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The Brave Report: Market Commentary for June 2018

Click here for the PDF version of this report: The Brave Report-June 2018

Are we still negotiating? For months the trade war fears have all been seen as just negotiation tactics. However, we are now entering a time when actual tariffs could be implemented.  Neither side seems ready to blink so the status quo has now been changed from just continued negotiations to actual implementation if nothing is done.  The levels of implementation are still at a very low amount but the longer these trade negotiations get drawn out the longer this uncertain cloud will weigh on the markets and start to cause companies to change their investment behavior.

The domestic markets have held up quite well considering all these uncertainties.  This has been primarily driven by solid economic numbers and continued strong corporate earnings results. The disappointing part, however, is wondering where we could be if this uncertainty wasn’t dragging on the markets.  If we can get past this trade tension, the fundamentals are there to see a decent rally in the markets.

Market Overview

The markets saw mixed results in June with the Dow Industrials losing 0.6% and the NASDAQ and the S&P 500 gaining 0.9% and 0.5% respectively. This dispersion was particularly pronounced in the middle of the month as the Dow notched 8 straight days of declines. Tech again rallied for most of the month only to sell off sharply later in the month.

After spiking in late May, the 10-year treasury again settled into the same range it has been trading in since the end of January, settling at a yield of 2.84 to end the month. The yield curve continued to flatten with the gap between the 2-year and the 10-year reaching 0.3%. This continued flattening will be important to watch as an inverted yield curve is often a sign of a looming recession. We aren’t there yet but as the Fed continues to raise short-term rates, the upward pressure on the shorter end of the curve will continue.

Trade War: With earnings season over, trade uncertainty has again moved back to center stage. With that, we are again seeing some market pressure with each tweet or news leak.  We are also entering a period where some of the proposed tariffs are actually starting to be implemented. I still don’t think this means we have moved past the negotiations stage and entered a more serious back and forth where the consequences have an actual economic impact and aren’t just posturing. Any implementation that does occur could easily be rolled back if a deal is reached.

At this point, China doesn’t seem too willing to back down and Trump’s ego prevents this as well.  With the market uncertainty we are seeing domestically, China is seeing a much harsher impact on its markets. In the last six months, the Shanghai composite is down almost 20%, while the S&P500 is right around flat. Some of this weakness in China is due to the continued trade tensions while a lot is also due to currency changes. While short-term market performance shouldn’t be a driving factor in long-term trade negotiations, I am sure the President is watching it.  Whether his counterparts in China feel the same is another story.

To date the actual direct economic impact of any tariffs is quite minimal and the longer term economic impact is still up for debate as the details get ironed out. Where we are starting to see some impact is at the company planning level. The uncertainty of the trade outcomes is causing many companies to cut back on capital spending. According to the Fed’s minutes, companies are scaling back or postponing capital investment until some of this uncertainty is lifted. This could have a few potential short-medium term impacts. If capital spending is scaled back, economic growth could suffer.  We have not seen this impact yet but if companies aren’t investing for the future, growth has to decrease.  The other impact, that we are already seeing, is an increase in share repurchases and buybacks.  If companies aren’t spending their money to grow the best use of this capital could be to buy shares back. Combine this uncertainty with the corporate tax cuts that were implemented earlier this year and we saw a record number of buybacks announced in the 2nd quarter and many expect this to continue.

Yield Curve: I haven’t written much about this in a while but it seems to be lingering in the background and could be the eventual tipping point for the markets.  Over the past few years, the yield curve has continued to flatten as short-term rates have risen faster than longer-term rates.  This can be especially worrisome as a flattening or inverted yield curve is seen as a sign of an impending recession.  The below chart tracks the spread between the 2 and the 10-year treasuries.  The shaded areas show recessions.  We are currently sitting at a level not seen since late 2007.  I am not saying we are about to enter a recession as we can see rapid market growth when this spread is low. This was seen in the mid to late 1990s. It will be important to keep an eye on.

Strategy Commentary

I cut my equity exposure slightly from last month as trade war fears still weigh on the markets.  I am still optimistic longer term but if trade negotiations continue to get drawn out we could see some short-term weakness as investors stay on the sidelines. If the trade war uncertainty can be lifted there could be a rush back to equities as a lot of the money that has moved to the sidelines gets put back to work.

Domestically I am still maintaining my overweights to technology and consumer discretionary.  I reduced my exposure to financials completely as weakness in the sector continues.  Technology and consumer discretionary have been outperformers for quite some time now and I don’t see this letting up.  As I have mentioned in previous reports, I still see technology as having the best long-term prospects for growth even with the run it has already had in recent years.

Internationally I continue to maintain my Japanese exposure but this play has not really paid off. It is on my watch list for a reduction. There continues to be weakness in emerging markets, especially in China. However, this recent weakness could lead to a buying opportunity as trade tensions ease. I am currently staying away from Europe as the growth in the region continues to lag the US.

I am still underweight on most of the fixed income space. While upward rate pressures have eased slightly over the past month I still expect rates to continue to rise.  With the small exposure I do maintain I am staying on the short end of the yield curve.  As a replacement for my fixed income exposure, I am maintaining higher cash levels.