2019 Mid-Year Update

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USA/China Trade War

Introduction
“As both long-term and tactical investors, we must balance the day-to-day “noise” of ongoing news stories such as trade wars, geopolitical events and conflicts with the longer-term trends of earnings, interest rates and economic data.”
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Halfway through 2019, global financial markets have teetered between euphoria and panic as global growth forecasts have been held captive by the seemingly unending trade war. Investors are getting a first-hand look at President Trump’s aggressive negotiating style, but he has found a formidable opponent in his Chinese counterpart Xi Jinping. At the onset of the trade dispute, consensus opinion was that the US had the high ground due to its position as a net importer of Chinese goods. After all, the US imported $539 billion in Chinese goods in 2018 while exporting just $120 billion to China.

However, while China may not be able to match the US tit-for-tat in the tariff game, it may just be able to out-wait President Trump. President Xi conveniently arranged for term limits to be abolished in 2018, while President Trump will be increasingly shifting his focus to re-election as 2020 approaches. This scenario has been fascinating to watch, as Xi called on Chinese citizens to prepare to endure hardship of a new “long march”, referencing the one-year, 4,000-mile military retreat undertaken by the Chinese Red Army in 1934. Since the beginning of the trade dispute, our prediction was that President Trump would strike a deal when he felt he had enough concessions to spin into a “victory” for re-election purposes. The Trump administration has repeatedly stated that the stock market performance is the yardstick by which its success should be measured, and a resolution to the trade dispute would likely spur markets to new highs and act as a tailwind for re-election.

Trade Balance Chart

Exhibit 1 – US Exports, Imports, and Trade Balance in Goods with China
Source: US Census, Chart by Hanlon Research

Thus far, moderately rising US consumer prices due to the tariffs have afforded some extra leeway, but pressure is mounting from the leadership of large US corporations to reach a conclusion. Some US companies have already begun to rearrange their global supply chains, perhaps permanently away from China, which is a consequence unlikely to deter the current US tactics. We know that President Trump loves to negotiate deals, and we also know that he holds grudges. If he wins re-election we would expect renewed trade hostilities with China, regardless of any deal.

As both long-term and tactical investors, we must balance the day-to-day “noise” of ongoing news stories such as trade wars, geopolitical events and conflicts with the longer-term trends of earnings, interest rates and economic data. Sometimes, the short-term disruptions run the risk of spiraling out of control and altering the long-term narrative. The trade war has the potential to escalate to a long-term conflict, derailing global growth. We aren’t at that point yet, and we remain convinced that a resolution is in the best interest of all parties, but we remain vigilant to the risks if the conflict spirals out of control.

Economic Backdrop

US economic data has been solid but somewhat uninspiring, leading some observers to posit we are starting to see effects of the trade dispute. GDP growth estimates from the Office of the Comptroller of the Currency forecast a rate of 2.9% in 2019, steady from 2018. Real GDP projections from the World Bank are more pessimistic, suggesting a US slowdown to 2.5% growth. Meanwhile, inflation remains soft with the latest Core Consumer Price Index reading showing a 2.0% annual increase. Unemployment remains near a fifty-year low, but May data showed signs of job growth deceleration as well as a pullback in wage growth. Combined, this data has market participants convinced that the Fed will be cutting interest rates in July, with mid-June Fed Funds futures markets pricing in an 100% likelihood of a July rate cut. Of course, should a trade deal be consummated, interest rate futures markets would turn on a dime and Fed Fund rate cuts would be less assured.

The Fed asserted its independence in December of last year, pushing through a rate hike that exacerbated the selloff in fragile markets. Since then, Fed policymakers have communicated a shift in their policy stance via language that that they will act “as appropriate to sustain the expansion.”

World Bank Charts

Exhibit 2 – Combined Percentage of World GDP from Countries holding General Elections, by Year
Source: World Bank June 2019 Global Economic Prospects Report

While the market is counting on at least two rate cuts, presumably in July and September, the Fed will have to be measured in its actions and communications – not cutting rates runs the risk of triggering a stock market temper tantrum, while being overly accommodative could give the impression that the Fed fears an imminent recession is on the horizon.

Predictably, the tariff dispute has also had significant impact on economic growth outside the US as well. The World Bank is projecting Euro Area growth to slip from 2018’s rate of 1.8% to just 1.2% in 2019. Emerging Markets are also anticipated to slow down in 2019, from 4.3% to 4.0%, with China, long the engine of the Emerging Markets, sliding from 6.6% to 6.2%. Hopefully, we see the long-awaited resolution to the tariffs before year end, but even if that issue is resolved there are other barriers to global growth. The specter of a disorderly Brexit still hangs over the UK and its European Union neighbors and the uncertainty has only grown with the search for Prime Minister Theresa May’s successor. Globally, political disruption is always a potential black swan, and there is an outsized risk this year as general elections are scheduled in countries cumulatively representing nearly 37% of global GDP. Populism, which tends to lean towards anti-trade / anti-immigration, is alive and well in many of these countries.

US Equity

During 2018’s year-end stock market washout, corporate earnings forecasts were slashed as companies began to price in the impact of a prolonged trade war on their forward-looking earnings guidance. In our 2019 Outlook, we raised the possibility that markets could rally sharply if a trade deal was reached or if the earnings revisions were overly pessimistic. While the trade dispute remains unresolved, it does appear that many corporate earnings forecasts were too conservative. In Q4 of 2018, 68% of S&P 500 companies beat earnings forecasts, a step back from Q3’s 77%, but not a devastating one. S&P 500 companies picked up the performance in Q1 of 2019, with 73% beating earnings forecasts.

As we also mentioned in our 2019 Outlook, corporate buybacks have been and should continue to be a stabilizing force for US equity markets, with record-setting $806 billion in shares repurchased in 2018. A recent forecast from Goldman Sachs predicted S&P 500 firms will repurchase $940 billion in shares in 2019. Our research also suggested that low interest rates would spur merger and acquisition activity in 2019, and we’ve seen two blockbuster mergers announced this year, with Bristol-Myers Squibb (BMY) acquiring Celgene (CELG) for cash and stock, and United Technologies Corp (UTC) acquiring Raytheon (RTN) in an all stock deal.

Another point of consideration we raised going into 2019 was that investors should not be overly eager to abandon growth stocks in favor of value. Indeed, the swift selloff that closed out 2018 was an excellent entry point for beat- en-down growth names, which have outperformed value by roughly 4.3%, as measured by the year-to-date performance of the SPDR S&P 500 Growth ETF (SPYG) and the SPDR S&P 500 Value ETF (SPYV).

SPYG v SPYV

Exhibit 3 – Relative Performance of SPDR S&P 500 Growth ETF (SPYG) vs SPDR S&P 500 Value ETF (SPYV)

Developed International Equity

Thus far, China has endured the brunt of President Trump’s ire, while the Eurozone and Japan have been somewhat of an afterthought for the self-described “Tariff Man”. A 25% tax on foreign automobiles was threatened, but the mid- May deadline was then postponed for six months. The end-goal is for the US’ developed foreign trading partners to buy more agricultural exports and “molecules of freedom”, or liquefied natural gas, which the European Union leadership has strongly resisted. President Trump has enjoyed a much more amicable relationship with Japanese Prime Minister Shinzo Abe, so perhaps he will focus on Japan as the path of least resistance in attempts to score some trade victories as the 2020 election grows ever closer.

The Eurozone has continued to struggle in 2019, with manufacturing activity, as measured by the IHS Markit Purchasing Manager Index (PMI), falling into contraction. This was somewhat offset by an uptick in Services activity, but still paints a concerning picture for the region. Meanwhile, the political situation continues to be messy with the now leaderless Brexit negotiations falling into chaos, and Euro-skeptic Italian leaders pushing back on budget limits.

As was the case in the beginning of the year, we still recommend long-term investors stay the course and remain allocated to developed international equities, primarily due to their relative position in the business cycle compared to domestic equities. Year-to-date, performance in developed international markets has been solid, with the iShares MSCI EAFE ETF (EFA) up 11.6%. Earnings growth for 2019 is expected to nearly keep pace with that of US markets, at a projected 13.2% year-over-year growth rate, but developed international stocks trade at a PE ratio of just 13.5 compared to approximately 18.4 for US equities and typically pay higher dividends than their US counterparts, which is attractive given the backdrop of declining bond yields.

With the US-China trade negotiation seemingly growing further from resolution, we may first get a US-EU or US-Japan deal, which could give developed markets a further boost.

Emerging Market Equity

Emerging Markets have continued to trail developed markets by a significant margin thus far in 2019. The crippling uncertainty of the trade war has resulted in dismal projections for year-over-year earnings growth, with 2019’s growth rate now expected to be just 1.8%.

Emerging Earnings Update

Exhibit 4 – iShares Core MSCI Emerging Markets ETF (IEMG) Earnings per Share and P/E growth (actual and projected)
Source – Bloomberg, Chart by Hanlon Research

This lack of earnings growth has made EM equity slightly more expensive at a projected 12.3 PE ratio, compared to 11.5 when we issued our 2019 Outlook. While we still maintain that EM equity is a crucial and too-often overlooked component for long-term portfolio construction, our short-term tactical view has become much less optimistic on the asset class and in Q2 we exited our EM holdings in the Hanlon tactical models, moving the capital invested in EM to cash for the time being.

Looking forward to the rest of 2019, it is difficult to envision a path to EM equity outperformance that does not include a US-China trade deal. If there is a deal however, the upward move in EM equity may be swift and straight up. The Shanghai Composite Index had recovered by over 33% on trade optimism through April but has since pulled back as the trade rhetoric grew more combative. As we predicted in our 2019 Outlook, the Chinese government has already stepped in with economic stimulus to soften the impact of the tariffs. Year-to-date, the Shanghai Composite has kept pace with the S&P 500, up over 20%.

Fixed Income

There is a misconception that bonds are boring, with Treasuries being particularly dull. Yet halfway through 2019, perhaps the most shocking development has been the recent unanticipated plunge in yields and rise in prices for Treasuries. After the 10-Year US Treasury Note interest rate stopped rising at 3.25% late in 2018, yields slipped below 3% and most investors, ourselves included, believed 2.5% to be a logical floor that would keep yields rangebound between 2.5% and 3.0%. In May however, yields slipped below 2.5% and haven’t looked back, briefly breaking below 2.0% after the June Federal Open Market Committee meeting. As mentioned earlier, multiple Fed Rate cuts have become a very real possibility. The decline in yields caught many forecasters off guard, as shown in the below chart from the Wall Street Journal Survey of Economists.

Yield on the 10-year Treasury note

Exhibit 5 – Actual yield on the 10-Year Treasury Note vs Surveyed Economists’ Projections
Source: WSJ Survey of Economists

Heading into 2019, our view on credit was positive, particularly for high yield bonds. As we noted in our 2019 Outlook, our view was that the year-end 2018 widening in spreads was inconsistent with what underlying ratings changes and default activity were telling us. High yield bonds were simply caught up in the selling panic and many investors had overextended themselves in the hunt for yield. Selling begat selling, and high yield bonds were oversold. We advised that this selloff marked an attractive entry point, and theory has played out nicely, with the Bank of America Merrill Lynch US High Yield Index up nearly 10% year-to-date.

Another theme we touched on at the start of the year was the relative attractiveness of Emerging Market debt. We anticipated that the high-flying US dollar would come back to earth at some point, which would make local currency EM bonds the preferred investment vehicle. While the US Dollar continued to appreciate with the prolonged tariff dispute and may continue to do so in the next few months, we think there is a possibility for a pullback in the latter half of the year. Year-to-date, local currency EM Bonds have returned around 7.3% (measured by the Van Eck Vectors JP Morgan Emerging Local Currency Bond ETF, ticker EMLC) while USD-denominated EM Bonds (using iShares JP Morgan USD Emerging Market Bond ETF, ticker EMB) are up 10.5%.

Commodities and Alternatives

US West Texas Intermediate Crude Oil prices were able to hold support around the $45 price range in late-2018, which we noted was a good estimate for the average break-even price required by US shale drillers. Since that dip, oil recovered all the way back to eclipse $65-per-barrel, cooled off significantly to trade in the low $50s, but is now approaching $60 due to geopolitical events and the Philadelphia refinery explosion. Our preference remains to avoid speculating on the price of oil and instead own the infrastructure, via investment in Master Limited Partnerships, or MLPs. MLPs have been a solid source of income thus far in 2019 and did not draw-down with oil in late May when prices plunged nearly $15-per-barrel. Year-to-date, the JP Morgan Alerian ETN (ticker AMJ), which we utilize in many of our client portfolios, is up 14.3% and currently yields near 7.5%. It is our belief that a US-Chinese trade deal will involve Chinese purchases of US-produced liquified natural gas, and MLPs with exposure to the storage and transport of the commodity would stand to benefit.

MLPs Have Weathered The June Decline In Oil Prices

Exhibit 6 – MLPs (JPMorgan Alerian MLP Index ETN, ticker AMJ – green line) have weathered the June decline in Oil prices (US West Texas Intermediate – blue line)
Source: Bloomberg

We have also actively utilized Real Estate Investment Trusts (REITs) in both our Strategic and Tactical portfolios this year. REITs have been the best performing sector, with the SPDR Real Estate Sector ETF (ticker XLRE) up over 21% year-to-date. Aside from being undervalued on a price-to-book ratio at the onset of the year, REITs have surged as Fed rate hikes have come off the table and stand to benefit further as we possibly enter a period of interest rate cuts.

Final Thoughts

The prevailing theme of our 2019 Outlook was that we would likely see a “reversion to the mean” after 2018’s summer surge to new all-time highs resulted in an equally spectacular melt-down in Q4 2018. The overwhelming pessimism faded quickly, but without swinging back into wild euphoria. Rather, the gains we have enjoyed thus far in 2019 have been more of a steady, measured advance. The intraday price movement in the S&P 500 supports this. In 2018, the S&P 500 had 36 trading days with gains greater than 1% and 34 with losses greater than -1%. Roughly halfway through 2019, the counts are just 11 and 7, respectively. We strongly prefer the current trading market to last year’s volatility since steady, trending markets are what all investors seek, and this investing environment is more conducive to the tactical investing methods we employ in our tactical models used in some client portfolios. We recognize that the market’s mood can quickly shift, and rest assured, we will remain vigilant to the threats – and opportunities – that inevitably present themselves during the duration of the year.


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