Quarter 3 performance: all eyes on currencies
% total return
|Year to date 2018
% total return
Most developed equity markets were in positive territory as second quarter earnings came in ahead of forecasts. US businesses reported particularly impressive figures as Donald Trump’s fiscal policies stimulated an already robust US economy.
Unsurprisingly, the S&P 500 index led the way, gaining over 4% in July alone. By the end of August it reached a new high, marking its longest ever bull market, and the momentum continued through September. Technology stocks remained in vogue until September when they suffered a bout of profit taking, and there was some rotation into value. In the UK, the twists and turns of Brexit negotiations determined the direction of the pound and consequently the market.
In August, there was a sell-off in emerging markets. A slide in currencies in weaker economies, notably Turkey and Argentina, had a negative impact on sentiment across the region. Investors also had to contend with the reintroduction of US sanctions against Iran and friction between Turkey and the US.
Concerns grew over Turkey’s ability to repay its debt and, although the country represents a small part of global GDP, the severity of its situation, shocked investors. China was affected by ongoing trade conflicts with the United States and the Yuan’s fall against the US dollar.
However, emerging markets rallied towards the end of the quarter, following sizeable rate hikes by the Turkish Central Bank and a more modest one by the Russian monetary authorities. Nevertheless, it has been a quarter with clear winners and losers in equity markets, with the 7.6% gain for the S&P contrasting sharply with a decline of the same amount for MSCI China. Japan was the top performer in local currency terms as its political outlook stabilised with the reappointment of Shinzo Abe as leader of the Liberal Democrat Party for a third term.
The oil price rose strongly over the period, reaching a 4 year high of above $80 in late September, after leading producers decided not to increase output further. Impending US sanctions on Iran offset weakening demand from China.
Key events of the quarter
The threat of all-out trade wars has cast a creeping shadow over global equity markets. Initial US tariffs on $50bn of Chinese imports were extended to a further $200bn of goods, with a pledge to cover virtually all imports by the year end, if a trade agreement is not reached. President Trump also hinted at additional sanctions, including curbing Chinese investment in US tech firms and blocking technology exports to China.
Another Trump target for sanctions was Russia, a response to the Sergei Skripal attack in Salisbury and interference in the US elections. He also singled out the World Trade Organisation for criticism, threatening to withdraw the US unless it was offered better treatment. However, on a more positive note, he agreed to work with European Commission leader, Jean Claude Juncker, towards eliminating tariffs and barriers on trade.
In August, the US and Mexico reached a breakthrough on renegotiation of the North American Free Trade Agreement (NAFTA) trade agreement, including stricter rules on Mexican car exports to the US. Canada eventually agreed new terms as well.
Splits in the UK Cabinet led to the resignation of Brexit Secretary David Davis and Foreign Secretary Boris Johnson. The growing possibility of a ‘no deal’ Brexit brought protests from the corporate sector, with Jaguar Land Rover (JLR) warning it would make it unprofitable to remain in the UK.
Elsewhere on the political front, Imran Khan was elected Prime Minister of Pakistan while Scott Morrison is the new Australian Prime Minister.
Economic trends and outlook around the globe
In its latest World Economic Outlook, published on 3rd October, the International Monetary fund (IMF) reduced its global growth forecasts to 3.7% for both 2018 and 2019, which represents a 0.2% downgrade for each year, from the July report.
Although this represents continued steady growth, the organisation sounded a note of caution that expansion has become less balanced and may have peaked in some major economies. Downside risks to global growth have risen in the past six months and the potential for upside surprises has receded.
The 2018 downgrade is attributed mainly to weaker than expected economic data earlier this year in the Eurozone, UK and Latin America. In the United States, momentum is strong this year, as fiscal stimulus takes effect, but 2019 has been revised down due to potentially negative effects from recently announced trade measures.
In emerging markets, the growth prospects of some energy exporters have been upgraded, a result of by higher oil prices, but growth was revised down for Argentina, Brazil, Iran and Turkey, due to country-specific factors. The IMF noted that while most advanced economies are still enjoying easy financial conditions, this is less so for emerging markets.
The IMF forecasts growth of 1.4% in 2018 and 1.5% in 2019. This reflects the slow start to the year and the fact that some companies, particularly those from overseas, are reluctant to commit more investment until the Brexit outcome is known.
Economic activity recovered from unfavourable weather conditions earlier in the year. The Office for National Statistics (ONS) reported a new measure of rolling growth, showing GDP growth at 0.6% in the 3 months to July, up from 0.4% for the 3 months to June.
A summer heatwave, plus a decent World Cup run for England, spurred consumers to spend more on food and drink, if not big ticket items. Total retail sales rose a modest 1.6% year on year in July, fading to 1.3% in August. An air of gloom on the High Street prevailed, with a number of companies calling in the receivers and others closing stores.
Manufacturing saw negative rolling 3 month growth for the 5th consecutive month. Construction has picked up as it catches up with the backlog from a harsh winter but this could be temporary. Fortunately, services, the biggest component of the UK economy, compensated for this weakness.
Inflation edged up over the quarter with the Consumer Prices Index (CPI) standing at 2.7% in August. The strong oil price could push it higher in the coming months. Unemployment stands at the lowest level for 43 years yet there is little real wage growth which advanced to 2.9% in the 3 months to July. Nevertheless, as widely expected, the Bank of England raised the base rate to 0.75%, the highest since March 2009.
Brexit is increasingly dictating headlines, as the October deadline for striking an agreement approached. The uncertainty may be behind a fall in consumer confidence in September. The EU’s chief negotiator, Michel Barnier, had suggested the EU was willing to offer ‘an unprecedentedly close relationship’. However, at the recent Salzburg summit, Mrs May’s Chequers proposal was rejected and she reverted to a ‘no deal is better than a bad deal’ stance.
The Chequers plan is seen as a preferred option for manufacturers, proposing a free trade deal and friction-less borders. However, services would face a ‘hard’ Brexit, which would hurt financial services, especially investment banks. The risk of a hard or no deal Brexit has kept the pound under pressure and the odds on a ‘no deal’ rose sharply.
The United States
The IMF kept its US GDP forecast at 2.9% for 2018 but expects a slower 2.5% for 2019, which compares with growth of 2.2% in 2017.
The US economy recorded its strongest growth since 2014 in the second quarter, 4.2% on an annualised basis, and indications are that this will be repeated in the third quarter.
Corporate results were impressive; earnings growth for the S&P 500 was a healthy 25% for the second quarter as tax cuts boosted performance. Higher profits are leading to increased capital expenditure which should improve productivity. The August Purchasing Managers Index (PMI) eased slightly from July’s levels but business investment spending still looks robust.
Consumers continued to benefit from the tailwinds of tax reform and the strong labour market. Retail sales beat expectations in July, consumer confidence was at its highest level since 2000 and wage growth was the highest since 2009. The low unemployment rate of 3.9% could present risks to inflation but productivity appears to be picking up. Wages are growing at an annualised rate of almost 3%, while second quarter productivity growth was 2.9% annualised.
In September the Federal Reserve raised the target Fed Funds range for the third time this year, to a 2-2.25% range, accompanied by a bullish assessment of the economy. The minutes of the meeting, along with Jerome Powell’s speech at Jackson Hole, suggest rates will continue to go up in a ‘gradual fashion’ which implies hikes of 0.25% a quarter.
The IMF now expects growth in the euro area to slow gradually from the 2.4% of 2017 to 2.2% in 2018 and 1.9% in 2019, a downgrade for this year and no change in 2019, from July.
Eurozone growth in the second quarter was 0.4% compared with the previous quarter, which is 2.2% annualised. This was better than initially expected and allayed fears of an export-led slowdown. Germany produced solid advances in consumer and government spending although consumption was more subdued in France, Italy and Spain. The corporate earnings season proved reasonably strong.
Headline inflation in the Eurozone rose by a provisional 2.0% year on year in August though core inflation remains stubbornly low at 1.0%. Nevertheless, wage growth is at its highest for five years and unemployment continues to fall to pre-financial crisis levels. The unemployment rate edged down again to 8.1% in August.
The European Union and the US are working together to reduce tariffs, while Japan and the EU signed the world’s biggest bilateral trade agreement which creates a trade zone encompassing a third of global GDP.
European Central Bank (ECB) president Mario Draghi reiterated his positive view on the state of the Eurozone economy but made no changes to policy or forward guidance and confirmed expectations for interest rates to remain on hold until autumn 2019. He indicated the ECB is on track to end bond purchase programme from December.
Unfortunately, political tensions overshadowed the good news. A bridge collapse in Italy, and migrant arrivals in the Mediterranean, led to clashes between the new Italian government and EU officials. The new Italian government’s budget plans, with a higher than expected deficit target, were deemed unlikely to meet stability and growth objectives.
The IMF has revised up slightly its growth estimate for Japan to 1.1% for 2018, leaving 2019 at 0.9%.
Japans’ economy bounced back from the setback of the first quarter; real GDP grew at an annualised 3.0% in Q2 after contracting for the first time in two years in Q1. Consumption recovered, supported by surprisingly strong wage growth at its highest level in over 20 years.
A mild slowdown from here is possible, given the recent spate of natural disasters, and the risk of a slowdown in the global economy hurting exports. Nevertheless, the corporate sector is currently producing high single digit sales growth and record profit margins.
Moreover, sentiment has been helped by the yen weakening against the US dollar since late-March, which should provide a positive boost to earnings. Japanese companies are stepping up investment in robotics and factory automation to counter labour shortages as a result of the tightest employment market for 4 decades.
However, even though the CPI rebounded to 0.9% in July, core CPI excluding fresh food and energy, remains low at 0.3%, showing that the underlying inflation trend remains below target. The Bank of Japan lowered the inflation outlook and said it intended to keep the current low interest rates for an extended period of time. The Central Bank is one of few set to continue with a bond repurchase programme, albeit with hints it may moderate it.
Prime Minister Shinzo Abe has potentially extended his tenure for another 3 years, after being re-elected as leader of the governing Liberal Democrats. While his policies have had setbacks, they are clearly delivering full employment, real wage growth, capital investment and strong corporate performance.
The IMF has maintained its growth estimate for China at 6.6% for 2018 and trimmed 2019 to 6.2%. Beijing government policies are likely to limit downside to projections. For other countries across the region the outlook is mixed.
Trade tensions and a strong US dollar continued to dominate the headlines despite satisfactory corporate earnings reports. However, earnings may be boosted by some purchases being brought forward before the first US tariffs took effect.
China’s Q2 GDP slowed a little, as expected, but was still an impressive 6.7% year-on-year despite ongoing deleveraging efforts. President Xi Jinping has prioritised keeping debt to levels needed to deliver target levels of growth. However, the Chinese Central Bank instructed banks to increase lending to infrastructure projects, an attempt to lift confidence after falls in the currency and stock market.
The Central Bank actually added $22bn to the banking system in loans to commercial companies, while reserve requirements for domestic banks have been cut to reduce financing costs and spur growth. Additionally, there have been tax cuts to stimulate domestic demand.
In August, trade relations between the US and China deteriorated further as the US threatened to increase the proposed tariffs on Chinese goods to 25%, from the previously declared 10%. These moves appear to be already affecting exports to the US from China, which fell 2.5% in July, versus June, while capital investment also slowed.
Currency weakness turned into a full blown crisis in some weaker economies. The Turkish lira fell sharply until the Central Bank eventually acted to support it by lifting interest rates by 6% to 24%. The Argentine peso fell to a record low against the dollar; interest rates were raised to 60% and further austerity measures unveiled. In India, the rupee has fallen steeply, pushing up the price of imported items. This situation, along with a large conglomerate defaulting on its debt, unnerved the stock market despite the underlying economy performing well.
While trade uncertainties may continue to weigh on emerging market economies and markets, there are also reasons to be optimistic, as demonstrated by the trade deal reached between the US and Mexico. Nationalist Andres Obrador comfortably won the Mexican presidential election with promises to increase infrastructure spending, pension reform and apprenticeships to kick-start the economy.
Outlook and prospects for stock market investors
As we enter the final quarter, the global economy is on course for another year of solid growth. However, volatility has returned to equity markets this year after an unusually calm 2017. The synchronized global growth environment of the last two years has given way to a more uneven path, with enduring strength in the dominant US economy sustaining overall progress.
While new Federal Reserve chair, Jay Powell, has highlighted the lack of inflationary pressure he promised ‘further gradual interest rate rises’ as the economy strengthens. At some point, as the rate cycle gathers momentum, the investment case for bonds will become more compelling. For now, equities remain our preferred asset class with the caveat of some downside risk if trade wars escalate.
In the US, the combination of tax cuts and increased government spending may have enhanced 2018 economic performance, leaving it difficult to replicate in future years. However, there are few signs of imminent recession and strong earnings growth is supporting demanding valuations. Investors have reaped excellent returns from US equities, so profit taking is understandable, while remembering the country is home to many unique technology investments.
Other developed markets look good value relative to the US. Europe and the UK are being held back by ongoing political uncertainties but in Japan Shinzo Abe has been re-elected as leader of the governing Liberal Democrats. The tentative success of his reform agenda, improving corporate governance and notable earnings and dividends growth, has pushed equities higher. This includes interest from overseas investors who have typically been underweight in the region.
As ever, there are hurdles to negotiate, not least on the political front with simmering trade tensions and Brexit. A general election in Brazil, and US mid term elections, are on the near horizon. Trade tariffs remain a significant risk to the global outlook with China the main target. However, to put these into context, Man GLG estimates that the $500bn of goods targeted for tariffs represents only 2.5% of its GDP and less than 1% of global GDP. Perhaps, like many of Trumps policies, the effect may be more muted than initially feared.
Even if China’s GDP slows as a result of tariffs, success in transitioning from a manufacturing based economy towards one driven by consumerism should mean growth is still likely to remain the best of leading economies. For long term investors, any setbacks could provide a good entry point as the long term drivers of growth remain in place, including technological advances and increased consumption by the burgeoning middle classes.
To sum up, I would remind readers that the economy is a different beast to the stock market and despite some unsettling factors, many companies are getting on with life and indeed doing rather well. Cash generated from activities continues to be paid out as dividends which are, in general, demonstrating attractive growth. Obviously, the cycle can’t trend upwards forever and at some point there will be a downturn but, as things stand currently, fund managers are still finding plenty of opportunities.
Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.