July 2019 - Risky Assets End First Half on a Very Strong Footing
Risk assets rebounded sharply in June, reversing the selloff in May. The MSCI All-Country World Index rallied 6.6% on the month in $US terms, raising YTD gains to 16.6%. U.S. and European stocks led while Japan lagged. The rally was driven by very dovish central bank communications (which stand ready to act in the case of a slowdown) as well as a trade truce between the U.S. and China; during the G20 meeting President Trump agreed to hold off on imposing tariffs on $300 bn of Chinese goods, he lifted restrictions on Huawei and both sides will restart negotiations. Although both sides may still be far away from reaching a historic deal given the complexities of enforcing intellectual property rights and the Huawei issue, we turned more constructive on risk in the near-term and selectively added risk. We think that stocks can continue to break all-time highs, and credit spreads should continue to tighten. The main risk in the near-term stems from the market’s very dovish expectation for rate cuts by the Federal Reserve (60 bps of cuts priced in by the end of the year) which may not materialize.
The S&P 500 returned 7% in June, marking the best first half of the year (18.5%) since 1997. On a sector basis, cyclicals outperformed more defensive sectors (a reversal of the prior month): Materials rose 11.5% while Energy and Tech rose 9.1%. Underperformers were Real Estate (+1.3%) and Utilities (+3.1%). Tech remains the top performers YTD (26%) while Healthcare is the laggard (7%). We remain overweight U.S. equities given a superior economy relative to other DMs. Sectors we currently like are homebuilders (given low mortgage rates), consumer discretionary (given strong jobs market), semiconductors (on a tactical basis) and cloud computing/cyber security (given long-term growth prospects). We are less constructive on energy, materials, and industrials given slower global growth.
In Europe, the Euro Stoxx 50 index delivered total returns (including dividends) of 6.4% in June, raising YTD gains to 19.2%. Top performers within Europe Sweden (7.4%) and Italy (7.2%) while laggards were Spain (1.9%) and Ireland (1.2%). The region’s manufacturing index decelerated again in June (from 47.7 to 47.6) while German exports continue to disappoint. We have a marketweight stance on European stocks given relatively attractive valuations vs. European bonds and stabilizing earnings-pre-share projections but are cautious on countries and sectors dependent on exports such as Germany and autos.
Elsewhere, Japanese stocks underperformed with the large-cap Nikkei 225 rising 3.4%. Japanese stocks continue to lag global peers (up only 10% YTD) and we remain underweight even as valuations are cheap. Elsewhere, Emerging market equities returned 6.3% in USD terms (10.8% YTD), led by Argentina (26.6%), Singapore (10.3%), and Colombia (9.9%). Worst performers were Pakistan (-16.6%), Hungary (-2.3%) and India (-0.5%). We are overweight EM equities and prefer countries with strong domestic growth prospects, such as Brazil, China (A-shares), and Indonesia. In USD fixed income, U.S. Treasury yields continued their descent (the 10-year UST yield dropped 14 bps to 2%) given weaker incoming economic data but credit spreads tightened amid expectations of Fed rate cuts. Investors moved to pricing in a full rate cut in July with some even expecting a 50 bps cut. Although the job market remains strong, the headwinds from global trade and subdued inflation will lead the Fed to cut rates by 25 bps in July, in our view. Beyond July, we think the market is a bit too aggressive in its pricing of rate cuts (60 bps of cuts priced by year-end) and may be disappointed.
US HY credit returned 2.3% (10.3% YTD) and credit spreads tightened 52 bps. Lower quality bonds underperformed on the month, with BBs returning 2.6%, Bs 2.3% and CCCs 1.1%. The banking sector outperformed (4%) while the healthcare sector lagged (1.1%). US HY funds received inflows of $1.6, bringing YTD inflows to $10.2 bn. In the primary market, corporations raised $27.3 bn in USD-denominated bonds ($130 bn YTD) with demand remaining strong. We remain slightly overweight US HY but given the stage of the economic cycle would stick to higher quality companies. EUR HY performed in line with US HY by delivering total returns of 2.5% (7.7% YTD) on the back of spreads tightening 61 bps to 371 bps. European HY credit should continue to perform well given the meagre yields available in government bonds and low default rates.
US IG spreads tightened 14 bps in June to 122 bps with total/excess returns of 2.3% (9.6% YTD). Higher beta sector outperformed (Telecom, Metals and Mining and Railroad) while defensive sectors such as consumer products and REITs lagged. Technicals remain favorable with IG mutual funds seeing inflows of 1.1% of AUM in June and hedging costs for foreign investors dropping. Supply volumes of $86 bn are tracking -12% lower YoY. We think US IG spreads will keep their tightening bias and prefer BBB credits whose management is committed to maintaining an investment grade rating.
Emerging Market sovereign debt was the top performing asset class in June. EM hard currency sovereigns returned 3.8% (12.3% YTD), led by Argentina and Ukraine. EM corporates returned 2.2% (9.3% YTD), led by Turkey and Argentina (6%). EM local currency sovereigns returned 5% in $US terms (2.2% of the return came from stronger EM FX), led by Argentina (22%) and Turkey (12%). EM debt funds did suffer from outflows in May, with roughly $3.5 bn of outflows (led by $2.6 bn from local currency funds). We continue to like EM debt given the global reach-for-yield (4.3%/5% for $/local EM sovereigns and 4.6% for $EM corporates) but emphasize the importance of country selection and diversification.
Overall, the restarting of trade talks and dovish central markets supported risky assets, which finished the first half with very impressive gains. We think there is room for markets to keep rising from here, but there’s also room for disappointment if the Fed’s rate cuts do not materialize. We are comfortable selectively adding risk in higher-growth sectors as well as ones that are still pricing in some trade uncertainty. As always, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.