We are now seeing lower highs. While we may still see an end to the trade tensions between the U.S. and China, we note that the nature of each bounce since the September peak has been successively weaker, now tracing a downtrend. Given the fading effects of the tax cut are bringing on a slowing in the rate of earnings growth, we would argue that what has been given back in the multiple will likely not return for a while.
The potential pause in rate hikes is not necessarily news to rally about. Rather than an excuse to get drunk on liquidity, the markets are now focusing on the idea that the pause in rates could signal a much weaker economy than previously considered. If the economy can’t handle a full normalization of rates, this casts significant doubt on future growth which sent the long end plummeting twice as much as the short end rose for the last thirty days.
Market Review: A Rough Ride
Global stock prices were largely driven by news regarding trade talks and a prospective trade agreement between President Donald Trump and Chinese President Xi Jinping at the G-20 Summit. The month began with an upward trend in stock prices until President Trump cast doubt on the prospect of a trade agreement. Tariff fears resulted in a continued downward equity trend until right after Thanksgiving when the Fed took a dovish stance on rates by announcing it may be nearing neutral on the fed funds rate. At 2.125%, the overnight lending rate is reaching a level that the Fed believes is no longer stimulating or restricting economic growth. Global equity markets reacted positively to the rate news. The S&P 500 Index rallied nearly 5% in the last week of the month.
U.S. Q3 GDP held steady at 3.5% in the second release. Inventory build increased to 2.3%, while the net exports drag widened to -1.9%. Consumer spending revised down from 4.0% but remained solid at 3.6%. Business investment slowed substantially to .3% growth, from 8.7% in Q2 and 9.2% in Q1, revealing tax reform stimulus effects may have reached their peak. Consumer spending accelerated into the 4th quarter, foreshadowing positive holiday sales momentum, while inventories continue to expand, and overall levels remain lean relative to sales growth. Manufacturing activity pulled back for the second month in a row, remaining at expansionary levels, but reflecting less labor and capacity stress. Input prices remain under pressure, yet inflation remains elusive. The Fed’s core PCE rate fell to 1.8% in October, after posting at the Fed’s 2.0% target for the three consecutive months.
A strong jobs report was released early in the month that showed unemployment dropped and wages rose. However, this was contrasted by another report showing that large companies had accelerated job cuts. The Federal Reserve left rates unchanged this month and appears to be staying on course for a December rate hike despite the President’s criticisms.
Meanwhile, Oil prices fell below $50 on over supply concerns. The U.S. agreed to let eight countries including Japan, India, and South Korea keep buying Iranian oil after it reimposed sanctions on the OPEC producer on the 5th of this past month. North Korea expressed its disdain for U.S. sanctions as it threatened to resume its nuclear program if the measures aren’t lifted. The Foreign Ministry’s Institute for American Studies said it could revive its policy of economic construction and nuclear development if sanctions continue.
The BOE had to sit tight on a rate hike in November as Brexit talks were deadlocked. Prime Minister Theresa May’s hopes of getting a Brexit deal through Parliament were dealt a large blow as a pro-European minister quit early in the month. Britain posted its fastest economic expansion in almost two years in the third quarter, but a sudden loss of momentum in August pointed to slower growth in the run-up to Brexit. U.K. gross domestic product increased .6% in the third quarter, the highest growth rate since the end of 2016. The pound fell, and British bonds jumped, as the U.K. Brexit Secretary resigned in protest at Prime Minister May’s Brexit deal. European Union leaders endorsed the Brexit deal. Now the question will be how they respond if the Parliament rejects it.
Euro-area growth slowed in the third quarter, dragged down by a contraction in Germany, the region’s largest economy. The car industry is proving to be the biggest driver of the German economy and is tasked with the German economic rebound. However, the nation remains cautiously optimistic, as automakers feel the pain of trade tensions. The European Union is beginning to write out its first bloc-wide rules to prevent foreign investments from threatening national security in the wake of Chinese acquisitions causing political unease.
The Bank of Japan’s massive asset purchase program has taken it into uncharted territory, with its rapidly growing holdings now larger than the country’s annual economic output. Asset holdings reached 553.6 trillion yen compared with nominal gross domestic product of 552.8 trillion yen.
Going Forward: Sliding into the Holidays
As the new month begins, an end to trade tensions between the U.S. and China looks to be forming. While the outcome will still likely be some form of trade tariff, it is not yet known and able to be discounted by the market. Global equity rallied into the news. However, the nature of the rally is worth noting. First, we observe that new highs continue to fail to overtake old highs, leaving us in a persistent downward trend since the peak of the U.S. markets at the end of September. In addition, this remains a defensive time period with value leading growth. Though growth attempted to reassert itself at month end, we are betting on continued value persistence, as we see earnings slow from the fading effects of the tax cut. More importantly, we are starting to see performance green shoots in the EM equity space, where value has been locked up by cheap valuations since the current administration took aim at China and oil prices simultaneously slumped. Though hardly an established trend, the recent price action is yet another positive sign for EM companies. Perhaps we are finally due for rotation away from large cap, U.S. growth stocks as the only game in town.
A Pause in Rates
The Fed pause is meaningful. Though rather than signaling a relief rally, it is effectively signaling concern about the health of the current expansion. The news led the long end of the yield curve to fall in a classic bond twist with the short end rising by half as much as the simultaneous fall in the long end. This is usually not a good signal to the stock market. This suggests that the pause in the hiking cycling is not so that the markets can get drunk on liquidity, but rather that the economy is starting to exhibit some cooling and continued hikes can no longer be tolerated at the same pace. The corporate sectors should be concerned given that earnings are naturally slowing from their stimulated levels.
Credit vs Equity
It is generally at this point in the cycle that investors must consider their exposure to corporate markets. If equity is having difficulty finding footing as the economy naturally slows, then it follows that the debt markets, which have been trading at decade low spread levels, should also be viewed with concern. The real question is which market has the most to lose? If you consider 16-17x earnings as a reasonable fair value range for large cap equites and a switch to value leadership, then we could be looking at losses from multiple contractions in the equity markets of 10% to 15% or more. That said, spreads, which signify the excess returns that investors demand to hold credit risk over U.S. Treasuries, are at very depressed levels. This means that investors are getting very little reward from holding credit over Treasuries, so it must follow that the perceived risk must be low. However, historical precedent for defaults and recoveries would suggest higher fair value spreads than the current levels we are observing. Unfortunately, the break-even for those is significantly higher, with investment grade debt vulnerable to the tune of a 15% pullback and high yield vulnerable to the tune of 25%, based on spreads alone. However, the complete risk is likely to be slightly lower than these levels, but still worth some concern. So, investors de-risking corporate equity with higher capital structure debt should be careful of the quality and pricing of the debt held, particularly in the junk bond and leveraged loan space. We see a period of time where lower quality debt could actually be more risky than equity because of valuation dynamics and relative value trades from debt to Treasuries.
Perhaps the biggest change going forward is in risk appetite. Whereas before, with extremely depressed yields, otherwise referred to as “financial repression” in policy circles, investors were forced to crawl out farther and farther along the risk spectrum and were willing to accept lower and lower yields as compensation for the risk. Now, investors can collect a near 2.4% yield without taking risk beyond 3-month cash. This dynamic will drive risk appetite lower and spreads and premiums higher to entice an investor to hold risk. This does not bode well for the broadly currently overvalued market. Cash could be king for a period of time as the markets settle into this new risk dynamic.
We continue to feel that the current environment is unclear. It is our view that there are as many reasons to be constructive as there are reasons to be cautious. As such we continue to view a hedged approach to the equity markets as a prudent course of action. In the fixed income market, we have continued to improve our portfolio’s credit quality while maintaining a low level of interest rate risk. We believe that an alternative place to generate excess returns is still in less efficient markets like value add real estate, and debt on real estate.
-Your Investment team at Lido Advisors