February 2018 Market Commentary: Mixed Signals Lead To Crossed Wires

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Includes: BIL, DDM, DFVL, DFVS, DIA, DLBS, DOG, DTUL, DTUS, DTYL, DTYS, DXD, EDV, EEH, EGF, EPS, EQL, FEX, FIBR, FWDD, GBIL, GOVT, GSY, HUSV, HYDD, IEF, IEI, ITE, IVV, IWL, IWM, JHML, JKD, OTPIX, PLW, PSQ, PST, QID, QLD, QQEW, QQQ, QQQE, QQXT, RISE, RSP, RWM, RYARX, RYRSX, SCAP, SCHO, SCHR, SCHX, SDOW, SDS, SFLA, SH, SHV, SHY, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TAPR, TBF, TBT, TBX, TLH, TLT, TMF, TMV, TNA, TQQQ, TTT, TUZ, TWM, TYBS, TYD, TYNS, TYO, TZA, UBT, UDOW, UDPIX, UPRO, URTY, UST, UWM, VFINX, VGIT, VGLT, VGSH, VOO, VTWO, VUSTX, VV, ZROZ
by: Benjamin Lavine, CFA
Summary

Global stocks returned 2.7%, led by Europe and the U.S., up 3.4% and 3.2%, respectively. Emerging Markets and Japan lagged, returning 0.2% and 0.0%, respectively.

The S&P Small Cap Index was up 4.4%, though outperformance over large caps narrowed towards the end of month. U.S. thematic, risk-based factors: Quality, Minimum Volatility, High Dividend, and Momentum outperformed.

Fixed income: U.S. High Yield continues to benefit from the beginning year risk-on rally, returning 1.7%. Broader investment grade market was flat, while international fixed income underperformed.

Investors continue to look past the weakening macroeconomic and earnings environment: 1) China: signs of increasing fiscal and monetary stimulus; 2) Global Central Bank easing and the willingness of the U.S. Federal Reserve to let inflation run above target for the time being.

Can the Fed and China engineer a soft landing that maintains the current global growth cycle while not prompting global central banks to tighten? This remains the central macro issue for 2019.

Data Source: Bloomberg

Source: istockphoto. Used with permission.

Global equity markets have had a strong start to the year, especially tje U.S. mid- and small-cap stocks as well as industrial commodities, led by oil.

Several professional investors are warning that the global risk is "overbought" and recommend de-risking into "high-quality"/lower-risk stocks and bonds. Further market advances seem dependent on whether the global growth engine can shake off the near-term slowdown and push forward, carrying risk-on cyclicals and corporate credit along for the ride.

At the margin, this global growth engine is heavily influenced by Chinese import appetite, as well as World Central Bank monetary policy, which seems to widely influence industrial production. Figure 1 (2/25/2018 WSJ Daily Shot) displays the drop in China's imports from its major trading partners (note the significant drop in U.S. trade imports as China seeks to flex its muscles during the trade dispute).

Figure 1 - Slowing Import Activity from China Points Towards a China Slowdown

We've written several times (here and here) that a future slowdown in global economic growth will largely depend on how China unwinds its excess leverage: a slow leak resulting in zombie capital with underperforming/non-performing assets held on lender balance sheets, or a giant deflationary collapse resulting from an implosion in its financial ecosystem?

Yet, these concerns are giving way to hopes that China is once again trying to reflate its economy through fiscal and monetary stimulus. According to Reuters, Chinese banks extended 16.17 trillion yuan ($2.4 trillion) in net new loans for 2018, "more than the [GDP] of Italy," with much of the growth in new loan activity occurring in the fourth quarter. Chinese appetite for domestic equities has also recovered with Chinese margin debt surging following the Lunar Holiday, according to the China Securities Finance Corp.

After dampening private credit growth in 2018, China appears to be opening the credit spigot once again to private (and shadow banking) lending (Figure 2, 2/25/2018 WSJ Daily Shot).

Figure 2 - China Reopening the Spigot on Private Credit Growth

And not too soon as more media leaks - like this one purporting China's auto production running at only half capacity - point to a more dramatic slowdown than the its government is reporting. From the article:

"But it's difficult to pin down how bad things have gotten, as the Chinese government is believed to downplay the country's unemployment to a high degree. The fact it's even admitting there's a problem should be telling. (Emphasis 3D)"

It's unclear how many more times China can launch debt-driven fiscal and monetary measures to counter a slowdown before the burdensome pile-up in private and public debt finally tips the economy over.

But given the strong market reaction, with the China MSCI up over 15% YTD through February, investors are willing to give China the benefit of the doubt. And there are high hopes China will reach some form of trade agreement with the U.S., though what happens with the existing 10% tariffs as well as any side agreements on currency levels remain to be seen.

Whether the Chinese growth engine can finance that growth remains to be seen. One note of caution: the increased vulnerability of Chinese banks to a downturn in the property market as highlighted by the S&P Capital IQ (Figure 3).

Figure 3 - Chinese Banking Increasingly Vulnerable to a Property Downturn

The U.S. Economy Is Slowing Down but Still Growing

Despite the drop-off in exports to China, the U.S. economy is enjoying low but positive, real economic growth: latest 4Q2018 real GDP growth came in at an annualized 2.6% with consensus expecting 2.0-2.5% in 2019. This is helped by a strong employment picture and a slow but steady sentiment in manufacturing activity (Figure 4).

While there are signs of economic slowdown, like the drop in retail sales and the Leading Economic Indicators (LEIs), this does not signal recession (Figure 5).

Figure 4 - U.S. Manufacturing Sentiment and Business Outlook Points to Slowdown

Figure 5 - Drops in Retail Sales and LEI Point to Slowdown

On the other hand, U.S. earnings growth continues to get downgraded. According to the 2/22/19 edition of FactSet Earnings Insight, consensus estimates for S&P 500 earnings growth in 2019 have dropped to 4.5% (revenue growth of 4.9%) from 7% at the beginning of the year, and 10% expected in October 2018. Yet, the forward 12-month earnings multiple on the S&P 500 continues to rise and now stands at 16.3x versus 14.4x at the beginning of the year (Figure 6).

Despite the less-than-robust earnings outlook for 2019, the U.S. continues to enjoy its status as the nicest house in a bad neighborhood.

Figure 6 - Forward P/E for U.S. Expands Relative to International Developed (EAFE) & Emerging Markets (EM)

Trapped by Quantitative Easing

It seems that the major developed markets - U.S., Japan, Europe - are trapped by, or addicted to, quantitative easing. The U.S. almost escaped the gravitational pull of zero interest rate policies and expansion of the U.S. Federal Reserve balance sheet, but now it appears the Fed is on hold, with no rate hikes expected by Fed Funds Futures in 2019 (Figure 7) and expectations that the Fed will stop paring back its balance sheet once it reaches $3.5 trillion (Figure 8).

Figure 7 - Fed Funds Futures Expect No Rate Hikes in 2019 (but a Slight Chance of a Cut)

Source: Bloomberg

Figure 8 - How Much Further Will the Fed Balance Sheet Decline (Constraining $US Liquidity in the Process)?

Mixed Signals and Crossed Wires

Following Fed Chairperson Jerome Powell's congressional testimony this past month, the Fed appears to have adopted a "patient" stance regarding normalizing monetary policy through further rate hikes and balance sheet reductions.

However, with this year's recovery in "risk-on" assets (cyclical equities, commodities, credit spreads) against a soft bond market (U.S. Treasury Yields), a strong U.S. dollar (heightened demand for liquidity), and a global economy feeling the effects of a China slowdown, the Fed finds itself on a tightrope between being patient and the risk of allowing near-term inflationary pressures to run ahead of policy.

Compare the recent run-up in oil prices against the U.S. 10-Year Treasury Yield (Figure 9):

Figure 9 - Will Treasury Yields Catch Up to Oil Prices or Vice Versa?

Another mixed signal: inflation expectations embedded in the spread between TIPs versus nominal Treasuries have risen above 2%, while the 2-10 Year Treasury Term Structure has barely budged (Figure 10). If the markets were expecting higher inflation, one would expect to see a steeper term structure.

Figure 10 - Mixed Signal: Rising Inflation Expectations (TIPs vs. Nominal Treasuries) vs. a Flat 2-10 Year Treasury Term Structure

One response to this mixed signal market: Mix up your asset allocation, buying high-quality equities as a defense against an uncertain outlook; and high yield fixed income for a cyclical recovery - an approach highlighted by Bloomberg: "Enter the 'Twilight Zone' as Stock Nightmares Meet Credit Dreams," and referenced in our December 2018 blog article "Flock to Quality."

Our approach: Flip this risk positioning. Equity investors are rewarded with more upside capture from a macroeconomic cyclical rebound versus high yield fixed income, where the risks are asymmetric due to the upside capped by the bond yield. Indeed, credit investors who wouldn't touch high yield at nearly 6% spread above Treasuries last December can't seem to get enough of high yield at a spread below 4% approaching 3% (Figure 11).

Figure 11 - Can't Get Enough "Junk" in this Risk-On Rally

If reflation picks up, the U.S. Fed could feel compelled to tighten monetary policy - even after being told by the markets last quarter that they can't withstand a tighter policy. Can the Fed and China engineer a soft landing that maintains the current global growth cycle while not prompting global central banks to tighten? This remains the central macro issue for 2019.

February Review

February saw a continuation of the beginning year rebound in global risky assets. Global stocks (MSCI All-Country World Index, or ACWI) returned 2.7% led by Europe and the U.S., up 3.4% and 3.2%, respectively, while Emerging Markets and Japan lagged, returning 0.2% and 0.0%, respectively (Figure 12).

Figure 12 - U.S. and Europe Lead All Major Regions in February

The S&P 500 rose 3.2%, with mixed sector performance: Cyclical sectors like Technology and Industrials and defensive sectors like Utilities led performance, while other defensive sectors like Healthcare lagged along with consumer sectors (Discretionary, Staples, Communication Services) (Figure 13).

Figure 13 - Industrial Sectors and Utilities Led U.S. Sectors

With the S&P Small Cap Index up 4.4%, it was another strong month for this sector - though towards the end of the month, it gave up a large chunk of its outperformance over large caps. Value lagged growth as investors began shifting their preference back towards earnings growth power.

Figure 14a and 14b - Industrial Sectors and Utilities Led U.S. Sectors

U.S. thematic, risk-based factors - Quality, Minimum Volatility, High Dividend, and Momentum - outperformed the broader market, while Value underperformed.

Figure 15 - Growth/Defensive Factors Outperformed Value

In Fixed income, U.S. High Yield continues to benefit from the beginning year risk-on rally returning 1.7%.

The broader investment-grade market, represented by the Bloomberg/Barclays U.S. Aggregate Bond Index, was flat for the month while international fixed income underperformed largely due to a strong U.S. dollar.

Figure 16 - U.S. High Yield Outperforms Other Major Fixed Income Segments

Finally, commodities outperformed Real Estate and Precious Metals, also reflecting the renewed risk appetite for global cyclical risk (Figure 17).

Figure 17 - Commodities Outperform Real Estate and Precious Metals

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.

Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as March 4, 2019 and are subject to change as influencing factors change.