So, do you want what’s interesting or what matters?
(this is an excerpt from our June 11 flagship report)
Just because something creates a headline, doesn’t mean that it is market moving. Just because you have numerous stories all worthy of the front page of the FT or WSJ doesn’t mean that we are in for a change to the status quo. Between trade, G7, the North Korean summit, meetings by the Fed, ECB and Bank of Japan, it would be easy to believe that this could be a transformative week for global assets. The reality is something more benign, as taking all these factors individually, no one issue is likely to shock investors and therefore won’t alter equities, rates, or the USD from the ranges / trajectory / volatility profiles that have prevailed over the course of 2018. Is all this really interesting?? For sure, but market moving? I don’t think so.
What matters to markets is growth, interest rates, and the value of the USD. US growth remains strong and we are seeing US 10-year yields pushing back toward 3%, a level where equities have faced headwinds. I see nothing different this time around. Developed market equity exposure should be trimmed as the SPX approaches 2800. The USD range for the year looks 90-95 on the DXY, so the USD looks capped. EM market currency pressure could ease a tad, especially if the strength of the Brazilian Real on Friday is any guide. If USD momentum runs out of steam, then EM stocks can start outperforming US and European indices.
What isn’t relevant?
Let me state again that determining what is interesting versus what truly matters can only be judged by the value of hindsight, but history can be our guide and using this metric, a lot of the news flow that is clogging our inbox will prove to be irrelevant:
- G7, G6+1, or whatever it is called this weekend is an historical yawn and for all of President Trump’s determination to demean America’s standing the world, a broad message condemning the US on trade isn’t going to matter to the USD, yields or equity returns. The spat between the President and Canadian Prime Minister Justin Trudeau shows the lack of civility that exist amongst US allies. Toxic? Yes!! Market moving. Not until trade flows start to significantly affect global growth.
- Trade concerns are not going to slow growth for the next few quarters, even if the rhetoric deteriorates and further tariffs are announced. European auto tariffs would be bad for global sentiment, even worse for the likes of BMW and Daimler but unlikely to derail the current path for markets. SPX down 2%-3% on this news? Probably but this will only reinforce the narrative that technology is a defensive sector (more below).
- The June 12th summit between Kim Jung Un and US President Donald Trump is nothing more than theatre and it is difficult to see how the official commentary from both camps isn’t positive, even if the media interpretations will be more skeptical. I stole this chart from the WSJ Daily Shot on Friday that shows that Korean equities have been sold aggressively after previous North Korean summits (Six Party Talks), so historically, these have been turning points in the outlook for Korean equities. The beta impact on global assets will be zero if the event goes well and temporarily negative if it goes poorly. All the good news, from a geopolitical standpoint, appears to be in the price. Therefore, we will cover half our Long Kospi trade.
- June 7th, Brazil was heading to the abyss. On June 8th, the currency was having its largest rally in three years. Is Brazil going to stop a St. Louis fund manager from buying Amazon? No, so Brazil volatility doesn’t matter either.
- This applies to the entirety of emerging markets and idiosyncratic problems they have with certain EM economies. Turkey, Mexico etc., aren’t going to break global asset markets out of the prevailing range.
- While the Fed always matters, the relevance of the Federal Reserve is reduced currently. Allow me to carefully explain this. US growth is strong, and the Fed will continue on its path of tightening policy every other meeting. We will get signals from the economic data whether or not growth is slowing to such an extent that the Fed will signal a pause in its tightening trajectory. Therefore, the Fed will respond to the same data we are witnessing. Hence, a change in tack should be well telegraphed.
Here is what does matter
- US growth is on fire and therefore, stocks aren’t correcting more than a couple of percent before finding support by investors who have some cash to put to work and can recognize that the US economy is booming. The course of the Fed is well and truly established and as stated above, we will see the same signals of growth slowing, when that happens, as the Fed does and therefore we will be able to get a handle on when the Fed is planning to stall. Given we remain well below neutral, the Fed is not slowing the tightening cycle while growth remains as firm as it is. Take a listen to my discussion with former Federal Reserve economist and Peterson Institute fellow, David Stockton and his constructive outlook for US growth. (Replay here)
- Right or wrong, technology stocks are viewed as defensive and the best tech stocks are in the US. NASDAQ will keep outperforming until something changes regarding growth, rates or an unexpected and dramatic acceleration towards technology regulation, which seems unlikely.
- Italian concerns won’t turn into an issue for global risk assets until “budget busting” legislation is put up in front of the Italian Parliament. This could take a few months. Bills covering the winding back of pension reforms, a universal basic income, and a two-tier tax code, if passed, could see the Italian deficit go to 6% of GDP in short order and this will put Rome on a collision course with Brussels, the ECB and global ratings agencies. This is the biggest risk I see to financial assets in the later stages of 2018. Other populist measures such as anti-immigration legislation, as abhorrent as I believe it is, isn’t going to matter to markets. Use President Trump as your guide. Financial markets do not have a social conscience.
- The strength of the US economy has the potential to give the Republican Party in the United States the opportunity to do much better in November’s mid-term elections than the consensus believes. It is assumed by many that the Democratic Party will retake the House of Representatives and thus has the ability to stall the legislative agenda of President Trump. If the Republican Party is able to hold onto the House, investors would rejoice, and equity multiples would likely expand. My dislike of President Trump is well documented, but it is impossible to argue that the continued strength of the US economy is in no small part to his policy agenda (ex-trade). For all his abhorrent behaviour regarding Russia, women, migrants and American citizens who don’t look like him, many voters will reward him for his handling of the economy.
In short, I do not see much on the near-term horizon that will see markets alter the path they have set themselves throughout the course of 2018.
- Tech will continue to outperform.
- Developed market equities will run out of steam and face selling pressure if US 10-year bond yields go back above 3%.
- A benign inflation outlook will see rates capped at the 2018 highs in all developed markets.
The USD Index, DXY, will be stuck in a range of 90 – 95, the Euro is 1.15 – 1.22 depending on Italy and USDJPY is 105 -111. While certain emerging markets face headwinds, the underperformance of emerging market equity will soon come to an end. Mexican political risk is clearly defined because the election of leftist candidate Andres Manuel Lopez Obrador looks assured. Yes, NAFTA could prove to be a concern because of the unpredictability of President Trump but in general, there is little about Mexico that can surprise us. Turkey is a worry, but won’t lead to contagion, especially in Asia. Long EM equity vs short developed market equity will emerge as a strong strategy in the latter half of 2018.
In summary, markets reacted to changes in the prevailing narrative. For all the headline risks that we face, there are no real surprises on the agenda. Relations between the US and her long held allies is getting worse but we have been traveling down this road for 18 months, so this should be a surprise to anyone. Markets haven’t responded negatively before so why now? Trade has been a non-issue for investors and will continue to be while US growth remain strong and the dominant narrative.
With strong US growth providing cover for all the negative global headline, the cap for risk assets comes in the form of US 10-year yields heading back to 3%. It has created headwinds for risky assets since yields and volatility spiked in February. There is nothing that I see that implies that this won’t happen again. So, the trade for the next several months is to assume 2018 ranges hold and to fade the tops of ranges in US yields, the USD and equities:
- Sell USDJPY at 110.75
- Buy US 10’s at 3.10%
- Sell SPX at 2800
- Sell European equity into a 2-4% rally
- Buy emerging market equities over developed as the USD fails to trade above 95 in the DXY.