December 2019 Market Update & Analysis
Quality will matter for bond holdings. Though we are not yet overweight bonds, we are starting to see opportunities to become quality conscious within the bond holdings. High-yield issues are experiencing downgrade activity at a time when the economic scenario is looking a bit softer. We remain concerned that the credit quality of the corporate high-yield issues have continued to degrade while the return for this risk has diminished, and it could be time to take that bet off the table.
Figure 1: Market Performance as of November 30, 2019 Source: Bloomberg
November began with a much-expected Fed cut of a quarter point for the third consecutive time; however, Fed Chair Jerome Powell suggested that the current rates were now “appropriate” suggesting a potential pause in the cutting cycle which began this past summer. U.S. equity markets stumbled off the block for the month on this news made worse by the doubts overhanging the market regarding trade. In addition to a weak start for equity, the U.S. ten-year yield bounced to just shy of 2%. As the month went on, trade deal news between the U.S. and China still took the spotlights of all. The continued negotiations between the two superpowers and President Trump’s tweets impacted investors globally. The U.S. stock market continued to hit highs with very brief pullbacks from a rapid acceleration of political interference into the chaotic situations in Hong Kong that froze the talk briefly and rebounded soon after both sides of leadership agreed with a positive signal on the deal. Though U.S. equity was affected by the trade talks, the overall growth of the equity market continued to climb. As payrolls, consumer sentiment, and manufacturing PMIs beat both expectations and prior readings, the unemployment rate and inflation stayed comparatively stable. As a result, the U.S. equity market kept climbing, and the U.S. Treasury curve flattened with an expanding U.S. economy.
Meanwhile, on the other side of the world, November started with the bullet dodge of the former Brexit deadline as the United Kingdom successfully received another flexible extension on the Brexit deadline until January 2020. This helped the MSCI EAFE Index hit highs through the first week of the month, receiving the boost from a general election called out by the Prime Minister Johnson which effectively paved a path to a potential second referendum, though not without political potholes. Unlike the U.S. equity market that is supported by positive macro data, the European stock market suffered from uncertainty surrounding U.S.-China trade tensions. Making matters slightly worse, the European Commission cut the GDP growth forecast, and Euro zone GDP growth weakened in mid-November. It rebounded back up as positive news came out on the U.S.-China trade talks and newly appointed ECB President Christine Lagarde called for a new mix for monetary policy. Overall, the European equity market was more volatile than the U.S. equity market in November on the back of weak growth and continued Brexit drama.
Emerging Markets was the biggest roller coaster ride of all with significant drivers of volatility focused primarily in Asia. The month began with a solid rebound on the back of U.S.-China trade optimism. However, that was brought to an abrupt halt early in the month with the acceleration of the chaos and conflicts in Hong Kong. Emerging market equity markets dropped significantly amidst the heated and increasingly violent clashes that made global headlines. The remainder of the month bounced in a range defined by clashes to the downside and trade optimism on the upside ending the month essentially flat.
Oil prices began weak but got a boost from the announcement of the much-anticipated Saudi Aramco IPO along with a positive OPEC World Oil Outlook and a weakening U.S. dollar. With the support of the Saudi Crown Prince, the IPO has successfully garnered significant interest with the institutional tranche 2.95 times oversubscribed according to Reuters. Aramco is selling 1.5% of its shares and is anticipating raising $25.6 billion to fund the Crown Prince’s ambitious Vision 2030 objectives.
To date, the market has treated the current presidential impeachment inquiry as a side show (think Clinton) not a major risk (à la Nixon). As a result, these news headlines, which read like a crime thriller, have had near-zero effect on the markets. We expect this to continue to present minor impact as the chances of a Senate conviction are highly unlikely.
Going Forward: Upside Versus Downside
Inflection points are notoriously hard to time as an investor. However, as a market trends either higher or lower, investors should pay attention to the upside versus the downside of that position. Though equity markets have continued to grind higher, the defensive quality of the market has persisted, suggesting an undercurrent that remains defensive. Value continues to outperform growth. Large continues to outperform small. Meanwhile, bond performance reflected a continued search for yield, with high yield outperforming high-grade credit and credit outperforming Treasuries. That said, the yield shifted down across the curve with the long end dropping slightly more in a mildly bearish fashion. And, though oil has been perking up all month, the rest of the commodity complex has significantly lagged the equity and bond markets. So, the tea leaves this month are particularly muddled, but we still see a defensive quality worth noting. More importantly, we must keep an eye on the upside versus the downside of each market when considering how to go forward into this particularly muddled market.
U.S. equity is a trade that certainly feels long in the tooth with valuations now back into a frothy territory at nearly 21x trailing earnings and 19x future earnings. With large-cap equities up 27.74% for the year, it has been the undeniable winner in the game of asset allocation, surpassed only by real estate. However, after such a strong move, how much more upside can we possibly expect from these markets, particularly at today’s valuations? Consider for a moment that trailing multiples for U.S. equity have varied between 14 and 23 for the last decade. At nearly 21x, the upside for valuation versus the downside, should markets revert to more normal levels, is not attractive, despite an expected EPS growth rate for 2020 of slightly over 10%. The reality is that any resolution to the trade uncertainty that continues to plague the U.S. certainly represents an upside to valuations along with expectations of an EPS growth rebound. However, if earnings growth stalls or the trade resolution creates excess inflation, we could see a hit to earnings growth as well as valuations, which is a double whammy.
We remain overweight value equity. We recognize the relative value opportunity that may be developing in the international markets but are still unconvinced that the time is right to increase exposure. Within fixed income, we remain underweight in high-yield bonds. We continue to keep a defensive posture.
–Your investment team at Lido Advisors