May 2019 - Trade or Tweet ?
Risk assets continued their upward trend in April, marking the fourth straight month of gains. The MSCI All-Country World Index rose 3.2% on the month in $US terms, bringing YTD gains to 15.2%. The rally was supported by stronger than expected economic data in China and the US as well as strong corporate earnings. Tech, Financials and Consumer Discretionary were the top performing sectors globally, while more defensive sectors such as Healthcare, Telecom and Utilities lagged the market. On a regional basis, U.S. and European stocks outperformed while Latin America, Japan and EM Asia lagged. We think that major equity indices are at risk of a pullback given President Trump’s recent escalation on the trade war front and volatility will increase from here. We therefore maintain a below target exposure to equities.
The S&P 500 delivered total returns of 4% in April, bringing YTD gains to 18.2%. The index now sits at all-time highs (forward P/E of 17.7x), and we expect limited gains from here. On a sector basis, financials (+8.2%) outperformed due to strong earnings and a steepening yield curve. Tech and communication services also rose by 6% each, helped by 80% of companies beating expectations on earnings. The notable laggard was the healthcare sector, which dropped 2.7% due to concerns about possible reforms to the healthcare system ahead of the 2020 elections. On the economic front, first quarter GDP came in much higher than expected (3.2%), though the main drivers (inventory buildup and government spending) will likely be transitory. Meanwhile, the labor market continues to show exceptional signs of strength, while core inflation has decelerated a bit but should increase from here. We remain overweight US equities vs. other regions given the potential for stronger than expected corporate profits during the year and still robust domestic economy but prefer more defensive sectors that are less reliant on China. If the U.S. follows through by raising tariffs to 25% on $200 bn of Chinese goods, China will likely retaliate. Sectors that would suffer the most are information technology, retailers and consumer goods that rely on Chinese imports.
In Europe, the Euro Stoxx 50 index delivered total returns of 5.5% in April, bringing YTD gains to 18.4%. Top performers within Europe were Sweden (7.9%), Germany (7.1%), and Austria (6%) while laggards were Finland and Denmark. European Q1 GDP was slightly higher than expected (0.4% QoQ) due to strong consumer spending in France and Italy. The region’s manufacturing index improved a bit in April but is still in contractionary territory. Wekeep our stance on European stocks at marketweight given that the P/E ratios remain relatively cheap (forward P/E of 14x) and signs of stability in China which should support net exports.
Elsewhere, Japanese stocks rose with a big differentiation between the broader TOPIX index (1.7%) vs. the large-cap Nikkei 225 (5%). Japanese stocks continue to lag global peers (up only 7.1% YTD) and we remain underweight on their exposure to slower global growth and a stronger Yen. Emerging market equities returned 2% in USD terms (11.8% YTD). EM Europe/Middle East and Africa outperformed (4.8%) other EM regions, led by Egypt (10%) and South Africa (7%). The onshore CSI 300 index rose 1% on the month (despite dropping 5% over the last two weeks) while Chinese offshore stocks as represented by MSCI China rose 2%. Overall, we move our overweight stance on EM equities(forward P/E of 11.8x) to marketweight given the risk of an escalating trade war battle and move our stance on EM Asia to underweight.
In USD fixed income, U.S. Treasury yields rose on the month due to strong consumer spending data and auto sales. Yields on the longer part of the curve rose more than shorter-term yields, with the 30-year yield rising 11.5 bps and the 2-year yield only 1 bps. The Federal Reserve kept rates on hold and said that it doesn’t see a strong case for either a rate cut or a hike in the near term. Despite core inflation dropping to 1.6% YoY in March, the Fed noted that some of the drivers of the decline are transitory and it expects inflation to rise towards its 2% target. The market is now pricing in a 56% probability of one rate cut this year, having reached a probability of 75% in mid-April. We think that the Fed will remain on hold this year and this environment continues to favour corporate credit, particularly BBs and BBBs.
US HY credit returned another 1.4% (8.9% YTD) as credit spreads tightened 32 bps. Lower quality bonds outperformed on the month, with BBs returning 1%, Bs 1.5% and CCCs 2.3%. On a sector basis, Supermarkets (3.4%) and Retailers (3.3%) outperformed in April while Aerospace & Defense and Health Insurance lagged (0.4%). US HY funds received another $2.8 bn of inflows, bringing YTD inflows to $13.3 bn. In the primary market, corporations raised $17.6 bn in USD-denominated bonds ($77 bn YTD) with demand remaining strong. We are neutral on US HY from here given that spreads (372 bps) are only 55bp off the post-crisis tights. EUR HY performed in line with US HY by delivering total returns of 1.4% (6.7% YTD) on the back of spreads tightening 27 bps to 365 bps. European HY credit should continue to perform well given the meagre yields available in government bonds and new Brexit timeline.
US IG lagged US HY with spreads tightening 11 bps to 118 bps and total/excess returns of 0.6%/1% (5.6%/3.5% YTD). Higher yielding sectors such as Telecom (2.3% excess returns), Autos (1.7%) and Tobacco (1.4%) outperformed while Consumer Products and Healthcare (0.5%) lagged. Technicals remain favorable with IG mutual funds seeing inflows of 1.1% of AUM in April. Supply volumes of $96 bn were met with strong demand, particularly Saudi Aramco’s $12 bn debut issue. We think US IG spreads are fairly valued at the moment but they may continued their tightening bias given the dovish Fed and improving macro headwinds.
Emerging Market debt lagged other global asset classes, due to negative developments in Argentina and Turkey. EM hard currency corporates and sovereigns returned 0.8% and 0.2% respectively while local currency sovereigns dropped -0.2% in $US terms. Argentina’s USD-denominated sovereign debt dropped 9.1% on the month due to a combination of higher inflation, weaker exchange rate, and concerns that Cristina Kirchner will win the October elections. Turkish assets also came under pressure, with the Lira dropping 6.6% as investors were concerned about a sharp drop in the level of FX reserves that the Central Bank holds. Aside from these pressure points, EM debt continues to benefit from fund inflows, limited supply and higher oil prices (which favour the external debt asset class more than the local). We continue to like EM debt (hard currency over local) given attractive yields but emphasize the importance of country selection and risk management.
Overall, we are seeing signs of an improvement in global growth (especially China) and decent corporate earnings, but doubts about a trade deal between the U.S. and China could result in a sharp pullback. We therefore think it is prudent to maintain a below target equity exposure. Should the U.S. and China reach a trade agreement in the coming week, risk assets will jump again and break new highs. 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.