My first piece that I am writing in my new function at Kristal AI, and I am already confronted with questions of fundamental importance to every investor who likes to believe in proverbs.
Let me lay out a few things that I found quite remarkable over the past weeks, which I think should be taken into consideration when it comes to asset allocation for the coming months:
1. S&P reached a new all-time closing high.
The September-December 2018 sell-off lasted 66 days, and we had it all recovered in just 83 days again. I have not found any move in the S&P 500 history until 1980’s where we have recovered such a magnitude drop in such a short amount of time. The last comparable move was in Q3 of 2015, with a 15% drop and a subsequent rally into the end of Q1 2016.
The drivers of the market back then were driven by China, with fears of a rapid slowdown and devaluation, which spooked the market, as well as the anticipated beginning of the Fed tightening cycle. In the end, the Fed started to hike rates, and equities read the news as positive after all, because rising rates must surely mean the economy is doing well. What resulted was a multi-year rally in equities.
And this time? We observe a big discrepancy between global growth expectations (and sentiment) versus the price action of equities. The sharp rally in bonds as well as equities at the same time is testament to this confusion. Maybe in part it’s the record number of share buybacks by companies. But for sure the biggest driver has been the reversal of the Fed’s sentiment towards rate hikes in late 2018/early 2019 which has caused this slingshot move higher.
I can’t help the impression that we may have entered an era where the tail of the risky assets is wagging the dog of monetary policy and not the other way round. It is no longer the fear of what economic growth can do to financial markets, it has reversed to the central bankers and politicians fear of what a sharp correction in the value of financial assets can do to the real economy.
2. The Q1 US GDP report looked re-assuring at first sight, but when you scratch the surface, not all things are rosy.
(Personal consumption has been weak, gains mainly driven by trade, market movement +3.2% vs. 2.3% as expected). My interpretation here is, that this GDP report is a consequence – to some extent – of the trade war. Stock piling of inventories by US importers in 3Q and 4Q 2018 was at record highs in anticipation of further tariffs, as was evidenced by record high warehouse utilisation in Q4.
After Trump’s postponement of further delay without action until last Sunday, the run off in inventories has now found its way into the statistics, painting a positive growth picture. We have also seen the May 3rd release of a new 20yr low in the US Unemployment rate, and at the same time Chicago Fed chairman Charles Evans said at an event in Stockholm, that his concerns on the inflation outlook have mounted, and he “wouldn’t be afraid to act if a rate cut is needed”. The Fed has now clearly switched into the mode of data dependency, and the task of their dual policy mandate (Growth & Inflation) puts them into the uncomfortable position of inactivity since those segments are pulling into different directions.
3. Political risk is back!
Sunday evening, Trump tweeted that he will impose an increased rate of 25% tariffs on USD 200bn worth of imports from China, citing the lack of progress in trade talks and “an erosion of commitments by China”. This was furthermore confirmed by R. Lighthizer on Monday in further comments.
North Korea has tested ballistic missiles over the weekend, and this morning (7th May) I am closely following reports about Iran threatening to exit the nuclear agreement with the US, which was followed by a white house announcement that a U.S. aircraft carrier was deployed to the Persian Gulf region.
4. Last but not the least: Seasonality
This has been studied numerous times, and indeed, as found by Bouman & Jacobsen (The Halloween Indicator, 2001), the markets tend to underperform in the period May-Oct on average compared to the Nov – Apr periods. There are many theories that range from the vacation period in Europe that reduces risk taking during that time, to better performance especially around November/December due to dearth of IPO and corporate bond issuance. We will not know for sure why, but statistically it is a significant phenomenon.
So, what does this mean?
Piecing together this 3 ½ piece puzzle (I discount the seasonality a bit here…), what does that mean for my outlook for the coming three to six months?
US Equities have reached an inflection point. Personally, I would like to believe that the market has now formed a triple top, counting the highs from Jan 2018, September 2018 and April 2019, and we enter a correction phase with a 10-15% downside potential (2500-2600 area), before having to make a fresh assessment of the situation then.
The second scenario of a liquidity bubble driven melt up of stock prices, that pushes S&P beyond 3,000, can also not be fully ruled out, but both are too close to call right now. I’ll be watching very closely if we can rally back above the 2,960 level on S&P500, which would give a good indication.
From an asset allocation perspective, with rates anchored at the short end of the curve in the near term, I prefer to keep a significant portion in fixed income and money market instruments, and remain underweight equities until a confirmation of recent mixed signals is reached.
Given a steady rates environment, REITs with a high correlation to interest rates are one of the preferred asset classes. For precious metals, the Dollar Index has broken the 97.00 resistance and stronger $ means usually lower Gold and Silver prices. I am watching that space carefully for a great opportunity to increase allocations to precious metals for a longer term trade. But more on this in the not too far future…
All the best for the week ahead!