Investment Outlook 04.2018
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
Will US politics derail markets?
In March risk-takers were punished. Almost all equity markets and high-yielding bonds sold-off. The exceptions were emerging market bonds denominated in local currency, which were able to resist the risk-off mood and gain 1%. Also, REITS, which are considered more defensive, recovered from a major sell-off earlier this year – they lost 8.4% in January and February together – and gained 1% in March. As a result, most multi-asset class portfolios had a second negative month in a row.
Among equities, emerging markets slightly outperformed, losing “only” 2%, whereas the S&P500 lost 2.7% and the MSCI Europe 2.5%. The general market trend, coupled with a stronger JPY, resulted in a loss of 2.8% for the Nikkei 225.
Despite more hawkish ECB and Fed statements in March, 10-year bond yields fell 12 basis points in the US and 16 basis points in Europe, driven by safe haven flows. European break-even inflation rates rose slightly, while US break-even rates remained stable.
The broad commodity index fell 0.6% in March. The development within the commodities complex was, however, very mixed. While industrial metals fell 4.4% on the back of US tariffs on steel and aluminum, Brent oil rose 6.8%. Gold enjoyed a small gain of 0.5% in March.
The EUR continued to be strong in March. It gained 1.1% against the USD, 0.7% against the JPY, and 2.0% against the CHF. The GBP recovered and gained 1.9% against the USD and 0.8% against the EUR.
All major PMIs weakened in March. This can partly be attributed to uncertainties in connection with rising protectionism. We would also expect that growth may have peaked early this year, which would mean we will see falling PMIs in the coming months. However, all major growth indicators suggest that growth dynamics remains very robust, at least for the coming 9-12 months.
While US non-farm payrolls disappointed and fell to 103,000 additional jobs in March, the three months average remains very strong and above the previous year’s level. Wage pressure remains muted, with average hourly earnings rising 2.7% after 2.6% in February.
While headline inflation nudged up to 1.4% in March after 1.1% in February, core inflation, which ignores volatile goods, like fuel and food, remained steady at 1.0%. The ECB expects headline inflation to be around 1.5% for the rest of the year. Still, a gradual increase in inflation gives the ECB additional justification to normalize monetary policy.
On 23 March the US imposed tariffs on steel and aluminum from some countries, including China. This provoked the first retaliatory measures from China itself. On 3 April President Trump announced an additional list of 1,300 Chinese products, which could be subject to a 25% tariff. Soon after, China published its own list containing 106 categories of US products. US tariffs would hit about USD 50 bn worth of Chinese export goods (9% of total exports to America) and the Chinese cover USD 50 bn worth of US goods (38% of US exports to China).
The US intends to hurt sectors which benefit from unfair Chinese trade practices. Among other things, China often fails to put protection of international property rights into practice. Furthermore, China has openly communicated its “Made in China 2015” strategy, which aims to redirect production from abroad to China. To achieve this goal China heavily subsidizes often state-owned companies in strategically important sectors. This makes it hard or even impossible for companies in other countries to compete. Such sectors include for example industrial robots, motors for electric vehicles, and semiconductors.
China’s retaliation measures aim at industries or states with powerful lobbies, which could put pressure on the US administration to moderate its trade policy. Such areas include aircraft and soybeans, among others.
So far, the lists are only threats and there has not been a formal decision to impose tariffs nor on a time line. The US list is open for public consultation until 21 May. China announced it would wait for the next steps by the US administration.
An option for President Trump is to invite Europe also to put pressure on China to comply with international standards. However, since the relationship between the US and Europe has cooled down, it will be much harder for the US to convince Europe to join the campaign.
On 8 March the ECB kept rates unchanged. It reiterated its intention to maintain its asset purchase program at EUR 30 bn per month until September. The communication can nevertheless be regarded as more hawkish, since the ECB dropped its so-called “easing bias”. For the first time in a very long time, the ECB omitted the sentence stating that it would be prepared to increase the level of bond purchases in the event that the economic outlook were to deteriorate. Furthermore, the ECB increased its growth forecast to 2.4% in 2018, 1.9% in 2019, and 1.7% in 2020. After the announcements, the EUR strengthened distinctly.
On 21 March the US Fed raised its benchmark funds rate by 25 basis points to the new target of 1.50% to 1.75%. This had been widely expected and had no special impact on markets. In fact, 2-year rates even declined after the meeting. It is believed that the Fed will hike rates three more times this year. The Fed increased its projection for future policy rates for 2019 and 2020, based on a positive economic outlook.
Fundamentals remain very favorable for equity and credit markets. The recent market correction has improved valuations since earnings growth has remained very strong. Still, valuations remain rich historically. It would be very unusual for equity markets to sell off for more than a quarter in a phase of such strong earnings growth.
The question remains as to whether there are risks which could drive investors into a risk- off mode, despite sound fundamentals. Clearly there are such risks, which we currently see as mostly related to US politics. We think that an escalating trade war and geopolitical tensions between the US and North Korea and the US and Iran are the most imminent risks at present.
While the possibility of a major trade war certainly rose significantly in March, there is still a good chance that negotiations lead to an acceptable solution.
President Trump could certainly also take tough measures on North Korea and/or Iran.
May will be a very decisive month. Firstly, on 21 May the 60-day consultation period for China tariffs ends. Secondly, the Iran sanction waiver expires on 12 May. Since the US is not trading oil with Iran, it cannot embargo it. However, there is a chance that the US will try to put pressure on Europe to tighten sanctions on Iran. This could intensify tensions and push oil prices up.