Tax cuts are having an impact to U.S. earnings. As Europe and Japan have peaked in terms of GDP growth, the U.S. is now attracting capital at the margins as investors rebalance.
Italy, North Korea and the Middle East could create support for U.S. Treasuries. We see ample support for Treasuries despite the continued upward grind at the Fed.
Oil could surprise on the upside. Fundamentals support higher oil prices along with the continued threat of conflict in the Middle East, even despite Russia’s recent supply increases.
Market Review: Many Moving Parts
U.S. stocks posted solid returns in May. U.S. corporate earnings blew past expectations and revealed early green shoots from U.S. corporate tax cuts, while U.S. economic news continued to surprise to the upside. Business investment and factory activity remains at a decade high level, while labor markets continue to trend toward full employment. Consumer spending finally showed some early signs of life on the last day of the month, surging .6% in May, as tax cuts and labor effects finally passed through to the consumer. President Trump’s decision to withdraw from the Iran Nuclear Deal and reinstate financial sanctions on the Islamic Republic lent a further tailwind to the energy markets, with energy shares rallying on speculation that crude oil supplies may not keep up with demand.
No doubt, political tensions tempered the market’s rally in May. Trade talks between the U.S. and China escalated, and then softened, with the two nations declaring a truce that will only prove temporary if either country fails to deliver on their vague commitments to re-balance trade. Trump reignited global trade war fears on the last day of the month by imposing tariffs on steel and aluminum imports from the European Union, Canada, and Mexico. The move sparked fears of retaliation by trade partners, and the equity markets sold off sharply at month end.
Moreover, the back-and-forth summit talks between the U.S. and North Korea left the markets feeling generally uneasy all month. Compromise seemed to be on the horizon, as North Korea agreed to dismantle one of their nuclear test sites. However, as talks progressed, North Korea felt President Trump’s demands were one-sided and Trump abruptly cancelled the summit. By month end, talks had reconvened in an attempt to bring the summit to fruition.
The Treasury yield curve flattened in May to the lowest level since August 2007. A combination of weaker-than-expected U.S. inflation data and solid demand driving record bond auctions, investors were not bashful about absorbing the extra supply generated by a steep back-up in yields. The ten-year U.S. Treasury yield passed through 3.1% just after mid-month before falling back to 2.8% by month end. The dollar rallied in tandem as global assets swiftly rotated into relatively safety of U.S. stocks and bonds.
European stocks were also rattled by the geopolitical trade and denuclearization tensions in May. They suffered further losses as Euro skeptics gained strength in the May Italian elections. For U.S. dollar investors, Euro market declines were materially exacerbated by currency effects in May, with the dollar rallying significantly amid the flight to U.S. assets.
Euro economic news left Germany’s economy growing at the weakest pace in more than a year. The economy has been held back by trade, amplifying a slowdown that’s been occurring across the euro area this year. Despite their weak growth, Germany’s unemployment rate fell to a record low of 5.2% in May, as companies stepped up hiring to work through backlogs, even amid signs of slowing growth. Germany’s struggles were further amplified by China’s recent pledge to buy more American goods as part of a deal to avert a trade war with the U.S. Germany is China’s biggest European trading partner, which puts them in a tough spot, given they will be first in line to suffer the negative impact of the trade reduction. Chancellor Angela Merkel is urging China not to follow through with its promise.
The European Union’s chief Brexit negotiator, Michel Barnier, accused the Brits of being masterful in the art of “stalling”. He implored the United Kingdom for the urgent need to take a more realistic position on the UK’s withdrawal, insisting the bloc’s courts must have a say in governing the final deal. On the economic front, British citizens got their first real pay increase in more than a year as first quarter wage growth finally overtook the rate of inflation in a tight labor market.
Italian bond yields proved volatile this month, surging and then moderately coming back down, as political turmoil in the country continued to reverberate through markets. The yield on their short-dated notes surged 100 basis points to levels not seen since September 2013, while their benchmark 10-year notes hit their highest level in nearly four years. The day following the panic, however, Italian bonds rebounded, with the 10-year yield falling as much as 19 basis points in a day.
Emerging market (“EM”) equities sold off sharply this month. U.S. dollar strength left EM equity investors concerned about the potential for a global debt implosion, given the significant amount of U.S. dollar denominated debt held by emerging market sovereigns and corporations. The problem could mount if the dollar continues its rally. Hong Kong posted its fastest quarterly growth since the first quarter of 2011, with its gross domestic product surging 2.2% in Q1. Mahathir Mohamad won a shocking victory in Malaysia’s election, ending the 60-year rule of Prime Minister Najib Razak’s party in a groundbreaking shift for the Southeast Asian country.
Going Forward: America First for Now
At first blush, the America First agenda is working. The U.S. has executed a tax cut, businesses are investing, and manufacturing is going gangbusters. That said, labor markets are tight, hourly wages are rising and yet consumption is just ok. President Trump has made a deal with China that takes Chinese consumption away from Europe and toward the U.S., theoretically anyway. As the dollar has risen, the search for yield has focused on U.S. high yield. As Italians are now moving toward populism, flows have favored U.S. Treasuries. As U.S. corporate earnings continue to fire on all cylinders, money flows have favored U.S. equities over global equities. However, we have always expected that this stimulus induced fervor has limited life.
Expansions come in two phases, as do contractions. The first phase of the expansion is generally marked by strong earnings in the equity markets, matched by even stronger moves in valuations. That optimism is often matched by rising yields, reflecting both growth and inflation. In the first phase of the expansion, we generally see equities as the solid winner, and bonds as the solid loser. However, as the expansion gets long in the tooth, eventually, the primary driver starts to give way and the economy starts to roll over. Earnings don’t generally go negative, but they will often slow, leaving investors to rationalize valuations back to levels consistent with what is possible. In this phase, yields continue to rise, but often less fast and in some cases, they fall with bouts of uncertainty. We believe we are entering the beginning of phase two, where earnings will start to slow, and bond yields will occasionally fall as they try to find their final place. While we still view the ultimate direction of yields to be up, the relative trade between bonds and stocks has become more neutral. The question becomes: will bond yields rise more than multiples will fall? Given the tremendous uncertainty in the markets, we would argue that it is a coin flip at this point, which is not a bet worth making. As a result, we find ourselves rather boringly neutral as we wait for some signs of where the chips will fall.
Stimulus Vs. Protectionism
Trump’s general plan has elements of stimulus (i.e. tax cuts and infrastructure spending) as well as elements of protectionism (i.e. anti-trade tariffs and anti-immigration deportations). With the tax cuts now solidly in the rear-view mirror as far as earnings impacts go, we are now left grappling with tariffs and immigration, neither of which has positive impacts to the economy. Moreover, mixed messaging out of the administration as well as the constant flips and flops by the President himself, have created an air of uncertainty in the markets. While the first phase of equity markets was helped by the tax cuts, the second phase of multiple contractions in the markets may be hastened by the same administration. The net outlook for equities looks to be possibly less optimistic than bonds from this perspective.
Italian elections have brought a fresh wave of concern over an Italian exit from the euro. While we see these concerns as generally overblown, there is always the fat tail risk that the country will be unable to form a government with technocrats and could see more right-wing populists take control and take the country and Europe to negative outcome. The volatility surrounding the formation of the Italian Parliament will be harrowing for the markets but will hopefully be short-lived. These actions, however short-lived, are a big driver for continued support for the U.S. Treasury, which has fallen in recent days and could continue to see a bid relative to European and periphery debt. While equity markets are generally showing signs of weakness, U.S. bonds are showing signs of strength, relative to European bonds which have fallen dramatically and are still not yet out of the woods.
Oil Prices Could Soar
Also bubbling in the undercurrent is the direction of oil prices. As oil prices fell at the end of the month along with the strong dollar, the underlying factors continue to point to stronger oil prices going forward just based on rising demand. That said, as the ARAMCO IPO has now been pushed off to 2019, OPEC will have a much harder time enforcing compliance. Rosneft is already out ahead of the OPEC talks with massive pumping, even despite Iranian sanctions. This could soften price, but we feel that the pull continues toward higher prices. Moreover, as tensions continue to mount in the Middle East, we see continued upside risk to oil as we head further into the era of U.S isolationism relative to the Middle East.
We are pulling back or underweight fixed income to neutral and initializing a small overweight to commodities with an eye toward higher oil prices by year end. We remain neutral across equities and fixed income as volatility is muddying the waters.
–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. 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)