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 July 01, 2019

Chart of the Week: With Fed funds futures currently pricing in a 100% chance of at least a 0.25% cut in rates at the July 31 Federal Reserve meeting, Avalon analyzed what happened historically with stocks in the year before and after an initial rate cut (see chart). Our analysis also looked at easings associated with recessions versus insurance cuts. On average the S&P 500 fell about 14% in the year before the first rate cut when associated with a recession, but then went on to gain 5% in the year after. In situations that turned out to be insurance cuts, the S&P 500 rallied by over 4% on average before the cut then continued to rise by 23% in the year following. While it might seem obvious to say with the S&P 500 near an all-time high, stocks do not seem to be discounting a recession currently. In fact, the behavior of stocks is very similar to previous periods where the Fed cut rates without a recession. The S&P 500 gained 4% in 2Q 2019 placing the one-year trailing price return at 8.3%. Avalon still believes that the odds favor no recession over the next twelve months. This likely leaves us with upside to stocks if the view holds, but significant downside if the global economy truly falters.

  WEEK IN PREVIEW

  • Geopolitical: Presidents Trump and Xi Jinping met during the G-20 last week. They agreed to restart trade talks with no additional tariffs on China for the “time being” and allowing U.S. companies to supply Huawei. President Trump also indicated that China would begin to purchase more agricultural products. Markets will continue to monitor the progress of trade negotiations between the U.S. and China. The White House is reportedly considering indexing the capital gains tax to inflation. OPEC and allies meet in Vienna to set production policy.
  • U.S.: ISM manufacturing for June probably slowed further to 51 from the prior month’s 52.1 but should remain above the level of 50 which defines expansion versus contraction. The June employment report will be closely watched to judge the strength of the economy. Nonfarm payrolls are expected to increase to 160,000 from 75,000. The unemployment rate should remain unchanged at 3.6%. Atlanta and NY Fed estimates of 2Q GDP growth are 1.5% and 1.3%. U.S. markets close early on July 3 and are closed on July 4 in observance of Independence Day.
  • Europe: May retail sales month-over-month for both the Eurozone and Germany are expected to improve to 0.4% and 0.5% respectively. German factory orders for May should continue their weakness at -6.3% year-over-year. U.K. June Markit manufacturing PMI expected to rise fractionally to 49.5 from 49.4. The process to succeed U.K. PM Theresa May continues with the next PM likely named around mid-July with about three months remaining until the October 31 Brexit deadline.
  • Asia: Japan’s Tankan indexes deteriorated overall for 2Q. China’s June official PMI manufacturing and service were little changed at 49.4 and 54.2. The Caixin manufacturing PMI reading was weaker at 49.4 versus 50.2 in May with the services PMI expected later in the week.
  • Central Banks: The central banks of Sweden, Poland and Romania meet with no major changes in monetary policy expected. The central bank of Australia is expected to cut rates by 25 basis points which is their second rate cut in this cycle. Global central banks have generally begun another easing cycle with both the U.S. and Eurozone signaling that future easing is now the baseline expectation.

  WEEK IN REVIEW

  • The S&P 500 corrected slightly by -0.3% after reaching a record high last week. Materials (1.5%), financials (1.5%) and industrial (0.3%) were the strongest sectors; while real estate (-2.7%), utilities (-2.1%), and healthcare (-1.2%) were the weakest sectors. Financials were helped by strong stress test results allowing a significant return of capital to shareholders. WTI and Brent crude were up 2.1% with tensions between the U.S. and Iran continuing and the OPEC meeting on the horizon. Energy stocks underperformed the commodity with sector up 0.2% and MLPs gaining 0.8%. Small cap stocks outperformed with the Russell 2000 up 1.1%. The 10-year U.S. Treasury yield declined to 2.01% and high yield credit spreads reflected decreased risk tolerance by widening.
  • The U.S. dollar was slightly weaker against both developed market and emerging market currencies. Developed international stocks as measured by MSCI EAFE outperformed the S&P 500 returns in U.S. dollar terms (up 0.6%); however, on a hedged-currency basis, developed market stocks were up 0.2%. Emerging market stocks outperformed the U.S., as the non-hedged return gained 0.2% for MSCI EM.
  • The 10-2 yield curve narrowed and ended at 24.8 basis points. Another curve measure of three-month yield six quarters forward – three-month yield was inverted slightly more and ended the week at -51.7 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 at least two net cuts in short-term rates over the next year and a half. Our view remains that the odds of a recession in 2019 remain low and Avalon now expects two rate cuts 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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