Perspectives & Commentary

Avalon produces a variety of investment commentaries.

Our perspectives and quarterly commentary are issued throughout the year and cover a range of investment-related topics.

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Source: Bloomberg, Avalon Investment & Advisory as of May 31, 2019

Chart of the Week: President Trump opened a second front of the trade war by announcing a 5% tariff on all imports from Mexico effective June 10. The tariffs will rise 5 percentage points every month starting July 1 until it reaches 25% or Mexico make substantive efforts to curb illegal immigration. Unfortunately, this action also reduces the possibility of NAFTA 2.0 being enacted. Tariffs have two primary impacts all other things being equal: decrease GDP and increase inflation. While it is impossible to know whether all the contemplated tariffs against China and Mexico will be implemented, the total “worst-case” package could knock as much as 1 percentage point off U.S. GDP. With inflation currently tame, Avalon now forecasts at least one Federal Reserve rate cut in 2019. With Mexico being the number one source of agricultural imports to the U.S., Avalon looks at a millennial staple, avocados (see chart). Due to a difficult growing season, avocado prices were already trending higher. This example also illustrates the impact complexity, since the peso weakened by about 2.5% against the US dollar since the tariff announcement which would cut the impact on the U.S. consumer of a 5% tariff in half. But keep in mind that a strengthening US dollar makes U.S. exports more expensive. Stocks are likely to continue to be volatile and global yields should remain low as markets grapple with the probabilities of a poor worst-case outcome.

  WEEK IN PREVIEW

  • Geopolitical: Markets will closely monitor any new developments in the U.S. trade disputes with China and Mexico. Please see the Chart of the Week for more details. Tuesday marks the 30th anniversary of the Chinese massacre of pro-democracy protesters at Tiananmen Square. President Trump makes a state visit to the U.K.
  • U.S.: May ISM Manufacturing are likely to maintain positive momentum and improve 53 from 52.8, well above the 50-level indicating the line between growth and contraction. The May employment report will be watched closely for signs of economic deterioration. The jobs report should show payrolls rising by 190,000, while the unemployment rate holds at the 49-year-low level of 3.6%. The Atlanta and New York Federal Reserve banks estimate 2Q GDP at 1.17% and 1.48%. In addition to the release of the Fed Beige Book on Wednesday, there are at least 13 speeches by Fed members including Chair Powell on Tuesday. Fedspeak will be monitored closely for hints that an ease could be more likely, as markets are pricing in an almost 95% chance of a rate cut in 2019.
  • Europe: The European Central Bank (ECB) is almost certain to leave its key interest rates unchanged and will present new economic forecasts. The ECB should extend its guidance on rates and provide more details about the new bank loan program. The race to succeed U.K. PM May will accelerate as she steps down on Friday with the U.K. still having no clear plan for Brexit. Markit U.K. Manufacturing PMI for May declined to 49.4 from 53.1. Germany’s April industrial production is likely to be weak month-over-month at -0.5%.
  • Asia: China Caixin Manufacturing PMI for May held steady at 50.2, above the 50.0 line of demarcation. The Services PMI is expected to decline to 54.0, lower than the previous month of 54.5. May Nikkei Services and Composite PMI along with the April Leading and Coincident indexes are expected in Japan.
  • Central Banks: In addition to the ECB, the central banks of Kazakhstan, Australia, Poland, India, Serbia, Ukraine and Chile meet with Australia, India and Ukraine expected to cut their monetary policy rates. This would be Australia’s first cut in almost three years.

  WEEK IN REVIEW

  • The S&P 500 posted a loss of -2.6% as the market continued to decline from escalated trade tension with the new tariffs on Mexico coming as a complete surprise. Energy (-4.3%), consumer staples (-3.9%), communication service (-2.99%) were the weakest sectors, while real estate (-0.8%), material (-1.6%), and information technology (-1.9%) were the relatively more resilient sectors. WTI (-8.4%) and Brent oil prices (-6.1%) dropped further, leading to the decline in MLPs (-2.7%) and the energy sector. The 10-year U.S. Treasury yield fell to 2.13%, 10-year yields in Germany and Japan fell further into the negative at -0.2% and -0.09% respectively. Both high yield credit spreads and investment grade credit spreads widened with the pressure on stocks.
  • Developed market outperformed the S&P 500 as the MSCI EAFE posted a -1.7% loss on a hedged-currency basis. Emerging market international stock indexes also outperformed the S&P 500 in U.S. dollar terms with a gain of 1.2%. The U.S. dollar was weaker against emerging market currencies and stronger against developed markets. The non-hedged MSCI EAFE posted a -1.9% decline.
  • The 10-2 yield curve widened to 20 basis points. Another curve measure of three-month yield six quarters forward – three-month yield further inverted at -70 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 significant 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 but Avalon now expects some easing 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

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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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