June 2019 -Will May's Pullback Bring Us Closer to a Deal?
Risk assets retreated sharply in May, with equities selling off, high-yield credit spreads widening and U.S. Treasury bond yields dropping sharply. The MSCI All-Country World Index dropped 5.9% on the month in $US terms, lowering year-to-date (YTD) gains to 9.4%. The selloff was driven by a breakdown in talks between the U.S. and China as well as a rise in tariffs: President Trump raised tariffs on $200 bn of Chinese goods to 25% and placed Huawei on a restricted list, prompting a response from China which raised tariffs on $60 bn of goods. In early June, Trump threatened to raise tariffs on Mexican products, prompting a further selloff. Our view is that the escalation is part of a tactic used by both sides to try and gain leverage and voter support before a final deal is reached. Both sides still have a strong incentive to reach a deal and tightening financial markets could drive both sides to make compromises, though serious issues remain on the tech front. If no deal is reached and tariffs are raised on an additional $300 bn of Chinese goods, equity markets will tank and global growth will decelerate sharply (the IMF warned that global growth would be reduced by 0.5% in 2019 in a full-blown trade war). We had maintained a below target exposure to equities given the risk of a pullback, a view that helped shelter performance. Although we still expect a trade deal to be eventually reached, we expect volatility to remain high and are not ready yet to fully buy the dip.
The S&P 500 returned -6.4% in May, the first down month of the year though YTD gains are still +10.7%. On a sector basis, cyclicals underperformed more defensive ones on typical flight to quality; Energy fell 11.7% on lower oil prices, Tech dropped 9% (led by Semiconductors which dropped 17%) and Materials dropped 8.5%. On the positive side, Real Estate (+0.9%) and Utilities (-1.3%) outperformed due to their bond-like characteristics with the former the best performing sector YTD (+17%). While we remainoverweight U.S. equities, we have a more constructive view on the homebuilder sector given the sharp drop in mortgage rates, as well as real estate, consumer staples and cloud computing. We are less constructive on energy, materials, and industrials given slower global growth.
In Europe, the Euro Stoxx 50 index delivered total returns of -5.1% in May, lowering YTD gains to 12.4%. Top performers within Europe were Switzerland (-2.3%), UK (-2.7%), and Norway (-3.2%) while laggards were Austria (-9.1%) and Italy (-8.8%). The region’s manufacturing index decelerated again in May (from 47.9 to 47.7). 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 dropped as well with the large-cap Nikkei 225 dropping 5.9%. Japanese stocks continue to lag global peers (up only 2.5% YTD) and we remain underweight on their exposure to trade and a stronger Yen, though the BOJ may ease their monetary policy stance to support growth. Elsewhere, Emerging market equities returned -7.8% in USD terms (3% YTD), dragged down by offshore Chinese stocks which dropped -13% on rising trade tensions. Other EM countries such as Brazil, India, and Russia managed to register positive gains on the month. In early May we had moved our view on EM Asia to UW due to the collapse in trade talks, but continue to see value in select countries such as Indonesia, India, Brazil, Russia and Mexico (despite the recent tariff threats).
In USD fixed income, U.S. Treasury yields dropped sharply on the month and the yield curve inverted again, while credit spreads widened. The 10-year yield dropped 38 bps to 2.1% while the 3-month T-bill dropped 10 bps to 2.3%. Investors began pricing in 3-rate cuts by the Fed over the next year, with one coming as soon as September. In recent remarks Fed Chair Powell indicated that the Fed will be open to cutting rates should the outlook worsen. Our view is that the Fed may cut rates as soon as July, if the economic data continues to deteriorate in the near-term, though it may take some time until the data weakens enough to prompt the Fed to cut.
US HY credit dropped 1.2% and credit spreads widened 86 bps. Lower quality bonds underperformed on the month, with BBs returning -0.7%, Bs -1.2% and CCCs -2.7%. On a sector basis, communications (0.1%) outperformed while energy lagged (-4%) led by the big drop in crude prices. US HY funds suffered outflows of $4.7, bringing YTD inflows to $8.6 bn. In the primary market, corporations raised $24.8 bn in USD-denominated bonds ($102 bn YTD) with demand remaining strong. We are slightly more constructive now on US HY given the big move in spreads but would stick to higher quality companies. EUR HY performed in line with US HY by delivering total returns of -1.5% (5.1% YTD) on the back of spreads widening 67 bps to 425 bps. European HY credit should continue to perform well given the meagre yields available in government bonds but risks remain from Italy and a hard Brexit.
US IG outperformed US HY with spreads widening 16 bps to 133 bps and total/excess returns of 1.4%/-1.3% (7.1%/2.2% YTD). Cyclical sectors such as Metals and Mining (-2.3% excess returns), Energy (-2.1%) and Telecom (-2.5%) lagged while Real Estate (0%) and Consumer Products (-0.6%) outperformed. Technicals remain favorable with IG mutual funds seeing inflows of 0.8% of AUM in May and hedging costs for foreign investors dropping. Supply volumes of $111 bn were lower than expected, and are tracking -9% YoY. We think US IG spreads are fairly valued but are careful to take too much duration risk given the possibility that longer-dated yields could rise again. Emerging Market debt held up better than US HY. EM hard currency corporates and sovereigns returned 0.6% and 0.5% but spreads widened 30 bps due to the move in rates. EM local currency sovereigns were relatively unchanged in $US terms. 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 attractive yields (5.7% for $ sovereigns and 5.1% for $ corporates) but think that local currency sovereigns (which yield 6.8%) should outperform in the near-term given the dovish Fed and lower oil prices.
Overall, the escalation on the trade front led to a sharp rise in volatility and pullback in risk assets. Our portfolios were well-positioned to weather this storm, but we are not yet ready to fully deploy all of our cash into the markets given the risk of a full-blown trade war. Rather, we like to selectively buy assets that appear to have sold off more than warranted and take advantage of the higher volatility by buying structured products with high coupons. 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.