Market commentary for 3rd quarter 2019 and the outlook ahead
Posted by Liz Rees in Market commentaries category on 17 Oct 19
|3rd Quarter 2019
|Year to date
Source: FE Analytics, performance on a total return basis in local currency, 30/09/2019
Quarter 3 performance: geopolitical worries
The quarter began on a note of optimism as trade talks resumed between the US and China. There was no early breakthrough but the first US interest rate cut in 11 years spurred stock markets ahead in July. The S&P 500 index touched record highs, driven by the dominant technology sector. Meanwhile, the FTSE 100 with its significant overseas earnings, benefited from further sterling weakness.
In August, markets reversed as trade war fears, and unease about a no deal Brexit, escalated. Falls in US shares were relatively modest as company profits beat expectations. However, it was a challenging month for Emerging and Asian markets as concerns about trade, US dollar strength and the global economy created unease.
Stock markets recovered ground in September, with all except China in positive territory, as August’s rally in bonds and defensive shares unwound. Value stocks showed tentative signs of a renaissance. There was little obvious good news other than some minor trade concessions between the US and China and glimmers of hope for a Brexit deal. Japan was the stand-out performer in the month.
Overall, there has been a notable slowdown in the global economy over the period. Investor sentiment was tested as economic data deteriorated. As safe havens were sought in August, long-dated government bond yields fell to a 30 year low. Simultaneously, the gold price broke through the psychological barrier of $1,500 an ounce in August for the first time in 6 years.
The oil price was volatile as weaker demand and an acceleration in US shale supply were countered by tensions in the gulf and tropical storms in the Gulf of Mexico. Drone attacks on Saudi Arabian oil infrastructure caused the price to spike and rattled stock markets briefly. This proved short-lived as production was swiftly restored.
Key events of the quarter
Progress on US-Chinese trade negotiations ebbed and flowed. On 1st August President Trump announced his intention to impose tariffs on $300 billion of Chinese imports. China retaliated with tariffs on $75 billion of US imports.
A 15% tariff on $125bn of Chinese goods took effect on 1st September but there were signs of compromise. The US delayed further hikes while China exempted some US products as a ‘goodwill gesture’. At the G7 summit, President Trump switched tack from calling Chinese Premier Xi a ‘US enemy’ to a ‘great leader’.
Monetary easing was back on the agenda. The Federal Reserve (Fed), the European Central Bank (ECB) and the central banks of New Zealand, India and Thailand all reduced interest rates.
ECB President, Mario Draghi, said the bank would resume its bond buying programme and advocated fiscal stimulus. Christine Lagarde, his successor from November, also supports an accommodative stance. Germany offered 30 year bonds at a yield of -0.11%, the first ever sale at negative yields.
Boris Johnson became UK Prime Minister, winning the Conservative party leadership contest with around two-thirds of the vote. He committed to leave the EU on 31st October, with or without a deal, and 21 rebel Conservative MPs were deselected after backing moves to stop ‘no deal’. A 5 week suspension of parliament ahead of the exit date was subsequently declared unlawful by the Supreme Court and MPs recalled.
In Asia, violence escalated in Hong Kong between the police and pro-democracy demonstrators, unsettling businesses and investors. Japan placed restrictions on exports to South Korea that are vital for semiconductor production. This has put pressure on supply chains just as trade was faltering.
On a more positive note, Shanghai’s new tech exchange, the Star market, launched successfully with many shares soaring. The aim is to attract innovative companies, which would otherwise have listed on the Nasdaq or Hong Kong exchanges.
Argentina’s President Mauricio Macri unexpectedly lost a primary election to a populist left-wing candidate. The country’s stock market experienced its largest one-day decline since 1990, falling over 50%.
In September, drone strikes on Saudi Arabian infrastructure, halved the Kingdom’s output and disrupted global supplies. Oil price gains were pared as global producers agreed to release reserves but political tensions simmered after the US blamed Iran.
Economic trends and outlook around the globe
In its latest World Economic Outlook, published on 15th October the International Monetary Fund (IMF) reduced its forecast for global GDP * growth in 2019 to 3.0%. They expect a pick up to 3.4% in 2020, primarily reflecting a projected improvement in economic performance in a number of emerging markets in Latin America, the Middle East, and emerging and developing Europe.
However, the IMF warned that with uncertain prospects for some of the above countries, and a projected slowdown in China and the United States, a more subdued pace of global activity could well materialize.
The IMF forecast the UK economy will grow by 1.2% in 2019 and 1.4% in 2020. A 0.1% downgrade for this year reflects investment held back by Brexit-related uncertainty while 2020 is left unchanged on the assumption of a positive impact from higher public spending announced in the recent Spending Review.
UK GDP* contracted by 0.2% in the second quarter, partly due to car manufacturers closing plants ahead of the original March EU departure date. However, concerns of a recession (two consecutive quarters of negative growth) receded when output jumped 0.3% in July. Services, which account for 80% of the economy, recovered after a flat period. A minimal decline of -0.1% in August (services +0.4% and manufacturing -0.4%) means recession should be avoided for now.
As the odds on leaving the EU without a deal rose, the pound came under pressure. Hopes of resolving the Irish backstop issue prompted brief rallies but a suspension of parliament, albeit temporary, left little time for an agreement before 31st October.
Many British exporters have left their prices unchanged and increased profits in sterling terms. On the other hand, import costs have risen, wiping out profit margins for companies reliant on overseas goods, for example retailers.
Consumer spending has been a key support to the economy but, with ongoing political turmoil, retail sales fell in August for a fourth consecutive month. Even previously strong online sales ground to a halt.
More encouragingly, real wage growth is positive. Wages increased 4% in the 3 months to July, well ahead of inflation. The Consumer Prices Index (CPI) was 2.1% in July and slipped to 1.7% in August.
Capital investment has been weak with companies reluctant to make long-term commitments. This is at a time in the economic cycle when it would normally increase. On the positive side, companies are still hiring and unemployment of 3.9% stands at a 45 year low. Nevertheless, the composite PMI (Purchasing Managers Index) dropped to 48.8, as the all-important services sector slipped into contraction. A figure below 50 implies a contraction in activity.
The Bank of England left rates on hold over the quarter but revised down growth to 1.3% in both 2019 and 2020. For 2021, it upgraded to 2.3% with inflation expected to reach 2.4% on a 3 year horizon.
The United States
The IMF expects growth of 2.4% in 2019, moderating to 2.1% in 2020. The slower growth next year assumes a shift in fiscal stance from expansionary in 2019 to broadly neutral.
US data has been mixed but does not point to an imminent recession. Second quarter GDP was ahead of expectations at 2.1%, assisted by robust consumer and government spending. The corporate reporting season was satisfactory and analysts expect positive earnings growth this year, although consensus forecasts for 2020 look demanding.
Manufacturing production has been most disrupted as trade wars weigh on business confidence, contracting by 0.4% in July. It bounced back in August but the forward looking ISM Manufacturing PMI had declined to 47.8 by September.
Domestic demand remained relatively resilient; retail sales were healthy thanks to a buoyant labour market. Job creations were strong in July but tailed off in August, before recovering in September. While the economy is adding jobs, growth in total hours worked has slowed meaningfully and real wage growth has slowed to 2.9%.
Consumer confidence declined marginally in September. The tariffs imposed on Chinese imports are having a direct effect on the consumer. If higher prices knock confidence it could damage domestic growth. Consumer price inflation was 1.7% in August.
The Fed said that July’s interest rate reduction was ‘not the start of a lengthy cutting cycle’ but an inversion of the US yield curve, a closely watched indicator of recession, raised concerns that further action would be needed.
Another reduction followed in September, again with a caveat that economic data did warrant more. Trump is thought to be considering other ways to reinvigorate the economy, including lowering capital gains tax and payroll taxes.
The IMF forecasts growth in the euro area of 1.2% in 2019 and 1.4 % in 2020. Activity is expected to pick up modestly over the remainder of this year, and into 2020, as external demand is projected to regain some momentum and temporary factors (including new emission standards that hit German car production) continue to fade.
The Eurozone economy has shown clear signs of a worsening outlook. There is concern that Germany, the powerhouse of the Eurozone, could be heading for recession as trade disputes have hurt the country. Growth in domestic consumption has only partially compensated. Despite a pickup of 0.3% in industrial production in August, two quarters of negative growth is a strong possibility.
German business sentiment surveys have deteriorated to six-year lows. This reflects problems in the car industry which this year has experienced a 12% fall in production, and a 14% fall in exports. The German government recognises the need for stimulus and has proposed spending of $55bn.
The ECB’s policy easing came against this backdrop of weakening growth. Inflation, which stood at 0.9% in September, is well below the 2% target, justifying the decision to reduce interest rates. Departing Mario Draghi called for further stimulus as it appears that weakness in manufacturing can no longer be offset by services.
The HIS Markit PMI for the Eurozone fell to a 6 year low of 50.4 in September, compared with 51.9 in August. This disguised considerable disparity as the manufacturing index stood at 45.6 while services held up better at 52.0. Furthermore, unemployment is at a record low and the housing market buoyant as domestic demand remains healthy.
Talks between the European Commission and Italy about its fiscal position provided a positive and political tensions eased. A general election, which could have led to a populist anti-EU party taking power, seems to have been avoided after an acceptable coalition party took power.
The IMF GDP growth estimate for Japan is 0.9% in 2019 declining to 0.5% in 2020. Strong consumption and public spending in the first half of 2019 outweighed continued weakness in the export sector. Temporary fiscal measures are expected in 2020 to limit an anticipated decline in private consumption following a rise in the sales tax rate.
GDP beat forecast in the second quarter, up 0.4% on the previous quarter. Annualised growth was 1.8% which gave Prime Minister Abe confidence to press ahead with his sales tax increase.
The tax presents a risk to an economy that is already feeling the effects of the global slowdown in manufacturing although reward points for making cashless payments are hoped to mitigate the effects. Retail sales had already been weak and consumer price inflation slipped to 0.3% in August despite an unemployment rate of 2.2% in July, a 27 year low.
In July, machinery orders were up an impressive 13.9% month on month against estimates of a small fall. However, the manufacturing sector shrank for a 4th month in August, albeit at a slower rate than in July, while services activity improved. The forward looking manufacturing PMI also slipped to 48.9 in September vs 49.3 in August.
Exports continued to decrease over the quarter, including shipments to Asia, against a background of slowing trade. The Bank of Japan made it clear that it was ready to step up stimulus if the downside risks to inflation increased. However, despite a challenging background, many Japanese companies are in growth sectors, have strong finances and are growing dividends, and are on attractive valuations.
In its quarterly outlook, the central bank edged down growth forecasts to 0.7% and 0.9% respectively. Inflation forecasts were reduced to 0.98% this year and 1.2% in 2020, near a 2 year low and way below the Bank of Japan’s target.
The IMF expects growth in the emerging market and developing economies group to be 3.9% in 2019, rising to 4.6% in 2020. All regions except emerging Europe have been revised downwards. China is expected to expand by 6.1% in 2019 and 5.8% in 2020 while the estimate for India is 6.1% and 7.0% respectively.
Chinese growth slowed in the second quarter. GDP was up 6.2% compared with 6.4% in the first quarter. The economy continued to slow with July data falling short of expectations. Industrial output increased 4.8% in July, against a forecast of 5.5%. The weakness was attributed to exports and housing construction while domestic consumption remains firm.
Without the prospect of a trade deal, the Chinese authorities were quick to implement both fiscal and monetary stimulus. The People’s Bank of China announced lending reforms to lower financing costs. It also let the renminbi breach the psychological barrier of 7 to the US dollar. Activity has since shown some signs of stabilisation as stimulus countered tariff fears.
Retail sales rose 7.5% in August and employment remained near record lows. While industrial output was up a modest 4.4% in August the predictive Caixin China manufacturing PMI rose to 50.4 versus 49.9 in July. A further advance to 51.4 in September indicates strengthening production although this may reflect demand for exports brought forward. Interest rates were trimmed by just 0.05% for fear of fuelling a property boom.
India announced a cut in corporation tax in September, worth $20bn, from 30% to 22% with the aim of reversing a dip in growth and the stock market responded with its biggest ever one day rise, up over 5%. The central bank also cut interest rates to 5.4% with hints of more to come.
Asian emerging markets have been the winners in the trade wars. According to the Asian Development bank, as China’s exports to the US have decreased, those from Vietnam, Malaysia, Thailand and the Philippines have benefited from a shift in production. Vietnam, for example, saw exports to the US rise 33% in the first half of 2019.
Prospects for investors
Western stock markets proved resilient in the third quarter as investors remained hopeful that renewed monetary stimulus would revive the global economy. However, manufacturing is now in recession across the globe and the slowdown appears to be extending to other sectors of the economy. In the UK, for example, all the September PMI surveys, manufacturing, services and construction, signalled economic contraction.
JPMorgan’s Global Manufacturing PMI remained below the neutral 50.0 mark in September for the fourth month running. New orders decreased at the fastest rate for nearly seven years, led by steep falls in international trade volumes.
On the bright side, looser monetary policy from key central banks, could provide some support for markets over the remainder of the year, although with interest rates so low there has to be a limit to their firepower. Instead, fiscal stimulus may be required to give a boost to corporate earnings and consumer confidence.
Much of the drag on global growth relates to geopolitical factors, the outcome of which could determine the direction of markets. Trade disputes have hurt factory output and any resolution could bring a swift pick-up in activity. With an election next year, the US may have more incentive to concede on any sticking points. At the time of writing, US tariffs due to take effect on 15th October have been suspended in return for promises from China to increase purchases of agricultural goods.
The UK, and the Eurozone, have been affected by Brexit uncertainty and may stage a relief bounce whatever path is taken. We have seen sharp moves in domestically focused companies on any inkling of a deal and volatility remains elevated.
Of course, recessions are a normal part of an economic cycle, and one may seem long overdue, but the inverted yield curve is the only indicator currently flashing red. What’s more, downturns do not always correlate with stock market moves so trying to time one could prove a risky strategy. Germany has been one of the weakest economies yet its DAX 30 index advanced 17.7% this year**.
It may therefore prove more rewarding to ignore the short-term noise and focus on the long-term. Of more lasting impact will be the disruptive effects of technology and environmental issues, in particular climate change. Companies which fail to adapt to change might be at risk of losing market share to new entrants.
With plenty of ‘unknowns’ a well-diversified portfolio is more important than ever. As well as spreading equity risk around the world, bonds and alternatives such as commodities, private equity and infrastructure may play a useful role as diversifiers. While keeping some cash aside can be useful to ‘buy the dips’, its low returns means that holding too much could make it more difficult to achieve your goals.
A blend of different styles (such as value, growth and smaller companies) is also worth considering, including funds with an income focus. Many companies in the UK, Europe and Asia offer attractive yields and dividends can offer an element of stability to returns when markets are volatile. However, it is important to avoid value traps where companies have declining earnings or excessive debt, putting pay-outs at risk.
Trade friction has driven down emerging market valuations, as share prices react disproportionately to downgrades. The region used to command a premium to the S&P 500 but this has been steadily eroded and relative valuations now look interesting.
The potential effect of tariffs on growth in China could be overstated as it is much less reliant on exports in the past. The emerging middle classes, along with urbanisation, in Asia are a powerful force in driving domestic growth in the region. Many countries are expected to grow in excess of 5% this year and have the available resources for stimulus, both monetary and fiscal, if necessary.
*Gross Domestic Product
** FE analytics 31/12/2018-30/09/2019 total return in local currency.
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.