Data Source: Bloomberg
Note to readers: We have sectioned the 2nd Quarter 2018 Market Commentary and 2nd Half Market Outlook commentary accordingly:
June 2018/2nd Quarter Highlights 2nd Half 2018 Outlook Supplemental charts and exhibits
“U.S. is not in [a] trade war with China, it is a trade dispute.” – Treasury Secretary Steve Mnuchin on Fox Business, 6/29/2018
The 2nd quarter of 2018 saw global equity markets sell off, much of it attributed to the growing trade war dispute that is taking shape between the U.S. and the rest of the world. Based on regional equity market and currency performance, the U.S. appears to come out on top of the trade dispute so far with the S&P 500 gaining 3.4% for the quarter versus 1.3% loss for MSCI Europe, 2.8% loss for MSCI Japan, and 8.0% loss for MSCI Emerging Markets. The trade-weighted dollar also gained 4.9% for the quarter and is now up 6.6% from its lows reached earlier in the year.
One can be forgiven for losing track of the tit-for-tat fury exchanged between world leaders as headlines seem to gravitate between retaliation and conciliation. The Tax Foundation is keeping track of all the announced tariffs and has produced a concise summary of the estimated worldwide trade tariffs that have been announced so far as well as their estimated impact on the world economies. The report encapsulates the Trump Administration’s message of ‘more pain for more gain’ approach to revisiting worldwide trading relationships. Some highlights from the report:
Now granted, this report comes from an organization committed to freer trade, but it highlights a reasonable scenario of the long-term negative impact on economic output from higher trade tariffs. ‘Trade disputes’ are never pretty and they can, indeed, produce ‘short-term’ pain in the form of higher prices (via higher imputed taxes), lower economic output, and loss of jobs.
Yet, the full fall-out of the global ‘trade dispute’ has yet to unfold, and we should be cautious and not succumb to hyperbolic apoplexy of the kind exhibited by this economist (incidentally, I’m not sure if I want Paul Krugman to negotiate my next auto purchase). And underneath the surface of all the apoplexy, the Trump Administration may actually be scoring some trade ‘wins’ (the following list courtesy of Rich Farr, Merrion Capital, from a report published on 6/20/2018):
China renewed U.S. soy bean purchases in late May following a cut-off in April (in response to the initial tariff threats). China to cut tariffs on imported cars from 25% to 15% (in addition to cutting tariffs on imported car parts to a standardized 6% from a range of 6-25%). China has pledged to allow more foreign ownership of financial sector by year-end (note: this may not be such a good thing for overseas financials given the heavy leverage within China’s banking system – see our 1Q2018 Market Commentary). Europe has joined the U.S. in putting pressure on China’s intellectual property transfer policies. South Korea negotiated a new trade deal with the U.S. on auto imports and steel/aluminum exports. Germany may be backing the abolishment of auto tariffs into Germany as well as eliminating the European Union’s 10% tariff on imported cars.
Investors and much of the financial media are struggling with what to make of the gyrating headlines over trade disputes, European migrant disputes, and increasing exertion of U.S. exceptionalism (non-endorsement of the G-7 communique, bilateral discussions with North Korea and Russia, exerting pressure on the global banking system to enforce sanctions on Iran). This wrestling with the headlines versus the fundamentals can be summarized by these two contradictory statements, separated by just one week, from Randall W. Forbes, who writes the Up and Down Wall Street column for Barron’s:
“The real news of the week, from the markets’ perspective, was that mundane fundamentals of growth and monetary conditions count more than hyperventilating [trade dispute] headlines.” – Tariffs, Nukes, Rates: More Sound Than Fury (6/16/2018 edition)
“…it would not be an enormous stretch for investors to downgrade global growth expectations, due to fears about a trade war (citing Arjay Rajadhyaksha, Barclay’s Head of Macro Research)…However the trade and capital-flows disputes ultimately are resolved, they create uncertainty for Corporate America.” – Tariffs’ Toll on Trade (6/22/2018 edition)
The end of the 2nd quarter demonstrated the challenge in publishing weekly market commentary that has characterized the market environment for much of 2018.
3D is a frequent publisher of commentaries covering market-moving narratives, so we can sympathize with those struggling to stay keep abreast of the headlines. When we survey our own writings, we find ourselves occasionally whipsawed by the ‘narrative’ of the moment. For instance, earlier in the quarter, we commented on how investors were starting to abandon ‘momentum’ style of investing only for it to become one of the best performing factors as it advanced well ahead of all the major factors before tanking two weeks prior to the end of the second quarter ( Figure 1).
Figure 1 – Momentum Maintains Factor Leadership In 2Q But Underperforms Late In The Quarter
Low/minimum volatility strategies outperformed in the quarter following a late June rotation into defensive segments of the market. Investors turned sharply towards risk-off near the end of June as the sound volume surrounding trade ‘dispute’ rhetoric reached 11. Defensive sectors such as consumer staples and bond-proxy sectors such as utilities and real estate outperformed in June (Figure 2), which helped contribute to low volatility/minimum volatility factors’ outperformance versus the broader market (partially confirming, once again, the interest rate sensitivity of said factors).
On the losing end were cyclical industrials and financials, the latter of which are suffering as the spread between short and long-term interest rates continues to narrow. Another market theme (cyclical reflation) appears to be busted for now although the strong performance of oil and energy stocks is keeping this theme on life support.
Figure 2 – Defensive Sectors Lead In June While Cyclicals And Financials Lagged
Another puzzling disconnect is the positive performance of below investment grade (high yield) credit (Figure 3) relative to other fixed income sectors, a sign of increased risk appetite, versus a flattening Treasury yield curve (2-10 year term structure) and wider investment grade credit spreads (Figure 4), both signs of early deflationary concern.
Figure 3 – High Yield Credit Outperforms Broader Fixed Income Despite ‘Risk-Off’ Positioning
Figure 4 – A Flattening Term Structure And Wider Investment Grade Credit Spreads Point Towards Increased Deflationary Risks
Along with the sharp underperformance of emerging markets (Figure 5), one starts to draw a conflicting picture of the market environment. Emerging markets felt the brunt of the trade war rhetoric, although early 2nd quarter weakness could also be attributed to ‘local’ issues across Turkey, Argentina, South Africa, and Brazil.
Figure 5 – Emerging Markets Are The Worst Performing Region In June
Much of this conflicting picture between risk-on cyclical reflation and risk-off deflationary concerns can be sourced to the Federal Reserve as they continue to embark upon their rate tightening campaign for the purposes of normalizing monetary policies and removing vestiges of the ‘Fed’ put (see our 1Q2018 and February 2018 Market Commentaries, where we, some would say ad nauseum, discuss this more in-depth).
In addition to the financial tightening that the rate hikes are starting to produce, the Fed’s reactionary function to market-disrupting events can be viewed more as a Fed ‘strangle’, rather than a Fed ‘put’. Credit goes to Stifel Financial macro strategist, Barry Bannister, for coining the ‘strangle’ concept which posits that the Fed has, theoretically, sold both a put and a call option but with much wider strike prices around current market levels versus what may have been observed with prior Fed regimes. Wider strike prices imply a lower probability of those put and call options from being exercised.
Under Fed Chairperson Jerome Powell, the imputed strike price on the Fed put is at a much lower level versus prior Fed regimes which were more sensitive to deflationary spirals brought on by the onset of volatile markets post the 2009 Great Recession.
In other words, the Powell Fed is less likely to step in to support the markets during a price swoon, and the sell-off would need to be much deeper to compel the Fed to react. In contrast, the high imputed strike price on the Fed call makes the call option less likely to be exercised as the Fed’s monetary policy seems to be more sensitive to market imbalances brought on by runaway asset prices or excessive risk-taking.
As long as the U.S. economy continues to grow at peak employment levels with inflationary threats just around the corner, the Powell Fed can maintain the policy strangle while pursuing a rate normalization schedule that brings short-term rates in line with the theoretical neutral real rate of interest. It will be interesting to see how the Powell Fed would react to a deflationary scare before the Fed Funds Rate reaches, and exceeds, the neutral rate of interest, expected sometime in mid-2019.
Diverging monetary policies between the U.S. (rate tightening) versus the rest of the world (Japan and Europe remain in quantitative easing mode) has caused concerns that the rest of the world will not be equipped to shoulder the higher interest rate burdens and reduced dollar liquidity from U.S. Fed tightening, especially for foreign borrowers that have issued dollar-denominated debt. Apart from trade disputes, the Fed remains the primary concern among investors as prior tightening regimes have ended with the U.S. in recession and the rest of the world suffering from the loss of liquidity.
The diverging performance between U.S. assets (equities, fixed income, currency) versus the rest of the world has produced a widening gap in relative valuations based on price / expected earnings over the next 12 months ( Figure 6).
Figure 6 – Forward P/Es: The Rest Of The World Is Starting To Look Cheap Versus The U.S.
However, the key to forward valuations is whether the ‘E’ or earnings can be stabilized; in the case of emerging markets, earnings estimates are starting to drop although they continue to grow in Europe and Japan.
As for commodities, the global supply/demand picture (Figure 7) has returned to balance after operating in a net deficit over the past year as the oil price rally has led to higher oil production. However, slightly lower demand has met increasing supply; trailing 12-month global demand dropped slightly in June although this was after a sharp increase over the prior 11 months. Commodity investors banking on further oil price rallies should be mindful of a potential tapering off in demand.
Figure 7: Global Oil Supply/Demand Differential More In Balance Following Oil Price Rally
Finally, U.S. fixed income is presenting a mixed picture of U.S. inflation and growth. The core component of the personal consumption expenditure (PCE) price index has reached 2% growth on a year-over-year basis which, along with the strong employment environment, giving the U.S. Fed ammunition to pursue rate tightening.
But, widening investment grade credit spreads and a flattening Treasury term structure suggest financial conditions have tightened to a point where the risk of a deflation has now emerged. If inflationary pressures have peaked, then investors may start gravitating back into long duration Treasuries and other safe-haven assets (i.e. the Japanese yen) as a hedge against market volatility.
Is the Trump ‘trade dispute’ enough to push key macro and market risk indicators into deflationary territory? We may get a glimpse over the summer, but investors should keep an eye on the term structure and credit spreads as early clues that the U.S. economy may slow down enough for the Powell Fed to hit the pause button on the rate hike schedule. The Fed may find itself in a bind if headline inflationary figures, driven by higher oil prices, remain elevated above the 2% comfort zone. This should make for an interesting summer.
This document provides charts and exhibits covering market performance and macro economic conditions. All data comes from Bloomberg unless noted otherwise.
QTD Ending 6/30/2018
YTD Ending 6/30/2018
High Yield And Investment Grade Credit Spreads
Global Energy Supply And Demand
U.S. Domestic Drilling And Employment
2- Vs 10-Year Treasury Spread And 5-Yr/5-Yr Forward Inflation Expectations
Primary Global Sovereign 10-Year Yields
Industrial Metals and Oil
U.S. Dollar Spot Index and Against Euro And Yen
Global Equity Valuations (Price / 1-Yr Forward Earnings)
S&P Operating Margins and Rolling 1-Year Revenue Growth
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