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Over to you G-20

The Days Ahead: G-20 meeting.

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One-Minute Summary. Markets had two things on their mind. One, the G-20 meeting and, two, quarter end rebalancing. What? Yes, rebalancing is a big deal given how many funds (think of all those target dates funds, pension accounts, risk-parity funds) have to maintain their Equity/Fixed Income allocations. After a barn-storming start to the year, with Treasuries up 7%, equities up 14% and similar recoveries in international and emerging markets, many portfolios will have rebalanced in the last week or so.

Outside the technical side, markets are running on low rates, the expectation of lower rates and the hope of a trade deal. Fair enough, but those have been the headlines for months now. We need a new narrative to keep things moving. While 2019 has been good (see below for our mid-year scorecard), we've only advanced some 4% since January 2018 with two corrections of 10% and one of 20%.

Now sit back and enjoy the G-20 meeting.

1.     How are Emerging Markets doing?  Better than 2018 (down 16%), which was worse than 2017 (up 37%) and much better than 2016 (up 11%). So far this year, we’re up 9%. The reasons why Emerging Markets took a hit in 2018 are pretty straightforward: trade tariffs, a strong dollar and interest rates.

What about all that growth, the richer middle class, the emergence of the, well, emerging markets? Well, all that's true but, one, these are countries that rely on exports for growth. For China and India, it’s 20% of GDP. For other SE Asian countries it ranges from 40% (Korea) to over 100% (Vietnam and Hong Kong). Compare that to the U.S. at 12% and you can see why the headline “trade wars hurts them more than us” holds true. And it's a general principle in capital markets that it’s not the level of change that matters as much as the rapidity of change. So a quick 10% fall in exports to some emerging markets is very dangerous indeed.

And, two, many Emerging Markets countries carry dollar denominated debt. China and India are at 14% and 20%. Some are more than double that, such as Turkey, Mexico and Indonesia. So when the dollar strengthens, debt-servicing costs rise.

Last year the Fed raised rates four times and the dollar strengthened by 8%. That was the average. Against the Renminbi, it strengthened 9.7% from 2017 lows. Against the Korean Won, it was 10% and against Turkey and Argentina (both in the news for economic crisis) it was 25% and 55%. That all meant higher debt service costs. And a lot of that debt is private so it hits companies and households.

Now, with U.S. rates on hold, a slower U.S. economy and lower short-term rates, we've seen some dollar weakness and that is good news for Emerging Markets.

We've shown the dollar (in blue) against the Emerging Markets index. The shaded areas show that when there's dollar weakness (blue line up), Emerging Markets do very well. And vice versa. While the dollar has not weakened materially this year, we think it’s likely to. The rationale is simple enough starting with the President calling for it, lower interest rates, the possibility of some, any, trade deal, the U.S.’ twin deficits, the rise of gold and the attraction of the Euro.

The last few weeks have seen a weaker dollar and, if this persists, it will undoubtedly be a very good signal for Emerging Markets equities.

2.     We said some things would happen in 2019, how did we do? Fair enough. The year’s not over but this is an appropriate time to pull out the scorecard. This is what we said:

1. Will the U.S. economy roll into recession? No. What we’re seeing is a slow down from peak performance.

Score: We'll stay with that. We’ve seen some slowdown. Every week comes with a slowing indicator. Last week it was consumer confidence but we think that was tied to the Mexico tariffs-that-never-were. Not enough to see a recession coming.

2. Will the Fed raise rates? Not in the first quarter and probably not in the first half of the year.

Score: Not only was there no rate rise but the whole talk shifted to cuts. We still think they’ll hold for a while. A July rate cut looks too soon.

3. Will there be a trade deal? Probably. We know that both sides have an incentive to close a deal.

Score: Not yet but we've had postponements of the extra tariffs with China. We still think something will break to the upside.

4. Will U.S. Equities start to recover? Yes, but it may be a rocky road. In 2018, U.S. stocks had their first down year since 2008.

Score: Wow, yes but we didn't expect the takeoff we saw since January. We’ve had a pause since May and we’re only recovered from September levels. We're cautious given the run up.

5. And how about international and Emerging Markets? Nearly 100% of global markets were either in correction (down 10%) or bear (down 20%) markets in 2018. But the markets are selling at a substantial discount to the U.S. and that looks like an opportunity.

Score: Right but for the wrong reasons. International stocks still look cheap but the trade and general slowdown has meant they've underperformed…but by a lot less than 2018.

6. Where will the U.S. 10-Year Treasury end?  About where it is now. We think U.S. treasuries will be a valuable “risk off” asset class especially as corporate credit spreads look vulnerable.

Score: Another one where we got the direction right but magnitude wrong. Treasuries at the end of 2018 were 2.7% and had rallied from 3.2% . Today we’re knocking on the door of a 10-Year Treasury with a “one handle” at 2.0%. They’re expensive but good insurance.

The year’s not over, we know, but so far we’d characterize 2019 as a lot of fire and brimstone but solid returns. And it will probably stay that way.

3.     Inflation, not a problem is it? No, it isn't but the Fed acts as if it’s non-existent. There has been plenty of talk over the last week that the Fed needs to get inflation moving. Here’s Neel Kashkari of the Minneapolis Fed arguing that inflation needs to grow and a 50bp cut in the Fed Funds rate will do the trick. The President should love this guy. And here's Jay Powell saying inflation is stuck at less than 2%.

But inflation is not absent, as we’ve described with the whole hedonic thing and here’s the latest Dallas Fed trimmed PCE.

The “trimmed” part is to adjust for outliers that tend to have a) small weightings and b) short term volatility. So out go eggs (0.09% of the index and down 23% in the last month) and car rentals (0.1% and up 26%). You're left with about 50% of the index and some big items, like home rents and meals. And that, as seen from the above, is sailing along at a pretty consistent 2% for the last year.

So what? Well, there may be reasons to cut (trade worries, a lower dollar) but collapsing inflation ain’t one (h/t Pantheon Economics).

Bottom Line: It still looks like defensive stocks are the way to go. We'd notice that dividend-paying stocks are having a day in the sun. Hold the Treasuries.

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Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

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