Submitted by Nick Colas of DataTrek Research
Today we have 3 suggestions for portfolio positioning in 2H 2019. First, overweight US equities; ever more negative global interest rates over recent weeks are a warning sign. Second, expect more volatility from late July (post Fed meeting) through October; seasonality and fundamentals align on this point. Lastly, be cautious on US small caps; they are more cyclical than large caps and are levered to financial conditions.
From a fundamental standpoint, nothing much good happened in the first half of 2019. Specifically:
- We didn’t get a US-China trade deal, and based on current press accounts we’re further away now than we were on January 1st. Moreover, bilateral tariffs are higher now than just a few months ago and apply to more goods.
- Corporate earnings growth has been slipping. For example, first quarter S&P 500 earnings were slightly negative as compared to last year. Analysts expect the same for Q2, and margins are lower than a year ago for both quarters.
- Slowing global growth. The export-driven German economy, long a bright spot in the Eurozone, likely slipped into contraction in Q2. Japan’s economy managed to post +2.2% GDP growth in Q1, but Q2 will almost certainly be slower. China’s economy has benefited from some easing of financial conditions, but trade tensions are clearly taking a toll as we start Q3.
But all this added up to a nice rally for global equities for the first 180 days of the year.
- The S&P 500 is up 19.3% YTD
- The MSCI EAFE (developed Europe plus Japan) is +12.6% in dollar terms
- The MSCI Emerging Markets Index is 10.0% higher in dollar terms
The reason for this seeming dichotomy: capital markets have reset their assumptions not just for current central bank policy but more importantly for long run “neutral” interest rates. Here is how that played out in 1H 2019:
- On January 4th, Fed Chair Powell morphed from hawk to dove. The reason: then-elevated US stock market volatility caused by US-China trade war uncertainty. Over the course of 1H 2019, markets have baked in expectations that the Fed will cut rates twice in the second half. Long-term rates have declined in sympathy, with the 10-year Treasury at 2.04% today versus 2.70% in January.
- But the truly important shift happened in late May, when German 10-year Bunds moved to new record low negative yields. That siren’s call, which grows louder by the day, is pulling global interest rates deeper into uncharted waters. As we have recently highlighted in these notes, over $13 trillion of global debt now “pays” negative interest rates and 25% of that is corporate (not sovereign) paper.
While the shift in Fed policy is cyclical, what’s going on outside the US is clearly structural and it is informing asset prices everywhere. A global economy awash in debt (both at record levels) is forcing both policymakers and markets to accept the fact that the neutral rate of interest is lower than either thought possible just 6 months ago. Fold in a global economic slowdown, necessitating a monetary policy response, and you get today’s ultra-low yield environment.
As far as what this means for making money in the back half of 2019, we have 3 suggestions:
- Favor US equities over all other geographic regions. At least American companies are still very profitable, which allows them to buy back stock, and the US economy remains stable. Yes, the S&P 500 is expensive at 17.1x forward earnings versus 12.1x for Emerging Markets and 13.6x for EAFE. But US markets also represent global best-of-breed companies, especially in Technology. There will be time for bargain hunting later, but now is not the time. That will come when global rates see their nadir.
- Expect to see significantly more global equity market volatility later in Q3 and through early Q4. Lower rates are juicing global stock markets just now, and that should continue through the July 31st Fed meeting. But both seasonality and common sense says ever more negative global interest rates are a storm flag, not a sign that says “come on in, the water’s fine”.
- Underweight US small caps. Recall that the Russell 200 is most heavily weighted to Financials and Industrials (15% apiece) where the S&P 500 is 13% Financials and just 9% Industrials. Further, about 30% of the companies in the Russell are unprofitable, necessitating access to outside capital which tends to grow scarce as markets wobble.
The bottom line here: in the first half of 2019 lower interest rates helped risk assets like stocks, but we feel that the second half will see some of erosion of that positive dynamic.