Market commentary for 1st quarter 2019 and the outlook ahead
Posted by Liz Rees in Market commentaries category on 11 Apr 19
|1st Quarter 2019
Quarter 1 performance: markets regain their momentum
Source: FE Analytics, performance on a total return basis in local currency 31/12/2018 -29/03/2019.
At the start of the year, safe haven assets, such as government bonds, were still in demand as investors weighed up the risks of an extended global economic slowdown. However, early dips in stock markets proved short-lived as bargain hunters emerged and January finished on the front foot.
A warming in China-US trade relations contributed to a sharp recovery, particularly in Chinese shares which were amongst the worst performers in 2018. Reports of progress in negotiations, and China’s Central Bank’s willingness to introduce measures to stimulate the economy, propelled its stock market back into bull market territory.
The improved sentiment continued through February, despite mixed news on the economic and political front. US shares were in demand after the Federal Reserve (Fed) took a softer stance on monetary policy. Investors brushed aside the lengthy government shut-down as confidence was lifted by better than expected earnings and strong jobs growth.
The March statement from the Fed suggested interest rates could be on hold for some time, which initially sparked a sell-off on fears of a looming recession. However, global markets soon resumed their upward trend after official and private sector surveys signalled an improving outlook for both the US and China, the world’s two largest economies.
The UK stock market has shown resilience in the face of domestic upheaval surrounding the Brexit stalemate, albeit with the biggest gains made by overseas earners. Nevertheless, it lagged other regions, with the exception of Japan, as international investors stayed on the side-lines. Meanwhile, in Europe stock markets largely shrugged off weak data on Germany’s manufacturing based economy.
By the end of the quarter, the mainland Shanghai Composite index was up an impressive 24%, while the US S&P 500 also had its best first quarter for 21 years. Furthermore, an absence of monetary tightening by Central Banks pushed the yields on bonds down, and their prices up, despite investors returning to shares.
Key events of the quarter
A key driver of financial markets was the tentative steps towards a resolution of the protracted US- China trade dispute. Sufficient headway was made to avoid US tariff increases which were due to be implemented on 1st
China committed to increase agricultural imports from the US but there are still hurdles to overcome in relation to intellectual property and Chinese subsidies for its domestic technology companies. A weaker US dollar and Chinese fiscal stimulus were also behind the positive momentum.
In the UK, Brexit continued to divide the political parties. Parliament backed Mrs May to renegotiate a deal and find an alternative to the Irish backstop, yet a number MPs from the main parties broke away to form an independent group. After MPs rejected Theresa May’s revised deal on three occasions, the EU eventually extended Article 50 to 31st
The Italian Budget was approved despite the country being in a technical recession. The focus is now on Spain after the Prime Minister, Pedro Sanchez, announced snap elections having failed to secure support for a new budget.
Oil prices rose strongly in the first three months of the year, following OPEC1
production cuts and US sanctions on Iran and Venezuela. OPEC has maintained its forecasts for global demand growth, despite concerns that trade tariffs would have an impact. A weaker dollar helped some other commodity prices, while gold registered further gains as investors sought protection against geopolitical risks.
The inversion of the US yield curve, with 10-year treasuries paying less than 3-month bonds, has been flagged as a good predictor of recession historically but the time lag can be considerable and the yield curve can invert without leading to a recession. With central bank intervention determining the direction of bond markets, the signal may prove less reliable than usual.
Economic trends and outlook around the globe
In its latest World Economic Outlook, published on 12th
April, the International Monetary Fund (IMF) reduced its expected outcome for GDP2
growth in 2018 to 3.6%. The organisation forecasts growth to decline further to 3.3% in 2019, before returning to 3.6% in 2020.
The IMF anticipates that global growth will level off in the first half of 2019 and then pick up in the second half as a result of policy stimulus in China, improved market sentiment and an end to the temporary disruption of new EU auto-emissions standards in the euro area.
Positive momentum for emerging markets is expected to continue into 2020 while, in contrast, activity in advanced economies is projected to continue to slow gradually as the impact of US fiscal stimulus fades.
Economic data has been on the whole disappointing, albeit recent outlook surveys are a little rosier. Industrial output has been worst affected while consumer spending is generally holding up better in most regions due to high levels of employment.
The IMF downgraded its growth forecasts to 1.2% in 2019 and 1.4% in 2020. This reflects prolonged Brexit uncertainty and assumes a deal is reached in 2019. The Bank of England also expects 1.2% this year and left interest rates on hold at 0.75%.
On the positive side, the Chancellor revealed in his Spring Statement that public borrowings will fall to just 1.1% of GDP this year, thanks to a rise in tax receipts. In fact, the public sector monthly budget surplus in January was the largest since records began. Improving government finances should allow a reduction in austerity measures and a net contribution to investment.
The British economy ground to a halt in February after a rebound in January. Manufacturing sentiment was adversely affected by production cutbacks from car manufacturers, including Honda, and concern about how supply chains would function in the event of a no deal Brexit.
The most recent figures for industrial production, employment, wage growth and retail sales have provided some cause for optimism, although this could prove to be a result of stockpiling inventories ahead of a possible ‘hard Brexit’.
Consumer and business confidence remain subdued but the IHS Markit manufacturers PMI3
- an outlook survey designed to provide a snapshot of the health of the economy- picked up in March. The index rose to 55.1 (50 is the line between expansion and contraction) as companies stepped up production.
After a poor Christmas, retail sales were strong in January, as spending was deferred to the sales, followed by a more modest rise in February. Later in the economic cycle consumption tends to focus on lower ticket items. Indeed, house prices have fallen for the first time since 2012, as buyers exercise caution until the outlook becomes clearer.
inflation edged up to 1.9% in February on the back of higher food prices. However, average wage growth of 3.4% in the 3 months to January (ONS5
data) was firmly positive in real terms. Furthermore, unemployment has been steady at around 4%.
Weak productivity has persisted as companies opt to increase headcount, rather than commit to capital spending which is harder to unwind. Unsurprisingly, workers can’t match the output of machines and technology.
The United States
The IMF expects growth of 2.3% in 2019 and 1.9% in 2020 as Trump’s fiscal stimulus unwinds. The downward revision to 2019 growth reflects the impact of the government shutdown and lower spending than previously anticipated, while a modest upward revision for 2020 reflects expectations the Fed will raise interest rates more slowly.
GDP growth slowed to 2.2% in the final quarter of 2019 and further disappointing economic data, including weak retail sales as consumers reigned back spending, has raised concerns about the economy losing momentum.
The partial shutdown, the longest in US history, impacted household and business sentiment. Manufacturing slowed most but the outlook has picked up with the ISM index6
for March reaching 55.3 on the back of new orders.
Job creation has remained robust confirming that, despite stalling in February, the labour market remains healthy. Unemployment stood at 3.8% in March while wage growth was 3.2%, well ahead of headline inflation.
At its March meeting, the Federal Reserve said it would maintain its target range for interest rate at 2.25-2.5%, until there is greater conviction that the recovery is underpinned. Moreover, quantitative tightening, whereby the government shrinks its balance sheet, will slow down and finish in September.
The Fed noted the absence of inflationary pressure which will help keep interest rates on hold. However, it is monitoring wage growth and oil prices. Analysts expect a slowdown in corporate earnings growth, from 20% last year to high single digits this year, as the tax stimulus has worked its way through the system.
The IMF has reduced growth forecasts for the euro area to 1.3% in 2019 and 1.5% in 2020. There were downgrades for several key countries, notably Germany (weak industrial production following the introduction of revised auto-emissions standards), Italy (weak domestic demand) and France (negative impact of gilets-jaune protests).
Growth was close to zero in the last 3 months of 2018, as Italy fell into recession and Germany narrowly avoiding doing so. A slump in German factory orders showed the country’s export-driven economy was feeling the effect of trade disputes.
Manufacturing activity remained very weak in recent months. New orders, especially for exports, have fallen sharply and inventories started to build up. Business confidence has suffered, which has made firms reluctant to undertake capital investment projects.
Consequently, the ECB (European Central Bank) downgraded its outlook and announced new measures to support the economy, including cheap funding for the region’s banks. It said interest rates will be on hold until end of year. Headline inflation fell to 1.4% in March (preliminary Eurostat estimate) and is forecast to fall further.
On the positive front, Eurozone unemployment has continued to fall and consumer confidence improved marginally at start of year. This was reflected in healthy retail sales which rose by 2.2% in January and 2.8% in February (Eurostat data).
However, there is a marked divergence between the service sector and manufacturing. There has been a build-up of inventory in the production sector and some PMIs3
in Europe have dipped to below the crucial 50 mark which signifies decline. Although the overall IHS Markit Composite for the Eurozone was 51.3 in March, the manufacturing index fell to 47.5 and in for Germany it was even lower at 44.1.
The IMF GDP growth estimate for Japan is 1.0% in 2019, and 0.5% in 2020. This year will be helped by additional government support to the economy, including measures to mitigate the effects of the planned consumption tax rate increase in October 2019.
Growth in 2018 was actually slightly better than anticipated, due to higher capital spending and inventory build-up which should provide further support for trade this year. Unsurprisingly, like elsewhere, escalating trade tensions in the final quarter hurt manufacturers as export demand dipped.
Overall exports fell again in February, particularly to Singapore and South Korea. On a positive note, exports to China were actually up 5.5%. Even more encouragingly, industrial production rose 1.4% in February, after 3 months of falls. Hopes of a trade settlement spurred companies to make the investment essential to drive exports.
However, business outlook surveys remain cautious. The Nikkei Markit manufacturing PMI3
dropped 48.9 in March from 50.3 in January due to falling demand. The widely watched Bank of Japan Tankan indicator of business sentiment also weakened in the first quarter, yet capital spending plans are still above expectations.
The services sector has remained in expansion territory in March. Unemployment fell to a 9 month low of 2.3% in February as the labour market remains tight but real wages fell due to lower bonuses in February and retail sales have fallen short of forecasts.
Ongoing stimulus policies have had little success in lifting inflation toward the 2% target, indeed the Bank of Japan downgraded its estimate for 2019 to 0.9%. Price rises of 4-8% from the likes of Coca Cola and Starbucks, did not help the CPI4
which increased only 0.4% in January, partly attributed to supermarket discounting.
Despite its export dependent economy, Japan’s low valuation relative to history means a slowdown is largely factored in. Unless there is a full-blown recession, the corporate sector should be able to deliver earnings growth. Along with a stable political scene, and progress with structural reforms, the outlook is favourable.
The IMF expects growth in the emerging market and developing economies group to edge down to 4.4% in 2019, then pick up to 4.8% in 2020. The dip reflects lower growth in China (6.3% for 2019) and contraction in Turkey and Iran. India stands out with an upgrade to 7.3% for this year. Conditions are projected to improve through 2019 as stimulus bolsters China and there is an end to recession in Argentina and Turkey.
A catalyst for the sharp falls in China late last year was fears global growth was waning. Despite this, China’s share of global exports has remained steady and manufacturing PMIs returned to expansionary levels in March, at just over 50, while other sectors were even stronger.
Government stimulus has included cutting the reserve requirement ratio for banks to increase lending capacity, though a close eye is being kept on levels of corporate debt. Infrastructure spending has also been increased, with $125bn of new rail projects and a package of tax cuts implemented.
Services held up better as China continues its transition from a manufacturing to a consumption driven economy. Consumer sentiment remains robust, boosted by tax reforms, with retail sales slightly better than expected. Inflation touched a 6 month low with the CPI4
standing at 2.1% in March (according to the National Bureau of Statistics).
India is a long way behind China in wealth creation, and so offers significant potential, assisted by Prime Minister Modi’s reforms. The Reserve bank has cut interest rates twice to boost credit growth ahead of April’s elections. A Modi victory looks the most likely outcome, but whoever wins is likely to support further economic expansion.
While Chinese stimulus is helping to lift Asian stock markets, Brazil’s newly elected president is having a similar effect on sentiment in Latin American. Jair Bolsonaro, took office in January and is pushing forward his pro-business agenda which, if successful, could help solve Brazil’s fiscal problems and reduce government debt.
After a long recession, Brazil is in the early stages of its economic recovery in contrast to much of the world. Combined with low interest rates and inflation, the medium term prospects look reasonably attractive, albeit with inherent risks.
In summary, for investors with a long time horizon and willing to accept higher volatility, emerging markets look set to continue to deliver superior growth to their developed counterparts in the years ahead. Periods when they are out of favour could present a buying opportunity.
Outlook and prospects for stock market investors
After the sell-off late last year, global stock markets entered 2019 on more attractive valuations relative to forecast earnings. The subsequent rally reflects optimism that trade disputes will be settled. While the outcome of negotiations is likely to influence the performance of shares over the remainder of the year, surprises on the upside for company earnings and economic growth may be necessary for markets to move meaningfully higher.
The need for Donald Trump to start preparations for his re-election campaign may spur him to get deals done, especially as the US remains vulnerable to a slowdown once the positive effects of one-off tax cuts recede. Certainly investors appear sanguine about the downside risk concerning possible tariffs, yet spats with Mexico and the EU, as well as China, remain unresolved.
There are tentative signs that global trade has stabilised for the world’s two largest economies. However, the Fed’s pause in rate-hiking will be monitored closely to see if it reverses the loss of momentum in the US economy. Investors also need to be wary of slower growth in China, any resurfacing of trade conflicts and a potentially a disorderly Brexit.
The views of economists are divided; some think there is little risk of recession in the near-term while inflation and rates remains low and balance sheets are not overstretched. Those who are more pessimistic believe high debt levels in China could produce a financial crisis, even though government measures have secured stability for now.
Undoubtedly, the outlook is likely to become more challenging as the economic cycle matures. For now, we believe that growth worries are overdone, but accept there might be pressure on corporate earnings in 2020.
China’s Central Bank may have lowered its growth target to 6-6.5% for 2019 but this remains attractive relative to developed markets. Furthermore, substantial investment is being made in high growth areas, such as artificial intelligence and biotech, which bodes well for the future. India’s burgeoning economy is a particular bright spot for investors in Asia while Japan, with its cash rich economy and spare production capacity, looks cheap relative to history and could attract investors if international trade recovers.
Although the path of Brexit is still unclear, any removal of the current uncertainty should be positive for UK equities which have been shunned by overseas investors in recent years. The economy may be subdued but many fund managers we meet, particularly those with a value style, are finding unprecedented opportunities to buy domestically-facing equities on the most attractive valuations seen for many years.
An active approach to investing, paying close attention to valuations and an appreciation of the importance of dividends to total returns, might be wise until the road ahead becomes clearer. Highly rated growth stocks have been subject to bouts of profit-taking when investors want to reduce risk. This illustrates the importance of having a well-diversified portfolio to smooth returns when volatility increases.
Ensuring you have exposure to defensive assets, along with recovery situations, alternatives and cash may be worth considering. When shares fell last year, government bonds and gold demonstrated their role as safe havens while having an element of cash in reserve allows you to buy the dips.
Organisation of Petroleum Exporting Companies
Gross Domestic Product
Purchasing Managers’ Index
Consumer Price Index
Office for National Statistics
Institute for Supply Management
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