Tax policy will either pass, or it won’t; though the reconciliation process will be critical to the ultimate tax reform outcome: Our outlook is that both the upside and downside are limited in either scenario as valuations are already at multi-year highs and continued positive earnings can buffer the downside scenario.
Germany will either form a government, or it won’t. In either scenario, Merkel’s power is greatly diminished: That said, Germany is very likely to continue its policy stance with regard to the European Union, Brexit, and other important matters. This continuity will be key for the continued gathering recovery.
Oil will remain supported, or it won’t, though Emerging Markets and US equity are each less vulnerable to a fall in oil prices: Though the Saudi Aramco IPO presents a specific need by one specific stakeholder, the market has found other sources of earnings in the form of consumption and trade to offset oil prices as a driver, leaving the threat of a price correction less concerning. Geopolitics remains the big fat tail.
Market Review: Hanging in the Balance
All eyes were on the Middle East in early November, as Saudi Arabian authorities arrested dozens of powerful and influential officials as part of an assertive push to root out corruption, leaving Crown Prince Mohammad Bin Salman – widely referred to as MBS – with a significant consolidation of power. Oil prices increased dramatically in response to this news, partially on speculation of a destabilization in the region and partially on the knowledge that MBS will continue to advocate production cuts in an effort to support oil prices through the Saudi Aramco IPO, a lynchpin to MBS’ Vision 2030 plans.
President Trump’s nomination of Jerome Powell to be the next Federal Reserve Chairman was an atypical move compared to past presidents who typically nominate the incumbent Chair. Powell is largely viewed as supportive of the pace of rate hikes set by current Fed Chairwoman, Janet Yellen. He is also believed to be open to bank deregulation, which is a position of interest to the President yet criticized by many, including Yellen. That said, broad US stock markets and financials reacted positively to the prospect of regulatory easing and supported the US rally, at least until the tax process stumbled early in the month and dampened the rally. By mid-month, the House passed a tax reform bill, leaving the US stock market largely advancing without looking back. As the month drew to a close, the Senate Budget Committee advanced their version of a tax reform bill to the Senate floor, while the Dow Jones Industrial Average broke 24,000 for the first time in history and marked its fifth 1,000 point gain this year.
Emerging market equities faced a slight downward trend mid-month; however, the approval of the House tax bill created a wave of investor optimism that permeated global markets, including the emerging markets. Emerging market equities ultimately bounced strongly in November, with better than expected global trade and manufacturing data and a continued reflation in oil and commodity prices being the primary drivers.
Despite the global reflation backdrop, inflation has been slow to come, though the Fed seems determined to hike ahead of inflation, which has resulted in a bear-flattening of the yield curve – usually seen as a bad omen for the economy. Europe and the United Kingdom also face the phenomena of a flattening yield curve, albeit to a lesser degree and predicated on similar expectations of muted inflation. These dynamics indicate that the global economy is absorbing excess capacity as global output expands, while lackluster inflation is feeding a self-fulfilling prophecy of low long-term inflation expectations.
The Bank of England raised interest rates for the first time in a decade, after which the pound tumbled and bond yields fell. Reinforcing the market’s reaction, many view Brexit negotiations as pivotal for capital markets and the interest rate hike did not come at the most optimal time for the United Kingdom. The UK’s economy looks fairly lackluster relative to the rest of the world, given that the effects of Brexit enforce a dampened economic outlook for the region.
Meanwhile, in Europe, the economic outlook looks much brighter, though the shadow of populism hangs over the region, with Angela Merkel currently unable to form a government in the south. Catalan efforts to declare independence from Spain while remaining a part of the European Union have failed. With each test of the European Union, the euro seems to sink further.
Chinese stocks suffered their worst day in months in November as the government took moves to stop small online lenders. This occurred just days after the Chinese government announced plans to streamline the oversight of asset management products sold by financial institutions. After draft regulations were revealed, local asset managers began selling stocks to shore up liquidity.
Going Forward: Road Map for 2018 – Binary Outcomes
As we head into the holiday season, it seems the world is faced with a series of binary bets which could have a significant impact on the road map for 2018. In the US, high valuations appear to be pinned to the outcome of the tax vote, which could occur as soon as the publication of this piece. However, despite tax reform’s shiny object appeal, global trade output is slowly expanding in the shadows and has been hugely underestimated as the driver of the US market’s advance to a record top. Though future market paths are in fact binary, we view forward market risk as being somewhat balanced, with the upside likely limited by the current high valuation levels and the downside buffered by expanding global GDP growth and continued positive earnings. That said, earnings have been revised down every month since April, which presents a challenge, particularly if earnings growth continues to slow and Q4 earnings present an immediate hurdle at the start of the year. Despite this earnings growth conundrum, the US growth outlook remains quite positive for 2018.
In the UK, Brexit negotiations have started to take on a binary feel, as the inability to make progress is starting to wear on British patience. UK growth is reflecting uncertainty regarding the slow Brexit negotiations. As if designed by a classic game theory professor, Europe simply has to continue to say no to win the game. In Europe, the inability of Angela Merkel to form a government has created considerable uncertainty in a region where populism still lurks in every corner. However, despite these looming political risks, the outlook for Europe continues to be revised up and the nature of the recovery has a very sustainable feel, given expanding trade outputs. However, the European equity trade has likely run its course for the year. In the Middle East, the need to keep oil prices up to support progressive ambitions, while still maintaining regional stability, presents its own challenges, though OPEC’s decision to maintain the cuts through 2018 with Russian agreement is a significant move in that direction. Finally, North Korea’s continued advance toward nuclear armament hangs as a grand binary event on a global scale.
The ”Benign” Outcome
While we we suspect that the current tax bill may be a negative for the economy as soon as 2019 or 2020, the passage of tax reform is likely not so benign. Although added accommodation will place a floor under markets broadly and support risk assets generally through 2018, the stimulation is coming at a time when a global recovery is in full swing, which will likely be inflationary and eventually drive up not only the short end of the yield curve, but also the long end. Increased borrowing costs will spell trouble for debt-laden high yield issuers, particularly those at the covenant-light end of the spectrum, as higher defaults bring little investor protections. Interest rate movements to curb inflation could eventually push the US economy into a recession by 2019 or 2020. For 2018, we expect global trade dynamics will lead global markets to more positive risk-on outcome, with emerging markets being the greatest beneficiary. We remain positive on Europe in this scenario, as a risk on rally in the US buffers potential negative news out of Europe; however, our resulting trade recommendation would be an overweight in US Equity and EM equity and an underweight in International Equity. We envision an underweight to Treasuries coming in 2018; however, we can’t get to that position today with inflation results printing far below Fed target and excess capacity absorption continuing to cap longer term inflation expectations.
The Worst-Case Outcome is Not So Bad
If the tax bill fails, which seems unlikely as we write this, then the markets may be facing a significant re-pricing. With that said, this could be the opportune time for that kind of failure. Currently, PMI’s are increasing to levels not seen in years, trade is continuing to expand globally and global growth appears to be on a more sustainable path. Earnings should continue to post solid progress; if not enough to meet overly enthusiastic expectations, they will still be good enough to underpin the markets. Though we caution that consumption in the US is being fueled by a drop in savings of late, which is unsustainable, savings depletion will not be enough to paper over 2018 results. We are likely to see only a small amount of valuation froth come off, perhaps back to 20x earnings. This will likely not dampen risk attitudes for long positions in 2018 and will keep the EM trade going strong and it could certainly keep the European/Japanese trade alive. In this case, we could see yield curves remain flat with the front end rising under a determined Fed and the long end falling while waiting for inflation. Thus, the curve could invert in this scenario over the course of 2018. In addition, we would issue a note of caution around the geopolitical fat-tail risk. The move to replace Rex Tillerson, a moderate, with Mike Pompeo, a hard-liner, as Secretary of State could be a major tipping factor towards a very ugly outcome.
2019 and Beyond
Without seeming overly dismissive of the importance of 2018, it seems that the likelihood is that 2018 will be a year of taking the economy and the market past a boiling point, after which we will experience the repercussions in 2019 or 2020, when the economic cycle will likely be cooling off. Rates may not be high enough to effectively battle a normal economic slowdown and assuming the tax bill goes into effect, will have heralded in yet more inequality, which will drive down money velocity and render monetary policy that much less effective. We will also still be a highly indebted country, rendering fiscal stimulus a significant challenge. Our expectations for 2018 are to see a continuation of the rally, an increase in volatility, continued support for oil prices, non-wage inflationary pressures building, a steady fall in money velocity and continued geopolitical fat-tail risks. Swim at your own risk, though for a time, the current could be friendly. However, when the tide turns, it could turn ugly quickly.
Given our view that the benign outcome is more likely but weighing the worst case against it, we maintain our current weight to US equity and will increase our exposure to EM equity by reducing developed markets exposure. Given our views for 2018 we continue to recommend hedged exposure to the equity markets whenever possible.In Fixed Income, we have started to extend portfolio duration and increase credit quality..
–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 publicly 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)