November Update: Another Rough Month for Markets

 

After a turbulent October, investors were hoping for a relief from the sharp selloff as we move into the slow holiday season. There was some initial relief at the beginning of November as markets rebounded but that turned out to be a dead cat bounce when market started selling off again as crude oil price started plunging. All three major indices, S&P 500, NAQSDAQ 100, and Dow 30 year-to-date return turned red for the fourth time this year.

From a sector perspective, Information sector led the selloff mostly driven by Apple as investors process the new quarterly disclosure policy where they will discontinue announcing the unit sale of individual product category. The market viewed this as a big red flag and raised concern over future iPhone sales which is essentially Apple’s primary cash-cow. This fear spilled over into semiconductor names such as Qualcomm and Skyworks because of their exposure to iPhone sales.

Energy was the second worst performing sector as oil price continue to plunge. Within the last seven weeks, U.S. WTI benchmark prices have dropped from the highs around $76 in early October to $52 as of 27 November. As in the case of any commodity, the drop was due to rising inventory levels. The weekly inventory level has been trending up since September and is edging closer to upper end of 5-year range. This 5-year range is an important barometer for gauging the health of physical crude oil market because it gives insight into the demand and supply balance in a historical context. Any deviation from the average will either drive up the price or pull it down. Should we continue on the current path and break above the upper end of 5-year range, we could possibly see a repeat of 2015/2016 sub $30 oil price.

 The Weekly EIA Inventory Chart

The Weekly EIA Inventory Chart

On the other end, healthcare and utilities were two best performing sectors as investors move into defensive sectors. Healthcare outperformance has been especially interesting because most of the heavy lifting in the sector were performed by major drug companies. Out of the top five best performer, four were drug companies. This quite puzzling because of the current negative political climate around drug pricing.

 

Technology Industry Outlook: E-Sports, Cloud, and Cyber Security

 

According to Aristotle, there is a fundamental irreconcilable split between the world’s process of being and becoming. Being connotes the part of nature that is static while becoming points to the ever-changing fluidity of the world. Today, in the technological era, our process of being, in terms of industrialization, has ended and our process of becoming, in terms of digitalization, has begun and is accelerating faster than ever. The global expansion of the web has flattened our world and made us more connected than before.

This February, during the NFL’s 52nd Super Bowl, the Philadelphia Eagles beat the New England Patriots 41 to 33 in front of 103.4 million viewers from across the globe. American Football is the most viewed sport in the U.S. and has lost 7% of its total average users since 2017. In the meanwhile, the League of Legends World Championship Finals held on October 21st, 2018, was able to garner a total of 200 million viewers worldwide. The up and coming Electronic “Sports” market is taking the world by storm and has already gathered crowds larger than those within some tradition sports leagues. According to Statista, the eSports market is expected to generate $905 million in revenue by the end of 2018 and $1.65 billion by the end of 2021; the sector is expected to grow at a CAGR of 38%. Currently, about 80% of this revenue is coming from sponsorships and advertising and the other 20% is coming from eSports betting, prize pools, tournament ticket sales, and merchandise.

 
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Companies like Activision has already generated nearly $1 billion in revenue off capitalizing on the eSports trend by selling off 12 Overwatch teams last year to sports team owners/supporters across major cities. This start-up Overwatch league has been a huge success so far, generating lots of money across multiple different tournaments, and will set them up next wave of team sales at higher prices. Take-Two Interactive Software also capitalized on this growing eSports trend by creating an NBA 2K League, where 17 of the 30 NBA teams would be represented.

Aside from the gaming companies, traditional technology giants have also been plotting plans to enter into the lucrative eSports market. Companies like Amazon acquired streaming platforms such as Twitch in 2016 in order to tap into the eSports market. Now, Google and Microsoft have recently announced efforts to let people play big-budget, visually complex games on internet connected devices without them having to spend too much on devices such as Xbox or PCs. The game-software sector revenue rose 59% since last year to $121.7 billion and is expected to reach $134.9 billion by the end of the year.

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Game-Software growth and eSport’s market growth carries huge growth opportunities for other parts of the tech industry as well. Demand for cloud and high-speed internet connection is expected to increase as a result of eSports because of the need to constantly integrate data at lighting speeds. During tournaments, a delay of even a quarter of a second can heavily skew the outcome of a game being players. This will accelerate demand for 5G networks once telecom companies start to role it out. Also, increased demand in gaming and 5G networks will also increase the demand for semiconductors which will benefit companies with Advanced Micro Devices and Nvidia. The semiconductor manufacturing industry is currently generating a revenue of $54.6bn with an annualized projected growth rate of around 2.2% per year over the next 5 years according to IBISWorld Research.


By Waiho Zhang - TMT Director, Baruch IMG

Energy Outlook: Looming Fears

 

Overview

The Energy Industry is a multi-factor industry that is not only affected by the performance of companies but the price of the commodity that is used by many companies within the industry. The global benchmark is Brent Crude, and the U.S. benchmark is West Texas Intermediate or WTI.

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Price Build-Up


The price of Brent and WTI have rallied since the crash to $30 a barrel but have recently undergone some strain. The rally was in part due to OPEC’s de-facto leader Saudi-Arabia working with Russia to put supply cuts. That combined with geo-political tensions including the death of Jamal Khashoggi at a Saudi-Arabian embassy in Turkey and sanctions announced on March 12th on Iran who exports nearly 3.5 Million barrels per day, have brought Oil futures to new 4-year highs.


Recent Decline


Oil demand is strongly correlated to GDP as it is inferred that as GDP increases, output has increased meaning a need for oil. We can see GDP globally being threatened specifically with South Korean GDP only expanding by 0.6% missing the expected 0.7% for Q3. The recent slow-down of the global economy has sent shocks to the price of oil. From the beginning of October, Brent is down 10.71% and WTI is down 12.48%. With the Federal Reserve set to raise interest rates again in December and planning three more hikes next year we see that the decade long bull run may be slowing down. There is also a rise in the U.S. dollar index of 1.44% hurting demand for dollar denominated oil futures. Most recently we’ve seen that Russia has weaned off its supply cuts and has no intention of freezing or slowing output levels with fear of undersupply combined with China and India looking to circumvent U.S. sanctions on Iran allowing for higher oil supply and hurting futures.

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U.S. Energy Industry

The U.S. has had a surge in oil production because of their ability to Frack. This allows them to drill multiple wells horizontally instead of one well vertically, allowing for more oil production per well. This practice has enabled the U.S. to surpass Russia as the largest oil producing nation. The largest area for fracking is the Permian Basin, an oil field in West Texas, second only to the Ghawar oil field in Saudi Arabia in production. This has come with some issues. The Permian Basin’s rapid increase of oil production to 3,496,000 barrels per day was not accompanied by an increase in capacity from oil pipelines which move oil to refineries to be turned into usable products. This has caused a supply glut in the Permian Basin forcing Upstream or E&P companies to sell their oil at a discount or transport it by rail hurting earnings. Refineries have benefited from this by acquiring oil at a discount boosting earnings. Refineries in Northern United States are also currently getting their oil at a discount from Canada. As Canada is a large oil producing nation that does not have enough refineries, drillers there sell their oil at huge discounts currently around 60% to American refineries.

By Joseph Vittoriano - Energy Director, Baruch IMG

 

U.S. Homebuilders Facing Onslaught from Higher Rates

 

After the market wide correction towards the beginning of 2018, a majority of the market has been able to recoup its losses, and even extend gains, the story is quite the opposite for homebuilders. ITB, a homebuilder iShares ETF is currently off 33.74% from this year’s highs and continues to edge lower. The decline in homebuilders can be attributed to an amalgam of factors, but the rising of interest rates has been the main driver.

After the fed approved the first interest rate hike of 2018 on March 21st 2018, homebuilders have reacted adversely to the news, and for good reason. As interest rates rise, you see the cost of borrowing follow that as well, causing mortgages to get more expensive and deter homebuyers from bidding on houses. With third rate hike of the year in September and another potential hike during the December meeting, the sentiment surrounding homebuilders will continue to sour. For this sentiment to reverse its path, we need to see moderation in hawkish tone from the FOMC members. 

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Unfortunately for homebuilders, the bad news doesn’t stop at the rate hikes. The current landscape makes for a perfect storm against the industry. The newly imposed 21% tariff on Canadian soft lumber, falling home sales, disappointing earnings/projections and negative analyst sentiment have been weighing down on the sector as well. 

One of the larger emerging threats to the industry is tariffs on Canadian lumber imports. This will cut into margins and adversely affect future growth projections for many companies. This increase in cost will most likely be transferred to the consumer, causing further increases in the cost of building new homes while discouraging even more homebuyers. This is already being shown in the forecasted cost of US homes, with a projected increase of 6.4% for the next 12 months.

The homebuilder industry is incredibly cyclical, and trends are seeming to rhyme with past interest rate hikes in 2007. Once the Fed began raising rates in 2006, the homebuilder etf XHB began its descent, falling 55.4% before the actual market downturn, which started a little more than a year later, in October 2007. The current trend is nearly mirroring the past tightening cycles, slowing projected job growth and the increasing frequency of disappointing earnings by companies within the sector.

 The homebuilding sector may seem relatively isolated, but it is quite the opposite. The industry is vast and has incredible influence over a sizeable amount of companies, including home inputs like Mohawk, Sherwin Williams, Masonite, Scotts Miracle Grow and Home Depot. Companies within XHB or ITB also have a huge impact on many raw material companies across America. A decline in the housing sector could mean trouble ahead for the rest of the markets.

Although the future for the homebuilding sector looks bleak, some analysts believe that there may be a sweet spot in home builders. The super-affordable segment, consisting of LGI Homes (NASDAQ: LGIH) (avg home 220,000-230,000), NVR (NYSE: NVR) and Meritage Homes Corporation (NYSE: MTH) seems like it may have some value left, considering its more affordable price range.

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The bottom line here is that home sales are declining because of rising prices driven by declining inventory of for-sale home due to “mortgage rate lock-in”, rising cost of raw materials due to the trade war, and rising cost of mortgage due to federal reserve rate hikes.

By the Portfolio Management Team, Baruch IMG

 

Industrials Outlook: Aerospace & Defense

 

As the geopolitical landscape continues moving with uncertainty and the world is entering a phase of heightened technological development, a constant focus is on the aerospace and defense sector. As a whole, the A&D (Aerospace and Defense) industry strengthened in 2018 as revenues increased by 7.65%, almost quadrupling last year’s 2.1% growth. Events such as the political dispute between the United States and China pose security threats for many involved governments. In response, the United States government has signed the omnibus spending bill, which set the Department of Defense’s budget at $700 billion, about a 20% increase in two years.

As a whole, Deloitte analysts expect a growth in global defense spending at a CAGR (compounded annual growth rate) of 3.0% from 2017-2022. Tensions in developing countries such as India also factor into this continued growth, which shows little signs of slowing down. As cyber threats continue to evolve, there is also a greater need for cybersecurity to help companies protect their clients' personal information. Therefore, global cyber security spending is expected to grow at an annual rate of 10.2% to $248.26 billion over the next five years.

Aerospace


At the moment, the aerospace market is dominated by large key players, such as Airbus and Boeing, which control a combined 92.4% of the commercial aircraft market. Growth in the aerospace industry is fueled by a rise in the middle class, which is estimated at an additional 140 million individuals annually. This leads to increased capital expenditure in related fields such as air travel, which was accounted for with the record high backlog of commercial aircraft at 14,215 units at the end of 2017.  The industry is facing increased demand and is becoming consolidated and efficient in moving forward.

Increased global fears of warfare and border disputes and increased trade activity are the primary drivers for growth in the aerospace sector. With the Pentagon pivoting its defense focus towards China, Russia, North Korea and Iran there is a renewed market for aerospace presence in these regions. China is also active in land disputes such as that in the South China Sea, which contributes to the overall security threat in the region. As a result, aerospace defense companies with a large government client base have seen a sharp uptick in their contract flow.

Lockheed Martin, with U.S government agencies as its largest client has recently been awarded a $2.9 billion contract for the manufacture of missile warning satellites for the U.S Air Force. This is reflective of the tense political situation worldwide and translates into overall gains for the aerospace defense sector.

On the basis of aerospace manufacturing and transportation, the industry is also showing significant signs of growth. Globalization and an increasing reliance on intellectual capital have resulted in businesses and individuals traveling overseas at one of the highest rates in recent years. In total, revenue passenger miles increased 7% in 2017, which is above 6% annual growth for the third consecutive year. As a result, major aircraft manufacturers are looking internally towards agile growth of their processes, as well as key acquisitions in the M&A space to continue innovating.

Boeing recently acquired a majority stake in the commercial aircraft arm of Brazilian plane maker Embraer SA for $3.8 billion, effectively thrusting the large American maker into the lower end market of aircraft. The expansion of aerospace company operations through M&A opens up the possibility for increased solutions for large-scale institutional clients, such as governments and private contractors.

Furthermore, the opportunity for machine learning and automation in aiding the manufacturing process is a touted possibility in the sector. Drone use for inspection of aircraft wear and tear and inventory management on blockchain systems are just a few examples of the potential for future aircraft production, and these can be potentially implemented into company processes in the coming years. As a whole, the aerospace sector is in the process of entering the next generation of solutions and has a positive forward outlook

Defense


Increasing global tensions are driving growth for the defense industry. The U.S and China have recently taken aggressive stances toward each other. Trump imposed multiple tariffs on Chinese goods, with China responding by imposing their own tariffs on U.S goods. Both countries are increasing their defense spending to prepare for a potential war. There is also increased demand for defense and military products in emerging markets. For example, ISIS is a major threat to countries in Africa, such as Syria, Iraq and Afghanistan. These countries are forced to spend money on defense to protect themselves against terror strikes and cyber-attacks. Due to these global tensions, defense stocks will become hot investments for the next 5 years.

The leaders in defense are the participants of the Pentagon’s MQ-25A “Stingray” competition. This competition was designed to create the U.S Navy’s first carrier-based drone, with Boeing winning the competition and a $805 million contract to produce four naval drones. The competitors also included Lockheed Martin and General Atomics.

Lockheed Martin is the world’s biggest defense contractor and specializes in aerospace defense. General Atomics is a private company that specializes in creating military drones. 

Another driver for the defense industry is the need for cybersecurity. Cyber-attacks, such as data threats, ransomware and malware outbreaks, can cause critical disruption for unprepared countries. Data breaches have surged over the past years, with digital security company Gemalto reporting that 1.38 billion records were breached in 2016 and 1.9 records breached in the first half of 2017. These data breaches can lead to leaked personal data and identify theft, which has affected 15.4 million consumers.

Due to these threats, the cybersecurity market is expected to grow from $138 billion in 2017 to $248.26 billion in 2022. The main attackers are Russia, China, Iran and North Korea, who have been testing destructive cyber-attacks that are aimed toward the U.S and its allies.

To combat this, U.S government has invested much of its spending towards companies that can protect them from these attacks. Companies that the U.S has relied on include Booz Allen Hamilton, Palo Alto Networks and CyberArk. Booz protects the government's information through encryption, which has shown to be the most effective way to protect data. Palo Alto Networks protects its customers through next-gen firewalls, and is best positioned among its competitors to experience robust growth in 2019. CyberArk is unique because it actually protects companies from internal threats such as corporate spies or disgruntled employees. As a whole, the defense sector is in the process of heating up as countries have prioritized spending on defense to protect themselves from other countries and cyber-attacks.

In conclusion, the aerospace and defense (A&D) industry has experienced significant growth in 2018, with expectations of greater growth in 2019.

On the aerospace side, global fears of warfare have caused the government to sign contracts with aerospace securities to protect themselves from outside threats. Due to growing globalization and improved transportation, many middle-classes citizens from emerging markets have travel overseas at a extremely high rate. Finally, major aerospace manufacturers are looking to move into the M&A space in order to attract new clients.

On the defense side, global tensions have resulted in a large amount of countries spending money on defense to protect themselves from cyber-attacks and missile/drone attacks. The U.S government has taken many steps to give defense companies new opportunities, such as increasing the defense spending bill and creating competitions between the defense titans to improve technology. Overall, the A&D industry is anticipating the emergence of conflict and new-age technology, and it is well-positioned to reap its benefits.

By Liam Minerva - Industrials Director, Baruch IMG, Nikhil Kumar and Anqin Chen - Industrials Analysts, Baruch IMG

 

U.S. Labor Market Update, No More NAFTA, a Review of 2018's Third Quarter

 

Last September, the percentage of unemployed people in the U.S. labor market fell to lowest level since December 1969 at 3.7%.

The jobless rate fell from 3.9% in August as the economy added 134,000 jobs, a record 96th straight month of job gains. Furthermore, the upward revision of July and August non-farm payroll numbers were especially encouraging.

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What does this mean for students?
The robust Employment figures and the Job Openings and Labor Turnover Survey (JOLTS) indicates a strong economy which should continue the steady demand for labor.

As of today, there are 6.9 million jobs opening for the 5.9 million unemployed people actively looking for job. Under these circumstances, employers will have to fight for the best talent. This is evident from the recent announcement by Amazon to raise their minimum wage to $15 per hour for all full-time, part-time, and seasonal workers.

The chief economist of job search site Glassdoor summed up the current state of labor market by stating, “This is the best job market in a generation or more”.

Where Does U.S. Labor Market Stand Against Rest of the World?
The current state of U.S. labor market is very robust with the unemployment rate below the 4% natural rate of unemployment.

In Euro Zone, the unemployment rate is more than two times that of the U.S. The situation is even more dire in Spain, where the unemployment rate is close to five times that of the U.S. at 15.3%.

While our Canadian friends up north are struggling with 5.9% unemployment rate, our southern neighbor seems to be in a great shape with the unemployment rate at 3.5%.

U.S. Labor Market by the numbers:

  • Unemployment rate lowest since 1969 at 3.7%

  • Women unemployment rate lowest since 1953 at 3.6%

  • 6.9 million total jobs opening

  • 5.9 million total unemployed people


Out with NAFTA, In With USMCA
On October 1, 2018, the United States and Canada reached to an agreement on revising NAFTA with a new accord called the United States Mexico Canada Agreement. Here are some of the biggest changes to come from the USMCA or Nafta 2.0:

  • 75% of the car parts must be made within the region to qualify for tariff-free.

  • 40-45% of a vehicle must be made by someone earning at least $16 an hour.

  • Canada will offer 3.6% of their domestic milk market to U.S.

  • Canada will scrap milk-pricing policy which has upset producers in U.S.

  • Duty-free shopping limit is raised to $100 to enter Mexico and $115 to enter Canada. This is a boon to the e-commerce companies like Amazon who can now sell more goods.

  • Canada agreed to extend pharmaceutical companies monopoly protection from 8 to 10 yeas.


2018 Third Quarter Market Review:

Healthcare was the best performing sector gaining +14.0%, followed by industrials at +9.7%, and technology at +7.4%. The newly created communications sector was the worst performing sector at -1.4% with materials just above it at +0.8%.


Among the style factor strategies, Midcap Growth was the best performing strategy at +8.5% with Momentum closely behind at +8.3%. The SmallCap was the worst performing strategy with returns of just +3.8%.


Among the qualitative factor strategies, quality outperformed the rest at +8.7% followed by buyback at +7.3%. The insider sentiment was the worst performing strategy returning -0.2%.


Based on the country ETFs, Mexico and Poland were the best performing countries with EWW gaining +11.5% and EPOL gaining +11.0%. The strong performance by Mexico can be attributed to their presidential election result.


On the other hand, Turkey was the worst performing country with TUR falling -20.9% as they deal with a currency crisis.

By Tenzin Thinlley - Director of Portfolio Management, Baruch Investment Management Group

 

Outlook on 2018-19 Consumer Goods & Retail Sector

 

The Consumer Goods & Retail Industry is composed of multi-national companies that manufacture and distribute finished goods and services to consumers. Companies in this industry classify as either consumer discretionary or consumer staples. The consumer discretionary sector deals with companies that experience an increase in demand for their goods and services during times of economic growth. On the other hand, in the consumer staples sector, the demand for a company’s goods and services tends to increase during times of economic contraction.

In the past year, the Consumer Discretionary Select Sector SPDR ETF (XLY) outperformed the broader market with a total return of 29.9% in comparison to SPDR S&P 500 ETF’s (SPY) total return of 15.2%. With an improving macroeconomic backdrop in the United States and a strengthening global economy, the consumer discretionary sector should continue outperforming the market while the consumer staples sector should continue underperforming.

Industry Tailwinds

Over the last few years, consumers are becoming more concerned with their health and the products that they are consuming. Individuals are shifting away from junk food and sugary drinks to premium, organic and all-natural brands. Companies such as PepsiCo, Inc. (PEP) and General Mills (GIS) are in a position where they need to align their product portfolios with consumer’s interests. On the other hand, companies such as Lululemon Athletica Inc. (LULU) and Planet Fitness (PLNT) have experienced an increase in sales and their stock price as a result of this trend.

Since the 2008 Global Financial Crisis, per capita disposable income has increased approximately 25% to $14,398.40. With the unemployment rate at the lowest level in almost 18 years and U.S. growth continuing to increase, per capita disposable income is only expected to improve. Companies who offer discretionary goods such as makeup, designer clothing, electronic appliances, and cars should experience increased sales.

As a result of recently passed tax reforms in the United States, companies are utilizing repatriated cash to acquire other companies and products. Recently, Michael Kors (KORS) announced the acquisition of Italian designer Gianni Versace SpA for approximately $2.35 billion. By doing so, Michael Kors will be able to improve a product portfolio that already includes the Jimmy Choo brand. We can expect other companies to follow suit as they are looking to offset any risk of a decrease in sales over the next few years.

Industry Headwinds

Consumer Goods & Retail companies generate a substantial portion of their revenues in developing regions. With Emerging Market equity and fixed income markets selling off as a result of political and economic instability, companies operating in this region can experience lower sales growth and can face currency conversion risk when reporting sales.

The yield curve, which is the difference between the 2-year and 10-year treasury yields, has been an accurate indicator for upcoming recessions in the past. As of September 28, the yield curve is currently at 0.24%, which is almost the flattest it has been since the beginning of the Global Financial Crisis. If the yield curve is an accurate predictor of economic slowdowns, we can expect consumers to shift from discretionary goods to staples in the next few years.

In general, the Consumer Goods & Retail Industry is expected to outperform the broader market over the next 1-2 years and to remain neutral in the long term with increasing worries of an economic slowdown. As long as a recession does not occur earlier than expected, the industry tailwinds discussed in this article should outweigh any headwinds. With increasing per capita disposable income, a decreasing unemployment rate, and improving macroeconomic conditions, consumers should be poised to continue shopping at retailers, more specifically, those that offer discretionary goods.

By Dominik Sochon - Director of Consumer Goods & Retail, Baruch Investment Management Group

 

Markets Update - DJIA and S&P500 Reach All Time Highs

 

Last week the Dow Jones Industrial Average and the S&P 500 reached all time highs as the news about trade discussion between U.S. and China was announced. While the S&P 500 has already passed its January high previously before the last week record high, it was the first time for Dow.

On the other hand, the technology heavy Nasdaq 100 Index was held back from taking part in the latest all-time-high by major tech names such as Apple, Amazon, and AliBaba. In the case of Apple, it appears that the comment from President Trump about potential tariff on Apple products pulled the company’s stock lower.

 
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Positive economic data on US wage growth has pushed the yields on 10-year U.S. Treasuries note back above 3% as investors anticipate possible further rate increase by the Federal Reserve. Going into 2018, market was expecting 3 rates increase from the Fed. But the slew of recent economic data indicating a robust economy has puzzled the wall street to the point where they are placing a 77.4 per cent probability of a possible rate increase during September meeting. If the Fed did decide to go ahead and hike the rates in September on top of another hike in December, this will the first time since 2008 where Fed has moved the benchmark interest rate more than four times.

 
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Oil price jumped more than 2% to hit its highest since November 2014 at $80.94. Traders are speculating a supply gap from the renewed U.S. sanction on Iran after Saudi Arabia and Russia ruled out any immediate production increase. According to BNP Paribas oil strategist Harry Tchilinguirian, this supply gap will be resolved through high oil prices. This is a heavy blow to President Trump who has called for action to raise global supply.

 
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There is a new sector in town called Communication Services and it includes high profile names such as Netflix, Google, Facebook and smaller names such as Twitter. According to Reuters, “The telecom sector, currently about 2 percent of the entire S&P 500 is expected to have a roughly 11 percent weighting under its new communication services tag”. Not all high-profile names are moving into this new sector with Amazon and Apple remaining in their old sectors. This latest shake up of the Global Industry Classification Standards (GICS) reflects the rapidly evolving global economy and the role of technology in our future.

By Sean O’Dea and Paul Menestrier - Portfolio Management Analysts, Baruch Investment Management Group

 

Outlook on 2018-19 Financials Sector

 

When looking at the financial sector in the beginning of 2018, it may be surprising that the sector’s performance did not lead the S&P500 with the tailwinds pushing the market. With the rising interest rates, recently passed tax reform, strong global economy, and regulatory relief the financial sector should have outperformed the broader market. These factors did contribute to performance but the financial sector ran into headwinds such as a flattening yield curve, trade concerns between key trading partners, and global economic concerns.

Potential Growth Factors:

  • Rising interest rates helps financial companies because as they lend out money, they earn more with a higher interest rate. Banks also are required to keep a certain amount cash reserves, which they will also earn a higher rate on. The Federal Reserve is expected to keep raising rates as the US economy shows no signs of slowing, continually beating expectations. The continual rate rising should help boost revenue for most banks.

  • Bank regulatory reform represents a re-balancing of many Dodd-Frank constraints implemented after the 2008 crisis. One of the recent Dodd-Frank changes regards banks and the total amount of assets that warrant stress testing. The limit used to be that banks with $50 billion in total assets would have to regularly pass a Comprehensive Capital Analysis and Review (CCAR) by the Federal Reserve – that limit has now been raised to $250 billion. This means that regional and community banks that were hesitant to make deals now have more freedom to expand their businesses. Given this, we expect M&A activity to pick up.

  • Volatility in the market boosts trading revenues despite the price declines that may affect the fees that financial companies make off of assets under management. The increased volatility is positive because the higher the volume of trades, the more traders have the opportunity to make spreads as well as commission on those trades.

Potential Negative Factors:

  • The yield curve has been a good predictor of how the financial sector will trade as it has been trading in unison as the curve flattens and steepens. The reason that a steeper yield curve helps banks is that they borrow in the short-term and lend in the long-term. This means that as the spread between the 2- and 10-year Treasury yields tighten, the less money banks are going to earn from net interest income, the main component of banking revenue.

  • Trade concerns hurt corporate confidence which could affect the amount of M&A deals in the broader market. Although trade concerns should affect deal-making, in theory, there has been no slowdown of M&A activity yet, according to S&P Global Market Intelligence, but these affects could be realized as time passes and these problems linger. A lack of corporate confidence also lowers the demand for loans leading potentially hurting the major corporate lenders. These trade conflicts have also contributed to the volatility in the market, a positive thing for financials.

  • Global economic concerns cause risk to financial institutions as an economic instability is bad for loan quality, creating more credit risk. The European economy has been sensitive to episodic events like Turkey’s inflation problem which could disrupt the otherwise positive global economic outlook. All financial institutions are more at home in a strong economy.

The general rating of the financial sector remains to be neutral in the short-term and positive in the long-term. The neutral short-term view is rationalized by the fact that we believe the headwinds in this market will be more impactful in the upcoming months than the positive growth factors. The tailwinds, specifically regulatory reform, tax benefits, and rising rates, should help the companies more in the long-term growth of their businesses. This viewpoint could change if the probability of recession increases at an unexpectedly.

By Noah Mazzola - Director of Financials, Baruch Investment Management Group

 

The State of Emerging Markets

 

2018 is shaping up to be an exceptional year for U.S. equities. The S&P 500 Index, comprised of the 500 largest U.S. publicly traded companies, has smashed through all-time highs and set a record for the longest bull run in history. This exceptional performance has been due, in large part, to a strong earnings season tied together with encouraging economic data points. Some of these key data points include:

  • A record-low unemployment rate.

  • A rising advance-decline line (a technical indicator measuring the number of advancing stocks less the number of declining stocks).

  • 27% year-over-year earnings increase and 11.2% sales growth in the S&P 500 since 2010 and 2011, respectively.

Though these figures are cause for celebration, Wall Street seems to be ignoring the elephant in the room: emerging markets. While the S&P 500 has gained 7.5% year-to-date, MSCI’s Emerging Markets ETF (EEM) has declined 11.8% since the start of January. Much of this significant decline can be attributed to three causes:

  1. The fear of an impending trade war sparked by President Trump's tariff and trade balancing measures.

  2. The U.S. Federal Reserve's decision to follow through with rate hikes going into 2019. Emerging market countries tend to run account deficits and rely on foreign capital to fund these deficits. When the Fed raises rates, ‘carry trade’ becomes increasingly expensive and less attractive to investors.

  3. Currency woes across the globe. As of now, the mayhem in emerging market seems to be contained, heavily impacting the countries depending on overseas money. Some of these affected countries include South Africa, with the Rand down 19.43%; Argentina, with its Peso down 52.70%; Turkey, with the Lira down 43.23%; Brazil, with the Real down 20.37%; and India, with the Rupee down 11.03%.

    • As these currencies tumble further, governments frantically try to halt, or at the very least decelerate the fall. For example, the Turkish Government increased regulations on foreigners shorting the Lira, the Brazilian Central Bank offered 15,000 currency swap contracts in an effort to reduce volatility, and the Argentine Central Bank raised rates from 45% to 60%, in addition to requesting a speeding up of the $50 billion bailout from the International Monetary Fund. Despite all these proactive measures, currencies continue to falter against the U.S. dollar.

Even though the US market is performing well, the Federal Reserve's effects on emerging market currencies has highlighted international dependence on the USD. Worries are now shifting to EM contagion as higher bond yields and expensive debt (caused by the Fed’s rate hikes) could possibly shift currency flow out of emerging markets, hindering local economies and international trade. Some of these effects have already been highlighted in the most recent Institute for Supply Management survey, indicating that America’s factory activity is at the highest level since 2014.

By Sean O’Dea and Paul Menestrier - Portfolio Management Analysts, Baruch Investment Management Group

 

A Review of Summer 2018 Markets

 

Let’s begin with the market update and catch ourselves up with what transpired this summer.

Starting off with major indices, since the official end of the Spring term on May 24:

  • The S&P 500 rose 5.39% (147 points) to 2874. This marks a new record high for the index.

  • The NASDAQ Composite rose 7.03% (522 points) to 7,946.

  • The Dow Jones Industrial Average rose 3.94% (978 points) to 25,789.

  • The Russell 2000 rose 5.96% (97 points) to 1,725.

Data as of August 24, 4:00PM

On to other economic indicators, the unemployment rate fell to an 18-year low of 3.8%, and gross domestic output grew at an impressive 4.1% annual rate in the second quarter, with the final year projection set to be 3%. The P/E ratio over the summer clocked in at around 18.8x as opposed to 21x highs in February. This has been primarily due to huge earnings growth in this quarter.

If there’s one word to mention, it’s “tariffs.” President Trump continued addressing his trade deficit campaign promises by instituting tariffs on Chinese goods, now totaling $50 billion. There are on-going discussions to set tariffs as high as 25% on an additional $200 billion, which if approved, are thought to be instituted in September of this year. China retaliated, placing tariffs on $50 billion worth of American goods. China hasn’t been the only target of the Trump Administration; the European Union, Mexico, Turkey, Japan, and many other countries have been targeted.

Markets have been sensitive to the tariff developments, and fear of a full-out trade war, and a subsequent drop in international trade, has put downward pressure on the markets. With every talk, threat, and speech, markets have bounced back and forth between optimism and despair. It will be interesting to see how this whole debacle unfolds.

The other major headline this summer has been interest rates, specifically the Fed raising the Federal Funds Rate, the interest rate that depository institutions charge each other for overnight reserve balance lending. In mid-June, the Fed announced their second hike, raising the rate a quarter point, to a range from 1.75% to 2%. The Fed Chairman Jerome Powell cited that strong growth and labor markets, tied with a close-to-target inflation levels were some of the drivers behind the decision. Rate hikes are a preventive measure to keep the economy from overheating and causing high inflation. However, the compromise is slowing down economic growth. Following the news, the stock market fell, as investors expect that higher borrowing costs will negatively impact earnings. There are currently two more projected interest rate increases for 2018, and with a September rate hike to 2.00-2.25% at a 96% chance.

The 10-year treasury note, an important confidence indicator, proxy for other interest rates, and widely observed financial instrument, had a yield between 2.82% and 3% over the past three months. Trade tensions and recent emerging-market economy concerns applied downward pressure to the yield, however, the guilty plea of Michael Cohen, President Trump’s former lawyer, over campaign-finance violations spiked yields. The current 10-year treasury yield sits at around 2.83% as of 4:00PM, August 24th, 2018.

Moving on to the yield curve, the curve formed by plotting treasury yields with respect to their maturities has markets talking. Typically, longer term yields are higher than shorter-term ones to compensate investors locking up their money for longer. However, the gap between those yields is closing, or in other words, the yield curve is “flattening.” This has led to a drop in financial stock prices, whose earnings will be negatively affected. There is also a fear that there will be an “inversion of the yield curve,” which occurs when short-term yields surpass long-term yields. Historically, inversions have been correlated with upcoming recessions. Could an approaching inversion be a harbinger?

In world news, Turkey and Venezuela have been grappling with out-of-control inflation. Turkey’s CPI increased by over 15% on the year, and with President Maduro’s program, the International Monetary Fund is prediction and inflation rate over 1,000,000% by the end of the year.

Lastly, to end with miscellaneous noteworthy news, Apple is the first company to hit the coveted one trillion-dollar market value mark. Amazon and Alphabet are approaching as well. Elon Musk tweeted that he was considering taking Tesla, the most shorted stock in the US on a dollar-basis, private (securities fraud?). He later abandoned the idea. Amazon announced it will diversify into healthcare, through its one billion dollar acquisition of the online pharmacy PillPack. AT&T is acquiring Time Warner, valued at around $80 billion. Microsoft acquired Github for $7.5 billion.

By Sean O’Dea, Karol Rychlik, and Paul Menestrier - Portfolio Management Analysts, Baruch Investment Management Group