As The Tri Polar World Turns - June 2019
Markets are again caught up in a growth scare as weak US data coupled with continued trade tweets and a nationalistic China press combine to put investors in a funk. Perhaps we need to get used to such in a Lower for Longer Global Growth World? May was a rough month for risk assets as global equities & commodities declined roughly 5% for the month across ACWI, ACWX & the US, while EM equity fell 8%. Long duration UST on the other hand, seemed to rally on a day in & day out basis and are now very overbought. The UST 3M - 10Y yield curve has inverted again while the 2/10 YC has steepened somewhat to over 20 bps. The USD continues to be the dog that doesn't bark, rising slightly over the month. Keeping in mind the sharp risk asset run up from Jan thru April the pullback seems somewhat healthy (like swigging castor oil).
Are markets getting it wrong, conflating the catch down US economy deceleration we have highlighted with a ROW bottoming? Will the two Presidents meet at the end of June G20, will it accomplish anything? Since our last Monthly, the US has reversed its view that talks were going well on 5/10, then effectively blacklisted Huawei, leading China’s press to discuss cutting off the US from China’s rare earth exports & hamstringing the US tech sector. Most recently Pres. Trump threatened tariffs against Mexico for failure to deal with the migrant issue while his Admin opened antitrust investigations against many of the country’s biggest tech players. By firing the tariff cannon almost without discrimination while merging economic & national security issues the US would seem to be making for more difficult negotiations; tech antitrust worries are just the cherry on top of such a risk adverse sundae.
All of the above can be encapsulated in the 3Ts, a designation we first employed last year but are bringing back again. Could today’s 3Ts: Trump, Trade & Tech - Make Value Great Again? What do we mean by this? Simply that the combination of these multiple issues could lead to a reversal of two trends that have dominated equities since 2009 namely US and tech (Growth) led global equity markets. Making Value Great Again implies global equity leadership shifting from the US to the non US DM which are both tech light and in part as a result are Value plays.
Both US equity outperformance and the Growth - Value performance gap are at or approaching record wide levels. Yet in May, ACWX performed in line with the US equity market while US tech underperformed broad US equity. It's too early to say for sure but the US could be setting the stage for a colossal own goal. Given our Lower for Longer Global Growth outlook we continue to favor equity markets that have room for multiple expansion to add to what is likely to be muted EPS growth. If one can add possible currency appreciation to the mix as in Europe then all the better. (See Chart 1)
Chart 1: : 2019 EAFE EPS Best in Class
What could take risk markets from a healthy correction to an unhealthy one? A US Full Monty tariff imposition (25% tariff on full $500B of Chinese exports) could get us there by cratering US tech stocks which are most exposed & weakening the economy. China has made it harder for the US to agree to a deal given its 3 red lines of tariff removal, no one sided penalties and a stable # for China purchases. It all seems quite binary and dependent on Pres. Trump recognizing both that the US economy is weaker than Q1 GDP would suggest (May jobs data just most recent data point) and that the Full Monty + tariffs on Mexico would further weaken the US tech industry, the stock market and the economy, not exactly a great reelection platform. Yet the President may think he will have the Fed cutting rates to offset stock market weakness (a 2% SPY up day on Fed rumors is pretty telling) and he can stomach the rest. An Osaka “can kick” and no additional tariffs imposed while keeping China as a tweet topic through the election cycle seems most likely & somewhat priced in but the Full Monty is not.
ECONOMICS: While the world’s press seems to be in full Chicken Little mode of weak and getting weaker global growth, the data we look at seems to tell a different story. The China data flow remains consistent with growth stabilization while the Govt continues to highlight its capacity to do more should it be necessary. The IMF just finished an extensive review of China’s economy and lowered 2019 and 2020 GDP forecasts by a mere 10 bps (assuming no additional tariffs). Europe’s data flow remains mixed but the ECB’s updated forecasts actually raised 2019 GDP estimates from 1.1% to 1.2%.EU economic sentiment has ticked up for the 1st time in almost a year while industrial output & new orders have risen 2 months in a row. Inventory levels are at their lowest since April 2016 & new order levels have only been noticeably lower during the GFC, reinforcing the idea of a production bottom. (Chart 2) Inflation remains weak and well below target while the service/consumer side remains relatively robust. Japan’s data flow has been mixed though Q1 GDP was better than expected at 2% annualized, 0.8% y/y. Japan’s Q2-3 outlook should be supported by fiscal stimulus and a consumption pick up in front of the likely October VAT hike.
Chart 2: EU Composite PMIs Bottoming
The US data has been unambiguously weak on both the consumer and the production side. Durable goods, Manufacturing PMI, retail sales, job numbers etc have all disappointed and various regional Fed nowcasts suggest Q2 GDP of 1.5% with similar growth expected for Q3. Q1’s inflated 3% GDP is now being given back - the worry is that the press and some investors are extrapolating that process to a 2nd leg down for the global economy. We don't see it and continue to feel that absent the Full Monty tariff imposition China has bottomed, Europe is bottoming and the US will bottom late 2019 or early 2020. US inflation remains below expectations & rates continue to decline, pricing in a Fed rate cut, reducing the US yield pickup & perhaps setting the stage for USD weakness as suggested by the Euro move above 1.13 post May’s job numbers.
POLITICS: India, Indonesia and the EU had major elections in the past month and all went well though some violence was reported in Indonesia. Modi won reelection in India and the equity market rallied to new highs - whether he will take the tough policy choices necessary to set the economy on a strong growth path remains to be seen. In the EU the populist fever of the past few years has broken as the various parties got 25% of the vote vs 30% forecast; turnout was the best in 20 yrs at over 50%. Pro EU Green and Liberal parties did much better than expected suggesting that EU political risk may be overstated as the UER fell from 10.5% in 2014 (last EU wide vote) to 6.5% today.
It's now onto the handing out of top jobs where an appealing combo would be Liberal Party candidate Margrethe Vestager of Denmark as EC Pres. and Jens Weidmann of Germany as the ECB head. Given the rising threat of a tech Splinternet, Vestager’s expertise in the tech area would be a real asset while Weidmann helming the ECB may allow Germany to be more flexible on fiscal stimulus, banking union and the creation of an EU safe asset. This last point is quite important as the BUND gets driven to lower and lower levels and Germany’s banking sector implodes (Deutsche Bank at ATLs).
Theresa May has resigned as UK PM & the Brexit question remains wide open as the Tory party tears itself asunder, Labor fails to get out of its own way and Nigel Farage becomes the leading voice of Brexit. It's important to note that he has no voice in the UK Parliament. Next steps include: Tory leadership contest (thru July) and the EU exit deadline of Oct. 31st which the EU has said it will not extend. Morgan Stanley sees 5% chance of orderly Brexit, 25% Hard Brexit and 45% Remain.
In the US the field of Democrats running for President now numbers well above twenty while Pres. Trump holds the Republican Party in thrall. Very little is likely to get done in DC for the next two years as Speaker Pelosi slow walks impeachment, Pres. Trump goads the Dems and issues like infrastructure become reduced to anything but sound bites.
POLICY: US trade policy remains front and center with Fed policy and Beijing policy watching close behind. A late June meeting of the two Presidents in Osaka remains on the table but recent rhetoric from both sides suggests little can be expected from that meeting. A can kick now seems most likely though one worry is that the tariffs to date have not impacted US consumer confidence perhaps giving Pres. Trump more room to press China and the markets.
I continue to think a Full Monty is unlikely as US growth weakens by the day and US tech stocks get whacked while China reminds the US that it too has weapons, including a rare earth embargo that could really hurt the US. Europe sits in the middle as a powerful swing player, which is one reason why a Vestager candidacy makes a lot of sense. Europe is not buying into the US case vs Huawei suggesting that the US needs to tread carefully on the tech side.
Chair Powell’s recent comments suggest the market may be right to price in a Fed rate cut this year creating a funhouse effect of a deliberate policy choice (trade tariffs) to damage the economy in order to get the Fed to cut rates and help the economy. One rate cut in 2019 is now an 85% probability while a 2nd cut is given a 45% chance of occurring. The latter seems V unlikely minus a Full Monty, tech stock crash and near recession conditions. Nonetheless with the 2 yr UST bond roughly 50-60 bps under the FFR, monetary policy seems a bit messy in the US.
An insurance policy rate cut in Q3 does seem increasingly likely. What that does for the USD is an interesting Q, perhaps a Fed rate cut + clear signs of EU bottom will catalyze the (very) long awaited USD rollover. A more dovish Fed also opens room for the EM led, global easing cycle we have discussed for the past several months, one coming into focus as EMs,especially in Asia,start to cut with India being the latest. (Chart 3).
Chart 3: Global Easing Cycle to Offset Growth Fears
China seems to be holding its fire - doing very little to reply to the Huawei blacklisting for example other than some heightened press rhetoric. Kevin Rudd (former Australian PM and keen China watcher) suggests that the US belligerence has backfired as the Chinese lay out their red lines & announce their own Unreliable Entity List. It may be that both sides see the benefits of letting this play out and perhaps it becomes like Brexit, something in the backdrop but priced in on a slow boil basis.
MARKETS: Should additional tariffs be put in place Morgan Stanley suggests 5% downside SPY risk though this does not include Mexican tariff risk. Absent the Full Monty, the bulk of trade risk would seem to be priced in with various risk assets down significantly in May & displaying oversold characteristics. Perhaps as we saw last December those first in the firing line also bottom first. Morgan Stanley notes that equity positioning is light and the S&P just had its first 4 week sell off since 2014. Q1 EPS were better than expected across markets and EPS revisions remain upward facing in the US & bottoming elsewhere which should also be supportive while non US valuation is attractive. (See Chart 4)
Chart 4: Japan Equity: Best Sale in 25 Years!
Source: Morgan Stanley
Our Lower for Longer Global Growth path continues to lead us to equity markets with room for both earnings growth and multiple expansion which means primarily the non US DM. The case for EU equity suggests PMIs need to bottom, BUNDs need to rise and banks will do well. Work by JPMorgan’s European strategy team supports this point of view and points out that value is at a cycle low valuation wise vs growth. Japan’s companies have announced the highest level of stock buybacks in over 13 years while the chart above demonstrates Japan is trading at a 25 yr low relative to ACWI on a valuation basis. In EM, China has given back much of its gains and yet EPS estimates remain robust while the Govt remains focused on growing consumption internally. Recent conversation with China based equity managers reinforce the EPS point.
The very aggressive rally in long duration UST has been painful for those underweight duration. The rally would seem to have more than priced in a slowing US economy; JPM points out that investors are as long as they have been since 2010. Far from confirming a growth bottom in Europe, BUNDS have broken to new cycle lows. On the plus side, EU peripheral debt continues to rally with Greece 10 yr debt under 3% and Spanish 10 yr debt well under 1%. Even Italian debt has rallied notwithstanding concerns over budget and debt conflicts with the EC. China 10 yr remains at roughly 3.3% and in our view confirming its growth bottom while broad EM USD debt has held in well. US HY has yet to support the bearish economic outlook implied by the UST rally; the same can be said in Europe where European HY has failed to confirm the BUND rally suggesting both may be driven more by a flight to safety than fear of an economic recession.
Amidst all the global angst the dollar has made little headway while the Euro picks up some interest and breaks above the 1.13 level which it has not seen for several months The Yen has rallied a bit vs the USD as yen based investors sell to buy higher yielding offshore paper (mainly EU based) and offshore investors buy Yen for safe haven purposes. EM FX has been flattish the past few weeks and off less than 1% over the past month. The USD seems tired amid growing talk of Pres. Trump “weaponizing” it which in an Orwellian twist means weakening the USD. Lots of chatter around RMB 7.0 to the USD; in our view, China has pretty much complete control over the FX rate & the Govt has warned speculators they will lose money if they test the PBOC.
Commodities have been hit hard with oil off 12% over the month with base metals off 7%, copper off 8% etc. CFTC data suggests Copper short positions are at 4 yr highs while copper and copper miners have been upgraded at several firms in recent weeks suggesting that absent a Full Monty and another leg down much of the growth worry has been priced in. The upcoming OPEC meeting will be important for the oil market as US production leads to bulging inventories and falling prices.
PORTFOLIO STRATEGY AND ASSET ALLOCATION (GMMA)
We have made a fair number of portfolio changes this month in order to refine our portfolio positioning. Given the sharp market moves much of the investment universe was either overbought or oversold at the time of our portfolio meeting, limiting more significant moves. As we have seen so far in June much of that technical positioning is being unwound. We remain slightly overweight equity, underweight bonds and have moved to neutral alternatives & overweight cash.
Within equities, we remain OW the non US equity markets. Within the US we shifted our technology holding to focus on cloud/software and away from the big tech that is more exposed to trade issues and regulation. Also better software and systems in a Lower for Longer Growth world is a great space for companies to invest. Similarly we exited our Industrials position, replacing it with a very beaten down Energy sector position.
In Fixed Income we reduced our risk positions in both EM debt and US HY while adding a position in global equity Min Vol.
We reduced our Alternatives position to neutral by exiting our Industrial Metals position. We added to our cash positions as we await the economic & political signals noted above to add to our preferred risk positions.
GLOBAL MACRO SUITE PORTFOLIO CHANGES
Global Macro Multi Asset (GMMA)
Within equities, we sold our US Industrials position, replacing it with an Energy position. We also switched our US technology position to a more cloud based technology ETF.
Within Alternatives we sold our Industrial Metals position and added to our cash position.
Global Macro Income (GMI)
We exited our EM local currency and US Fallen Angel HY positions while adding a Global Equity Min Vol position.
Global Macro Equity (GME)
As in our GMMA equity sleeve we reduced our US Industrials position and added an Energy position while also mirroring the US tech switch.
We also increased our US Min Vol position
We introduced an EM ECommmerce position
We also exited our Alternative positions in both Industrial Metals and Energy MLPs.
We hope you find this monthly piece of value and look forward to engaging with you on a monthly and quarterly basis as we go thru 2019.
Jay Pelosky, CIO & Co-Founder
TPW Investment Management
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