Market Focuses on Trade Policies

By Ketu Desai

July was an eventful and strong month for equity markets. For most of the year, investors have been weighing trade concerns versus strong fundamentals. In July, the fundamental data continued to come in strong, while trade concerns eased a bit. Second quarter GDP came in at 4.1 percent, the fastest rate since 2014. While the current recovery is approaching a decade, it has also been one of the slowest in cumulative GDP growth. One of the key reasons for this has been the limited productivity growth.

The latest GDP report showed that fixed non-residential business investment grew by 7.3 percent. This growth in capital expenditures in theory should lead to productivity growth, and sustained growth for the near-term, albeit, likely not at the current level. There is limited evidence that a recession is imminent.

In my judgment one of the key risks to the fundamental outlook is higher inflation, which can cause rates to spike and a more aggressive Fed. Most measures of inflation are near or above the Fed's target, however, the Fed has reiterated that they have a symmetric inflation target, and for now are not prepared to aggressively raise rates.

While there have been some notable earnings misses, overall 83 percent of S&P 500 companies have beat earnings expectations with grow north of 20 percent in the second quarter. The companies that have missed are being punished, with an average decline of 2 percent, and some notably worse such as Netflix, Facebook, Intel, Twitter, Electronic Arts, GM, and Ford. Financials were a particular area of strength for the market during the month, rallying near 5 percent.

Financials benefited from the yield curve slightly steepening, the 10-year moving closer to 3 percent, and strong earnings reports. As tech slid later in the month due to some key misses and being overbought, financials and industrials took the lead for the market.

The significant decline in some tech names is also a reminder for many investors that these are not “safe" stocks, and have volatilities north of 25 percent. It is also a reminder that each of the FAANGs has different business drivers and models, and the market may now bifurcate performance among them, as it did this month.

Industrials benefited from de-escalation of trade concerns, as Europe and the US are progressing on an agreement. It is also notable, that both the US government and the Chinese stepped in during the month to help lessen the impact of tariffs. The Chinese central bank lent more than 500 billion yuan to banks, a push to get them to lend, the largest one-time amount since such injections started in 2014. The Chinese State Council also encouraged local governments to quickly ramp up spending on roads and other infrastructure.

Progress on trade and Chinese stimulus weakened the dollar and helped emerging market equities to stabilize. According to Morningstar, emerging markets (EEM) trade at just 10.7x forward earnings.

Toward the end of July, we started to see a change in leadership, in particular, trades such as such as long tech, small caps, and dollar, started to show some weakness, while long financials, industrials, and emerging markets, started to show some strength.

From a factor perspective, value started to outperform growth. The market rotation helped mask some violent moves underneath, with many tech names in correction or a bear market.

Looking forward, the market will continue to focus on trade and fundamentals, as well as if we have some follow through on leadership change.

----------

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