Monday, May 20, 2019

What Comes Next?

Monday, May 20, 2019 - Trade issues and likely Fed easing dominated the news last week as US Equity Markets struggled to regain from Monday’s sell off and ended the week mixed. The large cap weighted S&P 500 closed at 2859.53 and the broader NASDAQ Composite closed at 7816.28 for a weekly loss of - .76 % and -1.27%. While investors are focused on day-to-day tit-for-tat tariff retaliations between the US and China and the apparent breakdown in talks at the diplomatic attache level, the POTUS indicated that he believed we would get thru this bump when he meets Premier Xi at the upcoming G20 Meeting at the end of June. Investors should plan to bring the connected devices to the beach as news events are likely to provided trading opportunities.

US Investors seem to discount the significance of last week’s new restrictions on US companies doing business with Huawai. These restrictions are designated as critical to national security. This has been met with strong criticism among the public in China which ends up restricting Xi’s ability to provide concessions in any trade deal on difficult topics like protection of IP and forced technology transfers.  China is very sensitive to either Japan or the US restricting their ascendance.

Now given more trade restrictions are likely to slow down the economy as well as damper investors’ enthusiasm to buy stocks since corporate earnings are likely to suffer, the upcoming Fed June 18th meetings become more critical for investors.

All of this led us to call upon our friends at DataTrek Research, Nick Colas and Jessica Rabe to get their view of what we should expect going into the end of Q2 given this confluence of complex events. Below is what they wrote us:

After a strong start to the year, global equities have lost some of their zip.  Here are Q2 returns-to-date for a variety of US and global stock indices in dollar terms:

S&P 500: +0.9%
Russell 2000: -0.3%
MSCI EAFE Index (non-US developed economies): -0.1%
MSCI Emerging Markets: -6.1%
MSCI All-World ex-US: -1.6%
Worth noting: the DXY dollar index has strengthened by 0.8%, but even correcting for that the MSCI EAFE Index has underperformed the S&P 500

At first blush, the outperformance of US large caps may seem anomalous since trade wars – the proximate cause of Q2-to-date volatility – should weigh on all risk assets to some degree.   That has not been the case and in the remainder of this note we will outline why this divergence exists and what it means for asset prices going forward.

There are 3 important dynamics to consider:

#1: Markets fully expect the Federal Reserve to cut short-term rates in 2019; this belief is both pushing long-term rates lower and supporting lofty US large cap valuations.

As of Friday’s close Fed Funds Futures discount a 73% chance that the Fed will have to cut its benchmark rates by at least 25 basis points before the end of the year. This market sees sub-par US inflation readings and worries about the economic uncertainties of a trade war as pushing the Fed to act, perhaps as soon as September.

Two-year Treasury price action is consistent with this point of view.  At a 2.20% payout, 2-years sport their lowest yields since Q1 2018. Ten-year Treasury yields, the risk-free rate that is the bedrock of US equity valuations, have fallen from their January 2019 highs of 2.79% to just 2.39% now on the same concerns.

Since Q1 US corporate earnings came in better than expected, renewed investor confidence in business profits combined with lower long-term rates has translated into resilient US large cap stock prices.  That’s how we end up with a 16.5x price/earnings multiple on the S&P despite only 3-4% earnings growth.

#2: US small caps (Russell 2000) have not fared as well in Q2 because their valuations are tethered to corporate high yield spreads.  The reason for that linkage: smaller growth companies often need access to outside capital to execute their growth plans.  High yield spreads are a proxy for both the cost of that capital and its relative availability:

The spread over Treasuries for US non-investment grade corporate debt stands at 4.06% today. This is notably higher than the 3.71% spread a year ago on this date as well as the 3.5% average of Q3 2018.

Given that we are in a very late part of the cycle and that the high yield/leveraged finance issuance calendar looks robust for the remainder of Q2 and into Q3, we do not expect high yield spreads to tighten any time soon.

#3: As for what’s going on with MSCI EAFE and Emerging Markets indices, that comes down to the fact that they are dramatically different animals from the S&P 500:

While the S&P 500’s official weighting to Technology sector may be 21%, remember that Amazon, Google, Facebook and other names are not in this category. Once you add in these and other names that are certainly “Tech” regardless of S&P classification, Technology’s real weighting in the 500 is 30%.

The MSCI EAFE Index, by contrast, is just 6% Technology.   Its heavyweight sectors are Financials (19%), Industrials (14%), Consumer Staples (12%) and Health Care (11%).  None, obviously, are as fundamentally attractive as US Tech shares and the two largest exposures – Financials and Industrials – are cyclical groups with negative operating leverage should the current expansion come to an end.

The MSCI Emerging Markets index does have similar Tech exposure (28%) as the S&P 500 once you perform the same adjustments as our first point, but most of that is in Chinese names. Tencent and Alibaba are 9.5% of MSCI EM, and those are primarily Greater China plays rather than having the broader global exposure of an Apple or Microsoft (the 2 largest names in the S&P at a 7.6% combined weight).

Summing up: global equity markets face largely the same fundamental trade-related risks for the remainder of Q2, but will likely continue to respond differently.  Large cap US stocks look the best insulated, buttressed by lower discount rates and resilient earnings. US small caps are no safe haven from the trade kerfuffle – their valuations ride on a late-cycle high yield market.  And for EAFE and Emerging Markets, we expect these two areas to have the greatest challenges.  Both may be cheap relative to US large caps, but valuation alone is never enough to make an asset class work.  For that, you need a catalyst.

And for the remainder of Q2, we suspect good news will be in short supply.

To keep up with Nick and Jessica’s views on the markets including cryptocurrencies and cannibis,  we urge you to check out their website at They have a generous trial offer which we encourage you to try out.

Thank you for reading the ETF Global Perspectives!

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