After Scorching First Half, Nobody Knows What Comes Next For Markets

If you didn’t know any better, you’d be inclined to think Donald Trump would be pretty pleased with how things have gone for markets during the first half of 2019.

Thanks in no small part to the Fed and their global counterparts pivoting decisively back towards accommodative policy, assets of all stripes have rallied this year.

Barring some kind of truly dramatic meltdown, US stocks will log their best first half since 1997. The high yield ETF is on track for its second-best half on record.

Meanwhile, the bearish cacophony around the dollar is growing as the prospect of Fed cuts along with cracks in the US economy are set to finally take their toll on the greenback, which, until recently, has been resilient despite plunging real yields and the dovish Fed shift. At the same time, long-term US borrowing costs have plummeted. The combination of a softer dollar and falling long-term yields is conducive to looser financial conditions.

Thanks to the concurrent rally in equities and bonds, this was one of the best H1 performances on record for a standard, 60/40 balanced portfolio. As Goldman notes, “US 10-year bonds had the best 1H performance since 1995 and the German 30-year bond actually posted a 15% total return, the second-best 6m return in the last 25 years – better than STOXX 600 and close to the S&P 500”.

(Goldman)

All of this should please Trump. To top it all off, gold – his favorite thing in the world besides Ivanka – is on fire.

Just to drive the point home, have a look at cross-asset performance globally (this chart is especially handy, as it breaks out May in the interest of showing you how the rekindling of the trade conflict weighed on certain assets).

(Goldman)

Again, H1 2019 has been remarkable. In many ways, this year has been the polar opposite of 2018, when USD “cash” outperformed ~90% of global assets.

But the president isn’t satisfied. He wants more. Or, if that’s not accurate, he wants the Fed to inoculate him against a recession which, if you trust the yield curve, is likely to come calling just months ahead of the election. Indeed, the bond rally described above (which has served to drive benchmark yields in the US to the lowest of Trump’s presidency), has created a marked divergence with equities, a “disconnect” some say argues for stocks catching “down” the bond market’s “reality”.

Of course, the irony is always the same. Trump himself has perpetuated global growth jitters and the trade tensions are almost surely behind the recent plunge in PMIs and confidence data stateside. At the same time, though, his trade war is one of the main reasons the Fed is now prepared to cut rates. Those rate cuts may well be the only thing that saves the US economy from rolling over. He’s a genius. Or he’s a moron. Or he’s both.

Nobody is quite sure where things go from here. In a testament to that, Goldman just upgraded bonds to Neutral for 3 months in their asset allocation. And they’re still noncommittal on risk for the next 90 days, with equities, commodities and credit all at Neutral too.

With everything up in the air and the world in flux coming off a scorching H1 and headed into a laughably indeterminate H2, Barclays is out with their latest global outlook, a 61-page tome which, as is custom, kicks off with a short letter from Ajay Rajadhyaksha, the bank’s Head of Macro Research. As H1 winds down, here is the proverbial lay of the land, from Ajay’s perspective…

Arguably the biggest development in financial markets in Q2 19 is the breath-taking rally across global rates. 10y US Treasuries have rallied 50bp in the past three months, the front end of the US curve is now pricing in over 100bp of easing by end-2020, and ever larger parts of the world’s bond markets keep sliding into negative yield territory. Central bank rhetoric has affirmed market pricing, with the June FOMC strongly hinting that rate cuts are coming and ECB President Draghi stating that “in the absence of improvement” in inflation data, “additional stimulus will be required.” Trade tensions between the US and China remain elevated ahead of a critical G-20 meeting, and sentiment indicators on global trade and manufacturing are under pressure. All seems as it should be: the global business cycle might be turning over in part thanks to trade tensions, central banks are going to ease accordingly, and bond markets are pricing this in. But if this explanation is correct, someone forgot to tell the world’s risk markets. US equities just hit all-time highs, global stocks are up over 15% on the year, and credit spreads in the US and Europe are well below the levels of December 2018, let alone the more serious widening in January 2016. What gives? How does one reconcile the gloom in bond markets with the cheery disposition of risk assets? One explanation is that equity investors have convinced themselves that central banks will ease quickly enough to offset trade-related drags such that global economies escape unscathed. But that argument assigns to central banks an almost magical ability to fine-tune policy and assumes that any cuts will immediately support economies. This is not supported by history: when business cycles turn, equities decline, even as central banks are easing aggressively. Instead, we believe a major reason for the bond rally is that investors have revised downward their assessment of “neutral” policy rates in the world’s major economies, most notably in the US. If this is correct and bonds are rallying because investors expect easing due to a recalibration of monetary policy, rather than purely for cyclical reasons, then the stock market move is more consistent with the bond rally. This argument is supported by the fact that long-dated rates have fallen in lockstep with the front end for much of 2019 and by the Fed’s recently marking down its long-term neutral rate significantly. The persistent weakness in inflation and market expectations in most major economies also supports this theory. We do not mean to downplay the economic effect of trade tensions. There is an industrial/manufacturing slowdown playing out, and the June payroll report suggested some spill-over into the broader US labor market. And the Fed has expressed caution about rising economic uncertainty and weak inflation. But one employment report does not a recession make. The global services economy remains in reasonable shape, job markets across the US and Europe are still healthy and the US consumer is still spending on big-ticket items, such as autos. The world economy should slow for the next few quarters, but we think this is not the end of the business cycle, but a lull in growth.