Weekend Markets Edition – 12/21/2019
Markets sustained momentum heading into the close of the year in-line with our prior expectations where we anticipated that sentiment would carry us into the close of the year with the S&P 500 trading at $3,222, and the Dow Jones trading at 28,480. The S&P 500 YTD performance was 30.94% whereas the Dow Jones was 25.08%, which was driven by a recovery rally to start the year, and diminished investor concerns tied to the economy, as fears over a recession abated despite headline risk tied to US-China trade.
When pertaining to US-China trade war, we’re finally entering a period of de-escalation, and to be fair, the impact was more one-sided, as Chinese equity markets slumped for the duration of the year. In most cases, buyers have more leverage than sellers, and as we have witnessed over the course of 2019, the markets priced-in diminished impact, as demand was partially impacted, whereas Chinese exports were heavily affected, which is why the Hang Seng Index returned markedly less with 7.95% YTD performance, and the Shanghai Composite Index returning 22.43% YTD. The Hang Seng lagged US Indices more this year due to the Hong Kong protests, but on balance the perceived impact was negatively affecting Chinese/Hong Kong equity markets more considerably, which is why the de-escalation of trade, and efforts to resolve the imbalance seem more likely as we exit 2019.
Both the US-China agreed to a phase one trade deal on December 13th, which diminished market volatility exiting the year with tariffs being reduced on some goods. Also, Donald Trump announced that they would sign a formal agreement on January 15th, 2020 which implies that U.S. Agricultural demand will increase considerably from prior levels with a range of $32B-$50B in total agriculture exports in an effort to rebalance trade with China. On-going negotiations tied to technology transfer will be a part of the phase 2 deal and could carry-into phase 3 deal negotiations as well.
Donald Trump Impeachment
In terms of what happened this week, the Donald Trump impeachment when pertaining to Congress passed, which is something we discussed as being highly likely in our prior markets edition: More Fed Rate Cuts in 2020, Elizabeth Warren Falls in the Polls, Trump Impeachment Heading to the Senate. Based on comments from Mitch McConnell on the Senate floor, the R-Senate Majority Leader maintained his ground, and so we don’t anticipate there to be a high likelihood of Donald Trump getting impeached in the Senate, and we’re not surprised by the Partisan party-line stance of both political parties.
Donald Trump will be put on trial in the Senate, and from what we can understand, the impeachment process involves the Senate, though there are some news outlets that insist that impeachment might not involve the Senate (but it absolutely does). Typically, impeachments require bi-partisan support due to the severity of a situation, but in this case, and based on the documents that have been released to the public, we have our doubts over the Ukrainian incident.
What’s more concerning is the pure Partisan stance of both parties, and assuming an absolute worst-case scenario for Republicans, it would involve a 2020 election outcome where they maintain the Presidency but lose majorities in the Senate and Congress. In that case, Donald Trump could be impeached on other grounds, and it’s why we view the possibility of a Trump impeachment tied more to 2020 election outcomes as opposed to the immediate present impeachment hearings.
Public polling figures when pertaining to the on-going impeachment trials hasn’t favored Democrats as much as hoped, because there wasn’t an explicit demand requiring something in return for the investigation into the Biden family when pertaining to Ukraine.
The average American hates political corruption, and when it’s tied to Hunter Biden, and his affiliation with various boards inclusive of Chinese companies, there has been nothing but question marks and silence. When it pertains to a corrupt vs. semi-corrupt dealings, and the absence of transparency tied to the Biden’s dealing in various foreign countries, it’s the confusion that’s leading people to question career politicians in general, and it’s why we don’t anticipate the average voter to favor the Democratic-leaning narrative. 46.8% of all voters support the removal of Donald Trump based on third-party data from fivethirtyeight.com, which means that roughly 53.2% of voters still support the current president and would not want him impeached, which is still a majority of the population. Democratic support for impeachment has dropped-off in recent weeks, which contributed to the favorable polling data.
The reason Donald Trump was elected in the first place was because he doesn’t sound like a career politician and doesn’t respond to scandals/crisis in the same format that a career politician would. So, while the Biden family has opted for silence, the Trump’s well… they just trumpet their views on the situation even louder, which is why the 2020 election is still a toss-up, but the recent Biden-Ukrainian investigation positions Republicans strongly in front of their voter base on the merit of fighting corruption, and also pulling the victim card.
The Democrats rally their base, because they’re fighting a dictatorial Presidency, and so… in doing they pursue impeachment, and can continue to rally their base on the basis of fighting back against the right-wing extremism/ideology. Again, the political environment is contentious at best, but we view the likelihood of a Trump impeachment highly unlikely given the 0 R-Congressional votes made in favor of impeachment, and with the number of required votes even higher in the US Senate, the likelihood is very slim if not at all, which is why equity markets aren’t pricing-in the impact, and it’s why it’s business like usual heading at the tail-end of 2019 despite the on-going political turmoil in Washington.
Housing data supportive heading into 2020
Source: Wedbush Securities
Home price growth trended lower over the course of 2019, which has been supportive for affordability. The y/y price growth ended the year in a 5%-5.5% range, which is still supportive in the current investment environment, and could drive demand, thus added price momentum in 2020. We also anticipate that lower interest rates will be supportive of demand, as inventory is trending lower (below).
While inventory has hovered in a 1.44 million – 2.05 million range over the past five years, the recent home builder cycle might have contributed to an influx of inventories. Migration could be another factor for heightened listings, but more importantly, the current aggregate inventory level is trending lower from 1.9M to 1.75M towards the end of the year, which implies that if inventory continues to decline to approximately 1.45M-1.55M we should see housing price growth in 2020.
We also anticipate that with interest rates returning to 2017 levels at 3.95% for 30-year mortgages on average for borrowers we should see some momentum in median home pricing, and so this should translate favorably for some of the publicly traded REITs, and home builders. When home prices become more expensive then it creates more room for rental growth, as the spread between monthly mortgage payments and apartment rentals tends to be in a $100-$300 range with rentals usually more expensive on average on a relative basis in most metros.
That being said, we view the recent housing data constructively, as inventory levels are trending lower, and interest rates are trending lower as well. This corresponds to more affordability, and a better environment for purchasing home, which should translate to more demand, thus returning median price growth to perhaps a 6%-7% range.
Source: Morgan Stanley
Also, with average mortgage interest hovering in a 3.95%-4.15% range, there’s been a pretty significant uptick in mortgage loan refinancing applications (volume). Based on the index, from the low in October 2018, the rate at which borrowers have refinanced mortgages has increased by 2.5x, which is a pretty significant improvement in financing activity, which continues to suggest economic strength despite the mixed sentiment on macroeconomics for the duration of 2019 thus far.
Healthcare sector themes worth watching
Recent reports suggest a permanent delay to the health insurance fund (HIF), which was supposed to be phased-in 2021, and also the Cadillac Tax, which was supposed to be phased-in January 2020. Both are unlikely to be phased-in given the bi-partisan budget deal, which is supposed to close in Q1’20. The big theme is that the last phased-in budgetary items tied to ACA (Affordable Care Act) aren’t going to impact the federal budget next year or affect pricing for health insurers heading into 2020.
Furthermore, the Cadillac Tax was unpopular as it taxes medical devices at 2.3% on top of the various other taxes (State and Federal) medical device makers pay. As such, we view the efforts to curtail the expanding budget tied to healthcare as a positive, though it diminishes some fiscal stimulus tied to ACA. Also, we anticipate Medical Device Makers to perform slightly better on news of the Cadillac Tax not getting phased-in over the course of 2020, which adds modest up-lift to Dil. EPS expectations for various medical device makers.
Healthcare SPDR (XLV) by Google Finance
Healthcare has rallied towards the end of the year, though the sector has under-performed when compared to broader indices like the S&P 500, as the XLV YTD performance was +23%. We view the more positive legislative environment adding some upside to expectations, so as long as drug pricing doesn’t get impacted by various proposals like an internationally-weighted drug price index, or the sudden implementation of various drug price reforms, which could spark higher uncertainty among the pharmaceutical names in the healthcare sector.
According to Kevin Caliendo from UBS, drug pricing for generics dropped:
The average generic drug in the dataset saw its price drop –4.8% yr/yr in November, a ~19bp sequential increase from the yr/yr decline seen in October (-5.0%). We note the 2-year stack improved by ~140bp sequentially to -11.3% from -12.7% in October. We believe this data continues to support stability in generic market dynamics and note that lower pharmacy acquisition generic pricing is generally more beneficial to drug retailers and negatively impacts wholesalers.
In terms of branded drugs (which tend to increase in price), the pricing growth has slowed considerably from prior year at +5% to +6% to low single digits, which also explains the softness in equity performance among healthcare names this year. The price growth for specialty and traditional hovered at 1%-2% from September to December of 2019, which is comparable to aggregate CPI (inflation) metrics.
This is healthy for the broader economy, but somewhat disadvantageous for healthcare names that have relied on stable pricing/volume growth absent meaningful improvements in drug portfolios to sustain growth in sales/earnings comps over the past 5-years. We don’t anticipate that this particular political environment is hospitable to drug pricing increases given the hostile policy measures that can be introduced in response to drug price inflation. Hence, we anticipate that drug pricing will remain in a 1%-3% growth range for the time being.
Source: Morgan Stanley
This is captured in the PCE (personal consumption expenditure) index, where healthcare services are anticipated to contribute less inflation, according to Morgan Stanley. But, core services, and housing is expected to contribute a larger components to aggregate inflation in 2020 according to prevailing estimates for 2020. Core PCE is expected to accelerate from 1.7% to 2.2% between 2019 and 2020, but much of that growth is tied to services spending, which is reflective of 50%-60% of personal budgets appx.
2020 is setting-up to be a great year for equity investors, as earnings comps are more diminished, some positives on the geopolitical front diminish perceived risks tied to the US-China trade war. We anticipate less news themed risks tied to trade, but perhaps more risk tied to political outcomes heading into 2020 where a split government is the most desirable scenario. However, when it pertains to the on-going impeachment trial involving Donald Trump, we don’t anticipate that Senate will pass the articles of impeachment via a vote.
Furthermore, the housing market is set to grow next year, we anticipate some meaningful acceleration in y/y comps with low interest rates being supportive of diminishing housing inventory, and heightened interest in new home ownership. Refinancing activity likely to trend higher, which should contribute to bank’s P&L next year, whereas the drop-off in interest rates also a headwind in terms of net interest margins absent of hedges.
Healthcare seems to be set-up more positively, albeit with less drug price inflation, for branded/specialty drugs that are still protected by patents, whereas generic drug price declines suggest some headwinds for some of the generic drug makers. In this environment, we think investors have to be very selective given the sheer number of healthcare names, and the divergence in performance driven by company fundamentals rather than being supported by macro fundamentals or market asset flows into healthcare.
Inflation metrics expected to trend higher in 2020, but not due to healthcare next year. This might diminish the degree to which the Federal Reserve might respond with further interest rate cuts or monetary policy easing, though it’s worth noting that the Federal Reserve is still expanding its balance sheet. The interest rate curve has steepened to a point where investors can price-in risk more appropriately for capital intensive projects, which should add some momentum to housing starts, commercial and residential developments. When it pertains to REITs, we view lower interest rates as being a positive, as companies are unlikely to de-leverage, but rather increase leverage at lower interest rates, which should add some momentum contingent on portfolio expansion, and pricing growth for rents.
Industrials, energy, and mining might struggle next year, as the lower interest rate environment doesn’t detach from the dependency on commodity prices. And without a broad basket of commodities increasing in price it’s a difficult environment to generate greater returns with value discounts likely persistent in these sectors with agriculture being the rare exception due to the pent-up upside tied to Chinese agricultural exports.
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