Market Overview

Figure 1: Equity market performance, base currency, to 30 September 2018. YTD: year to date. Past performance is not a reliable indicator of future results. Source: Thomson Reuters Datastream, MSCI: please see important information

Summary

US equities performed well, with the tax reforms implemented earlier in the year supporting both corporate earnings and economic growth. Japanese equities also made robust gains amid record corporate profitability, encouraging economic progress and constructive political developments. Despite strong earnings growth, returns from Europe were tempered by adverse political events in Italy and concerns over its financial sector’s exposure to Turkey. Meanwhile, UK equities lost ground as investors worried about the potential for a ‘no deal’ Brexit.

In contrast to developed-market equities’ progress, the emerging markets suffered amid a number of headwinds. These included tightening global financial conditions, the potential for economic contagion from Turkey and Argentina, the adverse effects of protectionist US trade policy and concerns about China’s slowing economy. This resulted in emerging-market asset valuations becoming cheaper, at a time when we believe concerns about further US dollar strength are overdone, and was a key factor in our Asset Allocation Committee’s decision to upgrade its outlook on the region, on a tactical basis, in September.

In sector terms, areas linked to our healthcare and technology themes performed well. While the former did better over the third quarter, the latter’s exceptional performance in recent years was exemplified by the fact that Apple and Amazon both became trillion-dollar companies. At the other end of the spectrum, the materials sector underperformed as the threat of a Chinese slowdown weighed on industrial commodity prices. Likewise, the energy sector failed to advance despite Brent crude reaching its highest price since 2014, with investors worried about the adverse effects of protectionist trade policy. Indeed, Donald Trump singled out the Organisation of Petroleum Exporting Countries (OPEC) cartel for criticism and pushed for actions to cut prices during his United Nations address towards the end of September.

Returns within fixed income markets were muted. Developed-world sovereign bonds generally lost ground as the world’s major central banks continued to tighten their policy stances, albeit gradually. Brexit developments and the aforementioned events in Italy also weighed on gilts and European sovereigns. The business-friendly environment helped corporates outperform government bonds, despite the general deterioration in quality that has been occurring in corporate bond markets in recent years.

The global economy’s ongoing expansion continues to underpin the current equity bull market, which is already one of the longest-running in history. We do not expect this dynamic to change in the short term and continue to favour equities over fixed income. Nevertheless, there are shifts occurring within the economic backdrop which warrant monitoring for signs that the investment environment may be beginning to decline. Developments relating to the growth outlook, inflation, financial conditions, and politics are already affecting markets and these are the key areas we will be watching in the coming months.

The third quarter was generally positive for developed-world equities…

…while emerging market assets underperformed

Market performance shows we are in a stock-picking environment

Sovereign bonds continue to face headwinds associated with policy changes and political developments

Asset market performance Q3 2018

The environment continues to be supportive of risk assets

September 18

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The robust growth backdrop and labour market strength allowed the Federal Reserve (Fed) to continue to tighten its monetary policy stance, with the interest rate corridor being raised again in September, to 2.00%-2.25%. The FOMC’s accompanying September statement acknowledged the fact that US monetary policy is no longer “accommodative”. However, inflation remains the key determinant of US monetary policy and although price growth has risen above the Fed’s mandate target level, it has underperformed expectations in recent months. While many investors are focusing on wage growth having increased to its fastest annual rate since 2009, there is no guarantee that this will feed through into broader inflationary pressure. Unit labour cost data, which also takes productivity into account, is better correlated to inflation than pure wage growth data and this does not suggest that an inflation breakout is imminent. We also note that import and

“We expect US monetary policy tightening to remain gradual, a view that appears to be shared by most investors”

The United States

US growth jumped sharply in the second quarter as the government’s tax reforms boosted corporate investment and consumer spending, while exports were front loaded to avoid trade tariffs (Figure 2). Although these factors may mean that the US growth rate has already peaked, it should remain robust in the near term as strong economic confidence and record corporate profitability drive investment, while employment growth and wage rises support consumption. Indeed, forward-looking survey data, such as the manufacturing purchasing managers’ index (PMI), are indicating encouraging levels of activity in the coming months, despite concerns over the threat of trade protectionism. Meanwhile the recent decline in the service-sector PMI can largely be attributed to temporary adverse effects relating to Hurricane Florence. These should reverse in the coming months, with pent-up demand released.

The economy’s progress has been in line with our expectation that the business cycle would extend as a result of Trump’s tax reforms. However, we are cognisant that cyclical pressures will increase in time. Employment growth has remained resilient to date, but it will eventually slow as the unemployment rate declines further (Figure 3). Meanwhile, tighter monetary conditions should begin to act as a headwind to growth. Indeed, there are early signs that higher mortgage rates are beginning to weigh on activity in the housing market, which offers a strong leading indicator for the rest of the economy.

The US economy is performing well and should continue to do so in the near term

We are watching for signs that cyclical headwinds are developing

Figure 2: US growth has been on an upward trend in recent years, with the economy helped by the positive impact of Donald Trump’s election on business sentiment and, most recently, tailwinds resulting from the tax reforms implemented earlier in the year. Source: Thomson Reuters Datastream

Figure 3: The US economy has added jobs in every month since the start of 2015. However, the unemployment rate continues to fall and wage pressures are now building as the stock of unemployed workers has declined. Eventually, job growth will come under more pronounced cyclical pressure. Source: Thomson Reuters Datastream

US GDP growth The US labour market

The economy’s strength has gradually coerced the Federal Open Markets Committee (FOMC) into tightening its monetary policy stance…

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Market overview September 18

producer prices have begun to fall, partly as a result of the dollar’s strength. As such, we expect US monetary policy tightening to remain gradual, a view that appears to be shared by most investors, given current market pricing.

Against this backdrop, US treasuries have remained under pressure. The ten-year treasury yield reached highs not seen since 2011 in September and ended the quarter at 3.06%. While higher bond yields are one of the key investment risks we are monitoring, they are not such a fundamental problem if driven by economic strength, as has been the case in recent months. This fact has been reflected in the country’s equity market, which pressed to all-time highs amid exceptionally strong corporate earnings growth. Corporate bond spreads also contracted, in spite of some concerns over deteriorating credit quality and the extent of US corporate leverage.

The United Kingdom

In July, Brexit Secretary David Davis and Foreign Secretary Boris Johnson resigned as the government pushed for a ‘soft’ Brexit deal. These resignations demonstrated the stiff opposition facing the Prime Minister’s secession plan from inside the Conservative Party. Subsequent comments from Michel Barnier, the EU’s chief negotiator, providing encouragement that a deal might be close, were offset by negative remarks from other politicians, including European Commission President Jean-Claude Juncker, which highlighted ongoing impasses around issues such as the Irish border.

Later in the quarter, perceptions that a lack of progress was being made exacerbated investor concerns that the UK is heading towards a ‘no deal’ Brexit. We note that the European Union (EU) will need time to ratify any deal ahead of the official secession date of 29 March and it has therefore suggested that negotiations will have to be concluded by December. Our central expectation remains that a last minute deal will be reached, although we are unable to hold high conviction in this view given the many variables involved.

Brexit-related uncertainty continues to weigh on the UK economy (Figure 4) and economic confidence (Figure 5). Investment is suffering as businesses wait for the outcome of the Brexit negotiations, while employment growth has slowed as the unemployment rate has already reached cyclical lows not seen since the 1970s. Meanwhile, real wage growth remains weak, despite some improvement in nominal wages, as inflation has picked up again against expectations. This is likely to ensure that the contribution of consumption to growth remains muted in the coming quarters, even though recent retail sales data has surprised to the upside.

…which is having global investment ramifications

Brexit developments continued to dominate UK newsflow…

…with a perceived lack of progress weighing on UK sentiment…

…and economic activity

Despite the headwinds facing the UK economy, it has outperformed the Bank of England’s (BoE) expectations since the Brexit referendum in 2016. With unemployment at low levels and inflation elevated, the BoE’s Monetary Policy Committee raised the UK base interest rate above its post-crisis lows in August, as was widely expected. Counterintuitively, there is an argument that higher interest rates could support domestic growth by strengthening sterling, thereby alleviating some of the pressure that weak real wage growth is putting on consumption. Nevertheless, we expect the BoE to take a cautious approach to further rate hikes as a result of the risks to the growth outlook. We note that activity has been supported by inventory build in recent quarters, potentially because of concerns over the availability of certain goods post Brexit, and this is unsustainable over the longer term.

Brexit uncertainty should prevent UK policymakers from raising rates again in the near term

Figure 4: Although it has exceeded the government’s expectations, UK growth has been slowing since early 2015, with pressure having increased as the Brexit secession date has approached (29 March 2019). Source: Thomson Reuters Datastream

Figure 5: Since the Brexit referendum, UK economic sentiment has remained at lows equivalent to those that followed the Global Financial Crisis. This is weighing on investment and, therefore, growth. Source: Thomson Reuters Datastream

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Market overview September 18

“Italy’s fiscal situation is likely to increase political tension on the Continent”

Against this backdrop it was a poor quarter for UK assets. Sterling weakened on a trade-weighted basis, but this was not enough to support UK equities, which lagged their developed-market peers. UK gilts also sold off as political uncertainty rose and the BoE surprised investors by providing a higher estimation of its neutral interest rate than expected (2.00%-3.00%, compared to consensus expectations of 1.75%-2.50%).

Europe

In July, German Chancellor Angela Merkel reached an agreement on immigration, thereby providing some stability to her new coalition government. Meanwhile, the threat posed to Europe by protectionist US trade policy also appeared to diminish as President Trump put aside his threat to implement tariffs on European cars. After announcing plans to taper its asset purchases over the remainder of the year, the European Central Bank (ECB) also used its July meeting to reassure investors that policy was set to remain accommodative for some time.

Over the quarter, investors became more concerned about the European banking industry’s exposure to the Turkish economy, at a time when it already faces the challenges associated with low interest rates. Italy then took centre stage, with rhetoric from key Italian policymakers exacerbating concerns that the country’s new, populist coalition government was on a collision course with the European Union over its forthcoming budget. Indeed, these fears were confirmed at the end of September when the government agreed to a budget deficit of 2.4% of GDP. This was above market expectations and the level at which most investors consider it likely that the country’s public debt will stabilise. At 130%, Italy’s public debt-to-GDP ratio is the second highest in Europe, after Greece, and well above the 60% debt limit established by the EU’s Stability and Growth Pact. As a result, further political tension and market volatility is likely when the government budget is presented to the European Commission in October.

Against this backdrop, Europe’s economy continued to expand, albeit more slowly than it did in 2017. Employment continues to increase and is supporting consumption, but forward-looking survey data showed that both business and consumer confidence is deteriorating, largely because of various political risks and slowing demand from overseas. This could weigh on economic activity in the coming quarters. Indeed, ECB President Mario Draghi noted the risks that emerging market stress and trade protectionism pose to Europe’s economy in September and used these to support his pledge to keep interest rates low for an extended period. He did this while acknowledging that inflation has accelerated and that wage pressures are increasing as spare capacity continues to be run down.

Although political risk intensified, European equities still achieved minor gains. They underperformed US equities, but outperformed those of the emerging markets, both by fairly wide margins. Meanwhile, the euro recovered from early losses to end the period roughly flat, perhaps indicating that sentiment towards it was already low at the start of the period. European sovereigns were the laggards within fixed income, with Italian bonds in particular under pressure given political developments in the country.

Sterling, UK equities and gilts are all underperforming

European equities started the quarter on sure footing…

…but sentiment deteriorated towards the end of July as various headwinds intensified

The economy continues to expand, but the ECB looks set to keep policy accommodative in the face of external threats

European assets’ performance has been mixed amid conflicting fundamentals

Market overview September 18

China and the emerging markets

The threat of trade protectionism weighed further on sentiment towards the emerging markets over the quarter, with US policymakers enacting two phases of planned tariffs on imports from China, on $50bn and $200bn of goods, respectively. President Trump also made further threats, including to place tariffs on all of the US’s remaining imports from China and to increase tariff rates. China responded with tariffs of its own, albeit of lesser absolute value and at lower rates, to which Trump responded by announcing subsidies for US farmers whose businesses are likely to see an adverse impact.

While the adverse economic impact of the tariffs is yet to be felt, China’s economy has already shown signs of slowing in recent months. Order volumes are falling as the government’s prior efforts to reduce leverage and risk in the financial system have begun to take effect, while it is clear that the threat of protectionism is also having a negative impact on economic sentiment. Together these headwinds are having adverse implications for employment growth and, therefore, household consumption.

As they have repeatedly done in recent years, China’s authorities have begun to loosen policy in response to the threat of slower growth, albeit they might now be slightly more willing to tolerate slower growth going forward. The People’s Bank of China (PBoC) had already cut bank reserve ratios earlier in the year and is expected to reduce them further, while it has also loosened some restrictions on infrastructure investment to support growth (Figure 6). As a result, we believe the economic drag caused by the authorities’ crackdown on credit creation may wane in time. We also note that the renminbi was allowed to weaken significantly in the first half of the quarter (Figure 7), likely in response to the US trade tariffs, before the authorities stepped in to stabilise the currency to support investor confidence.

Figure 6: While China’s authorities have been acting to control the rate of credit creation in the economy, they have softened this stance and eased credit conditions to support growth as economic data has underperformed expectations. Source: Thomson Reuters Datastream

Figure 7: China’s authorities have allowed the renminbi to weaken significantly against the US dollar in recent months, with the intention of supporting the country’s exporters in the face of US import tariffs. Source: Thomson Reuters Datastream

Chinese monetary conditions and credit growth Chinese foreign exchange policy

Aside from the threats of protectionism and a potential Chinese slowdown, investors also feared that contagion might spread from Turkey and Argentina if global financial conditions continue to tighten. Indeed, this was reflected in depreciations of currencies such as the Indian rupee. More broadly, emerging-market equities again lost ground and lagged their developed world counterparts. However, their underperformance has left valuations at more attractive levels. We believe that further dollar appreciation could be limited, while China is likely to act to support growth through stimulus. As such, we tactically upgraded our view on the emerging markets for higher-risk portfolios, with a preference for Asian exposure.

Japan

After breaking its longest run of consecutive quarterly expansion since the 1980s in the first quarter of the year, Japan’s economy bounced back in the second quarter (Figure 8). The unexpected first-quarter decline in household consumption reversed strongly, while positive business sentiment and record corporate profits drove a sharp increase in business investment (Figure 9). Meanwhile, the labour market remains tight and wage growth showed some signs of accelerating.

Donald Trump has shown little sign of moderating his protectionist stance when it comes to China

Meanwhile, China’s economy is facing domestic headwinds as its government seeks to bring structural imbalances under control

The Chinese government still appears willing to act to support growth

Much of the negative news has been priced into asset markets, with the region having suffered significant year-to-date underperformance

Japan’s economy is showing encouraging progress, although it continues to face structural headwinds

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Market overview September 18

Despite this, Japanese inflation remains subdued and the Bank of Japan (BoJ) continues to hold the world’s most expansionary monetary policy stance. Indeed, it kept interest rates at record-low levels and continues to provide liquidity via its large asset purchase programmes. Japanese policymakers also maintained their existing commitment to yield curve control, but professed an appetite to allow yields to move more flexibly, given technical factors pertaining to the implementation of the BoJ’s policy stance and developments in major overseas markets. Even though Japan does not appear to be a primary target of President Trump’s protectionist trade measures, it is likely that Japanese policymakers are concerned about the potential for a prolonged trade war, given the country’s deep integration into global supply chains.

As expected, Prime Minister Shinzō Abe again won the Liberal Democratic Party leadership elections by a wide margin, providing him the option to remain in office until 2021. By this time, he would be the longest-serving Prime Minister in Japan’s history. Given his commitment to ‘Abenomics’, his continued leadership is expected to underpin the BoJ’s accommodative monetary policy stance. It is also likely that the government may seek to enact further reforms designed to act against the country’s long-term demographic headwinds; for example, the proposal to increase the retirement age to 70 and further reductions on immigration barriers.

Following Abe’s victory in September, Japanese equities moved above the range in which they had been trading since the start of the second quarter, ending the period as the second-best regional performers after US equities. Despite the BoJ allowing longer-dated Japanese government bond yields to edge higher, changes in global yield differentials and improved global risk sentiment undermined the yen, which weakened to its lowest level since the start of the year against the US dollar.

Shinzō Abe’s victory in his party’s leadership elections provides more time for Abenomics reforms to take effect

This was taken positively by Japanese assets, which performed well over the quarter

Figure 8: Japan’s economy returned to growth in the second quarter, supported by a bounce back in consumption and stronger-than-expected investment growth. Source: Thomson Reuters Datastream

Figure 9: Japanese investment growth has accelerated as corporates are experiencing record profitability, while capacity has reduced as the labour market has tightened. Source: Thomson Reuters Datastream

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These include unfavourable demographics and a ‘deflationary mindset’

Prime Minister Shinzō Abe could now remain in office until 2021, by which time he would be Japan’s longest-serving Prime Minister

Market overview September 18

Important information

The performance indicated for each sector should not be taken as an expectation of the future performance. Investors should be aware that the price of investments and the income from them can go down as well as up and that neither is guaranteed. Past performance is not a reliable indicator of future results. Investors may not get back the amount invested. Changes in rates of exchange may have an adverse effect on the value, price or income of an investment. Investors should be aware of the additional risks associated with funds investing in emerging or developing markets.

The information in this document does not constitute advice or a recommendation and you should not make any investment decisions on the basis of it. This document is for the information of the recipient only and should not be reproduced, copied or made available to others.

The MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)

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