Markets are moving… finally!
The move in the long end of the yield curve is significant by our measure. It signifies future growth and an end to the decade of cheap money or future inflation and a decade of high margins.
Within stocks, we remain convinced that the rotation to value is upon us. The stock market had been getting more defensive quietly and then, seemingly without a catalyst, suddenly. We are strongly convinced that this will continue, heralding a market moment when future expectations for growth collided with reality.
The American First trade has gotten long in the tooth. With the revised NAFTA looking curiously like an update to the previous NAFTA, US equity markets are slowly starting to wane as earnings comparisons will get more challenging. While the more attractive overseas markets come with risks, we see the overall market ripe for a rotation abroad where earnings comparisons will be easier going forward.
Figure 1: Market Performance as of September 28, 2018
Market Review: Sigh of Relief Breathes Life into Equity
The U.S. Federal Reserve raised interest rates on September 25th and left plans intact to steadily tighten monetary policy, as it forecast that the U.S. economy would enjoy at least three more years of modest growth. In a statement that marked the end of the “accommodative” monetary policy era, Fed policymakers lifted the overnight lending rate by a quarter percentage point to a range of 2% to 2.25%. The U.S. central bank foresees another rate hike in December, three more next year, and one increase in 2020. That would put the benchmark overnight lending rate at 3.4%, roughly half a percentage point above the Fed’s estimated “neutral” rate, at which rates neither stimulate nor restrict the economy. Their tight policy stance is projected to stay level through 2021, the time frame of the Fed’s latest economic projections. There is no shortage of commentary and discussion why, if and how much interest rates should rise. Presumably, the Federal Reserve raises interest rates to keep the economy from overheating.
U.S. job growth accelerated in August and wages notched their largest annual increase in more than nine years, the clearest signs that the U.S. economy is weathering the escalating trade war with China. The Labor Department’s closely watched employment report published in early September showed slack in the job market was rapidly diminishing, with a broader measure of unemployment falling to a level not seen since 2001. U.S. manufacturing reports in September pointed to rising input prices and labor capacity as constraints continued robust growth.
U.S. stocks reached new highs in late September on news from China that tariff and currency moves could ease trade tensions. Treasury yields remained near their highest level this year, while the dollar slid. The S&P 500 Index soared to a record close — led by the technology, health-care and financial sectors — lodging its biggest gain in over a month. The Dow Jones Industrial Average also reached a new pinnacle, with 28 of 30 constituents flashing green. Most European and Asian shares also gained. Trade conflicts that had stocks gyrating mid-month cooled off by month end. China announced its plans to cut the average tariff rate it charges on imports from the majority of its trading partners as soon as next month.
Global Brent crude jumped more than 3% to a four-year high, exceeding $80 a barrel after Saudi Arabia and Russia ruled out any immediate increase in production, despite calls by President Trump for action to raise global supply. The Organization of the Petroleum Exporting Countries and non-OPEC states, including top producer Russia, gathered in Algiers for a meeting that ended with no formal recommendation for additional supply to counter falling supply from Iran.
The world economy remains on shaky ground a decade after the 2008 financial crisis as global economic growth is “spasmodic” and many economies are operating below potential, says the United Nations Conference on Trade and Development. The trade tariff tussle between the two major economies, the U.S. and China, is a symptom of a “deeper malaise”. However, the four BRICS nations, including India, are doing better because of increased domestic demand. This year is unlikely to see a change in gear. According to the U.N., since 2008 many advanced countries have abandoned domestic sources of growth, most noticeably with the turnaround of the Eurozone from a deficit to surplus region.
The European Central Bank kept policy unchanged, as expected, staying on track with ending bond purchases this year and raising interest rates next autumn, even as it warned that risks from protectionism were gaining prominence. With inflation rebounding and growth leveling off at a relatively healthy pace, the ECB has been gently removing stimulus for months in the belief that a range of risks, from trade disputes to emerging market turbulence to Brexit, will not be enough to derail an economic expansion that is now in its sixth year. In a subtle shift, the ECB said it would halve its monthly bond purchases to 15 billion euros in October, firming up its previous language, which said that such a move was only anticipated.
China’s fixed-asset investments decelerated further in August, to the slowest growth rate since official records were kept, as the country braces for additional tariffs from the US. Overall, Chinese economic growth continues to decline, notably due to the effects of U.S. tariffs on business sentiment. The yuan inched lower after President Trump imposed duties on an additional $200 billion of Chinese imports, drawing a sharp rebuke and warning from Beijing that it will be forced to retaliate. The escalation in the trade war between the two economic giants caused some wobbles in Chinese stocks. However, they bounced back after Beijing vowed to fight back. A rally in infrastructure stocks supported the broader market, with some investors betting that China will step up investment in roads and bridges to offset the impact of the latest tariff salvo from Trump, much of which has already been priced in by the markets.
Going Forward: Slowly then Suddenly
We seem to have caught the market in a naval gazing moment which, by definition, makes commentary at just this moment dangerous. However, much of what is playing out in the markets has, in our view, been playing out slowly and now suddenly. We see multiple themes playing out in the market which have been developing over time. Earnings reflected the massive windfall to corporations. At times, the stock market fretted over trade policy, but to a lesser extent, though the former significantly more than the latter. The result was highly skewed market that rewarded growth despite the seemingly unsustainability of that corporate profit growth. Now the fear that is front and center for investors appears to be interest rates. With the economic recovery in full swing, interest rate normalization would eventually herald the end of a decade of monetary accommodation and cheap access to debt. Higher interest rates will eventually have a negative effect on corporate earnings, economic growth, and the real estate market. Some would argue the wisdom of raising interest rates, but it’s important to remember that the Federal Reserve has a mandate to combat inflation. Given current levels of historically low unemployment, if wage pressure and other measures of inflation continue to rise, rates will also continue to rise. Knowing exactly where and when to stop raising rates is a difficult task, even for the Federal Reserve. The concern in a rising rate environment is that rates rise too much, to the point that the cost of debt begins to hinder economic growth, and a recession ensues. Additionally, given the current level of national debt, higher interest rates will have a negative effect on the government’s debt servicing costs.
While the Fed has been steadily normalizing the overnight interbank lending rate, the Fed Funds Rate, the longer end of the yield curve has been slower to rise. At times, throughout the year the longer end of the curve actually fell, leading to concerns about a potential for an inverted yield curve, normally a harbinger for recession. And, then, quite suddenly, the longer end shot up almost 15 bps. Though, to put this move into context, in the past twelve months, the long end has moved up 45 bps while the one-month rate has moved up 105 bps. This begs the question, is the long end pricing in expectations for growth, inflation, or both? If this is driven by growth, then, in the most optimistic scenario, we are could now at the stage of economic cycle where economic growth is steady, but financing costs will start to rise which will hurt corporate earnings to a degree, but equities would still be more attractive than bonds. In a slightly more pessimistic scenario, the bond market could be playing catch up and the economic growth picture is starting to peak out and naturally slow and without additional stimulus, earnings could see a dramatic slowdown, in which case the still frothy multiples will have to be repriced leaving equities less attractive than bonds.
The Value Rotation
Waiting for value to come back into favor has been like waiting for Godot, but after a few months of teasing, we seem to have more evidence that the market is becoming more price conscious and is looking for more defensive sectors. The high-flying technology stocks have been beaten down over the past several weeks A rotation into value makes sense at this point in time. The S&P 500 Value index currently trades at 14.07x forward earnings, while the S&P 500 Growth index currently trades at 20.41x forward earnings. When we factor in earnings growth expectations for the value index at about 25% for the year vs 17% for the growth index, we come to the conclusion that value stocks are not only cheaper, but also appear to have the growth to support gains, where as growth stocks still have solid earnings potential but much of this has already been priced into stock prices.
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.
We believe that the increased volatility will continue in both domestic and international equities. The wall of worry will continue to cite trade wars, interest rate pressure, and valuation as key reasons for this volatility. We believe the probability of a recession in the coming months as low. Look for a continued rotation to value. Volatility can create opportunity for the long-term investor. Although we are under-weight international, look for entry points into International and Emerging Markets. As interest rates rise, we continue to monitor credit spreads, defaults, and liquidity in the bond market in order to avoid potential losses in the bond market.
-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.
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 publically 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)