The Market's Back and Forth

By Ketu Desai

The market stories of the last few months continued to play out in June and July. It was back and forth between strong domestic economic numbers, corporate earnings, tax reform, and buybacks, against global growth, trade, and rate concerns. June started off strong as domestic economic numbers continued to come in strong, many are forecasting near 4 percent growth for the second quarter, including the Atlanta Fed at 3.8 percent. Although as the month progressed, trade and global growth concerns took over, and markets gave up much of their gains from earlier in the month. This back and forth has driven sector and factor performance for the year.

Perhaps one of the easiest places to see the divergence of performance is how global industrials have performed versus small caps. Investments in small caps are less exposed to trade and global growth concerns, while benefiting from the strong domestic conditions. While global industrials such as Boeing and Caterpillar have been proxies for trade and growth concerns and have performed as such. Despite the pain many industrials have felt, Chinese equities have fallen into a bear market, if that is any indication of the relative impact of the trade disputes.

The risk-off sentiment, has caused 10-year yields to fall a meaningful amount in recent weeks. In fact, Morgan Stanley thinks yields have peaked for the year. The 10-year got above 3.10% in mid-May and has fallen steadily since to current levels. While the 10-year has been falling, the Fed raised rates for a second time this year during the month. The Fed now expects to raise rates four times this year. As yields on the short-end have risen and fallen on the long-end, the yield curve has flattened.

The yield curve now sits the flattest it has been since 2007. We are moving closer to an inverted curve, especially with further rate hikes, which is often a predictor of recession. The yield curve has also added to the negative sentiment in certain parts of the market, particularly financials. Financials had their longest losing streak on record in June, according to Bloomberg, despite strong results from the Fed's stress tests, and being among the chief beneficiaries of deregulation and tax reform. Take for instance Citigroup, its stock is down over 16 percent from recent highs, while it will increase its dividend by 41 percent and buyback 10 percent of its shares. Similarly, Bank of America said it will increase its quarterly dividend by 25 percent and buyback 7 percent of its shares.

With much of the S&P impacted by trade, global growth, or rates, only four of the S&P's eleven sectors are positive for the year, with technology a notable outperformer. Earnings growth and share buybacks have provided support for this market. Second quarter earnings were expected to be in full swing in July with the expectation of 19 percent growth and nearly 9 percent revenue growth, the highest levels since 2011.

UBS estimates that companies will buyback $700-800 billion in shares. Buybacks are already up 83 percent year-to-date. Technology will buyback approximately $233 billion. I don't think it is any coincidence that markets have fallen during Q1 and Q2 buyback blackout periods. JPM estimates that companies have only thus far brought back about 10 percent of their overseas cash. Further, it is expected dividend issuance will top $500 billion and there will be approximately $1.3 trillion in M&A. The combination of these amount to about 10 percent of the S&P's market cap. Goldman Sachs estimates that trade could negatively impact S&P EPS by about 2-3 percent.

Further down the road there are risks developing, including tighter central bank policy both from the Fed and ECB, federal deficits, slower earnings growth, and diminishing returns of tax policy, however, for now, buybacks, dividends, earnings growth, and M&A, are quite a significant support to the market.

Looking forward, the markets will continue to follow the daily developments in trade talks, focus on second quarter economic and earnings reports.


Ketu Desai is the Principal of i-squared Wealth Management Inc. ( ), an investment management firm based in New Jersey.