- Equity markets have diverged into those that have peaked and those that can keep on going: The US and UK are showing signs of peaking while Europe, Japan and EM equity show signs of continuing at a fundamental level with continue room for multiple expansion.
- The search for yield, however, is back on with the Fed slowing the pace of normalization on the back of falling inflation: Treasuries have continued to compress in the globe as inflation fails to materialize and risks seem to be cropping up. This has driven flows and interest back into emerging markets and even high yield where investors are clipping coupons to meet obligations.
- Risk is back, though not apparent in the valuations or overall market returns: Despite two spikes in the VIX this month in response to concerns about global and then civil unrest, US markets continue to demonstrate an amazingly short-term memory. One of the largest and most devastating storms in history did not even rate a bump in the VIX and concerns over the debt ceiling and potential for government shutdown have all but dissipated with Harvey’s wind speeds.
Market Review: Not A Normal August
Tensions between North Korea and the US escalated in August, as North Korea warned they would strike Guam, after President Trump’s threatened to unleash “fire and fury” on them. The heightened geopolitical tension generally led the broader US stock market lower, which was reinforced mid-month, when Senate Majority Leader Mitch McConnell, questioned whether Trump’s Presidency could be salvaged after negative sentiment followed his response to the events in Charlottesville. Steve Bannon and Sebastian Gorka were out at the White House, while the new White House Chief of Staff, John Kelly, attempted to implement his own order. Speculation regarding the resignation of President Trump’s Chief Economic Advisor, Gary Cohn, sparked further concern later in the month, but the pessimism did not last long as key Republican congressional leaders and Trump associates started to make progress on framing a tax cuts package. By month end, North Korea’s ballistic missile firing over Japan and the effects Hurricane Harvey were weighing on the markets, with neither event materially dampening US equity returns.
The Q2 US GDP growth rate was revised up to a robust 3.0%, from initial estimates of 2.6%, on materially stronger growth in consumer spending and business investment. Durable goods, particularly autos, drove the higher consumer spending, while business spending was stronger than estimated on robust structure, equipment, and intellectual property spending. Low short-term interest rates and a strong job market are expected to increase global demand going forward and further advance business spending. Overheating remains at bay, however, as the core PCE inflation measure fell to 1.4% in July, persistently lagging the Fed’s 2% target.
At the long awaited central banking conference in Jackson Hole, Federal Reserve Chair Janet Yellen did not address future US monetary policy, devoting her time instead to financial regulatory reform. US short-term interest rate futures increased slightly, reflecting the Fed’s refunding expectations, as it seeks to reduce its balance sheet and replenish bank reserves. Recent economic strength is keeping the chance of a December Fed hike at 40%, while long Treasuries are trending lower on expectations of lower for longer inflation.
European equities declined sharply in August due to both terrorism and the geopolitical tensions between the US and North Korea In Spain, a van slammed into crowds, leaving 13 dead. The event led to a precipitous decline in European travel stocks. Eurozone inflation rose by more-than-expected in August, while the jobless rate remained at its lowest in more than eight years, underpinning expectations that the European Central Bank will soon wind down its extra-loose monetary policy.
China’s manufacturing sector is posting solid growth, with higher than expected manufacturing PMIs resulting from stronger infrastructure spending and a recovery in exports. China’s infrastructure and fixed asset spending is expected to remain at current levels through the fourth quarter of this year.
In Japan, core consumer prices have risen for seven straight months, providing a sign that the economy is making steady progress toward reaching the Bank of Japan’s 2% inflation target. The labor market continues to tighten, with shrinkage of the Japanese working population feeding a rise in labor demand.
Going Forward: Playing Chicken
The threat of global war, the threat of civil unrest, the threat of a government shutdown and an actual natural disaster…markets flat. Yet, in the undercurrent of the markets, reading the fund flows as one might read tea leaves, money is shifting out of US equities into international markets, but also, more worryingly, to safe haven assets like Treasuries and Gold. Volatility is up, yields are down, and the search for yield has resumed in earnest with EM debt on the receiving end. With OPEC cuts starting to show some results, however meager, the enthusiasm for EM equity is also official. Moreover, the recovery of the US, Eurozone and Japanese markets has officially passed through to earnings. Improving global trade reflects the same, though by following the earnings growth trends, it would seem that we may have peaked in some markets. The US is being revised sharply down, Europe is still on a gradual upward trend, and Japan and Emerging markets are on a strong upward revision trend. Finally, with China managing its slowdown better than expected, metals have surged while gas prices have started to slump. If this was your first day on the job, you would be right to be thoroughly confused. So, which themes will persist?
Keeping the Risk-On Game Going
It is about that time of year when economists start to admit that they may have been overly optimistic at the beginning of the year. US economists have revised GDP 2017 year-end estimates down from their peak at 2.3% to 2.10%. In the UK, GDP growth was revised as high as 1.8% but has since been revised down to 1.5%. However, on the opposite end of the spectrum, in Europe, economists are steadily revising up from 1.4% growth expectations for 2017 year-end to 2% growth expectations for year end. Similarly, in Japan, estimates for year end 2017 have been revised up from 1% in January to 1.4%. in Emerging Markets, China has been revised up to 6.7% growth from 6.4% growth at the beginning of the year. Mexico has been revised up from its low of 1.6% GDP growth expectations to 2.1% growth expectations and looks poised to surpass US growth estimates.
However, despite this growth optimism, inflation has been largely slowing at the same time, which paints an interesting goldilocks picture where growth continues, the dollar weakens in response to a slow-moving Fed, and global central banks normalize very slowly keeping yield scarce and assets out on the risk spectrum.
While the Risks Pile On
North Korea has not only threatened to unleash nuclear missiles on Guam but has launched missiles over Japan in a test of their abilities. The Trump Administration and Congress have been unable to pass any major policies, positive or negative, resulting in continued unproductive backbiting, finger pointing and ceremonial firings within the Administration. Threats of a government shutdown over the budget proposal were bandied about; meanwhile, the government is grinding to an actual halt under the continued refusal to appoint key positions, and the rhetoric out of the White House has turned uncomfortable. The stirrings of civil unrest threatened to come to the fore only to be knocked out by one of the most devastating hurricanes in weather history, which oddly seems to have refocused the political machine on real issues rather than manipulated ones. However, we are now faced with storm damage that could cost between $100 billion and $190 billion compared to Sandy’s costs of $31 billion relative to a Disaster Relief Fund with less than $3 billion currently available before the October debt ceiling deadline. In addition, more than a quarter of the refining capacity in the US has been knocked out and Texans have begun gas hoarding, which sets up a temporary, but none-the-less unhealthy, market dynamic.
Playing Chicken with Cycles
Yet, all of this is causing the US and by extension the global markets to play chicken with economic cycles. Because this cycle has been so elongated, market participants seem to feel they deserve a long recovery. However, the earnings revision data in the US and the UK would suggest that the party may be closer to being over than not. The rally in the Treasury and Gold markets may suggest that the party may really be over for everyone. That said, there are still signs of life in Japan, Europe, and several parts of Emerging Markets, the latter being the last to the party and perhaps the one with the most promise of continuing. Yield plays still seem to continue with EM yield aided by a slow Fed, a weak dollar, and moderated inflation. Can this continue? Yes. But, not forever and we see the US equity market as the most vulnerable to a shift in risk appetite or expectations.
In summary, our current equity allocation has not changed. In fixed income, we are cautiously maintaining our current position with duration at about 5. Should the rally in treasuries continue and spreads begin to expand, we will begin reducing duration and increasing in anticipation of a potential economic slowdown. Such a move would also warrant a move to positions of higher credit quality in anticipation of an increase in potential credit issues.
–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.
Lido Advisors, LLC is an SEC Registered Investment Adviser. Please note that adviser registration does not denote any particular competence nor ability and no inference to the contrary should be made. For complete information on the services we provide and our fees, please review our Form ADV at adviserinfo.sec.gov or request a copy from Lido Advisors, LLC at 1875 Century Park East, Suite 950, Los Angeles, California 90067, or by calling (310) 278-8232.
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)