Q1 2019 Market Commentary - Pull The Chute

by: Benjamin Lavine, CFA

Global stocks returned 1.3% led by the U.S. and Asia-Pacific ex Japan, up 1.9% and 1.5%, respectively; Emerging Markets, Europe and Japan lagged returning 0.8%, 0.6%, and 0.6%, respectively.

S&P 500 rose 1.9%, led by growth (technology, consumer discretionary) and defensive (real estate utilities) sectors, while industrials cyclicals and financials lagged.

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

The Bloomberg/Barclays Aggregate Bond Index performed in line with U.S. stocks, returning 1.9% while U.S. High Yield returned 0.9% despite some credit spread widening.

Between the strong performance in U.S. large caps (small caps and value, not so much) and corporate credit along with a bull steepener in the yield curve, we could be seeing a set-up for renewed risk-taking.

Data Source: Bloomberg

First Quarter 2019 Market Commentary – Pull the Chute!

Source: pxhere.com. Labeled for reuse.

As of the time of this writing, ‘Brexit’ has not been resolved, even though March 29 was the deadline for the United Kingdom to withdraw from the European Union.

Plenty of issues surfaced during the first quarter (more on those below) that drove diverging movements between global stock markets (indices strongly up) and global bond markets (yield sharply down).

But the unresolved Brexit negotiations remain front-and-center. Failing a desperate effort by UK Prime Minister Theresa May to put her negotiated deal up for an unprecedented fourth vote – it seems Parliament will not vote on an exit arrangement by the new April 12 deadline. And a long-term extension seems the new base-case scenario, as neither the UK nor the EU want to experience a ‘Hard Brexit.’

Or so you would think. Watching the Brexit drama play out reminds us of a scene from the 1991 movie Point Break. Towards the end, Johnny Utah (Keanu Keeves) jumps out of a plane, wearing no parachute, to chase after Bodhi (Patrick Swayze). Utah catches Bodhi mid-flight and points a gun to his head demanding information. A ‘game of chicken’ ensues with Utah pulling the chute before both hitting the ground. At the end of the scene, Bodhi won the game of chicken.

PM May made repeated attempts to push her negotiated Brexit deal through Parliament with unsuccessful (and some would argue humiliating) results despite pointing a metaphorical gun to Parliament’s head – using threats of a Hard Brexit, new elections, a new Brexit referendum, and the prospects of a long-drawn out delay that would produce no Brexit.

But Parliament is refusing to pull the chute – as Brexiteer MPs refuse to cede ground on an open Irish border, payments into the EU budget, and guarantee of EU citizens’ rights.

The EU appears to be emerging as the winning party in these negotiations: The longer the process drags on, the more likely a soft or no Brexit scenario is the outcome. However, any delay beyond April could result in the U.K. participating in European Parliamentary elections this May – not something the EU wants.

The EU has been positioning for a hard Brexit scenario, despite the damage to German exports into the U.K. resulting from a no-deal Brexit. Given how Brexit is currently playing out, we overestimated the UK’s negotiating stance versus Europe – possibly because we underappreciated European concerns over the rise of populist movements.

According to Bloomberg (“Populists and Authoritarians Have Taken Over the World Economy”), almost 70% of the G-20 countries’ GDP is “under the governance of either populist rulers in democracies or non-democratic regimes…a jump from 33% in 2016.”

Contending with movements like Italian politics and France’s Yellow Vest protests, and facing the prospect of more populist party representation following this spring’s European Parliament elections, Europe is willing to risk a no-deal Brexit to get its member countries to toe the line.

Unlike Point Break, however, it appears that all parties (May Cabinet, Brexiteers in Parliament, the EU) are willing to hit the ‘Hard Brexit’ ground rather than cede any more ground to the EU. But the conventional outlook now sees the new U.K. elections as the base-case scenario following the third defeat of May’s Brexit proposal. Brexiteers may now be facing a prospect of a soft or no-Brexit scenario, but at least they stood their ground even as they’re about to slam into it.

Will China Pull the Chute on U.S. Trade Negotiations (and Prevent the World from Hitting the Ground)?

China is reminding us again just how much of the world relies on its economic growth.

Global markets were spooked in early March following the release of manufacturing sentiment surveys (Figure 1) showing significant weakness across Europe (implied annualized European GDP growth is now down to 0.2%).

Figure 1 – European Manufacturing Slumps Due to a Significant Decline in New Export Orders (Read: Trade into China) (Courtesy of WSJ Daily Shot)

Indeed, both Europe (primarily Germany) and Japan are experiencing more of the pain from a China slowdown. The U.S. is holding a tariff gun to Chinese imports while continuing to demand trade concessions around intellectual property transfer.

The world is counting on China pulling the chute rather than serving as the proximate cause for the next major global contraction. If China remains the weak link within the global economy, they might not be strong enough to pull the chute, although a recent rebound in credit impulse could point towards a second-quarter recovery (Figure 2).

Figure 2 – A second Quarter Manufacturing Recovery Would Likely Be Led by a Recovery in China Credit Impulse (Courtesy of WSJ Daily Shot)

Longer-term, China’s debt leverage (318% of GDP) remains “stratospheric” despite efforts to boost economic growth. And should China face the day of reckoning on deleveraging to more sustainable levels, it could pose further deflationary risk on the global economy. The prospects for a new ‘Plaza Accord’ with China that would result in appreciation of the Chinese yuan versus the dollar have diminished, as China does not want to follow the deflationary path Japan experienced following the 1980s Plaza Accord.

China isn’t the only reason both Europe and Japan are facing stagnant growth, despite their central banks’ commitments to maintaining zero (negative) interest rate policies and cheap access to bank liquidity.

Germany’s car economy still suffers from the fallout over diesel-gate. And German taxpayers face the prospect of having to recapitalize a debt-encumbered Deutsche Bank-Commerzbank (NYSE:DB) (OTCPK:CRZBF) combination struggling with weak balance sheets and anemic profitability.

Meanwhile, Japanese consumers face the prospect of yet another hike in their value-added tax. And Europe faces near-term prospects of a renewed populist uprising in Italy, as it suffers from low growth and high debt levels while trying to carve its own economic partnerships, like participating in China’s Belt-and-Roads initiative.

As much as the U.S. does not want to partake in a global crash landing should China refuse to pull the chute on trade negotiations, the U.S. economy is in a relatively better position to withstand this compared to the rest of the world. Although revised down, U.S. real GDP grew 3% in 2018 and is expected to grow 2.4% in 2019 based on Bloomberg consensus estimates.

The U.S. Economy Has Its Own Parachute (i.e. the Fed)

The U.S. markets appear to be enjoying the Federal Reserve’s 180-degree pivot on monetary policy. Following the March meeting, the Fed struck a much more dovish tone on interest rates and balance sheet management than expected, resulting in a major decline in U.S. Treasury rates and an inverted yield curve out to 7-year maturities.

Many have interpreted an inverted curve (10-year less 3-month yield) as a sign of an impending recession. More bullish economists like First Trust’s Brian Wesbury believe an inverted curve is just the market’s way of signaling to the Fed that short-term interest rates are too high, and not necessarily that recession is around the corner.

However, it’s hard to argue with the bond market which seems to act as the tail wagging the Fed. Following the March Fed meeting, Fed Funds futures interpreted the Fed’s dovish stance as implying a possible rate cut by the year-end (Figure 3) to head off any impending slowness.

Figure 3 – Fed Funds Futures Now Pricing in a Rate Cut by Year-End

Source: Bloomberg

Focusing on the U.S. macro picture for a moment, we find ourselves at a crossroads – with conflicting signals from economic releases and U.S. risk-asset pricing, as highlighted in our February 2019 Market Commentary, “ Mixed Signals Can Lead to Crossed Wires.”

Yes, the curve is inverted out to seven years, but the 10-2 year spread remains positive despite the decline in long-term interest rates (Figure 4), which imply slowdown but not recession.

Figure 4 – 10-2 Year Treasury Term Spread Remains Positive and Inflation Expectations (TIPs vs. Nominals) Remain Close to 2%

Despite the defensive positioning following the Fed meeting, credit spreads remain well-behaved, unlike the growth scare from 3Q2015-1Q2016 (Figure 5). BBB-rated corporate spreads have actually narrowed rather than widened – a strong indication that the macroenvironment remains conducive for taking on credit risk.

Figure 5 – Corporate Credit Spreads Remain Well-Behaved Despite the Risk-Off Scare Following the Fed March Meeting

Undergirding capital markets is the fact that global financial conditions remain loose (or are easing) rather than tightening (Figures 6 and 7) – typically economic contraction occurs as global economy succumbs to the weight of tighter financial conditions (central bank policy, tighter private credit).

Figure 6 – U.S. Financial Conditions Remain Loose as the Fed Pivots Towards No Rate Hikes

Figure 7 – Asia and Europe Financial Conditions Improve as Chinese Credit Growth Recovers and Central Banks Continue Quantitative Easing

Hence, between the strong performance in U.S. large caps (small caps and value, not so much) and corporate credit, along with a bull steepener in the yield curve – we could be seeing a set-up for renewed risk-taking. Indeed, the market has been given the all-clear from the Fed that rates are not going up anytime soon, barring a major inflation scare.

Will we see economic conditions improve enough for the Fed to resort to its path towards policy normalization? Investors need to see several macro headline issues resolved or at least clarified – including Brexit, European Parliament elections, U.S.-China trade negotiations. As well as the assurance that ongoing local issues surrounding emerging markets (Turkey, Argentina, Brazil) do not lead to broader contagion risk.

March and 1Q2019 Review

Global stocks returned 1.3% led by the U.S. and Asia-Pacific ex Japan, up 1.9% and 1.5%, respectively; Emerging Markets, Europe and Japan lagged returning 0.8%, 0.6%, and 0.6%, respectively (Figure 8).

Figure 8 – U.S. (Once Again) Asserts Its Leadership Over Other Market Regions

S&P 500 rose 1.9%, led by growth (technology, consumer discretionary) and defensive (real estate utilities) sectors while industrials cyclicals and financials lagged (Figure 9).

Figure 9 – Growth and Defensive Sectors Outperformed in March

S&P Small Cap Index was down 3.3% in stark contrast to U.S. large-cap performance, while S&P Pure Growth outperformed Pure Value (2.2% vs. -1.6%, respectively) (Figure 10).

Figure 10 – Small Caps and Value Underperformed in March

U.S. thematic, risk-based factors: Quality, Minimum Volatility, High Dividend, and Momentum outperformed the broader market; Value underperformed (Figure 11). Investors ran for the high ground by seeking safety in low volatility and premium growth.

Figure 11 – Quality, Low Volatility, and Momentum Outperform in March

Fixed income: U.S. fixed income benefited from a sharp drop in interest rates following the March Fed meeting. The Bloomberg/Barclays Aggregate Bond Index performed in line with U.S. stocks, returning 1.9% while U.S. High Yield returned 0.9% despite some credit spread widening (Figure 12). The 10-Year U.S. Treasury Yield dropped to 2.41% at month-end from 2.76% at the beginning of March, having dropped to as low as 2.37%, its lowest levels since mid-December 2017.

Figure 12 – U.S. Fixed Income Outperformed Equities with the Sharp Drop in Interest Rates

Finally, U.S. REITs were a large beneficiary of the drop in interest rates. Commodities performed well with continued advances in oil prices. While precious metals lagged despite dovish central bank policy shifts.

Figure 13 – U.S. Fixed Income Outperformed Equities with the Sharp Drop in Interest Rates

First Quarter 2019 Performance Charts

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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 April 1, 2019, and are subject to change as influencing factors change.