2018 Mid-Year Update

Economic Backdrop

The “goldilocks” scenario of economic growth with low inflation, necessary for the US Federal Reserve (Fed) to continue its moderate pace of quantitative tightening, evaporated temporarily in early February when inflation data surprised to the upside. Sudden spikes in nominal interest rates from rising inflation expectations signaled an expectation that the Fed’s hand would be forced to raise the benchmark Fed Funds rate more quickly than anticipated. It seemed that the Tax Cuts and Jobs Act that partially fueled the equity rally was equally to blame for the return of volatility, as the economy was already operating near full employment, exacerbating tight labor conditions expected to push wages higher as businesses compete for qualified workers. Though, as subsequent consumer price indicators have cooled these demand-pull inflation concerns, the goldilocks set-up has returned as a viable scenario.

“as subsequent consumer price indicators have cooled these demand-pull inflation concerns, the goldilocks set-up has returned as a viable scenario.”

Other inflation threats still linger, as surveyed economic data from the business sector continues to show that input prices of raw materials are accelerating higher thanks to the threat of trade wars and real wars. With China being targeted for intellectual property theft and unfair trade practices, negotiations regarding trade deals with NAFTA partners and European allies have added complexity to the enduring economic and industry-specific effects. Uncertainty surrounding the implementation and effectiveness of tariffs from all sides has contributed to market volatility and is likely to continue to do so until someone backs down.

Retail sales in the 1st quarter were a conundrum, being surprisingly soft despite high consumer confidence thanks to the tax cuts and strong labor market. Expectations for a 2nd quarter rebound were dampened somewhat as discretionary expenditures were squeezed by higher gasoline prices, but the latest consumption reports from the Bureau of Economic Analysis (BEA) indeed indicate renewed strength.

The Fed predictably raised the Fed Funds rate in March and June, and released its dot plots predicting the movement for the rest of 2018. The minutes from the Fed meeting in May surprised the market with a comment stating that “a temporary period of inflation modestly above two percent would be consistent with the Committee’s symmetric inflation objective”. The dovish language led to a dramatic re-adjustment of the odds for additional rate hikes in 2018, depicted with a red oval on the September rate hike probabilities (Chart 1). The odds were nearly split until the June 13th dot plot release displayed the higher median Fed Funds rate for 2018, indicating the higher likelihood of a fourth hike. It is not, however, a forgone conclusion as the Fed members are almost evenly split on the forecast.

September Fed Funds Rate Hike Probability

US Equity

Equity market volatility has returned thanks to a bevy of factors leading to a 10% drawdown on the S&P 500 in early February. The upside surprise in price data was exacerbated by an unwind of a popular short volatility trade using instruments linked to the CBOE VIX Volatility Index. Uncertainty surrounding trade war escalation and flare-ups in Middle-East tension have added to equity whipsawing. Though still trending sideways, markets are off the lows as first quarter earnings releases did not disappoint despite lofty expectations. Promises of new stock buybacks have also helped equities hold above technical support levels (Chart 2).

S&P 500 Large-Cap

Large-cap equities, outside of the Technology sector, have been unable to make new highs. With tax cuts mostly priced in, it is highly likely that top-line revenue growth will be needed to re-ignite confidence in the rally going forward. Small-cap equities have shown relative strength (Chart 3) by reaching new highs, thanks to limited reliance on foreign markets, in general, hence they are more insulated from repercussions of a trade war. Smallcaps do, however, have greater exposure in the event of credit market stress and the relative performance will be closely monitored. Inflationary pressure on wages and input costs threatens profit margins, but more importantly, increases the likelihood of a Fed policy mistake. Increasing interest rates to pull the reins on an overheating economy has ripple effects on daily life across the globe, with differing and difficult to predict thresholds of financial stress. Marginal changes in at risk assets can be the “canary in the coal mine” for larger problems, but may just as easily be disregarded by the market for some time.

Small-Cap vs. Large-Cap YTD

Developed International Equity

International developed market equities have begun to falter due to deteriorating economic fundamentals and shaky US equity markets. Eurozone economies’ 1st quarter GDP figures have been below expectations, including a .3% increase for the largest European economy, Germany. Peaking European growth despite the European Central Bank (ECB) having yet to cease its accommodative policies would be an ominous sign for the years ahead.

The perception of existential threats to the European Union (EU) have resurfaced with populists in Italy taking over the political reins of a fragile economy with a precarious debt situation. Yields on 2-year Italian sovereign debt soared from a negative yielding -.3% in early May, to over 2.5% on May 29th (Chart 4). Italian anti-EU sentiment was likely exacerbated after the ECB declined to step in with support during an impending crisis. The lack of action and subsequent comments from Brussels were interpreted as an insinuation that the ECB was chastising the Italian people for voting populist.

Italian 2-Year Yield

Japanese equities have traded broadly in line with other developed markets, but are increasingly stuck in the mud as the Japanese economy unexpectedly contracted during the period from January-March 2018. If the next quarter ending June 30 were to shrink, then the country would technically be in a recession. So far, new data for April paints a bleak picture for consumer spending, while manufacturing and services business surveys show decelerating momentum, and tariffs threaten Japan’s ability to increase exports despite a weaker Yen. Prime Minister Shinzo Abe, while being accused of cronyism, should still have plenty of runway to expand the quantitative easing policy known as “Abenomics” thanks to the lack of inflation in the country.

Emerging Markets Equities

Emerging markets equities have been beat up in the 2nd quarter, as countries with a large amount of US-denominated liabilities such as Turkey, Argentina, and others have struggled mightily thanks to rising US interest rates and a strengthening US dollar. Turkey and Argentina were forced to drastically increase domestic interest rates, while Argentina has requested and secured a $50 billion bailout from the International Monetary Fund (IMF). Urjit Patel, Governor of Reserve Bank of India, is urging the US Fed to slow down the balance sheet reduction, which together with rising rates and the onslaught of new Treasury issuance to fund the US deficit, is causing substantial liquidity concerns and a shortage of dollars that threaten to derail global growth.

Not all emerging markets are created equal, however. China has displayed competence in its ability to maintain high levels of economic growth while also deleveraging by cracking down on riskier lending practices, particularly in the shadow banking sector. A small portion of Chinese yuan-denominated mainland equities are being added to the MSCI Emerging Market index, joining companies listed in Hong Kong that will leave China making up 42% of the benchmark. The move is a significant step in the symbolic “opening up” of investment in China, which should increase capital flow into the country, even though concerns surrounding capital controls and market intervention remain.

Fixed Income

It has been a bumpy ride for interest rates in 2018, leading to increased volatility in bond and equity markets. Central bank policy divergence has led to large speculative positions being placed and unwound as investors race from one side of the boat to the other. The yield on the 10-Year US Treasury Note rose throughout January, before spiking to 2.85% on the “hot” inflation print in late January and spent most of the year so far flirting with the psychological 3% level. When it meaningfully broke above 3.1% in mid-May, it brought the US dollar higher with it. Emerging market stress and European economic and political worries caused a subsequent flight to safety and treasury short squeeze which brought yields back down near 2.90%. Moderating inflation fears have caused Fed hike probabilities to retreat, allowing yields to take a breather as the so called “death of the bond bull market” will be anything but a linear move higher.

US 10-Year Treasury Yield

The weakened US dollar that helped local currency emerging market bonds during 2017 through the 1st quarter of this year has now reversed, contributing to relative weakness. The currency issue, as discussed in the Emerging Markets Equity section, is a major one, but may be providing opportunity in this space for long term exposure to relatively higher growth countries with more attractive debt and deficit situations than many developed markets. The risk of a continued adverse dollar move higher is significant, especially if global growth were to grind to a halt, but the proverbial “baby may have been thrown out with the bathwater”.

High-yield spreads have barely changed from the end of 2017, but the snapshots mask the rocky ride that it has been. High-yield bonds have fallen out of favor with investors anticipating interest rate increases and the corresponding relative attractiveness of similar yields in “higher quality” assets. In general, high-yield bonds have characteristically been less sensitive than investment grade to rising interest rates in a growth environment. The main risk to this market is a drastic repricing of risk premia from increasing credit/default risk if higher rates eventually put enough strain on borrowers, with corresponding illiquidity in those debt markets. While the spread on BB (one notch below investment grade) rated bond yields have widened nearly 15% over the corresponding risk-free rate, the spread on the perceived riskiest segment, CCC, has tightened by roughly the same amount since the end of 2017. The relative strength of the CCC bond segment, generally characterized by relatively low liquidity and higher levels of default, increases confidence for strength in the sector as borrowers have still been able to afford the coupon payments and find liquid debt markets to re-fund liabilities.

Commodities & Alternatives

Commodities in general have outperformed through the first half of the year, although, they are being driven by governmental policy as much as global growth. Tariffs have put upward pressure on industrial metal prices, even as China has tried to cut production in efforts to reduce pollution. China tariff retaliation led agricultural products including soy beans to stumble, but have since recovered.

Continued supply constraint, partly from self-imposed OPEC oil output caps, crisis in Venezuela, and increased Middle-East tension have caused oil to break-out of the $45-60 range for the West Texas Intermediate (WTI) price. A coincident strengthening US dollar decoupled from the historically inverse relationship with oil prices may persist as US-imposed sanctions on Iran may not be adhered to by many. Oil-dependent India has already stated that it will continue to trade with Iran, and do so using the rupee and rial, while by-passing the US dollar all-together. Yuan-denominated oil futures have begun trading and are gaining momentum as emerging markets aim to avoid exposure to USD movement in bilateral trade.

WTI broke above $70/bl. in May, with International Brent Crude knocking-on-the-door of $80/bl. until news broke that OPEC was considering ending the output cut earlier than previously stated. Heightened prices and new technology have led to favorable operating conditions and an unprecedented ramp-up in American oil production. Infrastructure limitations have caused logistical headaches and a multi-year high in the spread of Brent over WTI prices (Chart 6) despite the lifting of a US ban on raw crude exports in late-2015. A lack of storage and a bottleneck in getting raw crude to the proper refining facilities is straining the US refining infrastructure designed for cheaper “heavy” or “sour” crude, while a majority of the new oil is “light sweet” crude, and the transition of these refinery assets is costly and time consuming.

Brent - WTI Spread

Despite the infrastructure issues, the ramp-up in oil production has helped mid-stream Master Limited Partnerships (MLPs) rebound strongly from 1st quarter weakness. Rising interest rates were the main cause of weakness, though the tax cuts and closing of a tax loophole caused some companies in the sector to question the usefulness of the MLP tax structure going forward. Some MLPs may decide to switch to C-corps, but as the industry evolves shareholders may be pleasantly surprised with how capital re-deployed into the business contributes positively to earnings growth.

Rising interest rates and brick-and-mortar retail skepticism had caused Real-Estate Investment Trusts (REITs) to severely lag broad market equities through the end of February. REITs have outperformed since then, thanks to the inherent inflation protection that comes with landlords being able to raise rents during continued periods of economic growth. Mall operators also had good first quarter results, and eased concerns on the death of retail by indicating that willing tenants were waiting should some stores go out of business.

Looking Forward

Headlining the market-moving events in store for the rest of the year are the remaining Fed meeting announcements: June 13, September 26, and December 19. Great Britain’s withdrawal treaty with the EU is expected in early October, where the two sides will decide on a “divorce” payment, and how to handle the Irish border and citizens living abroad. The US mid-term elections, on November 6, will be an important barometer for the American people’s opinion of President Trump. Trade wars will continue to grab headlines, and could create market volatility. Earnings here and abroad should continue to deliver, and with a slow-rising interest rate environment, we should see higher equity prices by year-end in domestic, international developed, and emerging indices.

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