Market Update September 2018- Tax Stimulus has done its job, now what?
Tax Stimulus has done its job, now what? We see year-over-year earnings comparisons becoming an issue in 2019 as compared to such strong 2018 earnings numbers for US earnings as European equities could start to make a comeback.
As investors look beyond the tax stimulus, valuations will come into focus. We see economic growth struggling by year end, particularly if midterms put a dent in the current administration’s agenda.
Sources of volatility abound, though volatility remains muted for now. Trade war, tensions at the White House and in the Middle East are just a few areas that could create event risk.
Market Review: Shake It Off
Fears of a trade war and ongoing U.S. political turmoil reinforced the trend of strong U.S. equity outperformance in August, which is normally a quiet time in the markets. Resumption of growth appetite drove the tech sector to new highs, while defensive sectors, such as healthcare, also turned in solid performance. The Standard & Poor’s 500 Index (“S&P 500”) and the Standard & Poor’s 600 Index (“S&P 600”) propelled to new record highs in August, and within fixed income, high-yield, which lagged in the most recent bout of risk taking, outpaced investment grade, though lagged treasuries, as the “risk on” environment contained an undercurrent of concern. U.S. markets steadily outpaced the MSCI EAFE Index (“EAFE”), the MSCI Emerging Markets Index, JP Morgan Emerging Markets Bond Indices, as well as the Bloomberg Barclays Global Aggregate and European Aggregate Bond Indices as the U.S. dollar continued to finish flat after a roller coaster of further strengthening.
U.S. economic growth was stronger than consensus in the second quarter, notching its best performance in nearly four years. Gross domestic product increased at a 4.2 percent annualized quarter over quarter rate in Q2 and a 3.2 percent rate in the first half of 2018 – evidence of the effects of tax stimulus, though highly unsustainable. Consumer spending increased at a 3.8% rate, driving the strong quarterly result, while business investment continued to grow at a very robust 8.5% rate. Meanwhile, the trade war shifted at home with the U.S. and Mexico reaching an accord to revise key portions of the North American Free Trade Agreement. The deal threatens to jettison Canada from the trilateral trade pact, if the country does not get on board quickly. By month end, trade talks stalled.
Oil prices rose in August on a drop in U.S. oil stockpiles and signs that Iran’s August exports likely fell ahead of U.S. sanctions. The Energy Information Administration announced crude supplies tumbled by 2.6 million barrels in the August 24th week, after falling by 5.6 million barrels the week prior. Analysts polled by S&P Global Platts expect a 1 million-barrel drop in crude stockpiles and a 160,000-barrel decline in gasoline supplies, supporting oil dependent countries. That said, the IMF expects a rise in spending will leave the Saudi budget exposed should there be an unexpected drop in oil prices. Riyadh’s budget deficit is expected to continue to narrow from 9.3 percent of GDP last year to 4.6 percent in 2018 and to as low as 1.7 percent next year.
European Central Bank policymakers view the slower-than-expected growth as a temporary hiccup. The 19-country Eurozone’s upswing remains intact amid strengthening wage growth. Following the July 26th meeting, ECB policymakers announced any dip in output “would be largely temporary” However, they warned that global trade tensions posed a risk to their outlook. The Eurozone upswing is “solid and broad-based” with support from “strong consumption fundamentals, notably ongoing employment growth.” Officials were more confident of achieving their 2% sustainable inflation rate goal in the coming months, since June inflation hit 2.0 percent with more workers winning wage increases. Eurozone inflation reached 2.1 percent in July.1
China’s economy faces increasing risks in the second half of the year and policymakers need to step up efforts to hit key development goals, as U.S. trade tensions intensify. “Targets in economic growth, employment, inflation and exports and imports can be achieved through effort,” He Lifeng, the head of the state planning agency, told the standing committee of the National People’s Congress on Aug 28th. Weighed down by rising financing costs, China’s economy was already starting to cool before the trade dispute with Washington escalated. Investment growth hit at a record low in August and consumers turned more cautious about spending. Policymakers set a 10 percent growth target for retail sales for 2018, the same as in 2017, but that level was only reached in one month so far this year. Sales growth in the last few months has been the softest in China since 2003.
Japan’s economy is recovering moderately, despite slowing inflation and growth in exports, the government said in late-August. Consumer prices are “rising at a slower tempo,” reflecting a recent stall in price gains despite aggressive monetary easing by the Bank of Japan. Further, exports are “pausing,” which is a more pessimistic view than in July, when they were “picking up.” The Cabinet Office warned of looming risks, including international trade disputes and financial market volatility.2
Going Forward: Shifting Winds
August may very well mark the end of the honeymoon. Despite Q2 reaching the fastest growth in over a decade and the U.S. equity markets steaming ahead to record highs, we caution that the inevitable slowdown is now upon us. And, yet, in Jackson Hole, Fed Chair Jay Powell broadcast a rather mixed message of as many as six hikes over the next eighteen months, with two more this year and four next year, à la Paul Volker, while claiming to be taking a measured pace responsive to data, à la Janet Yellen. Equity markets read the most optimistic view in that message, while bond markets flattened, threatening to invert to remind everyone who is boss in a debt-laden world. Meanwhile, the dollar continues to strengthen, beating every other market down and trade war rhetoric is starting to look more and more menacing to global growth. Yet, volatility continues to bounce along in the 12-13% range. Given the backdrop, we see potentially significant shifts ahead worth considering.
The domination of U.S. equity may seem like it is here to stay, but let’s not forget what comes with stimulus induced growth that is not followed up quickly with more stimulus: challenging if not impossible comparisons. Earnings per share growth in the S&P 500 Index topped 25% in Q2 with every sector growing at a double-digit pace, except real estate. While we could have as much as six more months of elevated growth, we will inevitably start to see challenging comparisons by year-end and potentially flat to low single digit growth by early 2019. In this context, it is worth noting that European equity has been hitting singles and doubles all year, despite trade war threats and continued election turmoil. European growth has been steady since peaking in 2017 and could look significantly more attractive on a valuation basis later this year or early in 2019.
After five years of lagging, value equity is looking to make a comeback and several factors could support this rotation. Foremost, valuations have already started to unravel. Markets repriced equity multiples down from a high of 20x to just below 18x on a forward basis and from over 23x to just above 21x on a trailing basis, resulting in strong moves recently in value stocks. Though August saw a resurgence of growth stocks, we would argue that this could easily be the beginning of the end for growth equity. Politics may hasten the demise of growth within the specter of the midterm elections by effectively determining the fate of much of the rest of President Trump’s agenda. Finally, trade war threats and rising yields have so far served to add incremental demand for Treasuries as safe haven assets now with yield, which could cause a backlash for today’s low spread demand as interest costs rise and create distress in the corporate space. For now, corporate tax relief trumps rising interest costs, but the potential for Fed overshoot and yield curve inversion threatens to accelerate a broader market shift to equity price consciousness.
Capital Structure and Dry Powder
If Fed Chair Powell is to be believed, we could finally start to see cash pay again, which will take the wind out of the sails of equities and bonds alike. However, the specter of an inverted yield curve by 2019 hangs over the market as the long end continues to reflect the challenges that come with a continued shift from households to corporations in terms of tax burden and resulting profits. While still early in the U.S. monetary tightening cycle, we are reminded that cash yields are now about 2% and rising and come with significant capital preservation qualities. While we don’t predict broad deterioration in global economic fundamentals in the event of continued turmoil out of Washington, we do recognize that constitutional crises are never good for the stock market. The S&P 500 fell 14% from Oct 1st through November 1973 after Nixon fired Cox and then Attorney General Elliot Richardson resigned in protest, more broadly known as the “Saturday Night Massacre.” While bear market challenges were broad in 1973 – Watergate convictions, Nixon resignation, global oil shock, Middle East turmoil and dramatic spike in inflation – stocks losses widened to 42% by August 1974. Moreover, the S&P 500 fell nearly 20% in the weeks leading up to the special prosecutor’s report on Clinton, ultimately resulting in his impeachment by the House. The drop occurred in the late 90s, when the stock market and economy was booming. While unprecedented events surrounding Trump’s presidency have proved virtually unable to derail the equity market’s 34% post-election rise, we have seen significant volatility spikes around events that increase the likelihood of impeachment. The Manafort indictment resulted in a 10% drop in equity markets, only to reverse just a month later when tax reform passed. It seems that when the Trump agenda of tax cuts, regulatory roll-back and preferential trade is threatened, investors pull back on risk. While we don’t see imminent risk of policy reversals at this time, we do see elevated near term risk of a stock market correction, depending on the outcome of the mid-term elections and upon what the special prosecutor finds, which bodes well for investing higher in the capital structure and keeping cash levels at the high end of allowable ranges to allow for redeployment of dry powder in the event of a market correction.
-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 necessary 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 and has not been independently verified. 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. (Source: MSCI)
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, U.S. 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 Bloomberg Barclays Global Aggregate Bond Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. (Source: Bloomberg)
The Bloomberg Barclays Euro Aggregate Bond Index includes fixed-rate, investment-grade Euro denominated bonds. Inclusion is based on the currency of the issue, and not the domicile of the issuer. The principal sectors in the index are the Treasury, corporate, government-related and securities. (Source: Bloomberg)
The BofA Merrill Lynch U.S. High Yield Master II Index value, which tracks the performance of U.S. dollar denominated below investment grade rated corporate debt publicly issued in the U.S. 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)
The S&P SmallCap 600® measures the small-cap segment of the U.S. equity market. The index is designed to track companies that meet specific inclusion criteria to ensure that they are liquid and financially viable. (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 U.S.: 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 U.S. Universal: Unmanaged index comprising U.S. 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)
The JP Morgan Emerging Markets Bond Index Global (EMBI Global) tracks total returns for US dollar–denominated debt instruments issued by emerging markets sovereign and quasi-sovereign entities: Brady bonds, loans, and Eurobonds. The JP Morgan Corporate Emerging Markets Bond Index Global (CEMBI Global) tracks total returns for US–denominated corporate bonds issued by emerging markets entities. The JP Morgan Government Bond Index-Emerging Markets Global Diversified Index is a uniquely weighted version of the GBI-EM Global. It limits the weights of those index countries with larger debt stocks by only including specified portions of these countries’ eligible current face amounts of debt outstanding. (Source: Lazard Asset Management)