The trickle-down theory is boosting inflation. Core PCE inflation of 1.9% in March is just shy of the Fed’s 2% target and signals a clear normalization of interest rate policy.
Tax cuts and US fiscal risks. The hope that tax cuts will create a “growth offset” to counterbalance the falling tax receipts is still yet to be determined and could be a source of disappointment, though possibly will not peak until 2019.
Trade Policy. Growth in trade has favored Europe while the U.S. looks determined to explore tariff and trade policies with its allies. In addition, an isolationist approach to some global geopolitics could leave the door open market volatility.
Market Review: Inflation Fear is Back
The sideways move in the equity and bond markets in April largely reflected continued optimism in the economic recovery, while market volatility generally lessened as policy, political and geopolitical fears subsided during the month. U.S. stocks began the month on an upward trend, which was briefly interrupted by continued protectionist threats between the U.S. and China before reversing and ending the month on a positive note. Following the March FOMC meeting, Jerome Powell ignored the noise of the trade dispute with China by continuing with gradual rate increases amid a strong labor market and moderate U.S. economic momentum.
The March FOMC minutes describe the economy as moderate with inflation, while reaffirming movement of the Fed funds rate this year toward the 2% neutral policy goal. While inflation, tied to higher steel and aluminum costs, is becoming evident in factory orders and producer prices, it was not cited as a specific concern in the March minutes. Fed members did note that rising average hourly earnings rates increased concerns about the prospects for higher inflation and interest rates in March and contributed to a steep rise in volatility and decline in equity prices. Retaliatory tariff responses pose further downside risk, with agriculture cited as a specific risk. Rising government deficits and tax cuts are also a downside risk; however, members are uncertain as to the magnitude of the risk, given a lack of historical examples about how expansionary fiscal policy during a period of full employment will affect the economy going forward. The Fed raised the overnight lending rate 25 bps to a range of 1.5% to 1.75% in March and signaled two more 25 bps rate increases this year followed by three more next year. The market has priced in three more increases this year for a total of four. Core PCE inflation, the Fed’s primary inflation barometer, reached 1.9% in March and now stands only 10 bps shy of the Fed’s 2% target.
Inflation fears largely drove bond yields higher in April. Investors dumped falling bond prices and rotated into equities, which are perceived to be more insulated from modest inflation than bonds. The 10-year Treasury topped the psychologically key 3% late in April, before dropping back down to 2.93% by month end. The yield curve is considerably flatter than 15 months ago, when Trump took office. The 2-year yield is up 129 bps to 249 over the period, while the 10-year yield has backed up only 48 bps. While the yield curve continues to be upward sloping, bond investors continue to be less optimistic about future growth and longer-term inflation prospects than equity investors. On the demand side, longer term Treasuries continue to be attractive to liability-hedging pension funds and foreign investors seeking a higher yield than is yet to be found in the rest of the developed world. Smaller cap equities, believed to be less subject to the effects of global trade tariffs, were more attractive than large cap multi-nationals in April. Value-oriented stocks overall performed better than growth as investors became much more price conscience and sought dividend income.
Senators grilled Facebook CEO, Mark Zuckerberg, in congressional hearings over data breaches, informing him that his days of self-regulation may be over. It’s unclear how the internet privacy issues are going to play out, and the uncertainty had caused Facebook investors to be more cautious.
In geopolitics, President Trump commanded the State Department to suspend more than $200 million in funds for the Syrian recovery efforts, while the administration assessed its role in the conflict. Trump’s actions did not hinder the U.S., U.K. and France from launching missile strikes on Syrian chemical weapons targets in retaliation for an apparent chemical weapons attack outside Damascus by Bashar al-Assad’s regime. In the East, North Korea suffered a collapse of one of its major missile launch sites and indicated it would suspend further tests of atomic weapons and intercontinental ballistic missiles. In a historic step to reconcile the two Koreas, South Korean President Moon Jae-in met North Korean President Kim Jong-un at the demarcation line that separates the two countries for the first time since a 1953 armistice put an end to the fighting in the Korean War.
Internationally, while the global recovery continues, U.K. home spending grew at the slowest pace in almost two years as very cold weather kept shoppers in their homes. U.K. wages, however, rose at their fastest pace in almost three years, raising the prospect of an end to the squeeze on living standards. Despite rising wages, U.K. inflation dropped more than expected and it hit its slowest rate in the past year. The cloud of a hard Brexit still hangs over the U.K., which is having a reverberating impact across Europe.
Broader Euro-area inflation grew less than originally estimated last month, a setback for European Central Bank policy makers, as they considered turning down their unprecedented stimulus. Consumer prices in the region rose just 1.3% in March, up from a year earlier and .2% better than the previous month but fell short of the 1.4% initial estimate. Germany’s public-sector workers and employers agreed on a wage hike, averting the threat of more disruptive strikes in Europe’s biggest economy. Wages are set to rise by 3.2% on average, year-over-year in Germany, retroactive back to March.
Treasuries cheapened across the curve in Asia, with the benchmark 10-year yield up 2bps to 2.76% at the beginning of the month. Investors in China bought bonds after the central bank cut the reserve ratio for some lenders and pumped money into the banking system. The yield on 10-year government bonds fell 16 bps to 3.5%, the biggest decline since December 2016.
Trickle Down is Boosting Inflation not Growth
Financial repression is now coming to an end as the Fed continues to raise rates. Though still accommodative, financial conditions are tightening and will continue to tighten. More importantly, the specter of inflation has now taken hold of the bond markets, driving rates in the belly of the curve higher along with the front end. The long end, however, still has its doubts and lags the rest of the curve, resulting in continued flattening. However, oversees, the peak in Europe combined with lower than expected inflation are keeping the ECB more accommodative, which keeps the bid strong for Treasuries. Trade war and the potential for geopolitical conflict are the big fat tails hovering over the global investment landscape. We see the landscape largely riddled with challenges, despite the otherwise buoyant economic data that is expected to continue throughout 2018.
Tax Cuts Could Exacerbate US Fiscal Risks
The hope that tax cuts will create a “growth offset” to counterbalance the falling tax receipts is the big question, in our opinion, and likely will not peak until 2019. In the meantime, the U.S. Treasury will have to depend on the fact that the spread between the U.S. and the rest of the G4 will favor continued demand for the massive issuance that will have to be absorbed by the foreign market in the next twelve months. That said, this administration seems to be doing all it can to aggravate the largest buyers of U.S. Treasuries, particularly China. Recent demands of China have been met with what can only be described as a dead pan stare in what could be a dangerous game of chicken. Worse, our relationship with Europe is also at risk as we face off on not only trade and tariff threats, but also as we threaten to abandon the Iran nuclear deal. With this uncertainty, we have embarked on earnings season and so far, results have landed with a thud, not because they are not impressively high, but because expectations were even higher. More importantly, this year will represent the boost from tax cuts, but growth will likely not be seen for some time. In keeping with the idea that the peak is coming, the mergers and acquisition (“M&A”) cycle is picking up with gusto, possibly with some risks of antitrust concerns. However, we would anticipate that the M&A cycle will continue to pick up as companies look to gird themselves for a natural cycle peak and slowing in growth over the next few years.
China Bails Out the World While US Abandons it
European growth peaked earlier than the U.S. without a normalization of interest rates, leaving the region with few policy tools to combat a cyclical turn. However, the global trade boom, supported by Chinese demand, though slowing, continues to support growth in Europe. However, inflation is now coming in lower than expected, which could raise alarm of a liquidity trap, a la Japan. Though we did see some signs of life in the rates market as a minor taper tantrum drove rates higher, it was not significantly so. Europe finds itself in a position to be a massive beneficiary should the U.S. and the U.K. opt out of global trade, leaving Europe a natural winner given their increasing trade with China. However, the potential for a hard Brexit seems to be rising given May’s recent appointment of Brexit hardliners into her cabinet. One element of recent harmony has been the European and U.K.’s coordinated message to the U.S.: do not abandon the Iran Deal. We see this as a potential short term catalyst for short term global volatility. As the proxy wars in the Middle East continue to gain momentum, the continued Shia/Sunni confrontation could start to approach something more like the Reformation in terms of scope and length of conflict. This would be a dangerous outcome, but one that could be hastened if the U.S. does indeed pull out of the Iran Deal. At the same time, North Korea has achieved its goal of forcing its larger, more powerful and influential neighbor, South Korea, to talk effectively providing a semblance of legitimacy. While the risk of confrontation seems to be calming, the likelihood of productive talks with the U.S. is highly unlikely. Moreover, we see this as a continued risk to asset markets. While it could be a small risk to markets if China stays on the sideline, it will be a significant risk to the markets if trade war threats to China encourage them to come off the sidelines.
We remove our overweight to EM equities relative to U.S. and International equities. Our factor-based models continue to favor momentum and valuation factors, while we expect low vol to continue underperforming. Our style box based models tend to slightly favor value, and size is still at market weight. We continue to hold Treasuries at an underweight and remain neutral to investment grade credit and high yield debt. Within high yield, we maintain an overweight to higher quality BB/B corporates and an underweight to CCC and below.
–Your investment team at Lido Advisors