The article below is Aon's quarterly market review and outlook with perspectives on market activity and current investment trends for Q3 2019.
• Although most markets posted positive returns over the quarter, it has become clear that equity market momentum has markedly slowed, with low-single-digit returns among developed markets. At the margin, however—given the escalation in trade conflict, worsening global economic data flow, and standstill in corporate profit growth—Aon has become less confident of the prospects for equities.
• There is more concerted central bank easing in response to these trends, but their effectiveness is questionable given already low interest rates globally and the higher degree of geopolitical and economic policy uncertainty.
• Once again, U.S. bond yields slid further over the quarter—moving significantly during August, as trade tensions escalated, before rebounding in September. Weaker economic prospects have weighed on growth and inflation expectation which in turn have sent real yields and breakeven inflation lower. The impact of which led to significant declines in nominal yields over the quarter.
Macroeconomic and Political Moves
Global growth slows further and elevates future recession risks
The synchronized cyclical upswing that characterized much of 2017 and early 2018 has firmly given way to a broad-based global slowdown. While few major economies have entered recessionary territory (defined as two consecutive quarters of negative growth), we’re seeing more flashing warning lights and rising headwinds.
For the time being, at least, the U.S. does stand somewhat apart. Annualized GDP growth of 2.0%1 is close to trend. While Nowcast estimates for Q3 GDP growth point to a modest slowdown to 1.8% growth, the U.S. economic activity remains far stronger than most other developed economies. The resilience shown by the U.S. consumer, as well as remnants of fiscal stimulus, have staved off significant downward pressures seen in other parts of the economy— particularly in relation to contracting private investment.
Nonetheless, there are areas of concern that not only have perturbed financial markets, but also have goaded central bankers to turn on the liquidity “taps” to mitigate potential headwinds. The Fed’s own estimates of recession probabilities in the next year have risen to levels not seen since the onset of the global financial crisis, and the Institute of Supply Management (ISM)’s manufacturing index has slipped further into contractionary territory. Despite tight labor markets and a narrow output gap, these disinflationary forces have exerted pressure on inflation. Consumer price index (CPI) inflation has slowed to 1.7%2, while core PCE inflation remains below the Fed’s inflation target of 2.0%.
Manufacturing woes are not restricted to just the U.S.—J.P. Morgan’s Global Purchasing Managers’ Index (PMI) is now below 50, too. Outside the U.S., the economic environment and outlook appears even gloomier. Europe’s manufacturing PMI has slumped to levels not seen since its sovereign debt crisis earlier this decade. The combination of a slowing global economy, trade wars, and ongoing Brexit uncertainty can be viewed as factors weighing on the region.
In the UK, Prime Minister Boris Johnson’s prorogation of Parliament increased expectations of a “no-deal” Brexit and unsettled UK markets in the process. However, the passing of the Benn Act (which hampers the ability to pursue a no-deal strategy) and the unlawful verdict on the prorogation were damaging blows. We are still of the opinion that the October 31 deadline is untenable if any real progress is to be made; therefore, we have assigned a higher probability to another extension to the Article 50 process. Another delay to Brexit, however, will do little to alleviate uncertainty, so sterling is likely to remain depressed.
Central banks revert back to monetary easing: Monetary normalization remains fraught with difficulty
Amid this uncertain economic backdrop, central banks have moved to a firmly monetary-easing mindset. The Fed cut the federal funds rate for the second successive time in September, while the European Central Bank followed suit—cutting the deposit rate by 10bps to -0.5%. Additionally, markets are expecting further cuts from the major central banks in the future. The latest projections of Fed committee members’ rate expectations revealed division in the ranks, with some members arguing for rate cuts and others demanding more tightening.
Despite the monetary easing moves made over the quarter, the Fed has maintained that it is not set firmly on an easing path quite yet. Similarly, in his last ECB meeting, outgoing ECB President Mario Draghi outlined the limitations of monetary policy at current low levels while strongly suggesting that greater onus be placed on fiscal stimulus.
Global equity performance affected by trade and economic growth weakness
After a disappointing August, developed market equities rebounded and ended the third quarter slightly higher. In local currency terms, the MSCI AC World Investable Market Index returned 1.1%3 over the quarter, while U.S. dollar strength experienced a slight 0.1%3 fall. Concerns about slowing global growth and trade wars ramped up significantly over the quarter before giving way to monetary stimulus that helped bolster stocks.
While not the sole driver of emerging market underperformance, the impact of trade concerns continues to be a strong headwind for certain markets. In particular, a double-digit decline in Chinese stocks detracted from emerging market returns as both the rhetoric and the size of the tariffs increased.
The 2019 U.S. stock market rally continues to be driven by multiple expansion, but momentum has slowed. Defensives outperformed during what turned out to be a turbulent quarter.
With expectations of corporate earnings turning lower, the positive return for U.S. equities was driven by multiple expansion. In general, less economically sensitive sectors including Utilities, Real Estate, and Consumer Staples outperformed—which is not too surprising given the deteriorating outlook. U.S. stocks broadly outperformed their international peers, with particularly strong performance coming from the Financials sector. The Dow Jones Total Stock Market Index rose by 1.2%4 over the quarter.
The U.S. Health Care sector was an exception to the defensives’ outperformance, with pharmaceutical stocks facing headwinds in the shape of greater political scrutiny ahead of the 2020 U.S. Presidential election. Against a backdrop of escalating trade tensions, which depressed commodity prices, the Energy and Materials sectors produced negative returns over the quarter.
Outside the U.S., a similar theme of defensive outperformance was also evident, with strong performance from Utilities and Consumer Staples. Japan proved to be the exception— significant multiple expansion in that country saw cyclical sectors, such as the Consumer Discretionary sector, outperform strongly. Japanese stocks were the strongest performers (3.7%3) after lagging in the first half of 2019. Brexit uncertainty continues to weigh on UK equities, which returned just 0.9%3 in local currency terms.
Government Bonds and Yields
Downshift in economic growth expectations pulls yields lower
Equity markets appear to be more sanguine about the economic outlook as a result of strong earnings growth estimates over the next couple of years and a sustained market rally. But the bond market is anticipating a gloomier economic outlook, with yields moving to near-2016 levels. This was reflected in the ominous inversion of the yield curve, which indicated a great deal of economic pessimism among bond investors. Although there is admittedly more room for U.S. yields to fall relative to other markets, U.S. yield declines were still substantial—10-year Treasury yields dropped by over 30 bps to 1.68%5 over the quarter, while 30-year yields fell even further. Although short term rates also dipped lower, there was a clear flattening of the U.S. yield curve, with longer-term yields falling by more than short-term yields.
The steep decline in U.S. yields led to particularly strong performance for long-duration U.S. Treasury bonds, as evidenced by an 8.2%6 return for the Bloomberg Barclays U.S. Aggregate Treasury Over 20-Year Index. Similarly, long-duration European government bonds also performed well, with an 8.4%6 return for the Bloomberg Barclays Euro Aggregate Over 10-Year Index.
Aon remains negative on fixed income because of the low yield levels and because our probability weighted expectation of realized term premia is lower than our equilibrium estimates of what those term premia should be.
Risky areas of credit underperform as wider spreads offset the benefit from lower underlying government bond yields
Despite positive returns that were above most equity markets, credit market performance suffered over the turbulent midquarter period when trade tensions escalated—especially riskier credit areas. Investment-grade global credit spreads were more or less unchanged from last quarter; the bulk of returns came from the fall in underlying government bond yields. Furthermore, in a still benign credit environment, coupons have remained resilient and additive for returns. As such, corporate bonds outperformed less risky government bonds.
From a sector perspective, Industrials performed the worst—a theme similarly reflected in the equity markets. The same could be said for riskier high-yield bonds. Widening spreads offset the impact from lower interest rates, leading to a negative price return that even strong coupon returns could not fully overturn. The Bloomberg Barclays Global High Yield Index returned -0.67%6, while the Global Credit Index slightly outperformed with a return of 0.88%6.
We remain cautious on credit in general. The high proportion of BBB-rated bonds in investment grade indices makes us concerned that the universe, as a whole, will have greater sensitivity to a weaker credit environment than has been the case historically.
Trade and global demand concerns drive commodity prices lower, even as supply risks increase
Commodity underperformance carried into the third quarter with the S&P GSCI returning -4.2%7. Despite ongoing supply risks exacerbated by the drone attacks on two key Saudi Arabian oil infrastructure that accounts for nearly half of the Kingdom’s production, crude oil prices ended the quarter lower. The prevailing demand slowdown that has accompanied the deterioration in manufacturing activity has seen WTI crude oil prices slip by 7.0%8 to $54.12 per barrel.
Demand concerns also affected the Industrial Metals sectors, although not to the same extent. In this uncertain environment, Precious Metals such as gold outperformed. Viewed as a safe-haven asset, gold prices performed strongly— up over 5%9 to end the quarter at $1,485.30 per troy ounce (ozt).
The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.
1 U.S. Bureau of Economic Analysis, FactSet
2 U.S. Department of Labor, FactSet
3 MSCI, FactSet
4 Dow Jones, FactSet
6 Bloomberg Barclays, FactSet
7 S&P, FactSet
8 Commodity Research Bureau, FactSet
9 London Bullion Market Association, FactSet
Appendix: Index Definitions
MSCI All Country World Investable Market Index - A capitalizationweighted index of stocks representing approximately 49 developed and emerging countries, including the U.S. and Canadian markets and covering all investable large-, mid- and small-cap securities.
MSCI Emerging Markets Investable Market Index - A capitalizationweighted index of stocks representing approximately 26 emerging countries, and covering all investable large-, mid- and small-cap securities.
Dow Jones U.S. Total Stock Market Index - A capitalization-weighted index of stocks representing all U.S. equity eligible securities.
Trade-weighted U.S. Dollar Index (DXY) – A weighted geometric mean of the value of the U.S. dollar relative to a basket of foreign currencies, typically key U.S. trade partner currencies.
Bloomberg Barclays U.S. Aggregate Treasury Over 20-Year Index – An unmanaged index considered representative of fixed-income obligations with maturities over 20 years from the current date, issued by the U.S. Treasury.
Bloomberg Barclays Euro Aggregate Government Over 10-Year Index - An unmanaged index considered representative of fixed-income obligations with maturities over 10 years from the current date, issued by the European government.
Bloomberg Barclays Global High Yield Index - An unmanaged index considered representative of non- investment grade fixed-income obligations issued by global corporate, specified foreign debentures, and secured notes.
Bloomberg Barclays Global Credit Index - An unmanaged index considered representative of investment grade fixed-income obligations issued by global corporate, specified foreign debentures, and secured notes.
S&P Goldman Sachs Commodity Index (GSCI) – A composite worldproduction weighted index of commodities that is considered representative of the performance of the commodity market.
J.P. Morgan Global Purchasing Managers’ Index™ – The PMI® is a composite index based on the diffusion indexes of five of the indexes with equal weights across over 40 countries: New Orders (seasonally adjusted), Production (seasonally adjusted), Employment (seasonally adjusted), Supplier Deliveries (seasonally adjusted), and Inventories. Diffusion indexes have the properties of leading indicators and are convenient summary measures showing the prevailing direction of change and the scope of change.
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