Author: WCM (Page 7 of 9)

Several currencies in developing economies have been weakening against the US dollar and not surprisingly, volatility, depicted on the chart below, has been rising. Part of the fallout is related to US dollar strength against the Euro, Japanese Yen and British Pound but rising interest rates in the US are also a significant influence. External dollar-denominated debt issued by emerging economies in recent years has risen and repayment could be challenging if the dollar continues to strengthen. This warrants monitoring. We continue to have no emerging market debt exposure at this time.

John Williams, current head of the Federal Reserve’s San Francisco branch, will soon be taking over as head of the influential New York branch. He was recently discussing a range of topics including the flattening of the US yield curve, which measures the spread between shorter and longer-term US Treasury rates. The risk is that as the yield curve inverts – when short term rates rise above long term rates – a recession usually follows (represented as shaded areas spanning back three decades).

It appears that we may have some time before the curve inverts, if it does at all. Every cycle is different and this one is unique due to the absolute low level of rates throughout the world. Interest rates in Europe and Japan may anchor US rates lower than they otherwise would be. That, in turn, may distort the shape of the curve in coming quarters and with it change the economic impact.

Investors have been focused on gyrations in the US equity market and rightfully so. It has been quite harrowing to witness the large intraday price swings in the major US indexes as market participants react or sometimes overreact to tariff and trade-related posturing among the Trump administration and trading partners. Our sense is that the market is attempting to establish a new equilibrium once a new global export/import balance is established. A new global balance of trade may not be bad for the world as long as the outcome is truly fairer and freer trade, but still, the uncertainty around this issue has caused painful volatility.

Meanwhile, the US bond market as measured by the Bloomberg Barclays US Aggregate Index depicted below, has offered a relative safe haven at least since mid-February. However, the index is about 1.5% lower year-to-date. We are concerned about rising interest rates in the US and the impact on bond prices and potentially the stock market. In the bond portion of our portfolios we have allocated to investments that are shorter duration and tend to perform better in rising interest rate environments. On the equity side of the equation we have more exposure to less rate sensitive sectors. We view the interest rate environment as a major risk and we believe that the US Federal Reserve will continue to be highly transparent and deliberate as it raises policy rates. Another anchor to interest rates in the US is accommodative central bank policy in the Eurozone and Japan where comparable interest rates are expected to remain low for longer.

There has been an increased level of volatility in US equities across several key larger capitalization indexes going back to the first week of February. Lately, investors have been attempting to identify what may lead to a market bottom and many have been drawing attention to S&P 500 price levels relative to its 200-day moving average — a key long-term trend measure. On April 2nd the S&P 500 price index closed below the 200-day moving average for the first time since late June 2016. Today, the index recovered and closed slightly above that trend line. The question for investors is whether the correction will deepen or did yesterday mark the resumption of the bull market.

On a total return basis (which we find more relevant as that is what people actually get by investing), the S&P 500 has yet to close below the 200-day moving average. That is critical in our view, although we do acknowledge that this measure is precariously close to turning negative. What appears to be escalating trade friction between the US and China among other trading partners, potentially developing into a much broader trade war, is the most likely reason US equities have entered a corrective phase. The market is now trading at valuations last seen in 2016 which could be a bargain since fundamentals in the US remain strong and earnings are expected to be robust in coming quarters.

Every cycle is a bit unique, but usually small- and mid-size companies underperform in the late stages of market cycles and ultimately contract more than their large-cap counterparts as markets correct. There is much concern that this cycle is in an advanced state and a consolidation or correction phase is upon us. What we find interesting is that small cap US stocks are rebounding and approaching all-time highs. We view this as an important development if the trend continues, especially with the heightened volatility of late. We also note that it appears that small- and mid-cap stocks have contracted less over the past week or so than large-caps on days when the major indices are negative. If these key segments of the stock market can surpass levels reached earlier in the year, that would mark obvious positive milestones and could lead the overall market higher still. Fundamentals dominate our analysis, but these technical factors are worthy of our attention as well.