Quarterly Market Commentary – Q2 2019

U.S. Stocks:

After impressive gains in the first quarter (Q1), the U.S. stock market continued to rally in the second quarter (Q2). U.S. stocks notched the strongest first half of a year since 1997, increasing 17.35% as measured by the S&P 500 (SPX). The SPX Index has only managed to rise more than 15% in the first half of a year 12 times since its inception in 1957. According to Dow Jones Market Data, whenever SPX climbed between 15% – 18% in the first half of the year (1H), the index historically continued to rise the next two quarters. Growth oriented stocks outperformed value oriented stocks by 2.6% in Q2 according to J.P Morgan. Developed markets performed strongly in Q2 and 1H, while Asian and Emerging Markets continued to underperform given trade and global economic uncertainties. The Information Technology sector was the best performer in the 1H of 2019 as investors cheered the potential interest rate cuts by central banks across the globe. As central banks ease financial conditions the 11-year bull market might stay alive longer than previously anticipated. The Financial sector outperformed all other sectors in Q2 on news that all 18 major banks subject to review passed the Federal Reserve’s stress test in 2019. Stress testing determines the financial strength of banks under a severe economic downturn.

Share repurchases by companies remained elevated, but contracted in Q1 2019 for the first time in seven quarters. The trade war took a turn for the worse when President Trump blacklisted Chinese telecom giant, Huawei. The ban blocked American companies to sell or license technology to Huawei. The ban was significant since Huawei is a rapidly growing telecommunication company in China with $130 billion in revenue. Huawei is a pioneer in 5G deployment, but has been accused of intellectual property theft by American and European companies on numerous occasions. The administration views Huawei as a security threat, suspecting that 5G telecommunication equipment could be used by the Chinese government to spy on other countries. President Trump promised to lift certain restrictions on Huawei for now, in order to re-instate trade talks between the U.S. and China.

Notable & Interesting Company Specific Headlines from Q2:

  • Abbvie is buying Allergan, the maker of Botox, for about $63 billion in cash and stock
  • Facebook announced its Bitcoin alternative called Libra. Libra is planned to launch to 2.4 billion Facebook users in 2020. The digital currency would be pegged to the U.S. dollar and would create the means for instantaneous, fee-less transactions across the globe bypassing bank charges and long wait times. The currency faces immense pressure from policymakers.
  • E-cigarettes are about to be banned in San Francisco until further notice from the FDA. According to the CDC, one-fifth of all U.S. high school students reported using an e-cigarette in the last 30 days.
U.S. Macro News:

The economic cycle is expected to enter its 11th year of expansion in July, but it is still not displaying late-cycle characteristics, such as high inflation or elevated interest rates, even though wage pressures have accelerated in response to labor market tightness. Despite an unexpectedly weak Non-Farm Payroll report in May, the job market remained particularly strong in June with Non-Farm Payroll beating estimates, the Employment Cost Index showing 2.8% YoY growth, and the unemployment rate falling to 3.7%. The labor market has been strong, but wage pressure is only up moderately. Nordea’s leading wage indicator points to further wage gains ahead. The uptick in wages are boosting consumer sentiment and consumer spending. Real Consumer Spending  is up 2.7% YoY, and Real Disposable Income is up 2.2% YoY. The Bloomberg Consumer Comfort Index hit the highest level since 2000 (63.6).

Q1 U.S. GDP topped all expectations at 3.2%. Unfortunately, a closer look suggests that most of the outsized growth came from trade related inventory stockpiling. Many producers increased U.S. inventory levels by rushing goods into the U.S. before more tariffs hit. The Q1 GDP number was also boosted by strong consumer spending, which contributed 1.8% to the 3.2% GDP growth figure.

U.S businesses cut back spending on business investments such as machinery and equipment, due to trade-war related uncertainties. The ISM Manufacturing PMI Index (Purchasing Managers’ Index produced by the Institute For Supply Management) fell to 51.7 in June from 52.1 in the previous month, beating market expectations of 51. Still, the latest reading pointed to the weakest pace of expansion in the manufacturing sector since October 2016. The ISM Non-Manufacturing Index weakened further in June (Survey 56 vs. Actual 55.1), but it remains in growth territory (above 50).

Federal Reserve Chairman Jerome Powell remained under pressure to ease monetary policy by lowering the Federal Funds rate in July. Fed officials and the financial markets currently hold divergent views on the likely path of interest rates over the medium term. The strong June labor report certainly didn’t point to the need for rate cuts, but traders have already assigned a 94.6% probability to a 25-basis point rate cut by the Fed in July (according to CME Group’s FED Watch Tool data from July 5th that tracks Fed Funds Futures). The Fed needs to tread carefully as it tries to balance market expectations with real economic data and the uncertainties of a trade war between the U.S. and China.

Oil News:

The U.S. benchmark crude (WTI) oil price is up to $58.47/barrel, recovering from the lows of $52/barrel in early June. The oil price increase is supported by rising tensions between Iran and the United States and Europe over Iran’s nuclear program. Furthermore, OPEC and allied producers led by Russia agreed to extend their supply-cutting deal until March 2020. Price gains were mainly limited by the U.S.-China trade war that has dampened prospects for global economic growth.

Philadelphia Energy Solutions, the biggest oil refinery on the East Coast closed after explosive fires, impacting 1,000 workers. OPEC’s production cuts have been a boon for US oil industry. U.S. crude oil exports hit an all-time high at 3,770 thousand barrels per day. U.S. Renewables (solar, wind, hydro) plants surpassed American coal production in April for the first time.

Trade War:

The U.S. raised tariffs on $200 billion Chinese goods to 25% from 10%, aimed at hurting Chinese exporters. According to Bloomberg, out of 1,000 Chinese exporters only 300 had profit margins above 10% and only 60 above 25%. Bloomberg Economics estimated that an all-out trade war would wipe out almost $600 billion from global GDP by 2021.The most exposed countries to the trade dispute as % of GDP are: China (3.9%), Taiwan (1.7%), U.S. (1.3%), Singapore (0.8%), and South Korea (0.8%).

President Trump and President Xi agreed to a trade-war truce at the G-20 summit in Osaka, but there is a growing concern that the trade war is eroding short and long-term growth prospects. As part of the trade truce, President Trump agreed to lift certain restrictions on Huawei, and decided not to impose new tariffs on $200 billion worth of additional Chinese goods.

President Trump threatened to impose 5% tariffs on all Mexican goods exported to the U.S. until Mexico acts to stop immigrants from entering the U.S. illegally. 28% of Mexico’s GDP comes from trade with the U.S and any tariffs imposed on the Mexican economy by the U.S. could push Mexico into a recession. Mexican President Obrador pledged to work with President Trump on illegal immigration to avoid the 5% tariffs.

President Trump delayed imposing tariffs on the EU’s auto industry by another 6 months. The proposed auto tariffs on European automakers such as Mercedes, BMW, and Volkwagen could put pressure on Germany’s already waning economy. Germany is highly sensitive to trade as 29% of German jobs and 31% of labor income are directly related to exports.

Brexit

Prime Minister Theresa May decided to step down as she continuously failed to get her Brexit deal approved by a divided Parliament. Both candidates to replace May as prime minister, Boris Johnson and Jeremy Hunt, have promised to take the UK out of the EU this year, with or without a deal. Boris Johnson went as far as saying that leaving the EU on October 31st is a “do or die” situation. For the UK economy, the difference between a no deal and a no Brexit outcome is about 7% of GDP by 2030, according to Bloomberg estimates (with no Brexit deal being the positive outcome).

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