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Market Outlook - June 2019

Economy

In the Federal Reserve’s Beige Book, which provides both national and regional economic updates, economic growth for the U.S. is described as moderately expanding with improving conditions since April. All regions reported employment growth, with strong demand for retail, business services, manufacturing and construction industries. Job growth was constrained by the tight job market, with many regions reporting difficulty finding applicants for both high and low-skilled openings. While increasing, wage pressures were described as “relatively subdued” considering current unemployment levels. Price pressures were observed more within input prices than final selling prices.

The report noted greater uncertainty in the group’s outlook, with increased mentions of ongoing trade negotiations and tariffs. Several businesses discussed their plans of cutting business investments and payrolls to offset impact of tariffs. Respondents also view the increased tariff rate on Chinese imports (from 10% to 25%) as having a larger impact to consumers. To date, consumer spending showed growth – excluding auto sales which slowed.  

Equity Markets

May was marked by increasing volatility. During the month, large cap companies (S&P 500) fell 6.4% after entering the month at record highs. The shift in sentiment came six days into the month as negotiations between the U.S. and China broke down and President Trump increased tariff rates from 10% to 25% on $200B of Chinese imports. While trade tensions have weighed on market sentiment, the falling Yuan (relative to the dollar) has helped offset rising price pressures from Trump’s tariffs. Chinese exports rose 1.1% (versus an expected decline of 3.9%) during May. The outlook for U.S. companies will hinge on how a tightening labor market, with the unemployment rate at 3.6% and wages +3.1% Y/Y, impacts corporate earnings growth and profitability in the quarter ahead.

Global equity markets also sold off as European (-4.8%), Japanese (-6.5%) and emerging market equities (-6.6%) were impacted by geopolitics. Within the UK, British Prime Minister May announced she was stepping down June 7 as parliament failed to agree to terms with the European Union. The Chinese government is considering an additional round of stimulus, focused on autos and consumer goods. The outlook for the Eurozone has benefited from direct stimulus forecast in Germany, France and Italy. An article in the Financial Times citing economists from Goldman Sachs listed the Eurozone (potentially adding +0.6% to GDP) as a benefactor of increased Chinese stimulus.

Fixed-income markets

U.S. rates saw dramatic declines in the last month, with the U.S. 10-year bond yield now below 2.2%, from near 2.5% at the start of the year. Focused tariff battles between the U.S. and China, along with weak global GDP growth has driven up demand for safe-haven assets. At present, much of the European continent, along with Japan, have government bonds with negative yields (below 0%). The 2% yield on U.S. paper has attracted significant inflows, driving down rates across the yield curve. The inverted curve (10-year note yields lower than 2-year) also indicates some concern of weaker economy in the next one to two years. Real yields are also compressed, as Treasury Inflation Protected Securities (TIPs) have seen yields fall from 1% at the start of the year to 0.4% now. Short-term rates have been held up by Fed policy. Futures indicate that the Fed may reverse tack and cut rates at least twice (for a total of 0.50%) before the end of the year, bringing down the target rate below 2%. A reversal of Fed policy could bring an increase in volatility in non-government markets, as the policy would indicate economic weakness, and a need for stimulus. 

Spread sectors have seen good support, given low default rates in the last several years. With investment grade credit spreads at 160 bps (1.6% over treasury yields) investors are expecting near perfect economic conditions for the foreseeable future. This does not seem to tie with typical late cycle conditions, and corporate spreads may widen. Higher quality paper (A and AA rated paper) would most likely perform better than BBB rated paper, especially with a drawn-out trade battle with China. High yield and loan paper spreads are slightly wider in the last two weeks but could dramatically underperform with increased selling into relatively thin secondary markets. Emerging market debt spreads are attractive, however, the recent appreciation in the U.S. dollar has impacted these securities. Over the next year, however, performance could improve with stabilization or a decline in the U.S. dollar. 

Alternatives/Real assets

Global oil prices, measured in Brent crude, averaged $71 per barrel during May. Current prices are roughly $6 per barrel lower from a year ago. For the remainder of the year, the U.S. Energy Information Agency (EIA) forecasts prices to average $67 per barrel through the remainder of 2019 and 2020. The May report reflected a $3 per barrel move lower from its forecast in April. Falling oil prices of late and uncertainty in global demand mixed with increased U.S. production were attributed for the reduced estimate. Increasing U.S. production has offset reliance on OPEC, as imported oil from the organization reached its lowest level since March 1986 (data as of March 2019).

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