Aon's quarterly market review and outlook with perspectives on market activity and current investment trends.
- Late cycle fears and resurging trade war fears have hit the global manufacturing sector with the majority of developing economies registering contracting activity in the sector. Central banks have moved to a more proactive approach in a bid to arrest these fears that are stifling economic momentum.
- Most equity regions posted positive returns over the quarter with the exception of Japanese equities which were buffeted by yen appreciation. It does seem to us that equity markets are pricing in a more optimistic outlook which does present some vulnerability should earnings fail to meet expectations. Our view that we are in a transition market environment has not changed but we do see limited upside return potential from current levels.
- Once again, U.S. bond yields continued on their downward trajectory. The stall in monetary tightening has now seemingly given way to outright easing which alongside lower economic forecasts has exerted downward pressure on yields globally.
Macroeconomic and Political Moves
Trade war fears stoke recession risks while the U.S. enters the longest ever expansion
What a difference a few months can make. This time last year we were amidst a global cyclical upswing with the U.S. fiscal stimulus bolstering economic activity while monetary policy globally was generally accommodative. This 'goldilocks' environment would always be difficult to maintain, especially as capacity tightens as we progress through the cycle and this has been evident in recent months with a considerable slowing in economic momentum. Fears of economic deterioration have led to a change in tack by central bankers to more dovish stances.
On the face of it, the reacceleration in U.S. economic activity in the first quarter, as measured by real GDP growth, bucked a global trend of weakening economies. The 3.1% growth (quarter-on-quarter annualized), however, masked weaker private consumption and business investment. Both of which are arguably more sustainable sources of growth relative to the inventory stockpiling and more favourable net trade which boosted first quarter growth. Nowcast estimates of Q2 2019 GDP growth have fallen to 1.3%. This corroborates with the fall in the Institute of Supply Management's (ISM) manufacturing index to 52.1 – the lowest level in over two years. Moreover, the majority of all ISM manufacturing sub-indices moved lower over the quarter. Weaker economic data was not confined to just the U.S. with disappointing data releases in most developed economies. This has been a continuation of the trend we have observed since mid-2018 and reflected in the chart below, which shows the number of major economies1 with manufacturing PMIs below 50 – in contractionary territory.
Source: FactSet, Aon
As we outlined in the previous edition of this blog, there is a distinct lack of imbalances in the economy which prevents us being too bearish on economic prospects. Yet, we are cognisant of the very real threat that any further escalation in trade wars/protectionism can have on the economy. After all, the protagonists in the ongoing trade war drama have been engines of global growth in recent years. Although the recent meeting between President Trump and Xi Jiaping at the June G20 summit and ensuing trade truce has encouraged markets we are taking a more cautious line as we take the view that we are still far from any concrete resolution. We could easily see a further escalation or even the spat further spilling into other sectors, such as technology. As such, we would not be too comfortable in taking on too much risk in portfolios at this point in time. Indeed, we believe we may be approaching the time to move into an outright negative stance on equities.
Capacity in the U.S. continues to tighten with unemployment falling to a near 50-year low of 3.6%. Labor market tightness, however, has failed to translate to higher consumer price inflation, which slowed to 1.8%. The lack of inflationary pressures which appear to be more than just transitory has given greater scope for monetary easing by the Fed should economic momentum falter.
Three years and soon to be three Prime Ministers, yet scant progress has been made been on the Brexit front. The process for selecting a new leader of the Conservative party, and consequently Prime Minister, has already whittled down the possible selections to two although Boris Johnson's popularity amongst grassroot Conservative party members has him as the odds-on favourite. However, we believe such an outcome will do little to narrow down possible Brexit permutations and uncertainty will persist. This has already been reflected in financial markets with sterling and government bond yields falling over the quarter with the prospect of a harder Brexit under a Boris Johnson-led government a greater possibility. Nonetheless, we are still of the opinion that the October 31 deadline is untenable for any real progress to be made and therefore we have assigned a higher probability to a longer extension to Article 50. Another delay to Brexit will however do little to alleviate uncertainty which depresses sterling and is generally supportive for UK equities but it also stifles investment in the economy which has constrained near-term prospects and risk assets, in general.
The economic slowdown was particularly notable in Europe to the point that it continues to overshadow political developments such as Brexit and Italian budget concerns. Manufacturing PMIs in the Eurozone remain below 50 while investor expectations fell back late in the quarter. Eyes were turned to the nominations of significant positions within the EU – the ECB President and the EU Commission. We now know that Christine Lagarde (former IMF chief) and Ursula von der Leyen, respectively will take the posts in the upcoming months. The former's nomination has elicited a relatively positive reaction from markets with the belief that there will be a continuation of the pragmatic approach defined under Draghi's tenure which may help steer the economy and financial markets higher.
 Contemporaneous estimates of real GDP growth produced by the Federal Reserve Bank of Atlanta incorporating a wide range of macroeconomic data as it becomes available
End of the road for central bank tightening – when bad news may be good news
Near-term headwinds in the guises of trade wars and slowing economic momentum strengthened over the quarter and it would appear that central banks are now agreeing with that assessment. Gone are projections of interest rate hikes and instead replaced with expectations of a return to easier monetary policy. Similar to the pausing in the prior quarter, the increasingly dovish stance appears that the Fed is capitulating to pressure from financial markets which imply impending rate cuts.
Although there was no change to the Federal Funds rate over the quarter, there was clear signalling of lower rates to come at the June Federal Open Market Committee (FOMC) meeting. The “patience” terminology that the Fed adopted has now been dropped thereby suggesting a more proactive Fed. Indeed, Fed Chairman’s Powell’s comment that “an ounce of prevention is worth a pound of cure,” suggests just that. However, we are of the opinion that bond markets have potentially aggressively overestimated the extent of Fed easing with three cuts priced in for 2019 and four for 2020 (see chart below). We think the risk around this forecast is for fewer cuts: it is much more likely to be just 1-2 than 4-5 cuts. We believe that three or more cuts would require a substantial further deterioration in the economic data. In a similar vein, the European Central Bank also shifted to a more dovish stance with the statement that more easing is achievable whether that is further cuts to interest rates or through the ECB’s Asset Purchase Programme.
Source: FactSet, Aon
Despite comments to the contrary, especially from the ECB, questions do surround on whether there is significant ammunition left in central banks’ arsenals to mitigate the effects of a recession down the line. This has raised the prospect of a shift towards more expansionary fiscal policy (albeit at a time when government debt is still at high levels), or to more unconventional and controversial policies, such as the one prescribed in Modern Monetary Theory (MMT) whereby money is printed to sustain government expenditure.
Global equities continue their advance over 2019 although splutter on their way due to renewed trade concerns.
Concerns of slowing global growth and trade wars rattled equity markets in the middle of the quarter but signs of increasingly accommodative central banks and positive steps towards a trade resolution late in the quarter supported global equities. Monetary easing not only encourages a return to risk-seeking behaviour but could also help extend the earnings cycle. Although not repeating the prior quarter's impressive double-digit return, the MSCI AC World Investable Market Index returned 3.2% in local currency terms. Slight U.S. dollar weakness led to a 3.6% return in USD terms. All regions, except for Japan, posted gains over the quarter.
Unlike the excessive market weakness exhibited late in 2018 where equities had start to price in a rather significant economic downturn, the strong performance year-to-date appears to imply a more benign economic environment acting as a potential tailwind. This, however, appears to be incongruous with the downward trend in bond yields which would suggest a more marked economic slowdown. Indeed, yield-based models of near-term recession risks have risen over the quarter. Which market is right? Time will ultimately tell, but we believe it is somewhere between the two. Bond yields have arguably collapsed too aggressively in such a short space of time while equities are hinting towards too rosy a picture despite very real headwinds in the form of protectionism, populism and limited monetary tools to combat potential recession risks down the line.
As we approach the end of what we view to be a transition market environment, our neutral stance on equities will inevitably start tending towards an outright negative stance. This is not us calling the 'top of the market' – such a proclamation would be foolhardy in our eyes. Rather, we see risks are skewed to the downside even if further stimulus and potential thawing in trade tensions are on the cards. This is further emphasised by the fact that the majority of the 2019 equity rally has been driven by valuation multiple expansion, which if earnings were to disappoint going forward could see poor equity performance. We do not see this as a significant departure from our previous guidance which advocated greater diversification within portfolios and seeing episodes of market strength as an opportunity to de-risk.
U.S. stock market propelled higher by dovish turn by Fed. Unless earnings rebound following this year's falls, we believe there may not be much more gas left in the tank to sustain this rally.
More cyclical stocks outperformed in the U.S., particularly Financials which returned 8.0% over the second quarter. More defensive areas underperformed but it was only the Energy sector that posted negative returns over the quarter as crude oil prices slipped. The Dow Jones Total Stock Market Index rose by 4.1% over the quarter with the majority of the strong performance coming late in the quarter which reversed the poor performance over May. Similar to the prior quarter, valuation multiple expansion was key to the positive performance while earnings growth was negative. We still argue that further valuation multiple expansion from these levels will not be a sustainable driver for equity markets over the medium-term and requires an extension to the earnings cycle, which could find support from additional monetary easing but has been trending lower as we move later in the cycle.
Although recovering strongly in the latter part of the quarter, small-cap stocks suffered to a greater extent over May with the Russell 2000 Index plummeting 7.8% over the month. This, combined with a slightly stronger April, helped large-cap stocks outperform – double the small-cap quarterly return.
The strong start to 2019 alongside risks make us cautious on how much further equities can move higher
Receding risk aversion continued to propel equity markets higher in non-U.S. markets with the exception of Japanese stocks. Benefiting from its status as a safe-haven currency amid trade war tumult, the Japanese yen strengthened significantly over the quarter but to the detriment of the Japanese stock market with most sectors underperforming. Despite rising political risks, UK equities performed well over the quarter as a fall in the value of sterling would provide a boost to repatriated overseas earnings. More domestically-focused companies underperformed given the downward revisions to the UK's economic outlook. Given the Eurozone's greater exposure to the global economy and trade volumes, it is of no surprise that European stocks (especially those more affected by trade) were bookended by strong performance as trade tensions eased but dropped heavily in May as fears ratcheted up.
While valuations for EAFE equities still look reasonably attractive, given the level of risks (political risk with Brexit and European elections, economy showing signs of weakness in the UK, Europe and Japan) we believe this support is not strong enough to move towards a more positive view on the region.
EM equities struggle to keep pace with developed markets as trade concerns weigh on performance
As with the prior quarter, trade concerns continued to be felt through the emerging markets. Those more exposed to the trade spat, whether directly (China) or indirectly (South Korea), underperformed. In particular, technology-related stocks were caught in the crossfires as the trade war spilled over into an apparent battle for 'tech' supremacy. Overall, the MSCI EM IMI was relatively flat (0.2%) in local currency terms over the quarter.
The more dovish turn by the Fed did provide some respite for EM stocks, especially those with extensive U.S.-dollar debt exposure. Moreover, reflationary policies enacted in China have arrested some concern of a significant slowdown. Yet, risks to the outlook remain. Emerging markets are linked closely to the strength of global trade and economic activity. Should these continue to decelerate and impact equities in general, we cannot expect any form of EM outperformance in the near term.
Government Bonds and Yields
Yet another quarter where yields collapse under the weight of weaker economic conditions
There were three main drivers that sent yields lower over the quarter: a downshift in the economic outlook, lower inflation and growing expectations that central banks would ease monetary policy. Although falling across the curve, the U.S. yield curve steepened with short-maturity U.S. Treasuries falling by over 50bps over the quarter. The 10-year U.S. Treasury yield slipped to just under 2.0% while the policy-sensitive 2-year yield dropped to 1.73%; yet another stark sign that markets are pricing a rate cut sooner rather than later. This was not isolated to just the U.S. with yields falling on a broad basis. Japanese and German government bond yields reached record lows with the latter returning to negative territory.
We are of the belief that yields may have fallen to unsustainably low levels given the current economic backdrop and that the direction of travel is likely to up rather than down. However, tame inflation and slowing economic momentum temper our views that sufficient upside pressure will lead to much higher yields in the near term.
Against a backdrop of falling yields, the Bloomberg Barclays U.S. Treasury 20+ year index returned 6.1% which given its longer duration outperformed despite longer maturity yields falling to a lesser extent.
Monetary easing looks to benefit credit although episodes of volatility highlight the potential dangers in riskier areas
Credit performed well over the quarter. However, unlike the first quarter where riskier areas of credit outperformed, high yield credit underperformed owing much to the spread widening over May which led to lower overall returns in that month. Slightly lower spreads and the fall in underlying government bond yields supported investment-grade credit performance with the Bloomberg Barclays Global Credit Index posting a 3.7% return over the quarter.
Despite a balanced near-term outlook, aggressive re-leveraging trends, elevated issuance, along with M&A activity that tends to correspond to late credit cycle behavior are causes for concern. Excesses remain in the corporate credit system, and our view is that current valuations do not offer sufficient compensation for them. In line with our transition market environment outlook, we believe spreads will be susceptible to bouts of volatility as seen throughout 2018 and to a lesser extent in 2019. We continue to prefer long credit spreads to intermediate credit spreads.
As outlined above, the ECB also marked a change in their stance which led a precipitous fall in yields across most of the Euro Area. Greek 10-year yields saw the largest move over the second quarter; falling by 1.3% to sit at 2.43%. This is a remarkable turnaround for the economy after seeing its 10-year debt costs spike to nearly 20% in the middle of the decade and was close to 5% just late last year. 10-year German bund yields fell by 26bps over the quarter. The downgrade in Italy's economic outlook looks to once again jeopardise progress made in the Italian fiscal budget which given the downgrade has broken the EU fiscal threshold. Nonetheless, Italian government bond yields followed a similar pattern to other Euro Area yields and moved 41bps lower to 2.08%. The spread over German 10-year bund yield fell across the Euro Area with greater narrowing seen for peripheral Euro Area countries (Spain, Portugal and Greece). The Bloomberg Barclays Euro Aggregate Index rose by 2.8% over the quarter in local currency terms but this translated to a 4.3% gain in U.S. dollar terms due to U.S. dollar weakness.
U.S. dollar comes under pressure as relative yields and economic strength narrows
As measured by the U.S. dollar index (DXY), the currency fully retraced the appreciation seen over the first quarter and fell by 1.2% in the three months to June. Much of the depreciation occurred in June as expectations of Fed easing grew which pushed the U.S. dollar lower. Alongside a significant yield advantage over other major currencies, the 'greenback' has also found support from stronger relative economic growth, as reflected in the chart below. However, these cyclical factors are starting to wane and may therefore allow structural negatives, such as fiscal and current-account deficits, to put pressure on the U.S. dollar going forward. The start of this potential trend may have already started this quarter as the U.S. dollar index (DXY), the currency fully retraced the appreciation seen over the first quarter and fell by 1.2% with much of the depreciation occurring in June as expectations of Fed easing grew (withdrawing one of the supports of a strong U.S. dollar).
Source: FactSet, Aon
Elsewhere, increasing Brexit uncertainty as the UK waits on a new Prime Minister to succeed Theresa May has pushed sterling back to a new one-year low. The euro strengthened against the U.S. dollar despite the more dovish stance taken by the ECB while the yen benefited from safe-haven flows and appreciated by 2.7% against the U.S. dollar.
Fears of an economic slowdown appear to trump supply pressures as oil prices decline slightly while once-again attracting investors to gold
There is an interesting demand-supply dynamic at play in the crude oil markets. Commentators may well point to the supply risks, whether from Venezuela or the conflict in Iran which has supported crude oil prices in recent weeks, but drivers of demand are not as strong as this time last year. An oil-autarkic U.S. would be less affected by these geopolitical flashpoints or the whim of OPEC supply changes. However, with U.S. oil inventories coming off considerably in recent weeks from their 5-year average highs there could be some upward pressure on oil. We think crude oil performance is likely to be driven more by demand, which will be muted amid slower growth, even if supply is constrained by geopolitical events.
After surging by more than 33% in the prior quarter, WTI crude oil spot prices slipped back 2.9% to $58.42/bbl. This, however, compares favourably to industrial metals which almost fully retraced the prior quarter's gain following a 7.0% decline. The Goldman Sachs Commodity Index (GSCI) returned -1.4% over the quarter. Falling yields and a slightly lower U.S. dollar provided gold with a slight impetus and rose by 8.8% over the quarter.
Is now the time to add exposure to gold in this uncertain environment? Gold is a difficult asset to analyse given its status as non-yielding currency. Typically, gold will be doing well when inflation concerns are on the rise and the US dollar is falling or vulnerable. The recent rally in gold prices is odd at somewhat at odds with weaker near-term inflation expectations due to the global economic slowdown. However, the slowdown and the lack of tools to combat it brings a higher probability to the world moving to more directly inflation-boosting policies in the next few years. Alongside, or because of it, the US dollar is thought likely to depreciate. Gold is worth a look as a hedge against some portfolio risks which could upset growth assets.
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