The fundamental recovery in earnings has made the rally bulletproof against Washington drama for now: Sales and earnings continue to recover globally, but none more strongly than in the US where the data has been very robust.
Macro data, however, is starting move sideways, cycles are maturing and in some part of the world, rolling over: As we see the macro data soften, we will continue to expect that the sales data will likely follow suit later in the year. Treasuries and credit, however, may continue to remain fully valued and supported as this will likely slow the rate normalization cycle.
Commodities are reflecting stronger demand, though with oil stuck in a trading range, we can not expect too much from this rally on a broad index basis: Commodities are showing that the demand data is healthy and supportive of the macro data. However, the largest influencing commodity, oil prices, are still vulnerable to continued supply issues, leaving the overall complex mixed.
Market Review: Recovery Continues Despite Politics
Global markets marched even higher in July, as better than expected economic news prompted global central banks to strategize tapering their balance sheets and oil prices rebounded on larger than anticipated inventory drawdowns. Returns were positive across asset classes, despite internal US policy issues and significant geo-political headwinds testing the world order.
North Korea successfully launched a long-range missile just prior to the G-20 meeting in early July, where leaders were expected to discuss ways to restrain North Korea’s weapons program. In mid-July, Trump Jr. disclosed a controversial meeting between Trump’s top campaign staff and a Russian lawyer that sought to publicly reveal damaging information about Hillary Clinton. Moreover, US Special Counsel, Robert Mueller, expanded his investigation of President Trump to examine the Russian meeting and his financial dealings in Russia. By month end, US congressional leaders sent sweeping legislation to the White House to sanction Russia for election meddling and aggression toward its neighbors. The legislation seeks to sharply reduce the President’s power to reduce or remove the sanctions, which calls into question whether he will sign or veto the bill. Finally, the Pentagon submitted plans to the President to arm the Ukrainian government against Russian-backed rebels.
Despite the momentous geopolitical events, news continued to reveal a recovering global economy, keeping markets on an upward trajectory. US job growth surged more than expected in June. Employers added to worker hours, which raised optimism for future wage growth and the potential to close the inflation gap. The US dollar slumped to a 13-month low against a broad basket of currencies on soft inflation data and the Fed’s decision to stand pat on rates. US crude oil prices tumbled 2.5% on July 21st on reports of rising OPEC oil output, despite the coalition’s pledge to curb output; however, prices surged shortly thereafter as OPEC moved to cap Nigerian oil output and called on several members to boost compliance with production cuts to help clear excessive global stocks and support flagging prices.
Second quarter GDP growth came in at 2.6%, doubling growth in the first quarter and meeting consensus expectations. The economic release reflected a 2.8% pick-up in consumer spending and 5.2% increase in business investment, which included an 8.2% pick up in equipment investment, signaling that businesses expect future increases in global demand. Labor, household spending and manufacturing indicators continued to show strength throughout the month, while inflation continued to moderate. The Fed stayed on hold in July, after hiking rates a 1/4 point at the June FOMC meeting to the 1.00 – 1.25% range. The Fed fund futures market has one more rate hike priced in December and one priced for next year. The Fed’s statement indicated tapering could begin “relatively soon”, with markets expecting a December or early 2018 start; however, taper could start as early as September.
The International Monetary Fund maintained its global economic growth forecast for 2017 on expectations that Eurozone and Japanese growth will accelerate, while it cut its outlook for both the US and the UK. The ECB held interest rates and asset purchases steady, amid speculation that it will start to scale back its ultra-loose monetary policy in the fall. The UK’s economy grew modestly in the second quarter, following weak year-to-date growth results owing to increased inflation and a wage squeeze after a sharp decline in the pound post the Brexit referendum. The currency decline affected consumer purchasing power, raising import prices and choked off growth. The IMF downgraded UK growth in its latest forecast due to Brexit uncertainty, as it clouds GDP growth potential for the UK. In Germany, business confidence hit a record high in July, which was primarily attributed to a surge in domestic consumption, following declining unemployment and an increase in exports. Euro strength is expected to create a drag on export growth; however, the fundamentals of the German economy remain strong.
China’s economic growth came in at 6.9% in the second quarter, matching the first quarter’s pace, and primarily driven by solid exports, industrial production, and consumption. Analysts however, view the growth rate as transitory and unsustainable, as the country deals with the rising corporate debt, persistent industrial overcapacity and weak private investment. The IMF raised China’s 2018 growth forecast on expectations that authorities will maintain high public investment to meet their target of doubling 2010’s real GDP by 2020. The Chinese government announced in July that it would change the way it calculates GDP growth for the first time in 15 years, adding healthcare, tourism and the “new economy” to their overall figure.
The Bank of Japan kept its benchmark interest rate unchanged after its two-day meeting and once again pushed back its estimate to achieve its ambitious 2% inflation target. Moreover, it kept its aggressive bond-buying stimulus package intact, which led to decline in the yen. The central bank of Japan raised its GDP growth forecast for the current and the next fiscal year, citing better economic sentiment and higher exports.
Going Forward: Maturing Cycles
The summer has been anything but boring. The markets, however, have persevered through the noise to continue to paint a picture of a recovering global economy. However, the story going forward into the fall could start to paint a picture of moderation on the macro landscape. In the US, the soft data looks to be peaking with consumer confidence starting to roll over as growth in retail sales peaked out on a year-over-year basis at the beginning of the year. Retails sales have been falling since. In Europe, the cycle also looks to be maturing as the Euro has appreciated relative to the weakening US dollar, which will likely impact growth as well as corporate profitability. And China has continued to avoid the hard landing with a managed tightening in the housing market, at least in the big cities though small cities continue to accelerate construction and lending, keeping the boom from busting. This has supported a rally in industrial metals and other commodities. That said, the rally in oil could be somewhat tenuous as the cracks in OPEC are getting wider with Saudi Arabia taking up more and more of the compliance and more non-OPEC countries are bringing significant production on line. Elsewhere in EM’s countries seem to have gone through the crucible and are now set to recovery with Latin American leading the charge. This general outlook strongly supports a potentially subdued fall relative to where we currently are, so valuation could very quickly start to matter again. Though the fundamental picture looks as rosy as it has been in years, making the outlook somewhat murky. We see the expectations on the commodity front to be equally mixed, though positive for now.
From a valuation perspective, everything, it would seem, looks expensive. But, we must evaluate the different levels of expensive. Our favorite asset class, European Equity, has the strongest valuation scores on a Z-score basis as P/E’s have come down as earnings have improved more than prices have adjusted up. As far as we can see, this trade has a lot of juice left on a relative basis as well as an absolute basis. The Nikkei 225 seems to be stuck in perennially cheap territory, registering trading at a level significantly lower than the long term mean. This suggests that those playing this trade through EAFE shouldn’t see nasty surprises from Japan derailing a good European bet. Our research indicates that EM Debt and High Yield are the most overvalued asset at the moment. This has been the result of years of yield seeking on the part of market participants. With the Fed slowing their pace of tightening, this trade could still have a few more innings, though not many as we see it. Although we hardly see a major default cycle in the making, we would note that defaults are at historical lows. As long as the macro picture, interest outlook, and credit availability continue to support this, this source of financing can continue to roll. However, when the music stops, it is worth noting that corporate debt is now quite high and vulnerable. Sovereign debt, on the other hand, is not nearly as vulnerable as countries have become more robust.
Across the board, fundamentals look strong. In the US, the earnings recovery continues to pick up steam despite turmoil in Washington ranging from political gridlock in Congress to drama in the White House. Earnings and sales have shown strong absolute growth and have beaten estimates handily. The US has the strongest set of fundamentals, bar none. Europe, however, comes in a strong second with the recovery in Europe coming up from a weaker place. As a result, it has more to go, in our opinion. Though not on the same scale on an absolute basis, the recovery is still strong by historical standards. Japan is also showing signs of an earnings recovery. Emerging Markets equities, which have skyrocketed from very cheap valuations to very expensive valuations have a someone mixed outlook on the earnings front with a very mixed picture by sector. Fully half of the sectors are still deeply in the red on the growth front. We see double-digit negative growth in sectors like as energy, materials, consumer staples, consumer discretionary and telecommunications. So, while the earnings picture in EM’s is showing improvement, it still has a long way to go before being pronounced healthy again. Perhaps the least supported areas of the market are in the fixed income areas where the outlook is less rosy with spreads so tight and the macro picture starting to move sideways or roll over. The recent macro data in combination with ample liquidity have driven spreads to all time tights in many cases. The removal of liquidity, however slow, will be a persistent headwind to the asset class over time. The macro data, though rolling over, should continue to be supportive, though we are over eight years into this cycle and it is conceivable that the cycle should start to mature soon, possibly before interest rates are normalized.
Though most of the commodities complex seems to be tied to the global cycle, the rally afoot looks like it could maintain a pace with the recovery. Much of what is supporting this rally is good, old fashioned consumption. Industrial metals are being supported by Chinese consumption. Oil and the energy complex is being supported by seasonal consumption. The drawdown in oil supply was supported by strong May demand data after a weak streak in the data. Weakness in the dollar has also supported the rally. However, the outlook for oil prices are somewhat tenuous with oil climbing quickly back to the range highs. OPEC compliance was 95% in May and dropped to 70% in June with Saudi Arabia over compensating for OPEC cheaters. We see that as the fly in the commodities ointment, albeit a very short term one. In the end, oil seems to be stuck in range trading while the rest of commodities are rallying.
In summary, we maintain our current allocation to equity in the US and abroad. . In Fixed Income, we remain neutral in Treasuries, IG and HY credit. Finally, we continue to maintain minimal exposure to commodities.
–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.
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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, 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)