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Market Perspective for May 18th, 2018

Emerging Markets

I am nervous about emerging markets.  EM can handle a gradual strengthening of the US dollar to a point, but not the sudden surge that we have seen lately.  For an EM issuer, owning debt in dollar terms means that as the dollar appreciates, the amount of local currency needed to service that debt rises.  This leaves less currency in the local economy, so sudden significant dollar appreciation is like a sudden recession.  This plays out first in vulnerable economies and/or those countries whose debt profile favors dollar-denominated debt over local currency debt.  Turkey and Argentina have been hammered recently and Brazil is struggling as well.  This could ultimately spread throughout EM debt and equity markets, so the situation bears careful watching.    I still believe that investing in both asset classes is a prudent long-term asset allocation decision, but you always have to be aware that currency instability can occur at any time so periodic sell-offs like this are a WHEN, not an IF.  Those that are more tactical in nature will sell at times like this and they will buy into rallies, just as they did last year.  It’s the nature of the beast.

In the emerging market debt space, I believe that Doubleline Low Duration (DELNX) and Ashmore EM Short Duration (ESFAX) are worthy of consideration.  Both funds, by nature of their short durations, have outperformed longer duration alternatives, which is to say they have lost less.  If you want to make a tactical call on currency rates, you should consider a to shift to a hedged foreign bond (non-EM) like PIMCO (PFOAX) or the Vanguard or iShares ETFs (BNDX, IAGG).

On the EM equity side, less volatile funds may be a good way to access the asset class right now.  On the mutual fund side, I believe American New World (NWFFX) has performed relatively well.  iShares Currency Hedged EM (HEEM) is the defensive play on the ETF side.  A word of caution that frontier market funds like Ashmore Emerging Market Frontier Fund (EFEAX), , are especially vulnerable right now.

Commodities

Commodities tend to perform well in an environment where economic growth is increasing, such as we have now.  Interestingly enough, gold does not.  Gold isn’t really an industrial metal, so unlike copper or aluminum, demand doesn’t meaningfully pick up as GDP rises.  Furthermore, the expectation that the Federal Reserve will hike several more times this cycle means that real (inflation-adjusted) interest rates will continue to rise.  If you can earn a positive after-tax return in a safe security like a Treasury note, why do you need gold?  It is my belief that the time to own gold is when the economy begins to roll over such that the Fed can’t raise rates any further even though the inflation measures are still rising.  In other words, when real rates are falling or negative.

A couple of commodities funds that you may want to research further are PIMCO Commodities Plus Strategy (PCLAX) and Doubleline Strategic Commodity (DLCMX).  The former is more aggressive and as such has better performance in 2018.   If you’re interested in a more eclectic offering the LoCorr Long/Short Commodity fund (LCSAX) is one to look at. It’s a managed futures fund with the ability to go in either direction.  The managers tend to avoid financial futures (stocks or interest rates) which have really tripped up a lot of managed futures funds in recent years.

I also believe it’s a good time to be cautious in the energy sector despite the nice run-up over the last two months.   The oil futures curve is in backwardation implying the market expects oil to fall steadily through the rest of this year and 2019.

Interest Rates

Interest rates have been rising recently due to economic strength and the Fed unwinding its balance sheet.  The 10-year note hit 3.10% on May 16th, the highest level since July 2011 (yes, higher than at any point during the 2013 “taper tantrum”)<1>.  There is an element of “boiling frog risk” here, in that nobody knows exactly how high is too high for stocks to shrug off.  At the close of the market on May 16th, however, the 5-year T-note had a yield of 2.94% while the S&P 500’s yield is 1.94%<2>.  As people begin to realize that they can earn 3% yield in Treasury notes, I tend to believe that will begin to weigh on equities.  Not calling a top, just saying be careful.  Since 2009 we’ve been in an environment where there has been no return for savers.  Today there finally is although the yield remains modest.  It will be interesting to see if reluctant investors become savers again the next time stocks sell-off.

Election Related Seasonality

Seasonally, the six months leading up to mid-term elections tends to be one of the worst times to invest in the four-year presidential cycle.  Perhaps this is because the party in office tends not to do well and that creates policy uncertainty.  In any event, I just wanted to pass that along.


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<1> Source: YCharts.com

<2> Source: YCharts.com

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