- US Stocks continue to post gains, but a subtle shift from growth back to value could be a canary in a coal mine: Multiples remain stubbornly high with expectations that the recovery will be long and strong, but some of the steam is being let out of the markets via tech stock stumbles. We view this shift toward defensiveness as an important development and one that bears continued observation.
- The dollar staged a mini rally as the expectations for a December Fed Hike were priced back into the markets through the Fed Funds Futures market: This expectation, however, is not born out by the data as inflation continues to lag but Fed Chair, Janet Yellen, has made remarks that suggest that the Fed could consider hiking in anticipation of inflation.
- Oil prices are finally showing signs of a longer-term rally with demand data improving right a time when supply data is finally showing signs of tightness: While some of that is hurricane-related short-term tightness, the rig counts in the US were dropping even before Harvey and we could finally start to see a range patter for oil of higher lows.
Market Review: Global Normalization in Abnormal Times
September began with North Korea’s sixth nuclear test, raising geopolitical tension between Pyongyang and Washington and generally leading the broader US stock market lower. This dynamic was reinforced when Hurricane Irma drove toward Florida and investors braced for another catastrophic outcome. However, the pessimism did not last long as the market recovered on a stronger than expected consumer price index data release, which drove expectations for a Fed Hike before the end of the year.
In Europe, Chancellor Angela Merkel won a historic fourth term German election, but her party was weakened by a surge in far-right support. This resulted in the first seats won for the far-right since the defeat of the Nazis in 1945. The euro’s value fell as worry grew regarding the political fallout in Germany and other euro zone countries. The outlook for a more integrated Europe certainly seems less likely given this new political reality.
Also supporting the fall in the euro, the Federal Reserve announced its plan to start trimming its $4.5 trillion balance sheet in October in order to further normalize monetary policy. This decision strengthened the dollar for the first time since the beginning of the year. As widely expected, the Fed did not raise its benchmark interest rate in September, but did indicate that one more hike is likely this year, despite weak inflation. Although increasing Treasury yields indicate progress toward the Fed’s goals, the Fed’s preferred inflation indicator, the Core Personal Consumption Expenditure, posted 1.3% in September, falling well below the 2% target.
The dollar strengthened further in September, and US stocks led the S&P 500 higher, as strong economic data and the Fed’s hawkish comments helped boost expectations for a Fed interest rate hike in December. Banks and other financial company stocks were boosted by expectations of higher profits and lending rates. US consumer confidence fell in September due to the impact of the hurricanes, which, supported the view that these events would hurt economic growth in the third quarter. However, relatively high levels of manufacturing data continue to support the moderate global growth story, keeping the economy on fairly solid ground.
The ECB is expected to start winding down its stimulus efforts next year, where the Eurozone economy has continued to rebound rapidly although inflation results have been unexpectedly slow to respond. In the UK, Moody’s downgraded Britain’s credit rating as Brexit continues to pressure the country’s economic strength. British retail sales surged to a two-year high this month, boosting the chance that the Bank of England will raise interest rates in November.
In Southeast Asia, S&P Global Ratings downgraded China’s sovereign debt rating for the first time since 1999, citing that the risks from China’s rapid build-up in debt could lead to longer-term growth problems. China’s economic growth in the third quarter is expected to slip, but is still in far better shape than this time last year. China’s consumer price index increased 1.8% year over year in August, surpassing economist’s expectations of a 1.6% gain. Although modest inflation is a good sign for the economy, it is still below the central bank’s inflation target of 3%.
The Bank of Japan, as widely expected, maintained its negative 0.1% interest rate and kept their asset buying program intact at the most recent policy meeting, signaling its solid recovery will gradually accelerate inflation without additional stimulus. Analysts expect improving economic growth based on recent data on exports, consumer spending, and the labor market in the coming quarters. However, some economists remain concerned about their current policy, particularly whether or not it is sufficient to achieve the BOJ’s 2% inflation target in fiscal 2019, despite over four years of massive stimulus.
Going Forward: Where is the Other Shoe?
Bearish market participants continue to be confounded by the continuing rally, while bulls point to positive macroeconomic data and the cyclical global upturn as justification for present multiples. Yet, while it would seem that the markets are set on a path straight up, it is easy to lose sight of modest shifts in the market that are worth monitoring. First, the subtle shift out of growth and into value in the US is the first perceptible defensive shift that we have seen in the markets recently. While the trend is still only fourteen days old, it bears observation. Second, fluctuations in the dollar are causing some detectable fall out, most notably in EM, where the mini rally caused the markets to fall out of bed in the last week of the month. Finally, oil prices are showing signs of strength in their latest move to the upside. So, which trends will persist?
The US stock market continues to post improvements in earnings growth as macro data continues to surprise to the upside and establish a recovery. However, despite that visible growth, inflation continues to lag the Fed’s target, while expectations remain well ahead of reality. PEs are well above long term averages, even considering the growing nature of the current S&P constituency. Earnings expectations, which took a leg up after the election, have now been revised back down to $130, suggesting a more modest 11% EPS growth rate, largely supported by double-digit gains in the energy and materials sectors. The Fed looks poised to hike one last time in December, despite the absence of inflationary pressure, arguing that once inflation arrives, it could be too late. So, all readings for the US economy look to be on par for more upside. However, as technology stocks stumble and energy stocks rally, a subtle shift from growth to value is taking hold, which could be the harbinger of a reconsideration of the current lofty multiples. If large cap stocks look rich, small cap stocks, which are arguably the biggest beneficiaries of any version of the tax plan, are flying high in anticipation of a cut in the corporate statutory tax rate from 35% to 20%. The US markets look priced to perfection. Perhaps North Korea will be the trigger for a US correction and further VIX and gold moves, though we continue to see this as a low probability event.
The mini-rally in the dollar has thrown cold water on two of our favorite trades: overweight Europe and overweight EM. The fall in the latter was a slap in the face to our late entry into the trade. That said, the fundamental story is still intact. Europe appears to have settled into a self-sustaining recovery that still has legs. The ECB will likely begin the process of pairing back government bond purchases in 2018 in a well communicated plan to be laid out in October. Although Germany saw the far-right political party gain seats in the Bundestag for the first time since the mid twentieth century, the economic outlook is quite bright which should temper continued populist support. That said, this ushers in a new political reality that will make further European integration a challenge and could make Brexit messier than it already looks to be shaping up. The question is, will US Fed hikes and tapering outweigh the ECB tapering? In our opinion, it might well, which would imperil positions in other currencies, most notably EM. So, while we are less optimistic about continuing the European overweight and would look to scale that back, though we are not ready to abandon it. Moreover, while the dollar could strengthen against the euro, the EM growth story is very intact and there could be factors that keep EM currencies relatively strong and keep the EM story in play. Finally, there is the Devil’s advocate position that is worth considering, which is that the data in the US could indeed start to disappoint, perhaps led by seemingly benign hurricane effects that snowball into a broader slow down. In that scenario, the Fed will be forced to slow down rate hikes, while strength in Europe and EM could easily keep the dollar weak for some time. This is a possibility, though perhaps not our central scenario, so it is worth keeping the European and EM overweights as a hedge.
OPEC has finally made headway as global demand data is starting to improve. The hurricane effects, as well as a falling trend in US rig counts, have driven oil prices higher and toward a more sustainable long-term price target. That said, oil is still subject to the vagaries of supply and demand cycles, which are shortening. So, the next move for oil is more likely to go down than up, especially considering that China’s economy has been weak and this effect has not shown up in oil prices yet. With that said, we should settle into a pattern of higher lows that will eventually establish an upward trend. The latest move in oil is a welcome support to the seemingly overvalued equity markets, which could easily benefit further from oil’s solid footing.
In summary, we maintain our current equity allocation on the conclusion that the dollar will weaken once more. In Fixed Income, we continue to monitor the agency MBS markets and the potential affects the Fed’s comments have on interest rates.
–Your Investment Team at Lido Advisors
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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)