Market Perspectives

Sentinel Trust Company, LBA Investment Committee Bruce L. Swanson, PhD JUNE 2018

The combination of plateauing with low inflation numbers pushed out overseas growth and higher Treasury the path of Bank of England rate hikes. rates contributed to dollar strength that boosted European equities, but Japan’s corporate spending and labor not emerging markets. Overseas market remained strong, with the job- developed markets outperformed the opening-to-applicant ratio hitting 1.6X. US by nearly 2%, but emerging market However, investor attention looked equities finished modestly in the red. ahead to the September elections in News flow over the month included assessing whether Prime Minister Abe’s increasing Russia sanctions, US labor policies would continue. costs, tariff threat uncertainty, as well While China’s reported 6.8% growth as airstrikes in Syria and potential new (on strong retail sales) was reassuring, Iran sanctions (which fueled a 6% rally the large 100 basis point cut in the RRR in crude oil). (bank required reserve ratio) evidenced Economic Developments a shift in government efforts to offset macro credit tightening in the shadow Global growth continued to impress, lending market, as more stringent with the International Monetary Fund regulations were eliminated or delayed. (IMF) forecasting a robust 3.9% for 2018. A regional divergence has Market Action emerged, with growth rates declining overseas, but poised to pick up in the US equities managed a modest gain US. While remaining above trend, despite the strong dollar without Eurozone growth has rolled over, with significant style or capitalization biases, Germany lowering its 2018 forecast although the energy sector gained to 2.3%. European inflation also 9% and staples fell 4%. International disappointed, remaining unchanged at developed markets held up well despite 1% as goods prices were weighed down trade and geopolitical tensions, with Spring Recap by the lagged effect of the stronger lower relative growth translating into Euro. In response, European Central a respite from local currency strength Despite starting with the worst Bank (ECB) President Draghi followed and more hawkish monetary guidance. first day of the second quarter with remarkably dovish guidance, still European markets saw both UK and since the Great Depression, refusing to specify a target date for Eurozone issues gain 4% on dovish global equities ended the ending ECB bond buying. First quarter central bank guidance. Japan rose 1% volatile month modestly UK growth was only 0.1%, the weakest in dollar terms net of the weaker Yen as cyclical issues did well; the “BoJ higher. in five years, on weather-induced weak construction; that figure in combination put” was much in evidence as central bank equity purchases drove realized mix augured well going forward as index returns gained 3-5% depending volatility from 33 to 6 in ten days. capital expenditures increased 6% (vs. on their constituent weights, with 2% expected) and final retail sales aluminum up 11% (Russia sanctions), Emerging and frontier markets were in increased 1.9% with little change in Brent crude up 8%, and precious metals the forefront, falling on both systematic inventories. To be fair, weakness in core fractionally lower. Although foreign and idiosyncratic news. Argentina, European bond markets contributed to peers outperformed, US real estate Eastern Europe, and Brazil were down the poor Treasury market. investment trusts (REITs) overcame 3-5%. The higher interest rates to finish in the Turkish Lira Although “Emerging and frontier markets were in black. fell 11%, as weakening late- the forefront, falling on both systematic a popular month (as 10-year and idiosyncratic news.” carry trade Treasuries hit May Recap inevitably 3%), US high- Global equities again finished modestly unwound in front of upcoming yield bonds still managed a 0.7% gain. higher. May was another volatile elections after a long period of dollar As has been the case throughout the month that featured pronounced US borrowing and unorthodox monetary period of rising rates, lower rated issues outperformance as its 2-3% gains policy. Despite the 8% spike in Brent outperformed, with spreads tightening compared to 2-3% losses overseas. crude oil, Russian equities actually fell to post-crisis lows around strong Strong US earnings and the favorable 8% (the most since December 2014), earnings outlooks. CCC-rated issues growth outlook positioned domestic triggered by the Ruble’s 10% fall as gained 1.4%, versus 0.2% for higher stocks to maintain earlier gains in new sanctions targeted individuals rated BB bonds. such as metals mogul Oleg Deripaska Municipal bonds “Strong US earnings and the favorable growth (no obvious close ties to the Kremlin). outperformed outlook positioned domestic stocks to maintain Elsewhere, Indian stocks gained 4% on reduced net earlier gains in the face of trade tensions and Italian despite currency weakness and higher issuance, with oil prices on increasing confidence in political turmoil that briefly threatened an existential strength in the 10- Eurozone crisis.” the ongoing cyclic recovery. China year maturity range stocks were little changed. and in lower quality Bonds and Interest Rates issues. Non-investment grade bonds the face of trade tensions and Italian in the Puerto Rico and tobacco sectors political turmoil that briefly threatened After rallying early in the month on were up 1.5%. At the other extreme, an existential Eurozone crisis. The weaker than expected job growth and emerging market bonds were hard hit latter development triggered a flight flat hourly earnings reports, Treasuries by rising rates and weaker currencies, to quality in the forms of the largest fell as rates increased 15-20 basis points with dollar-denominated bonds falling one-day Treasury rally since the Brexit across a broad range of maturities, on 2% and local-currency bonds down vote and a spike in the dollar (that the Federal Reserve Board’s (Fed) more 3.5%. The offshore Chinese high-yield piled systematic risk on to self-inflicted constructive outlook, stronger retail market was weak on heavy issuance emerging economy woes across their sales, and rising employment costs and as local firms needed to refinance currency, bond, and equity markets). oil prices. March Fed Open Market maturing on-shore shadow banking Committee minutes showed little debt. May’s geopolitical shocker came out concern about sluggish first quarter of left (and right) field in Italy. The growth, while at the same time bringing The 2% gain in the popular dollar populist coalition’s platform combined forward their forecast for hitting the index understated its broader strength. the supply-side, low flat-tax ideas of 2% inflation target from 2020 to 2019. The greenback gained 3.5% against the (Northern) League with the welfare/ March retail sales beat consensus for emerging currencies, which were guaranteed income of the Five Star the first time in four months, finally negatively impacted by country-specific Movement, partially financed with a showing evidence of the effect of developments as well as by China’s 250 billion Euro sovereign debt write- tax cuts. Wage pressures increased threat to retaliate against possible US down. Investors cast their own vote, as private sector wages and salaries tariffs. With the strong oil move due triggering an eight-fold(!) blow-out in increased 2.9%, the largest since 2008. to the likely US withdrawal from the Italian-German two-year yield spreads Finally, while first quarter growth Iran deal, lower inventories, and strong in just a few days on fears that a slowed from the previous quarter, the refined product demand, commodity possible new election might become a referendum on Eurozone membership. market peers. While the broader index bad weather to blame: the European Subsequently, the crisis was avoided fell only 3.4%, Latin American shares manufacturing index fell to a 15-month as the coalition moved to plan B (by fell 14%. Brazil plunged 17% as the low and inflation disappointed transferring their potential Eurosceptic resolution to a massive trucking strike (although expectations picked up in finance minister to another department) called into question optimism over sympathy with higher oil prices). Japan and received formal approval to govern. future reforms and a market-friendly reported a negative 0.6% quarterly election outcome. While officially a growth with falling inflation, although Equities frontier market, Argentina fell 22% as industrial shipments suggested a near- US equities gained 2.8%, led by the central bank’s loosening of inflation term bounce. growth, quality, and momentum factors. targets in the context of an overvalued currency precipitated a currency crisis Interest Rates and Bonds Technology stocks gained 7.5% as that required IMF intervention. India financials, staples, and utilities lagged, Treasury market volatility increased fell 3.6%, as encouraging news on with the latter two posting negative 20% from the start of the month as growth, tax collections, and weather returns. Growth stocks outperformed 2-year and 10-year yields rose to (monsoon forecasts) contained the value stocks by 350 basis points, with 10-year and 7-year highs, only to damage from an unexpected interest smaller cap growthier issuers gaining fall sharply in response to Eurozone rate increase. China and Russia were 6% versus 0.6% gains for the large- geopolitical turmoil, before recovering relative safe-havens, gaining 1%, cap value sector. REITs and master on the strong late-month jobs report. with the latter benefitting from some limited partnerships (MLPs) continued The Barclays bond index gained 0.7%, sanction easing. Uncertainty over trade their recovery from earlier year lows as longer dated Treasury yields fell tensions weighed on the space, as US/ with US REITs up 3% (rising for the more than 10 basis points; investment- China appeared far apart and NAFTA third consecutive month), while MLPs grade corporate bonds gained 0.5% talks missed an important milestone. gained 5%. On a year-to-date basis, the despite modestly wider spreads. US technology sector has outperformed the Economic Overview high-yield bonds failed to participate, consumer staples sector by nearly 2500 being little changed, but lower rated basis points. While US growth appears to be issues continued to outperform with accelerating, international releases CCC-rated issues up nearly 1%. International developed equities fell continued to point to advanced- Municipal bonds outperformed across 2%, with a similar style pattern, as economy growth stepping down from the entire credit spectrum, even on a growth stocks outperformed value 2017 levels but still remaining above pre-tax basis, as 5-year municipals stocks by more than 4%, no doubt trend. Growth estimates for US (2.8%), gained 1% and lower quality issues reflective of weak financial sector Europe (2.3%), Japan (1.5%), and UK gained as much as 2%. Despite the performance in Europe (the Eurozone (1.5%) are near the highest levels for Treasury market gains, developed- bank index fell double digits). While the year. Even conservative estimates market non-dollar bonds lost more than broader European equities were flat in target at least 3% second-quarter US 2%, with non-dollar high-yield bonds local terms, the Eurostoxx index fell growth. First-quarter growth revisions losing more than 3%. Emerging market 6% in dollar terms as even the core saw a minimal inventory build and 11% bonds continued to be weak across markets of France and Germany fell annualized research and development the board as problems in Turkey and 4%. Not surprisingly, Italian stocks fell growth. The US Institute for Supply Argentina led to contagion elsewhere 12% after the new populist coalition Management report evidenced system- that intensified after the Italian induced government nominated a long-time wide supply bottlenecks on the heels of Euro weakness/dollar strength. Eurozone skeptic as finance minister. rising transportation costs, with factory Emerging market dollar-denominated Spain fell 9% on peripheral contagion backlogs at their highest levels since debt fell 2%, while currency weakness and an unexpected change in leadership 2004. Consumer confidence remained drove 5% losses in local debt. following a no-confidence vote. elevated despite higher oil prices. Developed market excitement was The unemployment rate fell to 3.8% Absent the Italian theatrics, Treasuries decidedly Euro-centric, with Canada, (not lower since 1969), with even the might have been little changed in Australia, Japan, and the UK all broader U6 unemployment measure at a May as both Fed commentary and finishing up about 1%. 17-year low. inflation reports were inconclusive. While the Fed left rates unchanged as Latin America was to emerging markets Elsewhere, Eurozone quarterly growth expected, individual members who what the Eurozone was to its developed fell from 0.7% to 0.4%, with more than previously were labeled as dovish have come out in support of the need announcement. While the year-end the US pursuing an unorthodox late- for ongoing gradual rate hikes. At curtailment of central bank bond cycle fiscal expansion, the burden of the same time, May meeting minutes buying was expected, the guidance that tightening will fall to the Fed and, more pointed to a collective comfort in the earliest actual rate hike would not generally, US financial conditions. letting inflation run above target. occur until after the summer of 2019 at As discussed in previous letters, the Inflation developments were similarly the earliest was not. tightening in financial conditions can mixed, with core inflation showing no signs of acceleration (falling “With central banks in Europe and Japan on hold until the end short of expectations in remaining at of next year and the US pursuing an unorthodox late-cycle fiscal 2.1% year-over-year). The Fed’s core expansion, the burden of tightening will fall to the Fed and, more personal consumption expenditures generally, US financial conditions. As discussed in previous letters, (PCE) inflation indicator was revised the tightening in financial conditions can take many forms, including downwards from 2.5% to 2.3%. On higher real interest rates, wider credit spreads, lower or range- the other hand, hourly wages rose by a bound equity prices, a stronger dollar, slower global growth, more warmer than expected 0.3%. volatile financial markets, less fiscal stimulus, and greater economic or geopolitical uncertainty. To be clear, additional Fed rate increases Currencies and Commodities on their own do not contribute to additional tightening, unless the increases are more than the market already expected.” A flight to quality and wider rate differentials, both of the “interest” For all of the talk about a hawkish take many forms, including higher real and “growth” varieties, contributed to Fed, policy remains accommodative, continued dollar strength. The dollar interest rates, wider credit spreads, particularly for this stage of the lower or range-bound equity prices, a was up 2% against major currencies, economic cycle where: particularly against the Euro, which stronger dollar, slower global growth, traded as low as $1.16 and fell more • growth is well above trend and more volatile financial markets, less than 3%. The Australian dollar, Swiss accelerating, fiscal stimulus, and greater economic Franc, and Japanese yen maintained or geopolitical uncertainty. To be clear, their value. Emerging market currencies • unemployment is already 0.7% additional Fed rate increases on their plunged once again, falling 3.5%, with below the Fed’s own estimate own do not contribute to additional 6% losses in the Mexican peso and of full employment, tightening, unless the increases are more than the market already expected. Brazilian real. • manufacturing is facing supply Commodity indices gained 1% despite bottlenecks, and Financial Conditions modest declines in crude oil and gold as • private sector wage growth is We had previously noted a remarkable natural gas spiked 7%. Brent crude hit picking up. statistic that as of late January, US a 4-year high of $80 against a backdrop financial conditions (as measured of potential Iranian sanctions before Furthermore, the Fed has already by Goldman Sachs) were even more falling sharply on reports that Russia communicated that a period of above- accommodative than during the 2000 and OPEC would loosen production target inflation will be met with relief, dot-com era. While conditions have cutbacks. not resistance. Even if the Fed wanted tightened overall as the dollar has to act more proactively, the prospect Current Thinking rallied 5% against major currencies, of at least 15 more months of negative intermediate Treasury yields are 35 The drafting of this letter was delayed rates in the Eurozone ties its hands as basis points higher and investment pending this week’s ECB meeting unexpected tightening might prompt grade credit spreads are 35 basis where President Draghi continued to a spike in the dollar. Finally, the Bank points wider. We are only returned surprise (me) with remarkably dovish of Japan recently reiterated the need to to December 2017 levels and have monetary guidance. One can see that maintain its asset-purchase program as probably moved little more than 33% of others thought the same because, in inflation shows little signs of picking where we need to be. It is worth noting post-announcement currency trading, up. that high-yield bond spreads are only for the sixth straight time the Euro With central banks in Europe and Japan 25 basis points wider, US growth is traded down after Draghi’s meeting on hold until the end of next year and accelerating, implied equity, and bond

2001 Kirby Drive, Suite 1200 Houston, Texas 77019-6081 www.sentineltrust.com market volatility is unchanged (despite makes up 43% of the European Union income” threaten long-term fiscal the elevated realized volatility) and economy, 28% of the broader Organi- solvency, 2/3rds of Italians support the regulators have given a nod and a wink zation for Economic Co-operation and European Union, government-debt-ser- to highly leveraged bank lending. Development – OECD - economies, but vice coverage will improve due to the only 13% of the US). lagged effect of lower interest rates and The recent tariff actions and risks of its the banking system has raised capital The US macro-backdrop is supportive further escalation can be placed within levels while making good progress for now, but intermediate-term risks are rationalizing bank loans. this “financial conditions” framework. rising and valuations are high. Accord- However, before doing so, as a trained ingly, while desirous of adding to risk The obvious place to search for funda- economist I am disconsolate that the exposures where fundamental value mental value is in emerging markets US is no longer the champion of free appears, we will continue to maintain a (EM), given the double-digit declines trade, a theory whose implementation defensive posture, selling into strength since late February. Whether, when, has lifted so many out of poverty across as appropriate. As outlined in our last how, and where to buy are questions the world. Sentiment aside, from a letter, we became incrementally more with less obvious answers, as there is a constructive on US equities, feeling fascinating debate between Harvard’s game-theory perspective, the US is that, with weak post-January perfor- Dr. Carmen Reinhardt who has predict- in a position to extract some “wins,” mance, the passage of time, corporate ed a true crash and various emerging however mis-defined, as our economy tax cuts, and a positive growth outlook, market apologists, often at sponsor is growing faster and is less open in valuations had improved, particularly in firms. terms of trade (can better absorb any the energy and financial sectors. Since adverse effect) and we have lower that time, the market has rallied 6%, the I find myself somewhere in the middle. It is true that many EM countries have existing tariff levels (easier argument). dollar is up 5% against major curren- cies, and the energy sector has gained gorged themselves on low-cost debt From a quantitative perspective, the (particularly in the corporate sector) most recent 25% tariff on $34 billion 13%, even more than technology. Surprisingly, the financial sector is little and that rising US interest rates and of Chinese goods amounts to only 1% changed despite higher interest rates. a stronger dollar might contribute to of total US imports, so while there Given these results, we sold into recent a downward spiral of (1) higher local may be increased market volatility and market strength, while lowering our tar- interest rates (particularly for oil im- very modest price pressures and output get energy weight over the period from porters), (2) a stressed corporate sector, losses, the real fear should be one of 14% to 10% and our technology weight and (3) an economic slowdown. QT escalating risks. In that regard, one from 14% to 12%. The financial sector (quantitative tightening) in the US will only magnify the challenges with the hopes that this negotiating approach was maintained as a large overweight. Incremental funds were allocated to cost and availability of dollars. Finally, yields some form of resolution before policy mistakes have been widespread our economy slows and populist consumer staples and healthcare areas, including large-cap biotech, on relative and upcoming election outcomes in pressures rise. weakness. Mexico and Brazil are viewed with less optimism. Near-Term Backdrop International Preference At the same time, I am sympathetic to The near-term macro backdrop seems We are maintaining our preference the view that emerging market fun- remarkably supportive, despite the trade for international equities and remain damentals are better now than in past war risks, to the extent to which my constructive on European peripheral crises and that valuations compares biggest risk is that of a boom/bust cy- banks, despite the angst in Italy and the favorably to its own history and to that cle. This might result partly from years prospect of yet another year of negative of the developed world. While EM of excessive monetary accommodation rates punishing net interest margins. government debt has increased from and partly from fiscal stimulus at such a At the same time, the unusually ac- 36% to 48% of gross domestic prod- late stage in the business cycle. Impor- commodative policy and associated uct since the financial crisis, advanced tantly, this would be occurring at a time weaker Euro will continue to support economy debt has increased from 84% when inflation is rising and the Fed will the ongoing economic expansion and to 104%. While 50% of EM debt in be unable to pressure the brakes any to mitigate the downside from trade the benchmark is dollar-based, 85% of harder. One could argue that trade un- risks, thus supporting the recovery in the broader EM debt market is in local certainty might dampen growth through real estate values and other forms of currencies. Furthermore, outside of a higher market volatility and economic bank collateral. While Italy is not Spain few benchmark countries, most local and political uncertainty. It might also (highly competitive, booming econo- EM debt is held locally; for example, in trigger an unsustainable spike in the my) and proposals to roll back retire- Brazil, the foreign share is only 12%. dollar, as US/international growth dif- ment reforms and hand out “guaranteed Importantly, the recent downdraft has ferentials might diverge further (trade

2001 Kirby Drive, Suite 1200 Houston, Texas 77019-6081 www.sentineltrust.com continue todeteriorate. consideration shouldmarketconditions EM equitiescanrally, animportant debt marketsmustfirststabilizebefore risk-management perspective,EM our fixedincomeportfolios.Froma would beanattractivediversifierin timing ispremature.Suchinvestments relative downsideriskismodestifour alternatives arenon-existent,andthe are attractive,highyieldingnon-dollar local currencyinstrumentsasvaluations in thepublicdebtarea,emphasizing strategies, myimmediatefocuswillbe of additionalEMpublicandprivate While wewillstepupourexploration rate. internally fundedfromthehighsavings similar toJapan,giventhatthedebtis is quitepossible,theaftermathmightbe while somesortofbaddebtimplosion complicates anyaggregateanalysis; the sizeofgrowthChina(anditsdebt) justment hasalreadybeenmade.Finally, suggesting thatmuchoftheneededad modestly overvaluedtosomewhatcheap, improved EMcurrencyvaluationsfrom are non-existent,andtherelativedownsideriskis attractive, highyieldingnon-dollaralternatives local currencyinstrumentsasvaluationsare focus willbeinthepublicdebtarea,emphasizing EM publicandprivatestrategies,myimmediate “While wewillstepupourexplorationofadditional modest ifourtimingispremature.” - 2001 KirbyDrive, Suite1200 Houston, Texas 77019-6081 www.sentineltrust.com