|2nd Quarter 2019
|Year to date
Source: FE Analytics, performance on a total return basis in local currency, 30/06/2019
Quarter 2 performance: looking beyond the clouds
Stock markets built on the gains of the first quarter, but this masks considerable month to month volatility as investors tried to interpret what ongoing political upheaval might mean for economic growth.
In April, optimism prevailed on hopes of a resolution to the US-China trade disputes, with the US market leading the way, after the Fed (Federal Reserve) moderated its guidance for interest rate rises. However, in May the US abruptly raised tariffs on Chinese imports, with threats of more to come, triggering a sell-off in shares.
Markets had become over-confident about the prospects for a deal and, while few countries escaped the shake-out, the MSCI China index unsurprisingly bore the brunt, falling over 10% in May. The stalemate persisted until Presidents Trump and Xi met at June’s G20 summit in Osaka and agreed to freeze tariffs and resume further talks.
Economic data deteriorated towards the end of the quarter, and once again the Fed rode to the rescue, indicating a willingness to cut interest rates to support the slowing economy. This drove share prices up, with the US indices recording new highs in June. The European Central Bank (ECB) also said it was ready to cut interest rates and purchase bonds if growth fails to pick up. Bond prices also rallied and their yields fell in anticipation of lower rates.
Gold registered a stellar performance; the yellow metal is considered a safe haven during times of political and economic uncertainty and its price touched a 5 year high, gaining 11.6% over the quarter.
Meanwhile, the oil price was broadly flat over the three months having suffered a big fall at the end of May when US stockpiles jumped sharply. However, it bounced back strongly in June following an attack on 2 tankers in the Gulf of Oman, allegedly by Iran, as well as a fire at a major US refinery.
Key events of the quarter
Investors latched on to a tweet from Donald Trump, in early April, announcing he expected to sign a trade deal with China within a month. However, talks floundered when neither side would give way on some fundamental issues. As a result, from 10 May, the US more than doubled tariffs, to 25%, on around half of all Chinese imports (worth c $200bn) while China hit back with its own tariffs on $60bn of US goods.
President Trump also threatened to impose higher tariffs on imports from Mexico, in an attempt to stop illegal immigration, but this time a pact to control inflows was reached and the plans were put on indefinite hold.
Against the trend for protectionism, the European Union (EU) and South American trade bloc, Mercosur, agreed to reduce tariffs across a range of goods, For the EU, the potential savings of 4bn euros, exceed those of recent deals with Japan and Canada.
Technology companies came under scrutiny as the US House of Representatives launched an investigation into competition in digital markets, while the UK government also promised greater regulatory oversight. The blacklisting of China’s Huawei by the US government has affected the many companies in its supply chain, though Trump appears to be softening his stance.
On the UK political front, Theresa May failed, for a third time, to get her Brexit deal through parliament and the March deadline to leave was extended to the 31st October. Her resignation triggered a leadership contest which saw Boris Johnson become the new Prime Minister at the end of July.
The UK’s unexpected participation in the EU elections brought a resounding victory for the Brexit party. Overall, the centrist pro-EU party saw reduced support with Nationalists and Eurosceptics increasing their share while the Greens took 69 of the 751 seats.
Spain held its third general election in 4 years and incumbent Prime Minister Sanchez increased the Socialist Party’s seats. The populist Vox party did not make the impact anticipated, quelling fears of a rise in anti-establishment movements across Europe.
In India, Narendra Modi scored another landslide Victory with over 300 seats (282 last time) securing another 5 year term. This gives more certainty to the outlook with a business friendly agenda likely.
Tensions persisted in the Middle East after Iran shot down a surveillance drone that it claimed entered its territory, the US threatened military action though has not yet carried it out.
Economic trends and outlook around the globe
In its latest World Economic Outlook, published on 23rd July, the International Monetary Fund (IMF) reduced its forecast for GDP growth in 2019 by 0.1% to 3.2%. The organisation anticipates a pick up to 3.5% in 2020, also a 0.1% downgrade.
The IMF pointed out that recent GDP figures, along with softening inflation, indicate weaker than anticipated global activity. Investment spending and demand for consumer durables have been weak across both advanced and emerging market economies as companies and households continue to hold back on spending. Consequently, global trade, which depends on machinery and consumer durables volumes, remains subdued.
The projected growth recovery in 2020 will require stabilisation in currently stressed emerging market economies and progress toward resolving trade policy differences. Risks to the forecast are mainly to the downside, including further trade and technology tensions, an increase in risk aversion and dis-inflationary pressures that increase debt service difficulties and limit monetary policy’s ability to tackle downturns.
The IMF forecasts the UK economy will grow by 1.3% in 2019 and 1.4% in 2020 (0.1 percentage point higher in 2019 than forecast in their April outlook). The upward revision reflects a stronger-than-anticipated first quarter.
The UK economy has slowed since a stockpiling boost earlier in the year ahead of the expected EU departure date. Manufacturing suffered most as factory shutdowns, planned to coincide with the March 29 deadline, led to a 24% fall in vehicle output in April. Manufacturing production declined 3.9% in April versus March while the overall economy contracted 0.4%. Export orders were weak but services, a major part of the economy, returned to growth. GDP growth picked up 0.3% in May as car production resumed.
Business confidence remains fragile with the Confederation for British industry (CBI) reporting that June’s manufacturing order book index hit the lowest level since 2016. Furthermore, sentiment has started to weaken across consumer and construction sectors, as political turbulence continues. The composite PMI is consistent with a 0.2% contraction in the second quarter.
Retail sales fell 0.5% in May and 1.3% in June, suggesting consumers are finally tightening their belts. This is despite wage growth remaining comfortably ahead of inflation of 2% in June according to the Office for National Statistics (ONS). Along with record employment levels, this would normally boost consumer confidence and spending.
Indicators point to a stalling of economic expansion in the second quarter and Bloomberg consensus estimates are for zero growth. Furthermore, the Bank of England has downgraded its growth forecasts to zero for the second half of the year and left interest rates unchanged at its latest meeting.
Corporate earnings forecasts have been pulled back slightly but are supported by overseas revenues and dividend yields are healthy. Furthermore, there remains potential for a post-Brexit bounce in domestic stocks which do not face structural challenges. Help could also come from a pick-up in government spending, with a potential Brexit war chest in reserve.
The United States
The IMF expects growth of 2.6 % in 2019 (0.3 % higher than in April), moderating to 1.9 % in 2020 as fiscal stimulus unwinds.
The US economy expanded by 3.2% in the first quarter, well above expectations despite a prolonged government shutdown, trade tensions and global slowdown. Business investment continued to grow and exports were robust.
Purchasing Manager Indices (PMIs), a gauge of sentiment, have become more subdued but remain just in expansion territory, which suggests a gradual slowdown rather than recession.
Consumer confidence hit a six month high in May giving hope that weaker April retail sales were a blip. Consumer price inflation edged up to 1.9% year on year, driven up by the oil price, but still stands below the 2% official target.
Disappointing job creation figures for May, brought a swift response from the Fed, saying it would act to support growth if necessary. However, non-farm payrolls recovered strongly in June, highlighting the dangers of overreacting to a single month's figures.
There had been fears that US companies would report disappointing figures for first quarter earnings yet, with a few exceptions, this has not happened. Many companies have beaten lowered expectations, albeit overall growth was marginal as the benefits of last year’s tax cuts ended. The dollar has weakened on hopes of interest rate cuts which should help exports.
The IMF forecasts growth in the euro area of 1.3 % in 2019 and 1.6% in 2020 (0.1 % higher than in April). The forecast for 2019 is revised down slightly for Germany (due to weaker export demand), but it is unchanged for France (where fiscal measures are expected to support growth) and Italy.
The IMF anticipate that Euro area growth will pick up over the remainder of this year and into 2020, as external demand is projected to recover and temporary factors (including the dip in German car registrations and French street protests) continue to fade.
First quarter growth was stronger than expected at 0.4% on a quarterly basis (1.2% year on year), helped by expansionary policies in Germany and France, while even Italy and Spain delivered positive surprises. Household spending, low unemployment and rising wages all contributed, as did an improved performance from the manufacturing sector.
By May, economic data had become much more mixed. The manufacturing PMI fell to 47.6 (below 50 indicates contraction) in June, after 47.7 in May. However, new export orders, while still below the critical 50 market, did edge up. A strong performance from services left the Composite PMI at 52.2 in June as retail sales exceeded expectations and consumer confidence reached its highest level this year.
Germany, whose export dependent economy accounts for a third of Eurozone activity, has been most affected by conditions in the global economy. Factory orders fell 9% in May. The German government has halved its 2019 growth forecast to 0.5%, though the Economics Ministry does expect a recovery to 1.5% in 2020.
Eurozone companies, many crucial to the supply chains of the world, are clearly reluctant to invest until the outlook is clearer. The ECB has clearly signalled that it intends to leave rates on hold for the remainder of the year.
The IMF GDP growth estimate for Japan is 0.9% in 2019 (0.1% lower than April’s forecast), declining to 0.4% in 2020, with fiscal measures expected to mitigate the impact of the forthcoming October 2019 increase in the consumption tax rate.
Japan reported solid economic growth of 0.6% for the first quarter of 2019, equating to 2.2% annualised, well ahead of expectations. The improvement was down to inventory building and strong machinery orders. Growth slipped back a little in April, falling 0.4% compared with March.
Exports, which are core to the economy, have been depressed by trade tensions and an extended holiday for the ascension of the new emperor. Data revealed a 6.7% fall, year on year, in June following declines of 7.8% in May and 2.4% in April. The manufacturing PMI for June was 49.3 vs 49.8 in May, reflecting poor business sentiment despite continued demand from key trading partners in China.
Consumer inflation picked up slightly in April to 0.9% year on year, before slipping back to 0.7% in May, still well below the 2% target. It has been a struggle to maintain real wage growth as companies scale back bonuses in tougher trading conditions. Wages fell in June for 6th month in a row, though the pace of decline slowed. Nevertheless, retail sales improved, with a 1.2% rise in May after a smaller increase in April.
The Bank of Japan has committed to ‘extremely low’ interest rates until at least spring of next year, possibly longer. In the absence of global recession, the stable political backdrop and ongoing structural reforms implies companies should be able to deliver further earnings growth.
The IMF expects growth in the emerging market and developing economies group to be 4.1 % in 2019, rising to 4.7% in 2020. The forecasts for 2019 and 2020 are 0.3% and 0.1% lower, respectively, than in April, reflecting downward revisions in all major regions.
China is downgraded slightly to 6.2% in 2019 and 6.0% in 2020 with policy stimulus expected to underpin economic activity. India’s economy is set to grow at 7.0 % in 2019, picking up to 7.2% in 2020. The downward revision of 0.3 % for both years reflects a weaker-than-expected outlook for domestic demand.
Latin America is expected to grow 0.6% this year followed by 2.3% in 2020. The 0.8% downgrade for 2019 is due to poor sentiment around structural reforms in Brazil and political uncertainty in Mexico.
China’s National Bureau of Statistics released a GDP growth estimate of 6.2% for the second quarter, in line with expectations. This follows 6.4% for the first quarter, which was boosted by an 8.5% jump in industrial production in March and supportive monetary and fiscal conditions. The slowdown was attributed to exports and housing starts; exporters are seeing the slowest rate of growth for 3 years.
Local government bonds were issued to fund infrastructure projects, and taxes reduced to boost consumer spending. These measures had the desired effect; retail sales jumped nearly 9.8% in June after 8.6% in May. However, the lack of a trade deal is hurting sentiment and Chinese shares lost momentum on worries the government might restrict additional stimulus. PMIs deteriorated further over the quarter, with the manufacturing PMI falling to 49.4 in June vs 50.2 in May.
Interest rates in India were cut for the second time this year ahead of the general election. In the event, the incumbent Prime Minister, Narendra Modi and his BJP party swept to a landslide victory. This gave him another 5 year mandate to continue with his programme of sweeping reforms which was taken positively by the stock market.
Latin America’s two biggest economies, Brazil and Mexico, both contracted by 0.2% in the first quarter as they were affected by lower commodity prices and weak productivity.
President Bolsonaro’s plans to reignite Brazilian growth appeared to have stalled as investment remained sluggish. Argentina goes to the poll in October, at a time of deep recession and falling living standards. Chile and Peru also weakened while Venezuela imploded as oil production collapsed.
Prospects for investors
Recent volatility highlights the sensitivity of markets to geopolitics and an all-out trade war remains the biggest risk. Although the quantifiable impact of tariffs to date is small, the ongoing uncertainty is having a negative effect on confidence leading to postponement of capital investment plans.
The JPM/Markit global manufacturing index stood at 49.4 in June suggesting falling output. New orders and business optimism also weakened. The resumption of trade talks is welcome but there remain significant hurdles to overcome. Of course, if a satisfactory deal is struck, China growth worries could quickly dissipate.
Manufacturing has felt the brunt of the slowdown but central banks have clearly signalled they will step in to support growth. At the start of the year, markets expected 2 rate hikes from the Fed, now they expect 3-4 cuts. Hence, in spite of the late stage of the cycle, low or falling interest rates and little inflationary risk does not suggest a global recession is imminent. Of course, with rates already so low there is little capacity to deal with more than a mild downturn so quantitative easing and/or fiscal policies may have to be revisited.
As markets hit record highs a note of caution is warranted. Global growth has been sustained by the strength of the US economy, while consumer spending worldwide remains reasonably healthy on the back of high employment and real wage growth. Although, certain disrupted sectors, such as retail and autos, are shedding jobs this has been compensated for by employment growth in expanding industries. If more companies start to cut jobs the consumer could retrench.
The quandary faced by investors is that, with a number of unpredictable events, markets could move in very different directions. This makes a good case for being well-diversified across asset classes, geographies, styles and sectors to reduce the risk of being wrongly positioned. Valuations, of course, should not be neglected as there are pockets of over-valuation, with certain government bonds and some technology stocks looking particularly expensive.
In recent years, we have seen cyclical sectors suffer and, with bond yields continuing to decline, it is hard to see these trends reversing unless trade disputes are resolved. However, even if we focus on quality companies with reliable earnings streams, we should still keep an eye on disruptive forces such as demographics and digitalisation. It is important to differentiate between companies with defendable positions and those which are failing to adapt.
The damage from the trade disruption has been seen most clearly in Europe which is highly dependent on international trade and capital spending. Recent strong performance by Eurozone stock markets may seem puzzling but suggests that bad news gets priced in early and investors are already thinking ahead.
In the UK, a no deal Brexit would probably mean more of the same; weaker sterling benefiting companies with international earnings over those with a domestic bias. A Labour Government could have a similar but more profound effect, with sectors such as utilities at risk of nationalisation. For now we have a two speed stock market, made up of expensive defensives and cheap cyclicals.
For investors with a long time horizon, and willing to accept higher volatility, emerging markets, especially Asia, look set to continue to deliver superior growth to their developed counterparts in the years ahead. Rising household incomes will allow the new middle classes to enjoy aspirational brands, tourism, healthcare and education.
Dividends are likely to be an important component of total return in coming months, and indeed years, and companies with healthy balance sheets should be best placed to maintain them whatever course the economy takes. Countries where pay-out ratios are low, such as Japan (50% of companies have net cash and shareholder returns are improving), may be worth consideration.
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.