But, reality will set in and we see U.S. large-cap equities as the most exposed asset class in this market dream. The downsides continue to outweigh the upsides. The reality is that there is still much more to go in the downside trade war scenario whereas the upside is already priced in. Emerging Markets remains the ugly duckling, though one could argue the attractiveness of EM equity multiples, rarely has EM outperformed when risk is generally off.

Figure 1: Market Performance as of May 31, 2019 

Source: Bloomberg

Market Review: Trade War

U.S. equities rallied at the beginning of the month after a release of data showing the U.S. added more jobs than expected (265,000) in April lowering the unemployment rate to a half-century record low of 3.6%. However, the gains were short-lived as tweets from President Trump threatening to raise tariffs on $200 billion of Chinese goods from 10% to 25%, later followed by action, triggered a sharp sell-off. China retaliated a few days later by increasing tariffs on $60 billion of U.S. goods to 25%, in turn, steepening the stock market slide. Stocks rebounded on the 13th as a series of tweets from President Trump suggested America will be making a deal with China soon, alleviating investors’ nerves over the dispute. The saga continued and stock prices began to slide on the 16th as news surfaced that the next round of U.S.-China trade talks were in limbo.

U.S. Treasury yields followed almost an identical pattern to U.S. equities driven by the same sequence of trade news. As stock prices fell, U.S. Treasury yields fell (prices rose) reflecting investors’ risk-off attitude and vice-versa when the stocks rebounded in the hopes of a resolution. Investment grade bonds followed similarly. In accord with the risk-off/risk-on mindset investors teetered between throughout the month, U.S. junk bond yields moved in almost exact opposite price trends to their safer investment grade and 10-year treasury counterparts.

The trade saga was not contained between just the U.S. and China as it was the key driver of price fluctuations in international equity markets as well. Equity prices in the EAFE index followed the same trend as those in the S&P 500 index driven by the same key events. Though the FTSE 100 and Euro Stoxx 50 saw the additional downward catalyst of Theresa May’s resignation announcement on May 24^th. Though the markets were on the same trade rollercoaster ride, the slide at the end of the month was further supported by the specter of “No-Deal” BREXIT.

German 10-year government bond yields fell at the beginning of the month following news that the European Commission revised down growth forecasts across Europe. The commission dropped its original forecast of Eurozone growth of 1.3% to 1.2% for the year. Yields rebounded slightly in the middle of the month as bonds across the Euro Zone saw their prices decline on news of the collapse of the Austrian coalition, raising chances of a snap election. However, the rebound was short-lived as yields ticked back down to two-year lows on a disappointing economic news release that the IHS Markit May Flash Composite Purchasing Managers’ Index, an indicator of economic health, moved up but still fell short of expectations by 0.1. This amplified concerns about potential negative impacts of trade wars. 10-year government bond yields in the UK followed a similar path impacted by the same drivers.

The escalation of trade war tensions caused equity prices across emerging markets to steadily fall as investors adopted a risk-off attitude. Slight rebounds in prices came throughout the month on slight glimmers of hope in the trade war, but overall, prices fell throughout the month.

U.S. crude oil prices fell at the beginning of the month after the release of a government report that showed a nearly 10 million-barrel increase in domestic crude supplies. However, prices rebounded and rose steadily for the remainder of the month as heightening tensions in the Middle East have ignited fears about a global supply compression.

Copper prices fell steadily throughout the month over trade war concerns as a trade war could erode demand for the industrial metal.

Gold prices moved opposite equity markets throughout the month by moving down to start the month, rebounding in the middle of the month, then falling steadily before rebounding to end the month. Demand for the asset increased to offset risk in times of heightened trade war concerns and decreased in times of alleviated concerns throughout the month.

Going Forward: To Risk or Not to Risk…

2019 has so far been the kind of year that makes every investor feel smart. Everything has outperformed cash, even Treasuries. However, very recently Treasuries have left equities in the dust as investors digest continued negative news out of China. More improbably, gold has staged a solid comeback after lagging all year. This all begs the question: to risk or not to risk? Equities have largely been climbing the wall of worry and still have a few quarters of lackluster growth ahead. Meanwhile, Emerging Market Equities, the darling turned ugly duckling of the year still arguably has tremendous unlocked value in those attractive multiples. Emerging Market Debt, which has rallied dramatically all year with high-yield is leaving high-yield in the dust as it comes back to life. Meanwhile, energy and oil, which started the year strong are falling out of bed. Where is an investor to allocate?

Trade

The trade picture continues to look very negative and, in many ways, the worst is yet to come. While this story has directly impacted Emerging Market multiples, we would argue that U.S. multiples continue to remain at risk to this story getting worse. More importantly, the impacts directly to the economy could result in a much weaker job picture along with falling revenues from the very highly geographically diversified S&P 500. Moreover, this ups the ante for China to continue to build manufacturing capacity to continue to disintermediate the U.S. using our own intellectual property. This will add to an already slow wage growth picture that will result in continued slowing aggregate growth picture. Uncertainty is starting to result in delayed hiring, and this will inevitably feedback into a weaker economy. Though large-cap stocks are exposed to this scenario, we would argue that mid and small-cap stocks will be equally vulnerable along with corporate debt, though to a lesser extent.

The Fed

The sharp change in Fed stance is enough to give an observer whiplash. At the start of the year, we anticipated one more rate hike according to the Fed dot plot and nothing according to Fed Funds futures pricing. Now, the Fed is starting to debate a rate cut and the Fed Funds futures is strongly pricing in a rate cut by July. While some market participants welcome the accommodation, we worry that this signals a very negative long-term liquidity trap in which rate normalization could not get above 2.5% at the short end and topped out at 3.2% at the ten year, only to fall below the 3-month rate in a worrying inversion. This lays out a very disturbing picture for equities in the long-term as well as in the near-term. However, this could spell an even more worrying picture for corporate debt.

Brexit

Though often forgotten in the U.S., the specter of Brexit hangs heavily over the European continent like the cold, wet fog that hangs over the UK. With the resignation of Theresa May and a battle for her replacement as Prime Minister, most bets are squarely on a “no-deal” Brexit which would be a disastrous outcome for all involved. This specter has driven money solidly out of European equities and into Japanese equities. We don’t currently see a political solution that avoids Brexit, so we see international equity as a higher risk category until this uncertainty is lifted.

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