Equity markets had their best week of the year following a four-week losing streak. The S&P 500 Index bounced to within 2.5% of an all-time high and recovered nearly two-thirds of the May loss. The S&P 500 is 2.5% off an all-time high despite clear slowing trends in the economy as the optimism on a rate cut supersedes the growth outlook. Investors are currently betting on both a positive resolution to the various trade disputes and a cut to the Fed Funds rate. There could be downside to markets if either of those items fail to materialize.
We have returned to the idea that “bad news is good news,” with disappointing economic data viewed positively as it reinforces the trend towards rate cuts. May payrolls disappointed at 75k compared with an expectation of 180k and the April reading of 224k. Interest rates fell sharply, with the 10-year yield back to the lows experienced before the 2016 elections. The consensus around pending rate cuts has grown, with an 80% chance of a cut by the July meeting embedded in the curve, up from 17% a month ago. By year end, there is a 98% chance of a cut with an 87% chance of two or more and a near-50% chance of three or more. While recent Fed speeches seem more amenable to a cut, it seems that investors are far more certain than Fed officials and economists. Investors may be careful what they wish for, as only the 1995-96 period saw rate cuts as a continuation of the business cycle and bull market. It is more often coincident with the end of the business cycle.
Trade tensions with Mexico thawed over the weekend with President Trump tweeting that he indefinitely suspended the tariff threat after it agreed to take strong measures to limit migration and increase purchases of agricultural products. While this is a welcome sign, it is too early to declare victory as the deal includes a provision that reinforces the notion that the U.S. will continue to use tariffs as leverage. The U.S. will review the effectiveness of the policies in 90 days. A meeting between Trump and Chinese President Xi remains scheduled for the G20 meeting on June 28-29, but officials are preaching caution, as there has been limited progress in recent weeks. At a G20 meeting last weekend, G20 finance leaders said trade and geopolitical tensions have “intensified”, raising risks to stabilizing growth, but stopped short of calling for a resolution to trade tensions between US and China.
M&A Activity: Another major M&A deal was announced this morning, with United Technologies and Raytheon combining to make an $120 billion company. We are in the midst of a multi-year ramp up in M&A activity, driven by continued low interest rates, the benefits of repatriation and the increasing difficulty in driving organic growth. This is a common trend in the later stages of a business cycle. It will likely be a tailwind for the current market environment, as it takes shares out of the market and it makes shorting very difficult. However, the trend must be watched as it was an indication of peak conditions at the end of the last cycle. Private equity funds have an estimated $2 trillion in “dry powder” with more than $600 billion in capital raised in buyout funds in the past three years.
Global Growth: The World Bank’s Global Economic Prospects report for June showed downward revisions to the global GDP growth forecasts to 2.6% in 2019 (down from 2.9% in Jan) and 2.7% in 2020 (down from 2.8%). The primary driver was a sharp negative revision for Europe and modest revisions in Japan, while the U.S. was unchanged. The report notes the balance of risks are to the downside including a further escalation of trade tensions, renewed financial turmoil in emerging markets and sharper-than-expected slowdowns in major economies.
Sentiment & Flows: Investors continue to flock to fixed income investments despite the historically low rate with global bond funds attracting $17.5 billion in the most recent week. This was the largest inflow in more than four years and brings the year-to-date total to $183 billion. Investment-grade funds attracted $18.5 billion, the best week on record, while Treasury funds had their second-best week at $8.9 billion. Risk assets were negative, with high-yield funds losing for the fifth-straight week and emerging market bond funds falling for the fourth-straight week. Equity funds saw another $10 billion in outflows, bringing the year-to-date total to -$155 billion. Investor sentiment was muted despite the strong market with AAII survey shows that only 23% are bullish (down from 26% last week) and 43% are bearish (up from 40%).
What to Watch
An important week of economic data awaits, including NFIB small business index and PPI on Tuesday, CPI on Wednesday, import prices on Thursday, and retail sales, industrial production and consumer sentiment on Friday.