- US Growth Strengthens and Impending Trade Wars
- Recap of Second Quarter: Strong Dollar, Global Growth Slow Down, Emerging Market Weakness
- Portfolio Positioning for Latter Half of 2018
- Firm Updates
US Growth Strengthens and Trade Wars:
By virtually all estimates the U.S. economy just completed an outstanding second quarter with robust growth. Bank of America Merrill Lynch officially revised its Q2 GDP forecast to 4.0%, and expects the US economy to grow by 3.0% in 2018. Looking ahead they expect some of the momentum and better productivity growth in the economy to carry over into 2019 in the form of better spending and investment, with expectations of next year’s annual growth number to 2.6%.
American factory activity accelerated for the second straight month in June, signaling momentum in the U.S. manufacturing sector. We’re seeing the small business confidence index continue to hold at the highs (107.8 in May). And why does this matter? Conditions for small businesses can be taken as a quasi-proxy for emerging/prevailing “main street” conditions. Recall, small businesses represent over 99% of total U.S. Employer firms and >60% of net private sector hiring on a monthly basis. So, collective sentiment matters in handicapping the prospects for labor and wage trends.
Yet despite surging corporate profits, robust growth, record low unemployment and strong consumer spending, stocks have largely moved sideways this year on talks of trade tariffs and the growing risk of an outright trade war breaking out between the US and its trading counterparts. Ironically, US GDP growth is more vulnerable to trade tariffs than that of its trading partners.
Consider the following narrative below:
What matters to GDP growth is not the dollar amount of targeted products, but their share of GDP. When the US goes to “war” with many of its trading partners, they can collectively impose a much bigger percentage point shock on US GDP than the US can impose on ROW (rest of world) GDP. Recall that in 2016 ROW GDP was almost $57tn, or three times as much as US GDP (almost $19tn). Hence if the US puts tariffs on all of its imports it only impacts about 4% of ROW GDP. By contrast, if ROW puts tariffs on all US exports it impacts 8% of US GDP. Therefore a 25% tariff on all US exports and imports is equivalent to a 2% of GDP tax on Americans, but only a 1% of GDP tax on the rest of the world.
A full-blown trade war, on which the US puts 10-25% tariffs on most imports and trade partners put tariffs on most US exports, may very well lead to a significant reduction in growth, decline in confidence and supply chain disruptions which could amplify the trade shock, triggering a global recession. For now, the probability of a full-blown trade war is relatively muted, but the risks are certainly rising which has put the US equity market rally on hold, for now.
Highlights from Second Quarter:
Strong $US Dollar
The U.S. Dollar Index, +7% off its YTD lows, has already inflicted some major pain in consensus macro views that were positive on investments like commodities and emerging market financial assets heading into Q2.
40% of S&P 500 earnings are international and impacted by a strong dollar. As Keith McCullough the CEO of Hedgeye put it, “The S&P 500 has international baggage, emerging market baggage, china slowing baggage, and European and Polish Baggage.” For more pure US investment exposure, consider investing in indexes like the Russell 2000 which are less impacted by a strong dollar.
Global Growth Slowing Down
Growth and economic data in Europe has been weaker than expected over the last several months. Analysts have cut Euro area growth to 2.1% in 2018, and 1.7% in 2019 from 2.4% and 1.9% previously. The global wave, one of Bank of America Merrill Lynch’s most widely recognized proprietary indicators which combines seven key macro indicators, has peaked for only the 10th time in 25 years! Following previous peaks, the MSCI All Country World Index averaged -3.4% in the next 12 months, and the US tends to be a more defensive region on average.
In looking at world equity performance from the 2018 market peak on 1/29/18, we’re now down -10% from $87 trillion in total market capitalization to $78.6 trillion.
Emerging Market Weakness
Emerging markets are struggling with a sharp and abrupt reversal in the dollar, rising rates, and concerns about global growth and idiosyncratic issues surrounding particular markets such as Turkey and Brazil. Below are the 10 worst performing emerging market countries since the 1/29/18 market peak:
1. Venezuelan: -77%
2. Luxemburg: -54%
3. Argentina: -44%
4. Turkey: -32%
5. Brazil: -28%
6. Kazakhstan: -25%
7. Poland: -25%
8. Hungary: -24%
9. South Africa: -23%
10. China: -21%
Portfolio Positioning for Latter Half of 2018:
Positive on US Large Cap Energy
We remain bullish on energy because inflation has been heading higher.
Positive on Real Estate Investment Trusts (REITs)
Increases in interest rates often are driven by economic growth that may support the growth of REIT earnings and dividends in the future. Research shows that REITs have often outperformed during periods of rising rates.
Neutral on US Consumer Discretionary and Technology
We remain cautiously optimistic on the Consumer Discretionary and Tech sectors because these are the sectors most tethered to the U.S. consumer and an acceleration in the U.S. economy. We recognize that after eight consecutive quarters of growth acceleration, the prudent move is to book some gains in cyclically sensitive sectors.
Negative on Emerging Market Stocks
Strategists on Wall Street continue to advocate for buying emerging markets claiming they are “cheap.” Based on price-to-book ratios, the MSCI Emerging Index is indeed trading at a 30% discount to MSCI World Index of developed markets. But with the headwind of a stronger dollar, emerging markets can continue to get cheaper in the latter half of 2018, which makes us near/intermediate term bearish. We’d like to wait for a more attractive entry point in adding more exposure to emerging markets in client portfolios that may be the only area of the market where we’ll see positive real returns after adjusting for inflation.
As I reflect on 2018 thus far, there are a number of updates I’d like to share with you, my valued clients. You may recall back in January of 2017, that I took a leap of faith in leaving Merrill Lynch to start my independent wealth management practice, Rapport Financial. Since then, each and every morning I wake up with one primary goal in mind – to provide you with the best possible client experience. For this, I feel a great responsibility to continuously improve upon my practice by seeking out the best suite of solutions in the marketplace. A few of these recent additions are listed below:
- Docusign. Electronic Document Signing
- Hedgeye. Independent Research Firm (responsible for the images you see in this commentary!)
- Right Capital. Financial Planning Software
There are other solutions being evaluated that I’m confident will improve upon the financial planning and risk management portion of my service offering and I cannot wait to implement these for you.
My job, as a client recently put it best, is to work with you to identify and implement the most appropriate strategies and solutions to meet your financial goals. To adjust your portfolios for the underlying conditions of growth and inflation that are directly impacting the value of your hard-earned assets. To provide advice that affords you a level of financial stability that promotes a healthy, wholesome personal and professional life free from financial stress.
This past month I was honored to be named an Investopedia Top 100 Financial Advisor. This list consists of advisors around the country who have contributed significantly to conversations about financial literacy, investing strategies, life-stage planning and wealth management.
Know that as your fiduciary advisor, I will (and am legally required to) always make suggestions that are in your best interest. But my commitment goes beyond that. Over the years I’ve continued my education in the field, from attaining securities licenses, to the life and health insurance license, and becoming an Accredited Investment Fiduciary where I took the fiduciary oath. I’m currently studying at the College for Financial Planning where I have taken classes on insurance, annuities, investments, taxes, and estate planning. The final step will be to sit for the rigorous CFP examination in November.
While the recommendations made in this commentary are backed by macro research and quantitative data, it’s important to remember that all investments are made within the framework of our long-held belief that diversification continues to be the foundation of each portfolio.
Aaron L. Hattenbach, AIF®
The opinions expressed herein are those of Rapport Financial, LLC (RF) and are subject to change without notice. Past performance is not a guarantee or indicator of future results. Consider the investment objectives, risks and expenses before investing. You should not consider the information in this letter as a recommendation to buy or sell any particular security and should not be considered as investment advice of any kind. You should not assume that any of the securities discussed in this report are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in this newsletter. These securities may not be in an account’s portfolio by the time this report is received, or may have been repurchased for an account’s portfolio. These securities do not represent an entire account’s portfolio and may represent only a small percentage of the account’s portfolio. partners, employees or their family members may have a position in securities mentioned herein. Rapport Financial was established in 2017 and is registered under the Investment Advisors Act of 1940. Additional information about RF can be found in our Form ADV.