- Equity markets may find out if there is a Powell Put, Part Two; short answer is no
- Falling equity markets this week reflect growth concerns stemming from renewed trade tensions
- Fed officials continue to push back against any notions of easing
- Our 1-rated grouping (outperformers) for Q2 2019 consists of Ireland, Singapore, Austria, New Zealand, and Israel
- Our 5-rated grouping (underperformers) for Q2 2019 consists of Greece, Germany, Japan, Portugal, and Italy
- Since our model update on April 10, our proprietary DM equity portfolio has fallen -0.4%, slightly outperforming MSCI World (-0.7%)
DM EQUITY OUTLOOK
Equity markets may find out if there is a Powell Put, Part Two. Short answer is no. Recall that the S&P 500 fell nearly 16% in December, prompting Powell and the Fed to backtrack from its December 19 hike and go full dove. Given current levels, the S&P would have to fall below the 2500 area to generate a sell-off of similar magnitude to December.
Back then, markets were pricing in significantly higher recession risks. The US economy was in the midst of a soft patch that could have been made worse by the government shutdown. No wonder equity markets were so jittery. Fast forward to today. We simply don’t think there is any economic justification for the Fed to consider cutting rates right now. The labor market is tight while the economy is humming along.
Falling equity markets this week reflect growth concerns stemming from renewed trade tensions. However, it is not up to the Fed to offset this potential negative with rate cuts. That is simply beyond the purview of the Fed. The Fed also should not counter any financial instability that is “man-made.” To address these issues, it is up to the Trump administration to ease off of its reliance on tariffs and tariff threats.
Fed officials continue to push back against any notions of easing. Yesterday, Vice Chair Clarida said that he (like Powell) also views recent disinflation as transitory. Clarida added that “We don’t see a strong case to move rates in either direction.” Likewise, Governor Quarles downplayed the need to worry about inflation running slightly below target, adding that “From my point of view, 1.8 is two” [percent].
We still think markets are overestimating the prospects of Fed easing ahead. The Fed Funds futures strip is currently pricing in solid odds of a rate cut in 2019 followed by another cut in 2020. These cuts were largely priced in even before this current equity selloff began.
MSCI World traded at a cycle high near 2185 on May 1, a level not seen since October 2018. Since then, MSCI World has fallen around 2.5%. Retracement objectives from the December-April rally come in near 2036 (38%), 1990 (50%), and 1944 (62%). The 200-day moving average comes in near 2071.
Despite the current sell-off, MSCI World is still up 14.5% YTD. This compares to 10.4% YTD for MSCI EM, a rare case where DM is outperforming EM on the upside. It’s worth noting that the correlation between EM and DM stocks is currently 0.61. Whilst below this year’s peak near .75 from last month, it’s slightly above the low around 0.58 at the start of this year.
We believe it is very important for investors to continue focusing on country fundamentals. Hedging out currency risk will become more important for US investors if the strong dollar trend continues as we expect. Furthermore, we continue to look for potential divergences within DM. Regionally, North America is the best equity performer so far in 2019 (16.3% YTD), followed by Europe (13.3% YTD) and Asia Pacific (7.9%). Looking at specific countries, the best performers YTD have been Ireland, Switzerland, and the Netherlands, while the worst have been Japan, Norway, and Finland.
Our 1-rated grouping (outperformers) for Q2 2019 consists of Ireland, Singapore, Austria, New Zealand, and Israel. New Zealand and Israel both improved from 2 to 1 and pushed Norway down from 1 to 2 and helped push Sweden down from 1 to 3. We note that of the top 10 countries, 5 are in Europe, 3 are in Asia, 1 is in the Middle East, and 1 is in North America.
Our 5-rated grouping (underperformers) for Q2 2019 consists of Greece, Germany, Japan, Portugal, and Italy. This is the same group as last quarter. We note that of the bottom 10 countries, 8 are in Europe, 1 is in North America, and 1 is in Asia.
There were several other notable movements. The US, Denmark, and Finland all improved from 3 to 2, while both Switzerland and Spain improved from 4 to 3. The UK improved from 5 to 4. On the other hand, Hong Kong dropped from 2 to 3, Canada dropped from 2 to 4, the Netherlands dropped from 3 to 4, and Japan dropped from 4 to 5.
Since our model update on April 10, our proprietary DM equity portfolio has fallen -0.4%, slightly outperforming MSCI World (-0.7%). Overweighting Australia and the US helped our return as these markets outperformed with relatively large weights. Elsewhere, underweighting Japan and the UK helped our return as these markets underperformed with relatively large weights.
What calls hurt our model return? Overweighting Singapore and Denmark hurt our return as these markets underperformed with relatively large weights. Elsewhere, underweighting Germany and Canada hurt our return as these markets outperformed with relatively large weights.
Our equity allocation model is meant to assist global equity investors in assessing relative sovereign risk and optimal asset allocation across countries in the DM universe. The countries covered include all 23 of the countries in the MSCI World Index. We have also included Greece in this model. Even though MSCI puts the nation in MSCI EM, we continue to view it as DM.
A country’s score reflects its relative attractiveness for equity investors – the likelihood that its equity market will outperform the rest of our DM universe over the next three months. A country’s score is determined as a weighted composite of 15 economic and political indicators that are each ranked against the other 23 countries in our model DM universe. Categories are industrial production growth, real interest rates, export growth, expected P/E ratio, real bank lending, yield curve steepness, real money growth, GDP growth, investment/GDP, per capita GDP, inflation, retail sales, political risk (EIU), leading indicators, and ease of doing business (World Bank). A country that is typically ranked first in many of the categories will end up with a low composite score (the lower the better).
From a portfolio construction standpoint, we are benchmarking to MSCI World. As a result, our BBH model portfolio weights will be Underweight/Overweight compared to the MSCI weights.
- Countries that are rated 1 will have a BBH weight that is 1.50 X MSCI World weight.
- Countries that are rated 2 will have a BBH weight that is 1.25 X MSCI World weight.
- Countries that are rated 3 will have a BBH weight that is equal to MSCI World weight.
- Countries that are rated 4 will have a BBH weight that is 0.75 X MSCI World weight.
- Countries that are rated 5 will have a BBH weight that is 0.50 X MSCI World weight.
To have the BBH model portfolio weights add up to 100%, there may be some exceptions to the rules outlined above. However, we will always try to keep to these parameters as closely as possible.
CHANGE IN METHODOLOGY AND COVERAGE
In the past, we have taken a simple average of each grouping (1 through 5) to determine model performance. That allowed small markets to skew the results. We are now taking a weighted approach, with country returns weighted by the BBH model weightings. Then, we compare our model performance against the benchmark MSCI World.