The U.S. Economy
GDP growth has now expanded for 20 consecutive quarters and last quarter's 3.1% was a positive surprise in many respects. In fact, looking at just GDP data would likely lead someone to conclude that the Fed would not be cutting rates. As we will show later, however, there are plenty of other indicators showing that growth might not be as robust as it seems.
The breakdown of GDP components for Q1 show a balanced economy, where no one component really stood out as driving the expansion. The balance was comparable to what we witnessed in Q32018 but the overall growth was much lower.
Source: Bureau of Economic Analysis
The Atlanta Fed publishes an estimate of forward GDP called GDP Now. By this figure, it looks like the economy will slow down considerably from previous quarters with the current estimate at less than 1.5% growth. As the chart below indicates, the GDP Now figure can be volatile, but it has not been much higher than 2%.
The ISM Manufacturing index is also pointing to slower growth. A result above 50 indicates expansion while a result below 50 indicates contraction. The US Manufacturing PMI is still above 50 but the decline from above 60 just 12 months ago is noticeable - and new orders is right at the 50 mark - declining from 65 just a year ago.
One area that still looks strong is the labor market. The unemployment rate remains below 4% and the U6 rate is approaching 7%. Fed officials are now wondering if the economy can sustain a much lower unemployment rate than previously thought without igniting inflation.
Average hourly earnings has finally started to get traction but doesn't seem to be accelerating very rapidly. In fact, the overall growth rate has been on a slightly downward trend since spiking in Q3 2018.
We could see a flattening in the number of non-farm payrolls as well. The metric is volatile but while the payroll number reached over 300k several times in 2014 and 2015, it has only reached that level once in the last 18 months. This was somewhat expected as a 300K increase was not sustainable, but now the magic threshold number is closer to 200K.
Initial claims also point to a kink in the labor market. They have been on a steady decline for years now but have now started trending back up. We've seen this before in late 2018 so it will be interesting to see how this plays out over the rest of 2019.
Consumption remains strong in the US partly due to the robust labor market and retail sales have been a bright spot. Most of the growth in retail sales, however, has come from nonstore sales, whose growth has remained above 10% since 2016. Meanwhile, overall retail sales are growing closer to 3%, which means more challenging times for pure brick and mortar retailers.
Only two industries had meaningful sales growth recently - motor vehicle and parts dealers as well as gasoline stations - mainly due to price increases.
Source: Census Bureau
An area of concern might be personal spending. It still showed month over month growth but the rate of growth slowed for the 2nd consecutive month. It's still too early to tell but if the rate of spending growth continues to slow, consumption may start being a drag on economic growth.
Source: U.S. Bureau of Economic Analysis
No surprise here. Inflation is nowhere to be found - well, prices are creeping up in certain areas - but overall, the Core PCE Index remains stubbornly below 2% which is likely why it will be easy - and safe - for the Fed to cut rates. The risk is that a rate cut is already priced in and a second rate cut is highly expected - if the Fed doesn't follow through, markets could decline.
One area where we have started to see the inflation effects is in the average hourly earnings figure - although the recent data shows it may have peaked.
Breaking down the components of CPI, we see that there are deflationary forces at work across the board except on Food, and to a lesser extent, shelter. The increase in y/y change of Rent of Primary Residence is one of the drivers we have highlighted for being bullish on Apartment and Single Family Home REITs.
New home sales have recovered but remain well below the peak reached in 2004. I'm inclined to say that we might get a small spike due to recent rate declines but it will be short-lived. The economy will have to find a growth driver somewhere other than the housing market this time.
The months supply of homes for sale has remained low enough to keep sales at bay - if there is no inventory of homes for sale, there can't be any sales.
The challenge of low supply is usually addressed by new construction but it looks like building permits may have peaked which means housing starts might peter out as well.
Where we have seen a bit of activity is in the existing home sale market. The annualized rate has remained above 5.2 million for 4 consecutive months, but keep in mind, that came on the back of increased supply.
Much has been talked about the inverted yield curve and how it leads to recessions. The 10 year - 2 year is quite flat but not yet inverted....
...but the 10 year/3 month has crossed over.
Looking back, here is how the yield curve and recession interact. Keep in mind, however, that not all inverted yield curves have led to a recession. The chart below shows the 10Yr-2Yr because our 3 month treasury data only goes back to 1990.
Asset Class Returns
Over the last three months, the best performing asset class was Emerging Market Bonds. Many of you may have heard the SeekingAlpha podcast where I shared some of my views on EM debt but after the recent outperformance, we may be pulling back a bit.
A noticeable underperformer was the REIT sector, represented here by the Vanguard Real Estate ETF (VNQ). As we will show later, it was one of the worst performing sectors within the US equity market. It is listed separately here as an alternative asset class.
Our coverage of equities includes US Large Caps, Mid Caps, and Small Caps, as well as International Developed Market equities and Emerging Market equities. While we might get into more granular segments of the market when allocating capital, these are our five major equity categories.
No surprise, US equity markets have outperformed non-US equity markets over the last 10 years. Our research shows, however, that the risk/return profile of non-US equity markets looks favorable relative to US markets. The challenge for us has been one of timing.
We did start to shift some capital from US to non-US equities - as is prudent when one asset class outperforms another over an extended period. But we have also started increasing our allocation targets to non-US equities. So far, it hasn't worked out, but we do feel like US markets are closer to the end of their expansion, while many international and emerging markets have a much longer runway.
The performance of each US sector by quarter since Q42015 is shown below. On the one hand, we can conclude that being well diversified would have been good considering the change in leadership from quarter to quarter. That is no surprise and has been well documented in a number of articles about proper diversification. On the other hand, an overweight to Technology would have resulted in very attractive returns.
The Vanguard Information Technology ETF (VGT) was in the top 3 performers in 10 out of the 15 quarters shown and outperformed the broader S&P in 12 of those quarters.
The other area where outperformance has continued is in the growth versus value styles. The S&P 500 growth has outperformed value by 35% since July 2009. We usually see a reversal to the mean in these cases but when and how fast is anyone's guess. In the meantime, we are slowly decreasing our Growth exposure and adding to Value.
ETF Fund Flows
It was a mixed bag of fund flows. There seems to be a shift towards fixed income with strong interest on the short end of the curve. Not surprising with the expectations of rate cuts. Another notable inflow was into the iShares Edge MSCI Min Vol ETF (USMV).
Here is another view of the US Treasuries Yield Curve as well as what it looked like last year and 6 months ago. Besides the inversion, the downward shift in the entire curve is noticeable, with 30 year rates down from 3.04% to 2.54%.
A similar decline can be seen across the entire corporate bond spectrum. Only CCC-rated bonds currently have a higher yield than they did last year.
If you want to take little to no credit risk, however, you won't be compensated for it. The yield on AAA rated corporates is now below 3%. Investors looking for yield will either have to slide down the credit spectrum or go overseas. Yields on LATAM EM bonds are around 5% - higher than even BB Corporates despite having credit ratings more comparable to BBB-. The caveat is that there are additional risks we must be aware of that are specific to each country and currency. For this reason, we suggest an ETF or fund approach to EM bonds.
When looking for a place to hide, many investor look to Gold or other 'alternatives' like hedge funds. I know hedge funds have underperformed over the last 10 years but we will see how they do when we finally have an equity market meltdown. After all, that is when they are supposed to 'work'. I'd also suggest to investors not inclined to look at hedge funds that most of the really good ones stay out of the limelight and are doing quite well. They should not be grouped into the same category of hedge funds that is included in hedge fund indexes. The performance of each fund within a hedge fund index can vary considerably.
In any case, many investors use cash or Gold as a way to hedge against inflation or uncertainty. As the chart below indicates, Gold has been range-bound for some time after having hit 1800 in 2011. But with the recent price spike, I wondered whether Gold was the best hedge investment or if any of the other precious metals would be better.
One way to determine the price of Gold is how it trades relative to the price of other commodities - like Silver and Platinum. As the chart below shows, the price of gold has recently spiked while the price of Silver has been on a steady decline. The result is a ratio of Gold to Silver price that hasn't been higher in the last 10 years.
The same relationship holds true between Gold and Platinum - with the difference being that the price of Platinum has declined dramatically since 2012 after outpacing gold in the late part of the previous decade. That said, the ratio of Gold price to Platinum price is also at a decade long high.
Lastly, we compare the price of Platinum vs. Silver. As already mentioned, the price of Platinum has declined considerably recently. The relative decline has now caused the ratio of the price of Platinum to Silver fall below its long-term average. On a relative basis, this means Platinum is cheaper than Silver and Gold.
We're not suggesting that one metal is undervalued or that another metal would be a better hedge - there are other factors that drive the price of Platinum and other metals but at least on a relative basis, investors looking at metals as a way to hedge against inflation or uncertainty, consider that Platinum hasn't been as overbought as Gold.
Price of industrial metals, on the other hand, are driven by supply and demand. As the chart below indicates, only Iron Ore prices have been rising over the last 6 months, while commodities like Aluminum, Copper, Lead, Nickel, and Zinc reached their peak in early 2018.
In the energy industry, the price of oil has been very volatile lately, with Brent Crude touching $80 before dropping to $50 and settling in at just above $60. The same movement is evident in the price of WTI Crude and Gasoline prices.
This volatility, in our opinion, has given us an opportunity to buy companies at below intrinsic value - particularly the MLPs, which aren't as sensitive to changes in oil prices over the short-term - yet their stock prices tend to move along with the rest of the sector.
We expect the number of oil rigs to decline until the price of oil recovers to $60 or more. As the chart below indicates, the number of oil rigs in operation has steadily declined since toying with 900 in 2018. At the time, oil prices were consistently above $60 and often reached as high as $70.
At current prices, we expect a slight reduction in the number of oil rigs but not a dramatic decline. We believe oil prices will remain between $55 and $65 for the time being - barring any geopolitical risks.
The US Dollar has been strengthening relative to both major currencies and emerging market currencies. The Fed's tightening cycle had the effect of strengthening the dollar, which now might come into question with the next rate move likely to be down.
We believe we will see a reversal of this dollar strength in the short-term with foreign exchange rates also being affected by what is going on with each of the other respective currencies.
The Euro and UK Pound, for example, have been weakening amid the disaster of Brexit and the uncertainty of it's timing and impact on the European and British economy.
Relative to EM currencies, the dollar has also strengthened with only the Korean Won and Chinese Renminbi remaining at levels comparable to ten year ago. All other currencies have weakened considerably over the last 10 years with the Brazilian Real and Russian Ruble both declining the most relative to the USD.
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