Market Commentary Q3
• Global equities made gains in the third quarter, primarily due to US market strength.
• Political uncertainty and the trade war narrative weighed on other regions, particularly developing Asia and Europe.
• Besides tariff related concerns, some emerging markets were additionally affected by the strengthening US dollar and domestic instabilities.
• Government bonds yields rose for the quarter, causing prices to fall.
US economic growth and earnings data remained robust, which reduced concerns around the escalating US - China trade war. US consumer confidence reached its highest level since 2000, while the initial jobless claims fell to the lowest level since 1969. Wage growth has been at the highest point since 2009, and retail sales grew over 7% year on year. Stability in growth and employment figures allowed the Federal Reserve (Fed) to implement its widely anticipated increase in the federal funds rate by 25 basis points, and reaffirm its outlook for further gradual rate hikes in 2019.
Against this remarkably strong growth backdrop it’s not surprising that US equities have delivered attractive returns, and in August the US equity bull market became the longest in history.
GDP growth for the second quarter was revised up to 0.4% quarter-on-quarter, in comparison to the initial estimate of 0.3%, while the September inflation figure was at 2.1%. Forward looking activity indicators continued to predict a modest expansion. There was no change in the European Central Bank (ECB) policy and we can expect interest rates to remain on hold until at least the summer of 2019.
Worries over trade wars and potential US tariffs on the automotive industry weighed negatively on the sentiment, even though this was somewhat improved after the meeting between US President Trump and EU President Juncker. This resulted in an agreement to work towards zero tariffs on non-auto industrial goods, while new car tariffs would be put on hold. Other concerns were the exposure of the Eurozone banks to emerging markets (primarily Turkey) as well as the Italian budget.
Eurozone equities posted a modest gain in the third quarter.
Economic growth recovered from the slowdown seen in the first quarter, encouraging the Bank of England (BoE) to increase interest rates by 25 basis points to 0.75%. Medium term projections for the economy however are not looking positive, given that a no-deal Brexit appears to be an increasingly likely scenario.
UK assets have also been weighed down by fears of a no agreement on Brexit. Recently, the inverse correlation between the pound and UK equities has broken down. This could be a reflection of investors viewing a hard Brexit as a more probable outcome than anticipated earlier, and even the benefits from the weak sterling would not make up for the potential losses in the stock market.
The economy rebounded strongly from the short-term weakness registered in the beginning of the year, and corporate sentiment remained relatively strong, especially given the tightness in the labour market and the uncertain global outlook. Earnings have continued to improve and the latest quarterly results season was largely in line with expectations. Trade tensions and the associated higher US tariffs on the automotive industry made an impact on investor sentiment, but towards the end of the quarter it was agreed that there will be no immediate implications for Japan.
The Japanese stock market ended the quarter with very strong figures, additionally helped by a weakened yen.
Asia Pacific ex. Japan
Asia Pacific ex. Japan equities lost value in the third quarter, primarily due to a weakness in China.
Chinese macroeconomic data was softer, and the authorities announced a range of targeted economic support measures, some of which are a shift to fiscal stimulus and credit easing. The stock market was negatively impacted by escalation in trade tensions with the US. The US moved towards tariff implementation and China retaliated with their counter measures. India underperformed too, and currency weakness amid rising inflation caused worries over the trade deficit.
Emerging market equities lost value in what was a volatile third quarter, with the US - China trade dispute and US dollar strength affecting the risk appetite. In terms of the latter, recent US dollar strength has exacerbated some of the domestic weakness in economies like Turkey, Argentina and South Africa. Even though most emerging market countries are much less reliant on US dollar funding than they were in the past, countries with large current account deficits remain vulnerable. Concerns of a full-blown EM crisis however appear premature at this point in time.
Turkey has been the weakest market and the lira sold off sharply. The currency fell as geopolitical tensions with the US worsened ongoing concerns over its large current account deficit, above-target inflation and central bank independence.
Core government bond yields rose over the quarter due to positive economic data, particularly from the US. This outweighed a bout of safe haven demand in August caused by concerns related to emerging market instability, trade tensions and political issues in Europe.
Corporate bonds had positive total returns in local currency terms.
Emerging market bonds experienced a turbulent quarter, largely caused by idiosyncratic factors.
The energy segment posted a positive return; prices rose amid supply concerns linked to the reimposition of US sanctions on Iran.
By contrast, industrial metals were weaker on global trade uncertainty. Precious metals were also down, continuing their weak performance so far this year, driven by the strength of the US dollar, rate hikes by the Fed, and lack of any serious upward surprises in US inflation.
The US market has been the best performing developed equity market so far this year, and projections for the next period look positive. For instance, 5 year forward earnings growth estimates for the S&P500 Index have been raised to above 16%, which is the highest level since 1999.
In a similar fashion, many economists have raised their real GDP forecasts for both 2018 and 2019. In response to such macroeconomic strength, Fed has been implementing a steady programme of quarterly rate hikes. While monetary policy still remains supportive, with the labour market ticking beyond full employment and core inflation at 2%, over the coming period we could see the Fed adjusting policy rates in line with a more restrictive stance.
A key source of risk for now is the trade policy between the US and China. Thus far it appears business confidence as well as hiring or capital expenditures have not been derailed, but businesses act with heightened caution. Should there be no disruptions caused by worsened trade conditions, the US economy and corporate earnings are likely to remain healthy over the next two to four quarters.
On the other side, the elevated expectations make it difficult to create any positive surprises for markets. In addition, equity valuations appear to be very expensive. The cyclically adjusted Shiller P/E ratio for the S&P 500 stands at 33x as of September, reaching its highest level ever outside of 1929 and the late 1990s. The expected total return on US equities over the next decade is therefore likely to be very subdued.
We maintain a modest underweight preference for US equities in global portfolios on the back of their expensive valuations.
The last few months have been challenging for Eurozone equities, amplified by trade war fears, stagnating Brexit negotiations, a new Italian government and bank exposure to Turkey. The economy has underperformed in the first six months of the year, and earnings expectations have been revised lower.
Even though this doesn’t paint a particularly good picture in the short term, we see a case for holding onto European exposure. GDP growth at 2.1% in the year to June is still above the potential growth of around 1.5%. Credit growth is ticking along, and the weaker euro together with low interest rates mean that financial conditions remain supportive of above-trend growth. Equities appear fairly valued and perhaps slightly oversold. Italian risk seems to be fading and European bank exposure to Turkey could be less worrying than originally thought. The main risk on the horizon is a potential escalation of US and China trade related tensions. Europe has a large trade exposure to emerging markets and could be severely affected by automobile tariffs.
Overall, the risks that dominated the past quarter seem to be getting smaller, the economy is likely to beat low expectations, and earnings forecasts should have the potential for upside revision. We continue to favour European equities despite some potential setbacks which we carefully monitor.
The outlook for the UK economy and market remains clouded by Brexit negotiations. With only months to go, there is little clarity as to how the whole process will play out. UK domestic investment is already being stifled by uncertainty and even a ‘soft’ Brexit will probably be negative for UK growth.
UK equity valuations have become slightly cheap but we continue to be cautious given the uncertainties surrounding Brexit and the economic slowdown.
Elevated trade tensions, a strong US dollar on the back of a more hawkish Fed, and tightening liquidity have all weighed on sentiment and reduced valuations of emerging market equities. We expect these themes to continue shaping the near-term sentiment. Currencies have come under considerable pressure, and this too has had a knock-on effect on markets.
Despite these short-term issues, emerging market equities look generally oversold. With the exception of some clearly troubled economies such as Turkey and Argentina at the moment, most markets still offer reasonable value on the basis of good fundamentals. We advocate a neutral to modestly overweight exposure to emerging market equities.
Asia Pacific inc. Japan
Asia Pacific has been heavily affected by the trade war concerns, a strengthening US dollar, and volatile commodity prices. The outlook remains fragile, particularly as the US has threatened with imposing tariffs on $467 billion of all Chinese exports to the US, and on the other hand China so far announced a 10% general rate on the $200 billion of US goods.
The Chinese economy has shown signs of slowing through the first six months of the year, driven by a deleveraging imposed by authorities and also partly due to some anticipatory concerns on trade wars. The government has already announced stimulus measures, amongst which infrastructure bonds and monetary policy easing, which should stabilise growth for the second part of the year.
Outside of China, developing Asian currencies have been sold off by the market, particularly Indonesia and India, due to their high current account deficits and national debt. The sell-off could have been driven more by sentiment than fundamentals, as both economies remain in a solid shape.
The Japanese economy has started to show signs of positive momentum as it enters the fourth quarter of 2018. Capital investment and consumption growth have been enhanced by strong levels of business confidence and rising income respectively. The Bank of Japan (BoJ) has taken a small step away from its extremely easy monetary policy; as inflation edges higher, further gradual moves could follow in the year ahead.
Australian growth has been strong so far in 2018, even though the economy may have reached its peak. Banking and housing markets are areas of concern, and uncertainty around the strength of the Australian consumer remains.
For the time being, most of the bad news seems to be in the market. As a result, we could see more investment opportunities within developing market equities in the Asia Pacific region as the situation unfolds, but a full-blown trade war remains the key risk. Japanese valuations look attractive given the shape of the economy. We are modestly overweight the region.
Bonds generally look less attractive due to rising interest rates and their inabi