Source: Bloomberg, Avalon Investment & Advisory as of May 24, 2019

Chart of the Week: As trade tensions have risen, risk assets have declined with the S&P 500 now about 4% off its highs. Investor sentiment has swung from overly optimistic at the end of April to very pessimistic currently. Interestingly, the current rebound off the 2018 Christmas Eve lows has faded from being one of the strongest to exactly equal to the average rebounds for 20% declines not accompanied by a recession (see chart). The good news is that if the current rebound continues to follow this average outcome then it would gain an additional 7% by the end of the year. Historically, only one of the fourteen post-WW2 rebounds ended lower from this point with median additional return of almost 13%. The bad news is that there are no U.S. and China trade talks scheduled and the heated rhetoric on both sides makes it unlikely that any agreement can be reached before Trump and Xi meet in late June at the G-20. Financial market volatility seems likely to remain elevated, but Avalon does not expect as severe a reaction from the S&P 500 as we saw at the end of 2018. The difference is that the U.S. Federal Reserve is not discussing rate hikes like in 2018 and is holding steady while monitoring the downside risks. Futures markets have priced in an almost 80% chance of a Fed rate cut, but that far overestimates the probability in our view. Avalon still expects a trade deal to eventually be reached and no recession in 2019 even if the trade negotiations drag on and additional tariffs are implemented.

  WEEK IN PREVIEW

• Geopolitical: Markets will closely monitor the progress of the trade negotiations between the U.S. and China after the escalation of tension regarding Chinese technology companies last week. President Trump visited Japan with a bilateral trade agreement expected perhaps in July.
• U.S.: 1Q GDP expected to be revised lower to 3.1% from 3.2%. May manufacturing readings likely show strength as Dallas Fed manufacturing outlook should rise to 5.8 from 2.0 and Richmond Fed manufacturing index doubles to 6. April personal income is expected to rise while spending slows. NY and Atlanta Federal Reserve 2Q GDP estimates are currently 1.41% and 1.26%.
• 1Q S&P 500 Earnings: 97% of companies have now reported with 76% and 59% beating earnings and sales expectations respectively. The blended earning decline improved to -0.4% year-over-year (Y/Y) with better consumer discretionary earnings driving the improvement last week. Sales are running at 5.3% Y/Y. Avalon still expects 5% Y/Y earnings growth in 2019 for the S&P 500 with some downside risks as discussed in the previous weekly notes. This week has eight S&P 500 companies reporting including DLTR, DG, GPS, COST & ULTA.
• Europe: The Eurozone has a host of May confidence readings which will be eyed in the wake of the continued trade tensions. Germany’s May unemployment rate likely held steady at 4.9% while retail sales for April should rebound back into the positive. U.K PM May resigned last week effective June 7 and the Brexit challenge will remain for the new government with no real path forward. The results of the European Parliamentary elections will be dealt with this week.
• Asia: April industrial profits Y/Y for China fell to -3.7%. May PMI readings will be watched closely to judge China’s economic momentum after cooling a bit last month. Japan reports April monthly labor data with the job market remaining very tight. April industrial production and retail sales should both improve over the previous month.
• Central Banks: The central banks of Ghana, Kenya, Hungary, Canada, Guatemala, Sri Lanka, South Korea, Bulgaria and the Dominican Republic are expected to keep monetary policy rates unchanged this week.

  WEEK IN REVIEW

• The S&P 500 posted a loss of almost -1.2% as the market reacted to the escalating tension toward Huawei and potentially other Chinese technology companies. Energy (-3.4%), technology (-2.8%), consumer discretionary (-2.2%) were the laggards, while utilities (1.7%), healthcare (1.2%), and real estate (0.3%) were the outperforming sectors. WTI (-6.9%) and Brent oil prices (-4.9%) were both very weak, leading to the decline in MLPs (-1.1%) and the energy sector. The 10-year U.S. Treasury yield fell to 2.32%. High yield credit spreads were unchanged last week, but investment grade credit spreads widened with the pressure on stocks.
• Developed market outperformed the S&P 500 as the MSCI EAFE posted a -0.9% loss on a hedged-currency basis. Emerging market international stock indexes also outperformed the S&P 500 in U.S. dollar terms with a loss of -1.0%. The U.S. dollar was weaker against both developed market and emerging market currencies. The non-hedged MSCI EAFE posted a -0.7% decline.
• The 10-2 yield curve further narrowed and ended at 15.4 basis points. Another curve measure of three-month yield six quarters forward – three-month yield continues to be inverted at -32 basis points. The yield curve has historically provided an accurate forecast of future recessions when the difference in these measures turns negative, also known as inversion. Yield curves are one of the major indicators that we monitor to judge recession risk, but these inversions typically happen a year or more in advance of an economic recession. In addition, stocks have historically had significant advances post-inversion. The three-month yield six quarters forward yield is now reflecting that the market expects a cut in short-term rates over the next year and a half. Our view remains that the odds of a recession in 2019 remain low despite the trade conflict and Avalon expects no rate hikes from the Federal Reserve in 2019. Avalon continues to monitor the data closely. Please see our Avalon Perspectives publication, The Yield Curve and Equity Returns, from April 26, 2018, for more details.

Phan Phan Duong, Senior Analyst

Henry J. Lartigue, CFA, Managing Partner

Samuel E. Rines, Chief Economist

Bill Stone, CFA, CMT, Chief Investment Officer

This report is furnished for the use of Avalon Investment & Advisory and its clients and does not constitute the provision of investment or economic advice to any person, nor the recommendation of any security. Persons reading this report should consult with their investment advisor regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report. Statements regarding future prospects may not be realized. The information contained in this report was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness, or completeness by Avalon Investment & Advisory. The information contained in this report and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in this report nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Avalon Investment & Advisory does not provide legal, tax, or accounting advice. ©2019 Avalon Investment & Advisory. All rights reserved.

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