial output slowed, steady growth heading into the second half of the year provides support to the potentially negative effects of trade barriers with the U.S. and to continuing multi-year efforts to control debt and clean-up the financial system. The world’s second-largest economy is forecast to slow this year, with the government’s growth target at 6.5%.
Core consumer inflation spiked in Japan late in Q2, but the rise was due largely to recent gains in oil prices. Other goods’ prices barely picked up, which was a setback for the Bank of Japan’s mission to lift inflation to 2%. The core-core inflation index, which is closely watched by the BOJ because it strips away the effect of energy costs, slowed for the third straight month, undercutting the central bank’s view that a solid economic recovery will nudge firms into raising prices.
Going Forward: Canary in the Coal Mine
Economic peaks and troughs are notoriously hard to call, though given the extra fuel added to the latest economic expansion in the form of tax stimulus; it is not too risky a proposition to suggest that 4.1% year over year growth is probably not a sustainable pace. While we may continue to get similarly strong numbers in the near term, it is unlikely they will maintain through 2019. To be sure, economic forecasts are calling for a cooling of the current global expansion. However, that cooling is expected to be moderate rather than recessionary, which still leaves room for continued robust growth, particularly in the Emerging Markets.
Trade war fear and uncertainty have eased, and winners and losers have generally been identified. U.S. market leadership is rebounding and, interestingly, EAFE and EM equity markets, where damage may not be immediately concerning, are following suit. However, compression in volatility may only be the calm before the storm. Namely, increasing inflation and underappreciated risks in the Middle East, including the potential for a significant oil supply disruption, could herald further spikes in oil prices and bring about a nasty equity correction. In addition, market confidence in the Fed’s ability to manage accommodation wind-down may wane if any evidence of runaway inflation or overshoot emerges. Further, the potential for a U.S. government shutdown is now on the table as President Trump continues to demand funding for his wall. Though the first is a low probability and the last can be avoided through Congressional action, the risk of Fed policy misstep looms large and it is worth noting that present volatility levels do not fully reflect the current risk environment.
Subtle Shifts in the Market
While the markets are rebounding on strong economic fundamentals, the recent compression in multiples suggests that the markets are reevaluating the forward-looking prospects for earnings and finding the prospects less attractive. But, what is not well appreciated is the degree to which the markets are becoming more defensive, particularly equity markets. Value is now outperforming growth and defensive sectors such as staples and utilities are beginning to hold their own. We suspect that the shift towards defensive stocks is somewhat consistent with the sluggish movement in the long end of the curve, which suggests that the outlook for long term growth is not that strong.
Despite our general concerns that the slowdown will herald a shift toward defensiveness, it is worth pointing out lower probability risks as well. First, as quantitative tightening continues globally, the path will likely be gradual, thus lessening the risk of a dry up in liquidity. This suggests further potential for credit and high yield relative to their riskier equity counterpart. Second, while we anticipate the economic peak, we do expect near term growth to continue to be robust, particularly in the emerging markets. Finally, as trade war fears ebb, so does the “America First” trade, which favored U.S. equities. We are not yet ready to pull the trigger in EAFE or EM but are watching both markets closely for signs that negative sentiment is no longer a concern.
We continue to maintain a neutral stance for fixed income. In addition, we remain neutral in commodities. We remain neutral in EM Debt. Within equities, we remain overweight in U.S. equities and maintain an overweight to Value equity within the U.S.
–Your investment team at Lido Advisors
Past performance is not an indication of future performance. The information provided in this newsletter is for informational purposes only and should not be considered investment advice or a recommendation to buy or sell any types of securities. There is a risk of loss from investments in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses.
The information contained herein reflects Lido’s views as of the date of this newsletter. Such views are subject to change at any time without notice due to changes in market or economic conditions and may not necessarily come to pass. Lido has obtained the information provided herein from various third-party sources believed to be reliable, but such information is not guaranteed. Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. Lido is not responsible for the consequences of any decisions or actions taken as a result of information provided in this newsletter and does not warrant or guarantee the accuracy or completeness of this information.
MSCI ACWI covers approximately 85% of the global investable equity opportunity set. The index is based on the MSCI Global Investable Market Indexes (GIMI) Methodology—a comprehensive and consistent approach to index construction that allows for meaningful global views across all market capitalization size, sector and style segments and combinations.
MSCI EAFE Index measures international equity performance and is comprised of the developed markets outside of North America: Europe, Australasia and the Far East. (Source: MSCI)
MSCI Emerging Markets Index is a free float Adjusted market capitalization designed to measure equity performance in global emerging markets and covers 800+ securities across 23 markets and represents about 13% of world market cap. (Source: MSCI)
The Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency). (Source: Barclay’s)
The BofA Merrill Lynch US High Yield Master II Index value, which tracks the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market. (Source: BofA Merrill Lynch)
The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market. (Source Russell)
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. (Source Russell)
The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market. (Source: Russell)
The S&P 500® is a market value weighted index that includes the 500 leading U.S. based companies and captures approximately 80% coverage of available market capitalization. (Source: S&P Dow Jones)
Dow Jones Industrial Average™ was introduced in May 1896, is a price-weighted measure of 30 U.S. blue-chip companies. (Source: S&P Dow Jones)
MSCI AC World Ex US: A market-capitalization-weighted index maintained by Morgan Stanley Capital International (MSCI) and designed to provide a broad measure of stock performance throughout the world, with the exception of U.S.-based companies. The MSCI All Country World Index Ex-U.S. includes both developed and emerging markets. (Source: MSCI)
Barclays US Universal: Unmanaged index comprising US dollar-denominated, taxable bonds that are rated investment grade or below investment grade. (Source: Barclay’s)
HFRX Global Hedge Fund: The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies falling within four principal strategies: equity hedge, event driven, macro/CTA, and relative value arbitrage. (Source: HFRX)
The Alerian MLP Infrastructure Index is a composite of energy infrastructure Master Limited Partnerships (MLPs). The capped, float-adjusted, capitalization-weighted index has 25 constituents that earn the majority of their cash flow from the transportation, storage, and processing of energy commodities. (Source: Alerian)