Gravity-Defying Rally Trips on Tariff Tightrope

June 11, 2019

The re-emergence of heightened volatility since the beginning of 2018 is a reminder that one should always expect the unexpected when it comes to investing.

Monthly Snapshot 

  • During May, the early-year global rebound in stocks came to a halt and government-bond yields declined in the U.S., U.K. and Europe.
  • The U.S. announced an escalation in tariffs on Chinese imports, delayed a decision on auto import tariffs, exempted Canada and Mexico from steel and aluminum tariffs, and then imposed immigration-linked tariffs on Mexico.
  • There’s no denying that a synchronized global growth slowdown is underway — but that does not mean the global economy is in (or near) recession.

The early-year global rebound in stocks came to a halt during May. Emerging-market equities were hit hard, particularly China, and cyclical sectors around the globe tumbled sharply alongside oil prices. Government-bond yields declined in the U.S., U.K. and Europe; the 3-month-to-10-year spread on Treasurys turned negative again after briefly inverting in March, prompting renewed speculation about the reliability of this fairly dependable recession indicator.

Prime Minister Theresa May announced on May 24 her intention to resign in early June following a poor showing for Conservatives in European Parliamentary elections. May’s inability to establish sufficient support for her Brexit deal or a viable alternative had become an impasse, and her recent overtures for a second referendum alienated a large subset of her party’s leadership. Since May’s announcement, more than a dozen candidates have announced plans to run as her replacement. Former foreign secretary and prominent Brexit proponent Boris Johnson was polling ahead of other candidates, offering campaign assurances that he would steer the U.K. out of the EU by the Brexit deadline of October 31 — with or without a deal.

Elections for European Parliament exposed support for centrist parties shifting toward more polarizing alternatives on the left and right. Concerns about the impact of climate change bolstered the Green Party alliance, especially in Germany, where it outpaced the Social Democratic Party (which serves as the junior partner in Chancellor Angela Merkel’s coalition government). Euro-sceptic nationalist parties also fared well, particularly in France and Italy, where they earned a plurality of votes.

The U.S. announced an escalation in tariffs on Chinese imports in early May as a trade delegation was headed to Washington, DC, and talks appeared to be in advanced stages. Tariffs on $200 billion of Chinese imports were increased from 10% to 25% (joining $50 billion of Chinese imports that have been taxed at 25% since 2018). The Office of the United States Trade Representative also proposed additional tariffs of 25% on the remaining $300 billion in U.S. imports from China, which could take effect in the coming months. China responded with plans to raise the tariff rates on about $60 billion of imports from the U.S. in June.

Elsewhere, the EU and Japan temporarily avoided tariffs on U.S. imports of their automobiles. President Donald Trump opted to delay a decision on import taxes in favor of trade negotiations with a limited six-month window. Mexico and Canada were extended temporary relief from broadly-applied U.S. tariffs on imports of their steel (at 25%) and aluminum (at 10%) as the Trump administration prepared to seek congressional approval of the United States-Mexico-Canada Agreement. The honeymoon was cut short for Mexico, however, with Trump’s late-month announcement that there will be 5% tariffs on all goods imported from the country beginning in June — until it stops illegal immigration across the southern U.S. border (an eleventh-hour agreement averted the tariffs). These immigration-linked tariffs are set to escalate by 5% on the first day of each subsequent month until reaching 25% in October.

The Federal Open Market Committee and the Bank of England’s Monetary Policy Committee held their respective meetings at the beginning of May; both declined to adjust their policy paths. Neither the European Central Bank nor the Bank of Japan convened monetary policy meetings during May.

Economic Data

  • U.S. manufacturing and services growth continued to decelerate in May, representing a precipitous slowdown — especially the services sector, which was strongly expanding through the end of the first quarter. The U.S. economy grew at a 3.1% annualized rate during the first quarter, based on a slight downward revision in the latest estimate.
  • U.K. manufacturing activity tipped slightly into contraction during May, as the respectable growth exhibited during April evaporated. Services sector activity remained modestly within growth territory. Labor-market conditions were firm in April, with the claimant-count unemployment rate holding at 3%; the broader January-to-March unemployment rate edged down to 3.8% (from 3.9%), while average year-over-year earnings growth eased to 3.2% (from 3.5%) in the three-month period.
  • Eurozone manufacturing conditions contracted in May for the fourth straight month. Services sector activity continued to expand, albeit at a slower pace. The eurozone unemployment rate edged down to 7.6% in April, primarily thanks to a large decline in Spanish joblessness.

Portfolio Review

The May selloff in U.S. stocks fell disproportionately harder on smaller-company stocks. Value and growth performed roughly the same in large caps, but value lagged among small caps. Our core large-cap strategy was challenged in May partially as a result of underweights to the real estate and utilities sectors, which each performed relatively well given their insulation from growth- and trade-related concerns. Stock selection in consumer staples also detracted, while an overweight to healthcare was beneficial. Our core small-cap strategy performed well considering the U.S. equity selloff. Strong selection within information technology, consumer discretionary and communication services contributed. An underweight to energy also helped, while an underweight to real estate detracted. Overseas, our international developed-market equity strategy lagged a bit in an environment that favored international developed stocks over U.S. equities. Selection in materials and the consumer sectors were the most significant contributors, although an underweight to consumer staples partially offset the favorable impact. Selection in communication services, energy and industrials were the most sizable detractors; an overweight to information technology also hurt, but this was mitigated by solid selection within the sector. From a country standpoint, selection in Japan contributed and an allocation to China detracted. Our emerging-market strategy performed in line with the benchmark during May, generating a significant boost from selection in consumer discretionary. Overall positioning in consumer services detracted, as did selection in materials and energy. Regionally, an underweight to China was the most beneficial active positioning, while allocations to North American stocks that have emerging-market exposure were the greatest detractors.

The high-yield market was the lone negative performing segment of the fixed-income universe in May — but our high-yield strategy performed relatively well in this risk-off environment.

Our core fixed-income strategy performed in line with its benchmark during May as U.S. investment-grade non-government fixed-income sectors trailed comparable U.S. Treasurys. Modestly long duration positioning contributed as yields declined, and an overweight to the long end of the yield curve helped. A slight overweight to corporate credit detracted as spreads widened during the second half of the month following four consecutive months of tightening; this unfavorable overweight was somewhat mitigated by its focus on financials, which outperformed industrials and utilities. An overweight to asset-backed securities (ABS) contributed, but was partially restrained by an allocation to student loans. An overweight to agency mortgage-backed securities (MBS) detracted, as did a higher-quality bias within commercial mortgage-backed securities (CMBS). Underweights to the strongly-performing non-corporate sector and taxable municipal bonds also hurt. The high-yield market was the lone negative-performing segment of the fixed-income universe in May — but our high-yield strategy performed relatively well in this risk-off environment. An allocation to collateralized loan obligations (CLOs) provided the lion’s share of outperformance, followed at a distance by an underweight to energy and selection in services. Relative gains of the strategy were partially offset by weak selection in basic industry, technology and electronics, as well as overall positioning in capital goods. Our emerging-market debt strategy slightly underperformed its blended benchmark in a low-return environment where foreign-currency-denominated debt fared better than local-currency debt. An overweight to short-term local Egyptian bonds continued to add value amid a strong economic recovery in Egypt. An overweight to China detracted, however, given concerns about the country’s trade with the U.S., its slower economic growth, and the decline in its currency (the renminbi).

Major Index Performance in May 2019 (Percent Return)

Major Index Performance in May 2019 (Percent Return)

Sources: FactSet, Lipper

Manager Positioning and Opportunities

We are cautious as U.S. equity valuations appear a bit elevated and volatility once again has become more common. Economic activity and corporate earnings continued to increase, but there are indications that the biggest increases are in the past. Our core large-cap strategy remained underweight some of the largest-capitalization stocks in favor of more attractively-valued opportunities further down the capitalization spectrum. Additionally, it was underweight utilities due to their interest-rate sensitivity, high-debt balance sheets, and low profitability. While May was a difficult month for small-cap cyclical value, we continued to prioritize its exposure (followed by stability) in our core small-cap strategy. We also maintained our relative underweight position in momentum. Our international developed-market strategy retained overweights to technology and communications services, consistent with our focus on the secular growth of internet and digital-services adoption around the globe. We were also slightly overweight to financials and energy, and underweight to defensive sectors such as telecommunications and utilities. Our emerging-market equity strategy was overweight technology and industrials given the long-term growth prospects of the sectors (in our view). The strategy’s largest underweight was within financials due to concerns about China’s state-owned banks; similar concerns drove our underweight to real estate.

Our core fixed-income strategy’s duration posture moved from approximately neutral to slightly long, as interest rates were trading in a narrow range before sliding in May. We added exposure to the front end of the yield curve given the Federal Reserve’s (Fed) recent dovishness, and remained overweight the long end of the curve as we expect inflationary pressures to gradually advance. We continued to modestly overweight to the corporate sector, although our overweight to banking was reduced on narrowing spreads; we also selectively added in the new-issue market. Overweights to ABS and CMBS remained, with an emphasis on higher-quality exposures given their competitive risk-adjusted yields. We maintained an allocation to non-agency MBS and an overweight to agency MBS. Our high-yield strategy’s largest active positioning remained a strategic allocation to CLOs; its most significant overweights were within leisure and retail. The largest underweight was within energy, followed at a distance by banking, services, financial services and capital goods. Within emerging-market debt, our strategy was overweight to local-currency assets. Its top country overweights were to Argentina, Egypt and Nigeria, while its top underweights were to the Philippines, Taiwan and Indonesia.

Fixed-Income Performance in May 2019 (Percent Return)

Fixed-Income Performance in May 2019 (Percent Return)

Sources: FactSet, Lipper. See “Corresponding Indexes for Fixed-Income Performance Exhibit” in the Index Descriptions section for more information.

Regional Equity Performance in May 2019 (Percent Return)

Regional Equity Performance in May 2019 (Percent Return)

Sources: FactSet, Lipper. See “Corresponding Indexes for Regional Equity Performance Exhibit” in the Index Descriptions section for more information

Our View

There’s no denying that a synchronized global growth slowdown is underway. However, it does not mean that the global economy is in (or near) recession. China and the U.K., for example, are the second and fourth worst-performing countries, respectively, according to the Organisation for Economic Co-operation and Development’s composite leading indicators. Yet China continues to post gross domestic product growth in the vicinity of 6%, while the U.K. recorded an increase of 1.3% last year (both in inflation-adjusted terms).

The spread between 3-month and 10-year Treasurys turned convincingly negative in May after narrowing throughout much of the expansion. Recession historically occurs within 12 to 18 months of the yield curve either narrowing to 25 basis points or inverting. The only time recession did not follow a yield-curve inversion was during the 1966-to-1967 period—although U.S. economic growth did slow dramatically.

Deeper recessions usually cause sharper share-price declines (as was the case in 1973). More expensive stock markets (as seen following the 1998-to-2000 tech bubble) also are more vulnerable. But the time between an initial yield-curve inversion and the emergence of a bear market can be extremely long.

By stressing patience and data dependence, the Fed’s change in rhetoric at the start of the year certainly has been a helpful catalyst in sparking the risk-asset rally and credit-spread narrowing. The central bank’s decision makers approvingly noted that the benefits of the long economic expansion are finally being distributed more evenly as the labor market tightens; they seem confident that the economy can grow without generating worrisome inflationary pressures, even as most measures of labor-market activity point toward accelerating wage inflation.

We see plenty of opportunities in emerging equities as investors gain confidence that the worst is behind us for the asset class. But a sustained improvement depends on better global growth. In our view, China is the linchpin; we are optimistic that the country’s economic conditions will improve as it begins to feel the lagged impact of easier economic and monetary policies. We also expect domestic political pressures will likely force the Chinese government to ease further. Those political pressures certainly have influenced China’s trade discussions with the U.S. Meanwhile, Trump is grappling with similar pressures; he does not want the U.S. economy to sputter or the stock market to turn down as the country heads into a presidential election year. To put it bluntly, the leaders of both countries need a “win.”

Global Equity Sector Performance in May 2019 (Percent Return)

Global Equity Sector Performance in May 2019 (Percent Return)

Sources: FactSet, Lipper. MSCI ACWI Index Components (as defined by SEI)

While it may seem like a remote possibility today given the recent acrimony between the U.S. and China, an expansive trade agreement would provide a much-needed boost to the Chinese economy. It also would benefit nations that have high export exposure to China, both directly and through the supply-chain network. MSCI Emerging Markets Index performance will depend on the economic fortunes of China, South Korea and Taiwan, which now account for 54% of its market capitalization.

Investor pessimism about Europe appears overwhelming. The European Central Bank recently cut its forecast for 2019 eurozone gross domestic product growth to 1.1% from 1.7% just three months earlier. It’s a wonder that the year-to-date performance of European equities managed to nearly keep pace with that of U.S. equities.

Many of Europe’s problems are structural and difficult to improve. Its demographic profile, for example, looks rather bleak. Europe is the only major region where the population is expected to contract between now and 2050. The unemployment rate for Europeans aged 25 to 29 is still in double digits (by comparison, the average annual unemployment rate in the U.S. for this age group is approximately 4%). Of course, demographics alone do not explain Europe’s poor economic performance. A well-developed welfare state has its costs in the form of high taxation, extensive work rules, and regulations.

The shadow of a looming trade war with the U.S. surely hasn’t helped sentiment in Europe. European autos appear safe from tariffs for the time being, but headline risks may continue to have negative impacts — and it’s still possible that Trump will turn his full attention to trade with Europe once his administration concludes negotiations with China. Speaking of which, China’s slowdown is an additional factor behind the slide in Europe’s exports. Not only was European industrial production in decline for the 2018 calendar year, but it started this year 23% below its January 2008 level.

In our view, the best-case Brexit scenario is one in which the U.K. maintains close ties to the EU through a customs union. Failing that, now that voters have a better understanding of the costs and consequences of leaving, we think a second referendum either on Brexit alternatives or on Brexit itself makes sense. However, a referendum on reversing Brexit would risk further political upheaval given the number of people who still support the divorce. It would be nice to say that a no-deal Brexit is off the table, but it may have actually increased with Prime Minister May’s approaching resignation.

The re-emergence of heightened volatility since the beginning of 2018 is a reminder that one should always expect the unexpected when it comes to investing.

The uncertainty surrounding Brexit outcomes and timing remains a depressant for economic growth in the U.K. and the rest of Europe. Bottom-up analysts expect U.K. earnings to decelerate to just 1.8% in 2019, which is in stark contrast with last year’s surprisingly strong rate of 10.9%.

The re-emergence of heightened volatility since the beginning of 2018 is a reminder that one should always expect the unexpected when it comes to investing. Cash was king in 2018, providing a 2.1% return, according to the ICE BofAML USD 3-Month Deposit Offered Rate Constant Maturity Index. However, cash was consistently one of the worst performers in most other years going back to 2009. Emerging-market equities fell at the other end of the performance spectrum in 2018, sustaining a total-return loss of 14.6% — but was the strongest category in 2017 and posted a double-digit return in 2016.

In a world where the best- and worst-performing asset classes tend to dominate the headlines, it can be easy to forget that diversification has historically been the most reliable approach for meeting long-term investment goals — especially when looking through the lens of risk-adjusted returns.


Global Indexes and Investing Terminology

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