Despite a rocky mid-point, precipitated by the infamous “tweet heard around the world” on May 5th, when President Trump once again pivoted to a more bellicose stance in the trade war with China, global equities eked out a solid gain of 3.6% during 02. Coincidentally, Fed Chair Jay Powell indicated that they were open to cutting interest rates (at a conference in Chicago on June 4th),in response to declining inflation expectations and further evidence of slowing global growth.

Among developed markets, European equities were boosted by a more dovish pivot by the ECB whilst Japanese equities continued to face headwinds from declining global trade and a poor fiscal environment. Meanwhile, the overvalued U.S. dollar went nowhere; caught in the crosswinds of unfavorable structural dynamics (growing twin deficits and poor valuation), a favorable cyclical tailwind from superior U.S. growth and a U.S. administration clearly focused on jawboning the dollar down. Oil prices declined by almost 3% during the quarter as markets continued to work through the lingering effects of last year’s tightening in financial conditions, which, along with extended angst over Sino-U.S. trade tensions, slowed commodity demand.

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Q2 2019 in Review

Despite a rocky mid-point, precipitated by the infamous “tweet heard around the world” on May 5th, when President Trump once again pivoted to a more bellicose stance in the trade war with China, global equities eked out a solid gain of 3.6% during Q2. Coincidentally, Fed Chair Jay Powell indicated that they were open to cutting interest rates (at a conference in Chicago on June 4th), in response to declining inflation expectations and further evidence of slowing global growth.

Among developed markets, European equities were boosted by a more dovish pivot by the ECB whilst Japanese equities continued to face headwinds from declining global trade and a poor fiscal environment.  Meanwhile, the overvalued U.S. dollar went nowhere; caught in the crosswinds of unfavorable structural dynamics (growing twin deficits and poor valuation), a favorable cyclical tailwind from superior U.S. growth and a U.S. administration clearly focused on jawboning the dollar down.  Oil prices declined by almost 3% during the quarter as markets continued to work through the lingering effects of last year’s tightening in financial conditions, which, along with extended angst over Sino-U.S. trade tensions, slowed commodity demand.

The performance of global equites in the first half of the year (+16.23%) is consistent with our commentary in the last two Market Outlook reports, which projected a late cycle rally.  The question is whether the strongest period might now be behind us? We think it probably is for U.S. equities, though in the short-term they could still be modestly boosted by “insurance” interest rate cuts by the FOMC.  In our Q1 and Q2 Outlooks this year we projected that performance leadership will shift from the U.S. to the rest of the world (RoW) during the second half of the year and we continue to believe that such a pivot will occur, particularly if the dovish pivot by major central banks materializes into actual policy.

Stock Market is a Better Near Term Forecaster

Much has been written about the contradictory messages being heralded by the bond vs. stock markets.  Whilst the stock market continued to climb a wall of many worries, since May the yield curve has inverted, with 10-year yields falling from 2.5% to 2.0%, seemingly heralding a darker near-term outcome (see Chart 1 on the next page). In this instance, we believe that the stock market is a better near-term forecaster. The key change which reconciles the message being sent by the bond market vs. the stock market is that inflation expectations have unhooked from growth and unemployment trends (see Chart 2). Chairman Powell’s dovish tilt suggests the Fed has now done the same thing with monetary policy. Consequently, given the bond markets’ increasing focus on what the Fed will do with short-term interest rates, yields tell us little about U.S. growth prospects or recession risks.

Inflation expectations are in turn highly correlated with oil prices (see Chart 3). Much of the current oil-price volatility is being driven by worries over damage to aggregate global demand, growth expectations in the wake of the Sino-U.S. trade war, and by what now appears to be a too-aggressive posture by central banks attempting to begin normalizing rates last year. In 2H19, we believe that accommodative global monetary policy and fiscal stimulus will revive demand for oil, particularly in EM economies. On the supply side, this week’s extension of OPEC 2.0’s production cuts into 1Q20 means supply growth will remain constrained. Prices should rise, and forward curves, particularly for Brent, should steepen as refiners are forced to draw inventories to meet product demand. This is a key reason why we believe that U.S. equity investors are too optimistic on the path of interest rate cuts by the FOMC.  Bond markets are pricing in 75 bps of interest rate cuts by the end of 2019 and 25 bps in 2020.  We expect a much more modest 50 bps insurance interest cut in 2019, akin to what the FOMC did in the mid-1990s.

RoW Performance Leadership Hangs on China

Our expectation that performance leadership will shift to the rest of the world in the second half of 2019, is based on our belief that China’s growth slide is bottoming and that, at least in the short term, the policy uncertainty from the U.S.-Sino trade imbroglio will be diminished because both sides need an apparent “win”, even if it does not substantively address their underlying strategic fissures.  

That said, the volatile Caixin Manufacturing PMI dipped below 50 and both the manufacturing and service indices weakened in June (see Chart 4 on the next page).  As mentioned in our 2Q 2019 Outlook, historically it has taken 6 to 12 months before the effect showed through via a rebound in global trade, commodity prices, and other China-related indicators.

While the authorities are once again boosting infrastructure spending by allowing local governments to issue special bonds (as exhibited by the material increase in social financing in Chart 5 on the next page), their clampdown on shadow banking also remains important.  Notably, “Entrusted Loans,” which typically are off-balance sheet, have declined, suggesting that despite the policy pivot towards reflation, balance sheet repair and deleveraging remains an important. The net effect of this is that non-state owned private companies remain starved for credit as well as a more nuanced reflation approach. We expect a more muted policy impetus to global trade and commodities than in 2016.

Mixed Messages on the EM Earnings Front

Across the emerging world, earnings and valuations are yielding mixed messages (see Chart 6 and Chart 7). Korea’s forward earnings outlook appears dismal and insufficiently punished by the market, despite underperforming the rest of EM by -10% in the past twelve months. Yet in June, Korea was among the best performing markets worldwide gaining 8.8% vs 6.5% for the rest of the world). Meanwhile, China’s -8% underperformance vs EM over the past year has coincided with a modest multiple contraction amid an earnings outlook that was not nearly as bearish as Korea’s. Latin America’s recent performance appears broadly in line with earnings expectations, thus showing signs of recent market efficiency. India shines as a lone bright spot among the major emerging markets where forward expectations are ahead of trailing performance, yet Indian equities have nonetheless lagged EM and the rest of the world YTD.

Geopolitical Tail Risks

Finally, despite our expectation of a continued late cycle rally which will pivot to non-US markets, geopolitical tensions remain a wild card that could abruptly disrupt this late cycle rally. The chief short-term risks emanate from simmering tensions between Iran and the U.S. as well as a no-deal Brexit in the fall.  The most important long-term risk remains the strategic rivalry between China and the U.S., despite yet another climb-down by the President at the G20 meeting in Japan. The good news is that actualizing the risks is not in the rational interest of any of the principal actors in all three scenarios.  President Trump does not want another unpopular war in the Middle East, particularly against Iran, which would require boots on the ground.  While China is a bi-partisan bogeyman that fires up the base, the risks of further escalation would stymie the all-important stock market yardstick, which the President cares deeply about. Finally, neither Iran nor China, despite bellicose nationalist rhetoric for domestic consumption, desires a full-blown armed conflict (in the case of Iran) and trade war (in the case of China). While both the EU and Boris Johnson (the leading candidate for leadership of the UK Conservative Party) are incented to publicly portray a more rigid negotiating stance, neither party benefits from a no-deal Brexit; so, the most likely course may be yet another delay.

Q3 2019 Forecast

For Q3 2019, we are moving the dial towards cyclical sectors and markets.  We maintain our neutral position to U.S. equities. We have reduced our overweight to the defensive Swiss market in favor of an increased weight to core European markets, which are more exposed to China reflation.  Despite the expected increase in the VAT, we maintain a neutral weight to Japan because of a more attractive earnings profile; Japan would also benefit from Chinese reflation.  Additionally, we have put on overweight to Australia, which should benefit from both monetary accommodation and China reflation.

As shown in Table 2 on Page 5, we are neutral to emerging markets.   Within emerging Asia, we remain neutral to China. Despite our incrementally constructive view on Chinese economic activity, we prefer to express that through DM equity plays. We have reduced our overweight to Korea amid a bearish earnings outlook and maintain a neutral weight to India from our long-time strategic overweight as the market settles into a post-election trading range and near-term economic data could surprise to the downside.  We retain an overweight to Thailand whose financial profile is less exposed to U.S. dollar liquidity and also trimmed further our long-time overweight to Russia. With respect to LatAm, we cut our overweight to Mexico and shifted to an overweight in Brazil as favorable inflation dynamics continue to lower the cost of capital in Brazil that should accrue to corporate earnings.  We expect continued progress on pension reform in Brazil, though we could look to exit the trade at signs of overexuberance in the market. 

 

Although there are precious few signs of improvement in global trade and manufacturing, we retain a more balanced allocation between Defensive Sectors and Cyclical Consumer Discretionary and other Late Cycle sectors.  We continue our overweight to Energy and Industrials.  Our perspective on oil prices was discussed previously. The industrial positions are largely thematic; made up of European Defense companies (a play on increased geopolitical uncertainty) and Chinese environmentally focused companies.  Please See Table 3 on page 6 for our sector and style positioning).

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