Investment Outlook 03.2018
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
Inflation fears and trade war
February was a damaging month for multi-asset class portfolios. Government bonds, credits, and equities sold off. Technical factors amplified the sell-off.
Peak-to-trough losses – between 26 January and 9 February – were 10% for emerging markets, roughly 9% for US and European equities, and 9.5% for Japanese equities. In the same period, US 10-year yields rose 20 basis points and European yields 12 basis points. The Brent oil price fell 11% and the price of gold 2.5%.
Such sudden and disruptive market moves usually create challenges for active managers, since investment rationales, established by fundamental relationships, lose relevance. This also holds true for hedge funds and absolute-return strategies. Accordingly, the hedge fund macro index fell 2.6% in February.
Our assessment, as published in our Investment Outlook on 8 February, looks accurate, since markets were quick to recover in the second half of the month. While the recovery was quite strong, the month-on-month performance remained negative for almost all asset classes.
European equities clearly underperformed year-to-date, while US equities and emerging market equities performed positively, 1.5% and 3.2%, respectively.
Insurance-linked bonds proved to be uncorrelated to other asset classes. The Swiss Re Cat Bond index performed positively in January and February.
REITS sold-off significantly in January (-3.7%) and February (-4.9%) but have recovered somewhat in March.
The broad commodity index fell 1.7% in February. All sub-indices but agriculture contributed to the fall. Energy was the largest loser, followed by industrial metals, which came under selling pressure after President Trump’s announcement that tariffs were to be imposed on steel and aluminum imports.
The EUR-USD exchange rate remained relatively stable in 2018. The EUR strengthened slightly by about 1.8%. The JPY was very strong and gained 4% against the EUR.
Almost all leading indicators point to strong and robust growth. Although the European manufacturing PMI fell slightly to 58.6 after 59.6, it remains solidly above the 50 level.
The long-awaited resurfacing of US inflation has been at the core of the recent repricing of macro and especially inflation risks. Those fears calmed down recently, since US headline inflation remained very stable, between 2.0 and 2.2%. In addition, wage inflation, as measured by average hourly earnings (see Fig. 6), declined in February to 2.6%. The January reading was at the core of market nervousness, since it unexpectedly rose to 2.9%. The market seems to confirm the inflation outlook, since break-even inflation rates have stabilized at a level slightly above 2% in recent months.
Nevertheless, we do expect that US inflation is going to rise somewhat in the coming months, albeit not at a worrying pace. Such a slow upward inflationary trend can be seen from the development of US core inflation, which ignores volatile food and energy prices. US core inflation began to go up in Q4 2017, rising gradually from 1.7% in September 2017 to 1.8% in February 2018.
Looking beyond the US, we observed higher inflation in China and Japan. Chinese consumer prices surged to 2.9% in February after 1.5%. While this figure is heavily distorted by seasonal effects, there is evidence that consumer demand remains resilient and food prices are rising. At the same time, producer price inflation is slowing, which is in line with China’s policy of decelerating credit growth.
Higher prices for fresh food pushed Japanese inflation up to 1.4% in January, the highest level in three years. However, inflation remains clearly below the Bank of Japan’s target of 2%. In addition, there is no evidence that wages in Japan are starting to rise.
On 8 March US President Trump imposed tariffs of 10% and 25% on imports of steel and aluminum. Steel and aluminum account for only 2% of world trade and this move should have only limited impact on global trade and growth. In addition, it seems that Trump is willing to make exceptions. As of now, Canada and Mexico are exempt. We assume that an escalating trade war can be avoided. However, if further tariffs were to be imposed on Chinese exports or European cars, for instance, retaliatory measures by the EU and / or China could lead to more drastic US action. A trade war has the potential to impair global trade, which would lead to lower growth and higher inflation.
Jerome Powell has taken the helm of the US Fed. At his first Congressional testimony on 27 February he was very positive on the growth outlook, which suggests that the Fed is willing to follow its dot-plot projection and hike rates three to four times this year. The market fully anticipates another 25 basis point rate hike at its next policy meeting on 21 March. The market currently discounts two additional rate hikes in 2018.
At its 8 March meeting the ECB left key interest rates and its asset purchase program unchanged. However, President Draghi dropped a sentence from the communication, which stated willingness to increase bond buying if needed. The market initially reacted with a stronger EUR but retreated thereafter. This change in wording is regarded as another signal that the ECB is moving towards normalization of its monetary policy.
We remain constructive on the equity outlook, since a moderate increase in inflation poses no threat on equities in our view. The major risk, however, is an escalating trade war. We think the chances are very high that such a scenario can be avoided, since there is too much at stake for everybody. President Trump has shown in the past that after vigorous initial rhetoric – most likely to build a strong negotiation position – he softens his position later.
We have shifted from a European and Japanese overweight to a US and emerging markets overweight.
We also reduced our bond positions (interest rate risk) further. Since credits – in our view – are priced to perfection, we started to underweight high-grade and high-yield bonds.
We increased our commodities allocation, since commodities usually benefit in a late-cycle reflationary environment.
We also became more positive on the EUR vis-à-vis the USD and reduced our USD exposure below our strategic level.