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The Brave Report: Market Commentary for May 2019

Click here for pdf version of this report: The Brave Report-May 2019

All good things must come to an end…. The euphoric start to the year finally hit a speedbump.  Over the first four months of the year we were cruising in a Goldilocks environment.  Uncertainty around the Fed was muted, earnings were better than expected and all signs were pointing toward great progress on the trade front.  This all changed at the beginning of May as Trump surprisingly imposed new tariffs and China responded with increased blame and finger-pointing. With both sides blaming the other for the deal falling through, the leaders seem to be digging their heels in and trying to rally their own domestic support. This has increased fears of a long drawn out trade fight and stoked the worries about overall slowing global growth. While expectations for a recession have increased in recent weeks, I don’t think a recession is imminent and there will be a number of policy opportunities to avoid any recession.

Even with this sharp monthly selloff, it is important to remember that we are still only around 6% off all-time highs and the S&P 500 is still up more than 9% so far this year.

Market Overview

All major indices finally took a step back this month.  The DOW and the S&P 500 both lost around 6% while the NASDAQ pulled back around 7.5%.  After such a hot start to the year, which saw most indices testing their all-time highs, we saw some rapid selling throughout the month.  The DOW has now been negative for 6 straight weeks, the longest such streak since 2011. While most of the selling can be attributed to the increased trade tensions and new tariffs, the selling was exaggerated due to the runup we saw in the first 4 months of the year.  Traders were very quick to trim their positions and capture some of their profits which put some extra downward pressure on a lot of names, especially the more tech-heavy momentum names.

While the stock market tends to get the majority of the headlines, the real movement over the last month has been in the fixed income complex.   The 10-year treasury rallied substantially over the last month. After trading at a yield of 2.57% early in the month the yield has dropped all the way to 2.14% as of the close of markets on May 31st.  This has been the sharpest drop in yields that we have seen since 2008.  Trade war fears and global growth concerns have increased the likelihood that the Fed will cut rates this year to try to mute the economic impact of this weakened growth.  The yield curve also continues to flatten (or even invert in some areas) which is a sign that long term growth expectations are becoming more pessimistic.

Trade war: All the perceived progress that was made on the trade front over the past six months seems to have been thrown out the window. It now seems that we are back to the drawing board with China as both sides continue to point fingers at the other for torpedoing the potential deal.  For much of the last year, I have viewed Trump’s hardline stance as a negotiation tactic, and I still think it could be, but it seems that China is finally fed up with it and the mixed message they are getting from the President and his representatives. China now looks less willing to make concessions, even if it means playing the long game and waiting out the president.

While the trade war with China is getting all the front-page coverage.  The most concerning development we have seen recently is Trump’s threat to impose tariffs on Mexico if Mexico doesn’t tighten their border. We are just completing our renegotiation of a North American trading agreement with Canada and Mexico in which both countries made concessions in order to get the deal done, but now the President is threatening tariffs for other ends. While I doubt the tariffs ever come to fruition, this is concerning for a few reasons. First, this sends the message to other trading partners, especially the ones we are currently negotiating with, that even if you make concessions to the US in the trade negotiations the President could still try to punish you with tariffs. It weakens the US negotiating stance because it reduces US trustworthiness.  If the President is just going to impose tariffs outside of the framework of a trade negotiation, then why should any trading partner make any trade agreements with us in the first place

Second, it is very rare for a country to use tariffs to try to achieve a non-economic goal, in this case, immigration reform. This tactic becomes a slippery slope because it adds additional risk and uncertainty that at any point the President may use tariffs to accomplish any goal and this does not put markets at ease.  The fact that US companies would be the real losers if there are increased tariffs on Mexico raises concerns that the President doesn’t fully understand the economic dynamics of trade.

I am still a believer that we will still get a trade deal with China sometime this year as there are rarely any winners when it comes to a long, drawn-out trade war. So far, most economists have concluded that US companies and consumers are bearing most of the costs from any new tariffs. Chinese companies will eventually have to adjust their pricing and will bear some of the economic impacts but on the short run, most of the tariffs are just passed along to consumers by American importers. While pro-American/ anti-China tweets play well with Trump’s base, the actual economic impact will eventually start hurting his supporters.  As we approach a campaign year it becomes more important for the President to get something done. He does not want trade uncertainty hanging over our markets, especially since Trump has linked his success to market success.

So how should these new trade developments inform investment decisions?  In the short-term, I think we will continue to see volatility and uncertainty in the markets as trade war fears weaken economic growth projections. In the longer term, I expect this volatility to present some great buying opportunities as a number of great companies are already trading at a major discount. As was the case in December, we have seen a lot of companies dragged down by trade concerns even though they have very little trade war exposure.  This creates some great opportunities. I think a trade deal will eventually get done and when it does, we will look back at this summer as a great opportunity to add to positions. I am not rushing to get in yet, but I will be looking to start building or adding to some long-term positions if we start to see some stability in the markets or on the trade front.

Rates:  Along with increased trade tensions, the entire rate complex took a dive this past month. This represented one of the sharpest drops in treasury rates that we have seen since 2008. This rapid drop can be attributed to a couple of things. Increased trade tensions caused a rush to safer assets as traders took profits. This drove up demand for treasuries.  Also, fears that a prolonged trade fight will slow global growth also raised the expectations for a rate cut later this year. After a few years of upward pressure on yields from the Fed, many expect them to reverse course in an effort to keep our economic expansion going. The Treasury market reacted accordingly, driving the rate on the 10 years to its lowest point since 2017.

Strategy Commentary

I cut some equity exposure early in the month as renewed trade war fears increased risk in the market.  As I mentioned last month, the market had already run-up substantially year to date so trimming a little while some trade war uncertainties dissipate seemed prudent. I do think we are in or near a longer-term buying opportunity, but I do not see a need to rush back into additional equity positions at this time. Once some of the volatility subsides, we will have an opportunity to add back to some positions.

Domestically, I trimmed my exposure to industrials and trimmed a little of my technology exposure.  I am still overweight technology and consumer discretionary but took some profits on the tech side. Utilities have been the big outperformer in recent months, and it seems I missed the boat on this trade. If volatility continues, utilities should still do well but I am not adding yet as I don’t see the need to chase the trade and buy it at the top.

On the international side, I reduced my overweight to emerging markets as the trade war has intensified.  I still like the opportunity in emerging markets, and I expect it to be a great outperformer in the near future, but I plan to wait till some of the trade war uncertainties subside to add back to my position.

Fixed income has been on a tear over the past two months and I missed an opportunity to increase my allocation. As I mentioned last month, I am no longer underweight fixed income and have moved more to a neutral allocation.  With the yield curve flattening, I am looking primarily on the short end of the yield curve.  My cash allocations are also up a bit as I am looking to have some dry powder ready for when the market bounces back.