After a tricky start to the year, most equity markets had a better experience in the second quarter. This was helped by data which confirmed that the weakness in global consumption during the first quarter was a temporary blip. Developed market equities gained 3.8% in 2Q18. However, trade angst and a rising U.S. dollar punished emerging market equities, which fell by 3.4%. Australia was a rare standout in both fixed income (+0.8%) and equity markets (+8.5%).
The Australian equity market was a solitary beacon, in which was a bleak time for global equity markets. The ASX 200 gained 8.5% over the quarter on a total return basis. Materials, healthcare and energy were the biggest sector contributors to quarterly returns, accounting for 3%pts of the gain (price return only). The telecoms sector was the only drag for the quarter. The strong gains in the second quarter are more than reversed the local market’s first quarter’s weakness and the ASX 200 ended the first half of the year up 4.3%.
Australia’s relative outperformance has been a function of better commodity prices lifting materials and energy sectors (iron ore +2.7% for the quarter), being viewed as a defensive market within Asia. The U.S.-China trade spat continues, as well as a weaker Australian dollar. Against the U.S. dollar, the Australian dollar fell by 3.7% over the quarter and was done 5.1% against the euro. The persistence in growth and interest rate differentials between the U.S. and Australia is likely to keep the Australian dollar in check.
The strong run in the Australian equity market has pushed valuations higher. The forward price-toearnings ratio for the ASX 200 was 15.7x at the end of June, close to one standard deviation above its long-run average of 14.2x.
Economic data released over the quarter continues to reinforce the middling state of the economy. Business sentiment unwound from its highs, but still looks supportive of stable growth. The unemployment rate declined slightly to 5.4%, but the pace of employment growth is only about half of that is seen in 2018, and wage growth is struggling to break the 2% threshold. Still consumers seem happy, and the consumer confidence index rose as retail sales did.
Economic growth (3.1% y/y) in the first quarter was boosted by positive net trade, as liquefied natural gas (LNG) exports finally came online, and government spending. The LNG impact will flow through into second quarter growth, but beyond that, the impact will likely fade.
The Reserve Bank of Australia is going nowhere fast and looks to be on hold throughout 2019. The weakness in the housing market is adding to worries over financial stability, while rising offshore funding costs may see retail banks starting to pursue out of cycle rate hikes.
A strong U.S. economy gave the Federal Reserve (Fed) the confidence to raise interest rates again in June and signal two further hikes to come this year, followed by three more next year. In contrast, after a string of disappointing data and still low core inflation, the European Central Bank announced that interest rates will not be going up until at least June of next year, although they did confirm that their quantitative easing programme would stop by the end of this year. At the end of the last quarter, markets were convinced that the Bank of England would raise rates in May. However, May and then June meetings came and went without any action. Nevertheless, a bounce back in economic data and firming wage pressure suggest that rates will rise this year and next unless Brexit negotiations prove disruptive. Against this backdrop, government bond returns have been broadly flat other than in Italy.
Currencies played a big role in investors’ returns in the last quarter. In emerging markets, a stronger U.S. dollar has often proved a headwind to equity performance and that was certainly the case this quarter. The direction of the U.S. dollar is likely to remain important for relative equity performance going forward and unfortunately is particularly difficult to predict currently, with different factors pulling the currency in opposing directions. In the short term, the outperformance of U.S. growth and interest rates may support the greenback, but at some point ever-rising levels of government debt and a large current account deficit will likely weigh on the currency.
Trade tensions ramped up over the quarter as steel and aluminium tariffs were imposed on Europe, Canada & Mexico and met with retaliatory tariffs on sensitive U.S. exports. A tariff of 25% will be applied to USD 34 billion to Chinese imports from 6 July, and Chinese authorities are expected to implement tariffs on an equivalent value of goods imported from the U.S.
The escalation of global trade concerns have weighed on equity markets, with those outside of the U.S. the most affected. European equities have been impacted by the potential for tariffs on car imports. The conclusion to this scuffle is unclear but the longer it drags, the greater the impact on business sentiment, which could be more damaging to economic growth and asset returns before a full trade war even eventuates.
The vulnerable emerging economies, which are with large current account deficits and high external funding requirements, such as Turkey and Argentina, have come under significant pressure reflected in sharp falls in both currencies and equity markets. Further interest rates rises from the Fed or a higher U.S. dollar could apply more pressure to those weaker emerging economies. However, investors have shown the ability to distinguish between the weak and strong in the herd and not all emerging markets are suffering. Indian equities were actually higher over the quarter.
Chinese equities have been the epicentre of the sell-off with the onshore Shanghai Composite Index falling into a bear market, a 20% decline from the peak. The softness in China is not
just about trade, as economic data has been softer than expected, thanks to tighter monetary and fiscal policies. While the People’s Bank of China has been cutting the reserve requirement ratio to provide liquidity to smaller banks (and causing the Chinese yuan to fall versus the U.S. dollar and on a trade weighted basis), it is using other measures to curb off-balance-sheet lending which is weighing on growth. The near-term pain is a symptom of the longer-term goal of financial stability and reduced leverage in the financial system.
A notable theme for the second quarter was the widening in spreads for investment grade credit. With corporate leverage elevated the U.S. investment grade credit market and interest rates rising, a degree of caution is warranted on the outlook for this segment of the fixed income market. Our preference is still for the high yield section of the market where carry is higher.
Overall, growth still looks healthy and corporate earnings growing strongly, but there are a number of potential political risks to markets over the second half of the year. The strength of the U.S. economy means that the easy money is being turned off and financial conditions will slowly tighten. Fiscal stimulus should keep economic activity high in the U.S. economy heading into 2019, but the fading impact of that stimulus at a time when interest rates may start to bite on growth could see a different outlook at 2019 draws to a close. The current healthy economy offsets against the political risks and late stage of the U.S. economic cycle and agues for a slightly more balanced approach to risk in portfolios.
By J.P. Morgan Asset Management
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