Quarter 2 performance: markets make progress despite geopolitical concerns
% total return
|Year to date 2018
% total return
The quarter began with investors in a cautious mood, unsure whether the global recovery was faltering, particularly in Europe. There was also some unease about the pace of US interest monetary policy tightening and how this might affect other regions. Nevertheless, buyers seemed prepared to seek out pockets of value on any setbacks.
The outstanding performance came from the UK, with a total return of 9.2% for the FTSE All Share. This reflects recognition of the extent to which the market had de-rated on Brexit concerns, leaving some sectors on attractive valuations. Substantial exposure to the buoyant oil sector contributed to the stellar performance, after the price of Brent Crude breached $80 a barrel in May. The export-dominated FTSE 100 received a further boost from sterling weakness, which also enhanced returns for UK investors in overseas markets.
The US, Japan and Europe also delivered decent returns as company results reported for the first quarter exceeded expectations. The US continued to lead the way in the first half, helped by gathering momentum in its dominant technology sector. US Dollar strength was behind the poor performance of Emerging Markets since many countries in the region have their debt denominated in dollars. Asian markets were negatively affected by the higher oil price due to their dependence on imported oil. China’s domestic Shanghai SE Index moved into bear market territory over the quarter, with a correction of over 20% since January, although the MSCI China held up better due to its higher technology weighting.
Meanwhile, markets in Latin America recorded steep declines after Argentina had to approach the IMF* for a $50bn bailout following a collapse in the Peso. Presidential Elections across the region this year, including Brazil and Mexico, brought further uncertainty.
Nervousness resurfaced towards the end of the period as investors digested the implications of a global trade war. Consequently, equity markets in Asia, particularly China, and in Europe slipped back in June. The performance of Bonds was muted as interest rate tightening cycles get underway.
Key events of the quarter
Donald Trump’s provocations are now so commonplace that investors have been taking them in their stride. Threats in recent months included a military strike against Syria, and further sanctions against Russia for supporting Syria’s alleged use of chemical weapons in Duma.
The US pulled out of the Iran nuclear deal, re-imposing sanctions on the country and snubbing close allies who were keen for the deal to remain in place. These sanctions, along with supply constraints from producers, contributed to the steep rise in the oil price over the quarter.
Not all actions from the President were hostile. A long-awaited summit with North Korea’s Kim Jong-un produced tentative agreement that the US would stop its military exercises on the Korean Peninsula in return for the Republic working towards de-nuclearisation of the peninsula.
Somewhat surprisingly, Trump instructed his economic advisors to consider re-joining the Trans-Pacific Partnership despite withdrawal having been one of his first actions in office. On a less positive note, the latest G7 meeting in Canada revealed a growing division between the US and its Western allies over free trade.
Mounting tension over a possible trade war with China is probably the most unsettling issue for investors. In June, it moved a further step towards reality as the US hit China with its first tariffs (of 10%) on $50bn worth of goods, with a further $200m planned. Beijing countered with 25% tariffs on a range of US imports. This could potentially have a disruptive effect on global supply chains, although Beijing has made some concessions, including increasing purchases of US farm exports and improving intellectual property protection.
Economic trends and outlook around the globe
In its latest World Economic Outlook, published on 17th July, the IMF maintained its global growth forecasts of 3.9% for both 2018 and 2019. However, the organisation warned that growth is less synchronized than previously and full implementation of the proposed US tariffs could reduce annual growth by 0.5% by 2020, representing the main threat to medium term growth.
While the US remains a driver of world growth, the IMF has reduced its estimates for a number of other countries, reflecting the weaker performance in the first quarter of the year. The Eurozone, the UK and Japan all had their growth figures trimmed.
The IMF forecasts growth of 1.4% in 2018, a downgrade of 0.2%, and 1.5% in 2019. This reflects the slow start to the year and the fact that some companies remain reluctant to commit to investment until the Brexit outcome is made clearer.
The UK economy expanded by only 0.2% in the first quarter, with the shortfall blamed on a significant contraction in the construction industry. Growth in the services and manufacturing sector fared slightly better. Severe weather conditions, muted productivity growth and slow progress with Brexit were blamed for the malaise.
CPI** inflation was unchanged in May and June at 2.4%, despite the strong oil price pushing up petrol prices, which implies the underlying economy is quite weak. More encouragingly, wages have started to outstrip inflation and unemployment fell to 4.2% in the 3 months to May.
Improving PMI*** surveys suggest the economy is set to recover from the Q1 setback, with activity in the key services sector expanding at the fastest rate for 3 months in May. The composite PMI, covering manufacturing, construction and services predicts a reasonable pick up in Q2.
The Bank of England left interest rates on hold, at 0.5%, on the back of the weaker data and it seems any rise may have now been deferred to August. However, the MPC**** expects momentum to be re-established as real wage growth improves. Retail sales have shown an encouraging rebound in the quarter, albeit assisted by the warm weather, a Royal Wedding and the World Cup.
Theresa May is proposing a Facilitated Customs Arrangement so Britain and the EU can trade without a border until an alternative to a hard border with Ireland can be found. The House of Lords inflicted a damaging defeat on the government by voting to remain in the EU, and two key Cabinet Ministers have resigned.
The United States
The IMF kept its US GDP forecasts at 2.9% for 2018 and 2.7% for 2019, compared with growth of 2.3% in 2017. The economy is starting to reap the benefits of fiscal stimulus and robust demand which has lifted output and pushed unemployment to a 50 year low.
Although Q1 growth was revised down marginally, this was due to less inventory replenishment. Most indicators suggest the US economy is operating at full throttle, which prompted the Federal Reserve (Fed) to lift interest rates by another quarter point in June to a range of 1.75%-2.00%. Guidance is for at least two more rises this year while the Fed also raised its growth forecast for 2018.
The positive effects of tax cuts drove an impressive results season, with S&P 500 earnings per share ahead by 25% year on year. The key technology sector is actually seeing growth accelerate, and with the 7 largest stocks in the world now being tech companies, this momentum could continue. The tailwinds from tax cuts and the energy sector should offset any pressure on consumption from higher petrol prices. Unsurprisingly, consumer confidence is still close to the 17-year high reached in February and retail sales surged an impressive 6.8% in May.
The dollar tested new highs for 2018, following the interest rate rise. Bond yields also edged higher with the 10 year US Treasury breaking through 3%. CPI Inflation ticked up to 2.1%, it’s highest for a year, while unemployment fell to 3.8% in May before picking up a notch in June.
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, downgrades of 0.2% and 0.1% respectively. Germany and France saw forecasts trimmed due to slower activity in Q1 while Italy was affected by tighter financial conditions as political uncertainty weighs on domestic demand.
Growth in the Eurozone slowed from the exceptional pace of 2017, coming in at 0.4% in Q1 2018 compared with 0.7% in Q4 2017. The weakness was attributed to cold weather, strikes, production bottlenecks and flu.
A fall in German business confidence suggests manufacturers are worried that machinery and cars, made by their subsidiaries in China and exported to the US, could be hit by tariffs. Nevertheless, industrial production bounced back in May.
Inflation in the Eurozone accelerated to 1.9% in May, just below the Central Bank's 2% target. Falling unemployment and rising wages should keep consumer spending strong enough for the Bank to withdraw monetary stimulus by the year end, although interest rates are unlikely to go up until the summer of 2019. Furthermore, most activity and business sentiment indicators remain positive, implying second quarter growth of 0.4-0.5% or 2% annualized.
Political risk resurfaced in Europe. In Italy, the government formation process hit problems when Sergio Mattarella, the president, rejected the euro-sceptic candidate nominated for Finance Minister. This caused short-term turmoil in equity and bond markets until Populist parties, Five Star and the League, gained approval to form a government. In Spain, Conservative Prime Minister Mariano Rajoy was ousted following a corruption scandal, and replaced by Socialist Pedro Sánchez.
The IMF has revised down its growth for Japan to 1.0% for 2018, a downgrade of 0.2%, while leaving 2019 at 0.9%. The organisation expects the economy to improve over the rest of the year and into 2019 as consumption, external demand and investment pick up.
Japan’s economy contracted by 0.6% in Q1. This marked an end of a lengthy period of growth, extending over 8 quarters. Inventory reduction, rising energy costs, the implications of trade wars on the export-led economy and Yen strength all took their toll. Weather was a factor too, with a lot of snow this year. Japanese companies are particularly sensitive to the global economic cycle and the Yen’s ‘safe haven’ currency status.
Despite these headwinds, corporate earnings were broadly in line with consensus. Industrial production remains relatively robust, while the Tankan survey of business sentiment is reasonably positive, predicting an upswing in capital investment to address a shortage of workers.
Wage growth has yet to pick up significantly, despite the tight labour market. Ironically, this may be a consequence of Prime Minister Abe’s structural reform; attracting women and retirees back to work has put downward pressure on wages. However, although wage settlements are below the 3% government target, they are at least improving after decades of stagnation.
With core inflation slowing more than expected, the Bank of Japan remains highly accommodative, a change of direction from the first quarter when there were hints that it was set to reduce monetary stimulus.
The IMF has maintained its growth estimate for China at 6.6% for 2018 and 6.4% in 2019. This represents a slowdown from the 6.9% of 2017 due to tighter regulation of the financial sector and softer external demand.
India is still expected to deliver the strongest growth, at 7.3% this year and 7.5% in 2019, although this has been downgraded, by 0.1% and 0.3% respectively, due to the higher oil price and faster than expected interest rate rises. Nevertheless, it still represents a decent advance from the 6.7% of 2017 as the disruption from implementation of various reforms diminishes.
Latin America is projected to produce more modest growth of 1.6% in 2018 and 2.6% in 2019, a reduction of 0.4% and 0.2% from April’s outlook. While stronger commodity prices have been a positive, prospects in key economies have been hurt by: tighter financial conditions in Argentina, strikes in Brazil, and trade tensions and the uncertainty of a new government’s policy direction in Mexico.
Confidence in Emerging Markets has been knocked by a stronger US dollar. To defend their currencies Turkey, Argentina, Indonesia and the Philippines all raised interest rates. For weaker countries, this can trigger soaring inflation and economic turmoil as Argentina found to its cost.
China, as the second-largest economy in the world and a destination for exports, continues to be the driver of the region’s performance. Its economy expanded by 6.8% in Q1, equal to the previous quarter, with a pick up in private investment outweighing a deteriorating trade surplus. The Caixin PMIs remain healthy.
US tariffs, along with the need to control debt and property prices, are a risk to growth prospects but, as a state controlled country, China has a record of delivering on its targets. Beijing has lifted ownership rules that limit foreign investment, showing a willingness to concede to US demands.
The Central Bank loosened monetary policy, meaning companies should be able to access more credit at lower cost if new tariffs hurt trade. The Bank also sold US treasuries (of which it is the biggest foreign holder) after trade talks stalled, having been a net buyer earlier in the year.
The Indian market made gains as investors started to recognise the long term benefits of reforms, including the Goods & Services tax and a move to digital payments. GDP growth is now expected to exceed that of China over the next few years.
The Reserve Bank of India raised interest rates for the first time in 4 years, in response to inflationary pressures. It also announced a surprise cut in the reserve requirement, the amount of cash commercial banks are required to deposit with it, in order to prevent growth momentum slowing.
The fallout from Argentina’s problems has had reverberations across South America. The country had to ask for an IMF bail-out following a succession of interest rate rises that failed to halt the slide in the peso. A $50bn refinancing deal was agreed.
Sentiment in Emerging Europe was adversely impacted by political developments in Italy, and countries with relatively high debt levels and current account deficits, such as Greece and Turkey came under increased scrutiny.
Clearly the outlook for emerging economies is mixed, and investors must be selective. Whilst many Asian countries are net importers of oil, others such as Russia are seeing a big boost to corporate profits. Overall, however, much of the region is in better shape than for some time, and well placed to take advantage of demand from the burgeoning middle classes.
Outlook and prospects for stock market investors
Notwithstanding a few hiccups in economic data, and a plethora of political twists and turns, the global recovery largely remains in force. Against a background of modest inflation and gradual normalisation of monetary policy, recession does not appear to be around the corner. Indeed, history shows that decent returns from equities often occur in the later stages of the economic cycle.
The combination of protectionism and higher oil prices is currently affecting sentiment towards exporters in Europe and Asia. Meanwhile, the US, accounting for over 50% of the MSCI World index, remains the engine of economic growth. Along with interest rate differentials, this has produced dollar strength, presenting challenges for some Emerging Markets. With mid-term elections approaching, Trump may decide to tone down his aggressive stance on tariffs to protect the domestic market and employment.
In the second half of the year, we could see some re-acceleration in growth outside of the US as high employment and the availability of cheap credit show through in capital investment. The strong earnings season has left equity valuations looking less stretched than earlier in the year. The outlook for the UK consumer could improve next year while the yield on the market is attractive with improved dividend cover. Of course, a satisfactory Brexit deal is vital for the UK’s prospects.
Although volatility has been lower than the first quarter, it has picked up as US tariffs take effect. This tends to produce a more cautious attitude to risk but can present buying opportunities. There is also the divergence in styles to consider; some experts think the high growth technology sector is approaching bubble territory, while others think it actually has defensive qualities because it can thrive independently of the economic cycle. A value approach tends to favour companies with cash-rich balance sheets, consistent free cash-flows and business models that can weather downturns.
While much of the developed world is in the later stages of an expansionary cycle, many Emerging Markets are still at an earlier stage in the cycle, supported by robust economic and earnings growth. Over the longer term, I retain confidence that Emerging Markets-particularly in Asia-offer the greatest opportunities. A global growth Fund can give you a foot in all camps while identifying the most attractive opportunities at any given time.
For the remainder of this year, equities still offer the prospect of positive, albeit probably more modest, returns compared with other asset classes. A cautious stance on bonds in this monetary tightening environment seems warranted but as interest rates go up, their yields will eventually become compelling again. High yield bonds should prove resilient while company fundamentals remain strong, with low default rates. A strategic bond Fund aims to diversify across all regions and types of bond, adjusting weightings when appropriate.
*International Monetary Fund
** Consumer Prices Index
***Purchasing Manager’s Indices
****Monetary Policy Committee
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