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After impressive gains in the first quarter (February to April), returns for the MSCI ACWI plunged from 7.5% to just 0.5% in the May to July period. This belies a gain of 0.9% for developed markets, but a loss of 3.2% for emerging markets (EM). These developments took place amidst a series of different, competing narratives.
On the one hand, the US economy is decelerating, although it remains some way off recession. It is experiencing its longest expansion on record, yet also one of its most sluggish ones even though unemployment has reached a record low. Its economy is taking full part in the global manufacturing slump. But rather than worry about the slowdown, investors have chosen to espouse a different narrative and focus on the policy reaction, in the form of renewed monetary accommodation. Given that the level of US interest rates remains low despite nine successive rate hikes, the Fed delivered a well-telegraphed “insurance cut” in July on the basis that “an ounce now saves a pound later”. The characterization of the move as a “mid-cycle adjustment” took investors aback initially and they subsequently scaled back rate cut expectations for the remainder of the year.
However, the third narrative promptly intervened and revived easing expectations. In late July, President Trump announced the imposition of additional tariffs on China, despite having agreed with President Xi to restart trade negotiations only a few weeks earlier in Osaka. This triggered a series of tit-for-tat moves that included a currency depreciation by China, the ban of US agricultural products by SOEs and the branding of China as a “currency manipulator” by the US Treasury. Given that the Fed had clearly linked its outlook for rates to the ”uncertainties” affecting global trade relations, this immediately led to lower rates being priced in once again. Markets thus now have a trade-, a tech- and a currency war to contend with.
While the Fed’s actions managed to stabilize equity markets, bond markets have begun to price in increasingly apocalyptic scenarios, with nominal (though not real) bond yields in several countries lower than they have ever been. If this were not enough, there are additional political flashpoints in countries all over the globe. In Developed Markets these include the disruption caused by the exit of the UK from the EU, the change in leadership in EU institutions (including the ECB), the political crisis in Italy (again, affecting the EU), shifting political dynamics in Germany and the rising tensions with Iran, to name just a few of the key developments. As ever, there is also the risk that the politics of brinkmanship by the Trump administration result in a miscalculation that may lead to unintended consequences. In EM, recent developments include the government machinations of Mexico’s President AMLO, the rising resistance against Brazil’s President Bolsonaro (balanced by progress on the pension reform), India’s seizure of Jammu & Kashmir and bubbling political tensions in the Philippines, Russia, Turkey and Hong Kong/China.
From an earnings point of view, the Q2 release season revealed deceleration of growth everywhere, although it also showed that a much-dreaded US earnings recession had been averted. Earnings growth in the US remained in the low single digits (3% yoy) in Q2, whereas it was broadly flat in Europe, negative in Japan (-9% yoy) and sharply in the red in EM (-12% yoy).
The developments of the past three months have led to a series of sharp market adjustments, generally in a risk-averse direction: the VIX rose to 20% (from around 15% previously), gold reached a six-year high, the US yield curve inverted further and the universe of negative yielding debt widened to some $14 trn. In the midst of this shift, EM equities sold off sharply and have now generated a return of a mere 0.5% for the year. While this complicated backdrop weakens the case for holding cyclical risk assets, and equities in particular, there is still a strong case to be made for a judicious allocation within global equities.
Our starting assumption is that the US expansion is slowing, but is not at an end. It is set to benefit from additional and early policy support. Activity (and earnings growth) will likely be lower in the other major developed economies and renewed policy support will not be fully effective in offsetting the slowdown. A similar scenario – of weakening growth and partially offsetting policy stimulus – is likely to play out in China. As far as trade relations are concerned, we expect neither a full resolution, nor a complete breakdown. On the whole, escalating tensions create a long term structural downdraft for growth and at the same time raise event risk in the short term. But between episodes of brinkmanship, negotiations will likely continue or be renewed at various levels and lead to incremental, if punctuated, progress.
*The publication reflects asset performance up to 31 July, 2019, and macro events and data releases up to 9 August, 2019, unless indicated otherwise.
The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.
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