A Market Nagged by Geopolitical Concerns Rises
June 14, 2019

In this strategy briefing…

FSInsight Investment Views

Near Term View: Choppy but not toppy. U.S. stocks remain the safe haven
YE Target: 3,125 (YE P/E 17x · 2020E EPS $184)
Style: Cyclical
Additions: AMP, GRMN, ITW
Deletions: QCOM, ABBV, D

Your Weekly Roadmap

Vito J. Racanelli
Formerly a Senior Writer at Barron's, where he covered stocks, bonds, and financial markets.

A Market Nagged by Geopolitical Concerns Rises

Pick your poison. Markets added one more nagging concern to fret over: potential military conflict in the Mideast. No, it’s not particularly original, but investors like worrisome scenarios with which they are familiar. Then there are the trade wars and the potential global slowdown, and the question of will the Fed cut rates soon or not. The market inched ahead 0.5% last week anyway.

To me the Mideast is one more worry that shouldn’t be ignored but it is not particularly convincing in its bearishness. Wars have a habit of breaking out at unexpected times, but I still think it’s a low probability. What’s in it for the theoretical combatants?

On Friday, in particular, equities suffered following an attack late Thursday on two oil tankers in the strategic Gulf of Oman, which is an important crude shipping channel. In quiet summer trading, such headlines seem to take more urgency. The strike heightened anxiety about conflict in the Persian Gulf. Oil and gold prices jumped The U.S. blamed Iran, which denied involvement. I’m always amazed when the market suffers from Mideast tension, as the headlines say. Sadly, it seems the Mideast was ever thus.

More pessimism was engendered by a report from Morgan Stanley Friday that said its proprietary Business Conditions Index fell the most since it was created, reaching the lowest since the 2007-08 financial crisis. Hmmm.

Fading—at least for now—is the ferocious rally of early June that came on the Federal Reserve’s subtle but clearly communicated potential turn away from monetary tightening. Though it has faded from the headlines, it remains still very much uppermost in investors’ minds. The Powell Put keeps support under the indexes.

As noted above, behind the seesaw action last week lay free-floating anxiety about China’s economy, which evidences a slowdown, as well as the ever present threat of a worsening U.S.-China trade situation. The Standard & Poor’s 500 index finished at 2886. It briefly moved above the 2900 level but could not hold it.

Friday, data released showed U.S. May retail sales rose a seasonally adjusted 0.5% from a month earlier. It suggests economy generally remains on a steady course, despite all those worries discussed above. According to Bespoke Investment Group: While it may not have looked like anything special given the weaker than expected headline reading, there actually wasn’t much not to like about May’s retail sales. In addition to being slightly better than expected after stripping out autos/gas, April’s report was revised significantly higher.

Inflation remains tame, a dilemma for the Federal Reserve, but a positive development for American consumers looking to shop. Remember, there’s a switch located deep inside the Marriner S. Eccles Federal Reserve Board building, rumored to be in the chairman’s office. When it’s flipped up then rate cuts come, and stocks rally in kneejerk fashion. (For more on Fed see page 6.)

I’m still of the mind that it will likely be an up and down summer (see our technical view on page 8 from Robert Sluymer) for stocks. Yes, that’s no fun, but really, look at how far the market has gone just from the December low.

Separately, Uber (UBER), Lyft (LYFT) and Beyond Meat (BYND), fairly recent IPOs, will soon be added to the FTSE Russell indexes. That’s likely to attract some index and exchange traded funds buying of the shares, though for large cap Uber and Lyft stocks it might not be enough to move the needle. So far, Uber and Lyft share action has been underwhelming while Beyond Meat has been sizzling.

Yields on Germany’s 10-year government bonds fell to their lowest level on record at minus 0.262%. The yield on 10-year U.S. Treasuries was flat at 2.08% from previous Friday. Yields fall as bond prices rise. Gold prices hit a 14-month high before paring back slightly, with spot gold up 0.1% at $1,341.70 a troy ounce.

Bottom Line: Continued choppy action until Q3.

Quote of the Week: From Ten years ago, all the smartest people told us that it was impossible for us to “drill our way out” of out oil and natural gas dependency: the U.S. simply didn’t have enough oil and gas reserves. Well, ten years later where are we? The world’s largest oil and gas producer. We’re now exporting both energy commodities. As recently as 2005 the Department of Energy was still projecting that by 2020 the U.S. would need to import as much as 20 percent of its natural gas needs. So we started building LNG terminals to handle the imports. Handy that turned out to be—now they are serving as export terminals.

Questions? Contact Vito J. Racanelli at or 212 293 7137. Or go to

signature of Vito J. Racanelli
Vito J. Racanelli, Managing Director, Senior Editor and Market Intelligence Analyst

Tom Lee's Equity Strategy

Tom Lee
Previously Chief Equity Strategist at J.P. Morgan from 2007 to 2014, top-ranked by Institutional Investor every year since 1998.

Non-Consensus View: Cyclical Stocks Should Come Alive

The market consensus is sometimes correct but sometimes wrong. I like to push against the consensus. Not only is it intellectually stimulating, but when the consensus is wrong investors can do well by using a contrarian approach.

Currently, for example, the central thesis of market skeptics is that numerous political risks—such as the ongoing U.S.-China trade spat, a looming hard Brexit later this year, and President Donald Trump’s regular shoot from the hip tweets—will undermine corporate and financial market’s confidence sufficiently enough to lead to a selfsustaining economic contraction. That’s otherwise more commonly known as a recession. This is a consensus view and as such, investors are defensively positioned.

Yet there’s some cognitive dissonance here: Why then are cyclical stocks—such as consumer discretionary and industrials—doing well this year and also leading in the rally from the June 3? (See nearby chart.) Secondly, why is the real estate sector second best?

sp500 sector relative performance to sp500 Non Consensus View: Cyclical Stocks Should Come Alive

I believe that cyclical stocks are responding to, among other factors, the steepening long term yield curve and to rising inflation expectations.

Cyclicals are leading year to date, and do so despite the 7% correction in May. The interesting sector anomaly is real estate, which reflects a rising inflation risk.

Historically, the only time the market generally sees strong cyclical relative performance is when the long-term yield curve is steepening. This is the case currently, and I think owning cyclical stocks is the appropriate investment stance as well. This is analogous to the 2009 2010 period, which is fitting because I believe a new bull market started in December 2018, when stocks fell 20%–a bear market—from the September’s all-time high, on an intraday basis.

The inflation risk is perceived to be rising because the Fed’s forward 5-year breakeven inflation rate less the consumer price index—a measure of that risk—has risen this year. (The breakeven rate is derived from the nominal 5-year Treasury yield minus the 5-year TIPS yield.) The gap between expected and actual inflation has widened, suggesting financial markets are pricing in a rise in inflation risk.

Investors shouldn’t misread the drop this year in the US Treasury 10-year yield, which as I have argued several times earlier, is more due to zero interest rates in much of the rest of the world’s major bond markets than to a potential economic slowdown.

Meanwhile, even as bears fret about the inversion of the 3 months-10-year Treasury yield spread and as the front end of curve is pricing in a Federal Reserve easing of the Fed funds rate quite soon, the more important long-term yield curve has moved counter to that and is steepening.

Indeed, the best indicator of business cycle health is the long term yield curve, notably the 30 year-10 year spread. And its steepening suggests long-term growth outlook is accelerating and there is stronger growth ahead. The spread, now about 40 basis points, was just 12 bps one year ago. That’s bullish for cyclical outperformance, and similar to 2009-2010.

us treasury 30y 10y yeald spread Non Consensus View: Cyclical Stocks Should Come Alive

The inversion in the front end reflects the need for the Fed to cut rates to correct for having tightened financial conditions in 2018, which aren’t hurting the long-term growth outlook.

Additionally, as all the world knows by now, the Fed has made a very quick about face in the last month and is now expected to cut interest rates in 2019 instead of hike. Fed futures are pricing a rate cut potentially as early as next month. A rate reduction often leads an expansion in the market’s price/earnings (P/E) ratio.

When the economy is not in a recession, as now, such Fed cuts lead to an average P/E expansion of 1.7 times over the next six months. This implies the forward P/E (2020) should rise to about 17 times, which would put the S&P 500 index comfortably at 3,100 or higher by year. My yearend target of 3125 is based on 17 times my S&P 500 Index EPS estimate of $184 in 2020.

What could go wrong? With purchasing managers index surveys weakening, the current stall in economic momentum could lead to an economic downturn. However, this isn’t my base case and the US economy remains fairly resilient.

Bottom line: I’m constructive on equities and see tailwinds for cyclicals. The following are the ticker symbols for 21 highly-ranked cyclical stocks: TRP, GM, BKNG, LMT, MMM, NSC, CSCO, ADP, MSFT, LYB, APD, NUE, CVX, XOM, PSX, BLK, NTRS, COF, FB, GOOGL and DIS.

signature of Tom Lee
Tom Lee, Head of Research

Fed Watch

The Fed Funds Rate Cut Watch Is On

Next week sees a Federal Open Market Committee (FOMC) meeting June 18-19 but markets don’t expect any fireworks, to judge by the CME’s fed futures market. (The FOMC sets the Federal funds rate, the interest rate at which depository institutions lend reserve balances to other depository institutions overnight, on an uncollateralized basis.)

The CME market has been a pretty good indicator of where investors believe rates will be at each FOMC meeting. Currently, futures have a probability of a first rate cut at almost 90% at the July 31 FOMC meeting.

I have to interject that in my years of watching the Fed, a rate change in mid-summer without a compelling reason seems less likely than the CME’s 90%. I defer to markets, but my read of it is, as I have noted, the Fed has clearly changed the direction of its stance and it’s only a matter of time for a cut. I’m guessing September. The Wall Street Journal recent poll of economists says three-quarters of them look for a reduction by the fall.

The Fed has its hands full with conflicting data. The world economy is slowing down but inflation isn’t threatening and hasn’t yet sustainably approached the Fed’s 2% target. The U.S. May import price index dropped 0.3%, according to data released Thursday. That follows a May inflation report that showed growth in consumer prices slowed to 1.8% on the year and a May producer-price index rise of just 0.1% from the previous month. Clearly, inflation isn’t a threat.

The yield on the U.S. Treasury 10-year bond was flat at 2.08% from one week ago. Yet the rate curve steepened, as the two-year note fell faster and harder than the 10-year.

Upcoming: 6/18-19 – FOMC meeting. The press conference afterwards needs watching. The next FOMC meeting is July 30-31.

Recommended Stock Ideas

Focus Insight Stock List - Week 24

Below we’ve highlighted the FocuS stocks that we recommend across at least two of our investment strategies for 2019.

Figure: Focus Insight Stock List
As of 06/14/19, source: FS Insight, Factset

06151 Focus Insight Stock List   Week 24

The Focus Portfolio outperformed the S&P 500 by 10 bps since its inception.

Technical Strategy

Robert Sluymer
Former Managing Director leading RBC’s U.S. Technical Research team with over 26 years of expertise in investment research and technical analysis.

Be Patient, Hold Your Fire and Keep the Powder Dry

So far, markets look to be tracking reasonably well the roadmap I’ve highlighted in the past: the previous weeks’ action is part of the temporary zig-zag I expect to continue into early Q3. Weekly technical indicators, which track 1-2 quarter shifts, should return to neutral to oversold territory, setting the stage for another multi-month upside move in equities later this year. Overall, the bigger picture pattern looks very similar to what developed in Q2-Q3 2016 and is the reason I remain optimistic for 2H19.

Small-caps action, however, has been notably sluggish and uninspiring, causing some clients to pushback on my outlook. However, I’ve seen markets transition from worry back to optimism over many cycles and it always feels and looks very uncertain in the late stages of a multi-week correction, about where we are today. Always.

So, let’s take a closer look at the Russell 2000 chart below of weekly data to identify technical levels that will help signal an improving technical backdrop.

1) Momentum – The top panel, a weekly momentum indicator, was overbought and peaking in late Q1, one reason I cautioned Q2 was likely to be more volatile. While still negative, I’m expecting this indicator to bottom and turn up by early to mid Q3. The Russell needs to rally just over 4% to turn that momentum indicator positive and thereby signal a new upside move underway.

2) Price – The current price pullback continues to look very similar to what developed in Q2/Q3 2016 shortly after the cycle low in Q1 2016. The Russell 2000’s price today is pulling back after a strong Q1 rebound from what I believe was another cycle low in December 2018. Given an uptrend is defined by higher highs and higher lows, a move back above the Q2 highs at 1618, just over 5%, is needed to confirm the index has resumed its uptrend.

Russell 2000 Index

20190615 FSinsight Technicals 2 Be Patient, Hold Your Fire and Keep the Powder Dry

3) Relative performance versus the S&P 500 – This is where my bullish view is less convincing given the relative performance trend has been down since the middle of 2018 AND is challenging levels last seen near the 2016 lows. Interestingly, this downtrend looks similar to what I see for many banks, which isn’t surprising, as the small-cap index is heavily weighted in financials and other cyclicals. It’s important to note, though, that it would not take much small-cap index rally to reverse that relative downtrend. What could cause that? I expect an oversold rebound in bond yields will likely be the catalyst in Q3.

201906151 Be Patient, Hold Your Fire and Keep the Powder Dry

Bottom line: Stay patient and keep the powder dry into Q3. The markets need to consolidate further into Q3 before I expect to see a more definitive technical improvement develop.

201906152 Be Patient, Hold Your Fire and Keep the Powder Dry
signature of Robert Sluymer
Robert Sluymer, Managing Director and Technical Strategist

US Policy

L . Thomas Block
Formerly Global Head of Government Relations at J.P. Morgan for 21 years, and previously served as Legislative Assistant and Chief of Staff in the House, and Legislative Staff Director in the Senate.

Congress-White House Fiscal Cliff Discussions Underway

Under the radar, the U.S. Congress and the White House have begun quiet discussions on trying to avoid the fiscal cliff that lies down the road this fall for the federal government.

The Feds are facing a triple monetary threat: a need to raise the government’s debt ceiling; pass a budget by October 1, and deal with the mandatory $50 billion and $70 billion in cuts for domestic and defense, respectively, required under the Budget Control Act of 2011 (BCA).

The White House would like to increase its leverage for spending cuts by removing the threat of a government default and increase the debt ceiling in a separate bill. However, House Speaker Nancy Pelosi (D) Thursday announced she would have none of that plan, that there will be no debt ceiling increase without a budget deal that increases domestic spending.

Senate Leader Mitch McConnell (R) shepherded several debt ceiling and budget deals through the Congress while negotiating with the Obama White House, and he favors a bipartisan deal that increases the BCA caps and suspends the debt ceiling. Under his program, both the BCA caps that lead to sequestered cuts if not raised and the national debt would be included in a two-year plan taking the issues off the table past the 2020 election.

McConnell knows a budget crisis never ends well for the party in control and his top priority is preserving the Republican Senate majority in 2020 that includes his seat in Kentucky.

On the 2020 Presidential front the Democrats have announced that 20 candidates qualified for the first primary debates June 26 and 27, and that three announced candidates didn’t qualify.

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L . Thomas Block, Washington Policy Strategist
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