Global Momentum Goes Separate Ways
After a broadly positive start to the year, markets in the second quarter showed further signs of divergence as U.S. growth accelerated while the rest of the global economies experienced pockets of weakness and even some flattening. Inflation in the U.S. continued its gradual uptrend and finally hit the Federal Reserve’s 2.0% target after a six-year miss. Elevated consumer and business sentiment in the U.S., historically low unemployment, solid GDP growth and fundamental strength in earnings has supported U.S. markets, even as heightened volatility and trade fears kept a lid on overall returns. Meanwhile, weakening fundamentals in emerging markets and Europe were magnified by escalated trade tensions, rising short-term U.S. rates, and a stronger USD.
As a result, overseas markets moved in the opposite direction to the U.S., resulting in widening performance divergence around the globe.
Growth Less Synchronous
Global economic output rode a path of two steps forward, one step back during the second quarter as Europe and Japan experienced modest setbacks while the U.S. continued to strengthen.
Although Eurozone growth remains positive, weakness in Germany at the start of the quarter affected expectations, and concern over Italian politics later in the quarter added to the headwinds. Japan’s economy reported its first contraction since Q4 2015, which we do not view as a sign of a looming slowdown in Japan, but it did cause a downward revision to 2018 growth forecasts. In contrast, U.S. Q2 GDP expectations rose from 3.1% in June to 4.0% q/q in mid-July. Consumer and business sentiment remained elevated, reinforcing the domestic economy’s fundamental strength and further runway for growth. The boost from tax reform and fiscal stimulus continued to propel expectations; unemployment hit an 18-year low; and the U.S. has proven its resiliency in the face of increased trade tensions. As such, we expect this upward trend to persist throughout the remainder of 2018.
Central Bank Policy Divergence
Adding to disparate global asset class performance are central bank policies that have more clearly moved in different directions.
The U.S. Federal Reserve under Jay Powell signaled a moderately more aggressive tightening path based on the strength of the economy and labor market and the assumption that inflation will remain around its 2.0% target. The Fed indicated that it intends to hike a total of four times in 2018, one more than previously expected, and an additional three times in 2019. Notably, the Fed will now hold a press conference after every meeting starting in 2019 which suggests that it wants more flexibility to change rate policy.
In contrast, the European Central Bank and the Bank of Japan have pushed their tightening cycle further down the road as recent data in those regions have been weaker than expected, signaling a stubborn soft patch.
Even as increasing oil prices have driven headline CPIs higher, core rates continue to languish. Further disappointing results in the Citi Economic Surprise Index for Europe and a downward revision in 2018 GDP growth estimates have pushed the ECB’s first anticipated rate hike out into the fall of 2019. Likewise, Japan’s sluggish economy has held the BOJ back from taking its foot off the QE gas until it sees a more sustained pickup in inflation and economic activity.
This central bank policy divergence has caused the yield curve in the U.S. to flatten.
As the Fed drives rates up on the short end, the long end remains subject to the effects of other central banks’ easy policy which pushes those rates down. Investors looking for safety have continued to flock to long-term U.S. Treasuries in part because of negative yields in other developed bond markets such as Europe and Japan. The result is the flattest U.S. Treasury yield curve since August 2007. The market is split as to whether this is a harbinger of a looming weakness in the U.S. or simply an artifact of global central bank intervention. Given continued signs of strength in the U.S. economy, including the uptick in job growth nine years into the recovery and clear signs of building inflation, we fall more in the latter camp.
While monetary tightening in the U.S. indicates a strongly functioning economy, a subset of EM countries with high current account deficits (i.e. Argentina, India, Mexico, and Turkey) were recently forced to hike rates in an effort to protect their financial stability in the face of rising U.S. short-term rates and a rally in the USD. These rate hikes are different in kind to those implemented under conditions of strengthening economic fundamentals. Increasing rates when not warranted by strong economic fundamentals could take a toll on these EM countries’ overall growth because it increases financing costs at a time of economic weakness rather than strength further adding to economic challenges.
China remains in heightened focus for investors. China’s trade dependence has led market observers to believe that China could allow the yuan to depreciate in order to make their exports more attractive, offsetting some of the pressure from tariffs. An interesting move by the People’s Bank of China in June reduced the ratio of banks’ required reserves by 50 bps, which should increase their ability to boost lending and restructure debt. This could indicate that China’s policymakers are willing to take action to insulate the economy from the negative effects of a trade war and tightening global financial conditions.
Trade Policy — Unequal Players
The pace and trajectory of trade disputes heated up materially during the second quarter.
Driven by the U.S. administration’s belief that it is negotiating from a position of strength, the U.S. has imposed tariffs on steel and aluminum, 25% tariffs on $34B of Chinese imports and has threatened 25% tariffs on European auto imports in the near term. Other nations have responded in kind, most noticeably China which imposed tariffs on politically sensitive U.S. agricultural imports and on U.S. auto imports.
These latter sectors are politically fraught as these regions supported President Trump by lopsided margins in the 2016 elections. Caught in this cross-fire were European automakers which manufacture cars in the U.S. for export to China. Although a full-out trade war is not positive for any economy, the strength and resiliency of the U.S. economy should be able to withstand the shock better than others. As a percent of GDP, exports make up 12% in the U.S., 20% in China, and 45% in the European Union. With the U.S. announcement that it will impose 10% tariffs on an additional $200 billion of Chinese goods, China faces the prospect that it may need to reach for other tools to retaliate as imports from the U.S. comprise far less than that amount.
Winners and Losers Emerge
An environment of strong and rising earnings and solid fundamentals for corporate America have put a floor under S&P 500 performance, but end-of-cycle worries and trade fears continue to threaten the direction of sentiment and investment.
Wider performance dispersion has been evident in various sectors and market cap categories, a trend we expect to grow more pronounced throughout the remainder of the year. The most dramatic dispersion in the U.S. can be seen in the performance difference between large and small cap equities where small caps led by roughly 500 bps YTD as of June 30, driven by their relative insulation from trade tensions. In addition, domestically focused businesses received the bulk of the tax overhaul benefit, seeing a significant bump in earnings and cash flow as a result.
Outside the U.S., international developed markets showed mixed performance — broadly negative, albeit modestly. European and Japanese market weakness was driven by softening economic indicators and stubbornly low inflation readings. As investors digested key economic indicators and trade actions, overseas markets became less attractive compared to the U.S. As such, capital flow and investor sentiment soured for international markets.
Although most EM countries have posted negative YTD returns, performance divergence was wide due mostly to investors drawing a line between systemic factors (USD strength, rising U.S. rates and trade frictions) and idiosyncratic factors (political instability and external financing vulnerabilities). In addition to an overall global liquidity dry-up, select EM countries such as Argentina, Brazil, Turkey, and Mexico face idiosyncratic vulnerabilities that are set to burden their real economies.
Focus on Fundamentals
There are a number of factors currently priced into markets; namely, two more rate hikes in the U.S. and the $34 billion of tariffs between the U.S. and China with a promise of more to come.
What remain as more prominent risks to global markets are the carry-on effects from policy divergence and trade friction that could have a marked impact on consumer and business sentiment, global capital flows, and investor risk appetite. The market tends to react to these types of risks before they affect real economies, which raises the possibility of delayed negative effects on global growth that markets are not prepared to withstand and, in the U.S., are not fully pricing in. As uncertainty grows over the future course of trade actions, investment and sentiment could suffer, even if the initial effects to the economy are negligible.
Global equity markets for the remainder of 2018 will be an arbiter of the effect of the trade war as trade tensions are more likely to affect markets than economies in the short-term. At this point, the U.S. market appears to be counting on a negotiated settlement rather than an all-out war, but we caution investors that there is real risk of the latter. As with hot wars, trade wars may be easier to start than to steer, and there are multiple possible outcomes, many of which are detrimental to sectors, markets, risk behavior, and ultimately the real economy.
When risk-aversion causes investors to pile into popular safe-haven trades, valuation disparities grow as multiples expand in crowded sectors, while falling in avoided sectors. This can be seen in international markets where valuations fell further below their historical averages due to the flight to safety in the U.S. More attractive valuations in Europe and Japan; economic and earnings momentum in those regions that should pick up relative to the recent soft patch; and still supportive central banks may warrant an increased allocation from investors.
As for emerging markets, compared to the taper tantrum in 2013, most have improved their economic and financial conditions. With the exception of Turkey and Argentina, most of the countries with persistent current account deficits have improved their deficits in the last five years, and many have implemented buffers such as boosting their foreign exchange reserves to defend their currencies against external shocks. In general, those markets that can withstand tighter global liquidity and increased trade tensions are likely to outperform, particularly as their valuations are already discounting trade actions.