2019: Second Quarter Wrap

It has been 3 months since our “Welcome 2019: First Quarter Wrap”. Now that the 2nd Quarter is over, let’s see where we are:

Starting with the U.S.: A mix bag of economic and corporate data

Research indicates that the U.S. economy will grow 2.7% this year (1.7% to 20% in 2020). Dividend increase follows earnings growth and it is for this reason that the S&P 500 has posted a staggering year to date return of +17% (its best half performance since 1997).

The next FOMC meeting is slated for end July and between then and now there is going to be much debate about macro indicators. On the positive side, early data suggests that Q2 earnings may come ahead of the expected -2.6% decline and unemployment rate will remain unchanged at 3.6% (180,000 jobs added in June). On the negative side, the Chicago PMI has fallen to 49.7 i.e. into contraction territory and trade data for May could be lower than that of April. The Fed is concerned about low inflation expectations. It targets 2.0% sustainable inflation and inflation is below that – this should lead to (at least) a 25bps cut in Fed Fund Rates. Given the U.S. National Debt has hit $22tn / 105% of GDP, a rate cut also reduces the interest rate burden.

President Trump measures his success as U.S. stock market success. He will do what  is needed to be done to stimulate the stock market by his tweets, tariff’s etc. with China and interest rate reduction by pressuring the Federal Reserve. Remember U.S. elections are next year.

Moving on to Europe: Collapsing interest rates and Brexit

While U.S. stock markets have been rising to new highs, European interest rates are collapsing to new lows. The German 10-year bund has fallen below -0.3%, the French 10-year bond yield slipped below 0% and the Swiss 10-year yield dipped below 0% for the first time ever. The interest rate collapse all started in the wake of the European Parliament elections – there is lack of consensus on who should lead the European Commission. Populist movements and coalition governments may result in early elections in major countries like Italy and Germany.

Brexit is still on track for October 31 and the consensus is that it will be a no deal hard exit. A hard exit presents a very bearish outlook for the British pound and the chaos in the EU will impact the euro and there is a fair chance of the euro becoming weak as well. All this is triggering flight of capital and the U.S. dollar continues to strengthen and remains the preferred reserve currency.

China: The Trade war and G20 meeting

An update on the U.S. China Trade negotiations: According to IMF, the global economy will have a GDP of over $87tn in 2019. Approximately one-fourth ($21tn) comes from the U.S. and $14tn from China. Collectively $35tn / over 40% comes from two countries in the middle of a trade dispute.

Global markets were essentially “on hold” as investors waited for the outcome of G20 meeting in Japan with President Trump and Chinese President Xi. Latest economic data in both China and the U.S. shows slowing growth and much of the blame is pinned on the trade war. In exchange for returning to the negotiating table to pick up where China and U.S. trade negotiators left off, Trump agreed to postpone any additional tariffs, creating a face-saving atmosphere that makes both Trump and Xi both look good to their respective countries for negotiations over the summer. As it stands, current tariffs remain in place and U.S. suppliers are free to equip Huawei. Trump is buying time for the U.S. economy to remain strong – a positive for his re-election campaign and Xi is waiting to see if an alternate will emerge.

Closer home in India: Time to deliver has come

With elections behind us and a resounding victory for Prime Minister Modi, there are a lot of expectations that the government needs to deliver on. With a stable government, the next five years the Government should focus on building the economy without having the fear of one party arm-twisting the other with threats of bringing it down.

The Indian financial system is going through an unprecedented clean-up. Overall there is a “risk-off” mode, right from auditors and rating agencies to the banks and funds, everyone is tightening standards. In the long term, this is a very healthy development, as it ensures that meritocracy will triumph. But in the interim you will see that corporates want to deleverage and therefore are not interested in capex. In such a scenario the capex has to be front loaded by the Government.

In the fixed income space, RBI has again reduced interest rates for the third time in a row and is likely do two more. The credit spreads between G-Sec and AAA have widened to over 100bps and between AAA and AA to c. 200bps.  Whilst risk does exist, the widened spreads provide a good opportunity to lock-in attractive yields if selected with a bottoms-up approach.

In the equity market, select large-caps have continued the bull market whilst the breadth of the market is negative. Since early 2018, mid-caps and small-caps have been generally bound southward. This run of falling prices comes after a record rally and pricey valuations, which had funds turning wary of the segment. Funds still prefer the stability of large-caps, but are starting to turn optimistic on mid-cap stocks, with allocations creeping higher. Small-caps are yet to find favour. Perhaps the time is ripe to add allocations to small and mid-caps in a systematic manner.

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