Market Viewpoints

Summary:

As markets tumbled in December, the US Federal Reserve (Fed) realised the errors of its hawkish stance and decided to change tune. In January, the Fed confirmed a pause in interest rate hikes and an end to its balance sheet normalization this year. In March, Fed Chair Jerome Powell doubled down on the Fed’s dovish stance, signalling no hikes in 2019 and an end to the balance sheet reduction by September. As a result, the US equity market had its strongest first-quarter in more than two decades. When it comes to market recoveries from a correction, they don’t get much more V-shaped than the last seven months. I wouldn’t say that the Fed is a “hostage of the market” for I firmly believe that the Fed will raise rates if US inflation were to accelerate. However, a “Powell Put” – a reference to Fed Chairman Jerome Powell and the Fed’s sensitivity to equity market selloffs – is firmly in place. South Korea’s economy unexpectedly contracted by -0.3% in the first quarter, the worst in a decade.  It doesn’t bode well for other manufacturing and technology exporters such as Germany, Japan and Taiwan. It also means that the Fed will be under little pressure (if any) to raise interest rates this year.

Earlier this month, India kicked-off its general election, the results of which will be declared on May 23. Polls indicate that current India Prime Minister Narendra Modi is likely to return to power – albeit with a reduced majority – and may have to rely on like-minded allies to form a government. Regardless of the outcome, India will be a key market for investors to focus on for years to come. India is the fastest growing G-20 nation and, this year, is forecast to become the world’s fifth largest economy, surpassing the UK, and behind only the US, China, Japan and Germany. As China’s growth decelerates and labour costs rise, investors are beating a path to the doorstep of India to take part in its middle-class growth story. By the end of the 2020s the number of households active in India’s consumer economy will have grown to 312 million – that’s the size of Germany, France, UK, Italy and Spain all put together.

Who let the doves out?

On Tuesday this week, The S&P 500 index (SPX) had its highest closing on record, breaking past its previous record set on September 20, 2018 (see chart below). The SPX has surged by over +16% this year and up +24% from its December low. Yet, things were looking so different in Q4 last year when the SPX fell by nearly -20% from early October to Christmas. US recession fears, a hawkish Federal Reserve, and the end of the equity rally were the talk of the day. As the VIX – the measure of the stock market’s expectation of volatility – soared, doom and gloom were predicted for the equity markets.

In my November Newsletter, I wrote: “I do not see a US recession on the horizon. The US economic cycle has further to run and US consumers, in particular, remain strong. The sell-off, therefore, represents a buying opportunity for global stocks”. The SPX fell further and in my December Newsletter, I wrote “ …despite the news of a yield curve inversion at the front end (2 year and 5 year), I put the probability of a recession in the US next year at very low. The US economy is set to grow at over +2% rate in 2019. This leaves a window for equities and other risk assets to show renewed strength given the recent sell-off.” Here we are now with all that equity sell-off behind us and an all-time high on the SPX, the DOW Jones Industrial Average (DOW) and the NASDAQ!

So, who let the doves out? The Fed, of course.

In December 2018, the Fed raised the Federal Funds Rate and signalled another two hikes in 2019, as well as continued to unwind its balance sheet at the rate of up to $50 billion per month – even as US economic data started showing signs of a slowdown. However, in January, as markets tumbled the Fed realised the errors of its hawkish stance and changed its tune, to confirm a pause in the rate hikes and an end to its balance sheet normalization this year. In March, Fed Chair Jerome Powell doubled down on the Fed’s dovish stance, signalling no hikes in 2019 and an end to the balance sheet reduction by September. As a result, the US equity market had its strongest first-quarter in more than two decades. Also helping was renewed optimism around the US economy, which still shows signs of expansion. When it comes to market recoveries from a correction, they don’t get much more V-shaped than the last seven months (see chart below). Rising stocks have been accompanied by a sharp drop in stock market volatility. VIX – the so-called “fear index” – is down more than -50% this year (see chart below).

S&P 500 Index and VIX (last 12 months)

Source: Bloomberg

I wouldn’t say that the Fed is a “hostage of the market” for I firmly believe that the Fed will raise rates if US inflation were to accelerate. However, a “Powell Put” – a reference to Fed Chairman Jerome Powell and the Fed’s sensitivity to equity market selloffs – is firmly in place.  Add to this, the widely perceived “Trump Put” – US President Donald Trump’s sensitivity to a move down in US equity prices as well as the “Xi Put” – China’s President Xi Jinping’s sensitivity to China’s GDP growth tracking at least at the 6% level or a stimulus package would ensue.

Can the rally continue?

I don’t see any signs yet of the Fed bringing an end to this rally. A US recession or inflation acceleration also look distant at the moment. However, given the strength of the rally in equities this year it may be prudent to take profit and reduce long positions in anticipation of “Sell in May and go away” playing out this year – a well-known adage that warns investors to divest their stock holdings in May to avoid a seasonal market decline and then wait to reinvest in November. The phrase is thought to originate from an old English saying, “Sell in May and go away, and come on back on St. Leger’s Day” and refers to a custom of the English aristocrats, merchants, and bankers who would leave the City of London and escape to the country during the hot summer months. St. Leger’s Day refers to the St. Leger’s Stakes, the oldest of England’s five horseracing classics and the last to be run held on the second Saturday of September. Stock market return patterns have supported the theory behind the adage. According to the Stock Trader’s Almanac data – since 1950 the DOW has had an average return of only +0.3% during the May-October period, compared with an average gain of +7.5% during the November-April period. Health warning – please bear in mind what happened last year. The “Sell in May and go away” approach would have cost you dearly last year, as the SPX continued to move higher from May to September and had a steep sell-off in November and December. Caveat Venditor!

India goes to the polls

On April 11, India kicked-off its general elections for its 543 parliamentary seats. Nine-hundred million Indians are eligible to vote. The sheer scale of the operation means the election will run over seven-stages and last just over a month. The results will be declared on May 23. Incumbent Prime Minister Narendra Modi and his Bharatiya Janata Party (BJP) are seeking a second term in power, with a campaign that has revolved largely around – national security, economic development, relief for farmers and welfare measures targeted at reducing poverty. In 2014, Modi and his BJP party secured a spectacular victory and won a rare absolute majority to form the national government. For three decades, prior to elections in 2014, India’s voters refused to give any single political party a majority in Parliament. A coalition government was the order of the day, with an associated lack or slowness of crucial reforms.

Will the 2019 election see a return to a coalition government or a return of Modi with another majority government?

Polls indicate Modi is likely to return to power, albeit with a reduced majority and may have to rely on like-minded allies to form a government. Regardless of the outcome, India will be a key market for investors to focus on for years to come. India is the fastest growing G-20 nation and this year is forecast to become the world’s fifth largest economy, surpassing the UK (see chart below), behind only the US, China, Japan and Germany.

India is the fastest growing G-20 nation and, this year, is forecast to become the world’s fifth largest economy, surpassing the UK, and behind only the US, China, Japan and Germany.

India, UK Gross Domestic Product (in millions USD)

Over the last decade, India’s Gross Domestic Product (GDP) has grown at an average rate of +7.2% per annum. As a result, the budget deficit (as % of GDP) over the same period has fallen from a giddy -6.5% to the current level of -3.4%. Inflation in the same time period has fallen from over +10% to less than +3%.The International Monetary Fund (IMF) expects India’s Real GDP to grow by +7.3% and +7.5% in 2019 and 2020 respectively – the highest of any G-20 nation.

Even as inflation has fallen, the budget balance improved and GDP grew, curiously but understandably, the yield on Indian government bonds, has not narrowed over the last decade and instead has gone up from +6% to +7.5%. This is because the current account balance (as % of GDP), has stayed in deficit and is currently at -2.4%. This deficit has put pressure on the USD/INR exchange rate, as India needs to earn USD from exports to pay for its Oil imports. India is the third biggest importer of crude oil behind China and the US. India’s Oil import bill at $115bn, is nearly 30% of its foreign exchange reserves. Compare that to China, whose Oil import bill, at $240 billion, is only 7% of its foreign exchange reserves. Unlike China, India’s exports have not kept pace with its GDP growth. GDP growth has necessitated increased oil imports and hence greater need for foreign exchange reserves to pay for them. Unless India grows its exports (or strikes oil domestically that cuts the oil import bill or sees a sustained surge in Foreign Direct Investment which brings in USD), the yield on Indian sovereign bonds will stay elevated. India’s total exports for 2018 at $292 billion pales in comparison to China’s $2.4 trillion. As growth accelerates, India’s Oil bill will only grow and put downward pressure on the Indian currency.

Despite that, as China’s growth decelerates and labour costs rise, investors are beating a path to the doorstep of India to take part in its middle-class growth story.  As the chart below from Gavekal indicates – by the end of the 2020s the number of households active in India’s consumer economy will have grown to 312 million – that’s the size of Germany, France, UK, Italy and Spain all put together.  Within this total, the number of emerging consumer households in India will double from 71 million to 141 million. Aspiring households will triple from 32 million to 101 million. And the number with incomes above the affluent threshold will leap almost four-fold from 18 million to 71 million.

A positive outcome in the elections – a majority government with a focus on continued reform and a fiscal policy stance which improves domestic credit conditions and therefore increases capital expenditure – will see the Indian equity  markets rally substantially. With the USD strength waning, the external environment looks supportive for investment in India in particular and Emerging Markets in general.

Markets and the Economy:

We have talked about US equities and my views on them remains constructive as does my view on Emerging Markets. The “take profit” recommendation is only tactical and being overweight the US v/s the Rest of the World is still the equities trade to be in. This morning, poor economic data out of South Korea, one of Asia’s biggest exporters will raise questions about global trade. South Korea’s economy unexpectedly contracted by -0.3% in the first quarter, the worst in a decade.  This doesn’t bode well for other manufacturing and technology exporters such as Germany, Japan and Taiwan. It also means that the US Fed will be under little pressure (if any) to raise rates this year. The S&P 500 index therefore is unlikely to correct much as rate cut expectations will keep it bid

Benchmark Equity Indices Performance (year-to-date)

The Financial (XLF) and the Healthcare (XLV) sectors, which have lagged the SPX, offer good opportunity to rotate into from the Technology (XLK) and Communication Service (XLC) sectors which have rallied a great deal.

US Equity Sectors Performance (year-to-date)

European financial stocks are attractive so long as the narrative from the European Central Bank (ECB) remains supportive. Negative interest rates, as we currently witness in the Eurozone, effectively means that banks pay the ECB to park their excess liquidity with it overnight. A tiered deposit rate would relieve banks from paying the 0.40% annual charge on a portion of their excess reserves, thereby boosting their profits.

I expect the current Italian government to fall soon after the European Union (EU) elections and for Matteo Salvini to be the sole PM as the LEGA party and its allies win the next general election. Brussels spent valuable time arguing about Italy’s deficit target, when not just Italy but the EU as a whole should have focused on policies that promoted growth. To make matters worse, Rome will need to find almost €23 billion of savings to avoid a hefty increase in Value-Added Tax (VAT) which is scheduled to kick in unless the government finds alternative measures. A VAT increase would only see resentment and populism rise. The Bank of Italy sees Italy’s 2020 budget deficit at -3.4% without a VAT hike. One can safely assume that the deficit will be at -4% by the end of 2020 given the serious lack of growth plans in Italy or in the Eurozone. Italy is a serious risk for the EU to deal with. This, when the engine of the Eurozone – Germany – is grinding to a halt. The German Finance ministry has halved the official 2019 German GDP growth forecast to only +0.5% ( it was at +2.1% this time last year). The German business group, BDI, said recently, “The best times for the economy are over.” This will be the weakest German GDP expansion in six years. It is time for Germany to start spending some or all of that 2% budget surplus. That will be good for the whole of Eurozone. However, will they?

A few thoughts on China. China’s GDP grew at a better than expected +6.4% in the first quarter of this year. While this has buoyed risk appetite in stock markets globally, and many see it as a game changer, I don’t.  One has to look at broader data coming out of China. Here is one – China land sales revenue growth collapsed to -33% in 1Q (see chart below) from +11.8% in 4Q18. The biggest drop since the financial crisis of 2008.

Land sales accounted for roughly half of the local governments’ total revenue sources in 2017 and it is perhaps still around 30% of fiscal revenue for local governments. While monetary policy will continue to be accommodative, the deleveraging agenda—curtailing shadow banking and excessive local government borrowings, will remain a top priority of Xi Jinping’s government. As long as the State Owned Enterprise’s (SOE) and local Government’s finances improve or get on a solid footing, Beijing will hold back on stimulus and stay the course on deleveraging even if it means accepting lower growth targets. The US-China trade deal is unlikely to conclude before June and the market seems to have accepted this so long as the talks continue and no new fears arise. Understandably, the negotiations are tenuous given this is no simple trade deal. Expect China to continue with a stop-and-start-stimulation process that helps meet its GDP growth target of +6%. Over stimulation, which can help particularly the moribund Eurozone economy is not on the agenda. The US and Europe will have to rely on their own growth. While the US and China are headed towards a compromise, Trump has a major decision to make about auto import tariffs and it is very likely the “New NAFTA” can’t pass Congress (at least not until after the Nov 2020 election). So headlines on EU-US tariffs are going to soon dominate the news. The EU has a weak hand to play but the EU mandarins secured in their “ivory tower” in Brussels hardly ever care about a “weak hand” or, for that matter, “realism.”

For specific stock recommendations, please do not hesitate to get in touch.

Best Regards,

Manish Singh, CFA