Investment Outlook 07.2018
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
Emerging markets under selling pressure
June was a difficult month for financial markets, as geopolitical events, especially in the form of erratic US policies, dominated market developments. A major victim was the Chinese equity market, which fell 7.7% in June and dragged down the broad emerging market index, which fell 4.6%. Developed equity markets were down only slightly, i.e., by 0.2%. The US S&P500 and the Japanese Nikkei 225 both gained 0.5%, while the MSCI Europe fell 0.9%, depressed by disruptive German coalition talks.
Government yields remained roughly stable in June, with the exception of US short-term yields, which rose 10 basis points. Inflation expectations remained more or less unchanged. However, credit spreads, especially for high-yield and emerging markets, continued to widen. Emerging market bonds came under severe selling pressure in May and June, which transformed a 4% YTD performance end of April to a 6.4% YTD performance end of June.
REITS, which suffered from a significant sell-off in January and February, bounced back strongly and gained almost 10% from end of March.
The Bloomberg Commodity index fell 3.5% in June, mainly due to softening prices for agriculture (10.5%), industrial metals (-4.8%), and gold (-3.5%). In contrast, the price for Brent oil rose 2.4% in June.
With markets being driven by politics rather than fundamentals, hedge funds had difficult times: the HFRI UCITS index fell 0.7% in June.
The EUR-USD exchange rate stabilized between 1.16 and 1.18 from end of May. Asian currencies, especially CNY and JPY weakened. The GBP depreciated, due to uncertainties around Brexit talks and the recent reshuffling of the British government. The CHF regained some strength after the Italian elections and the Germen coalition talks, but gave back some of the gains in June.
The US economy is heading towards 4% growth in Q2 QoQ, annualized, and earnings of S&P500 companies should grow in excess of 20% YoY, according to the latest estimates of Thomson Reuters. The US ISM index rose to 60.2 in June after 58.7.
At the same time, we saw some softening of major Euro-area growth indicators. For example, the EMU Markit manufacturing PMI fell distinctly from 60.6 in December last year to 54.9 in June. This can partly be explained by the EUR appreciating 6% in 2017, which significantly lowered export growth. However, the current PMI reading remains strong in absolute terms and indicates continued vigorous European growth.
In line with strong growth, US consumer price inflation rose to 2.9% in June, while the more stable US PCE core inflation rate rose to 2% in May.
In the EMU the June inflation rate rose to 2% from 1.9% in May. At the same time, the EMU core inflation rate fell to 1.0% after 1.1% in May.
On 13 June the US Fed hiked rates to a new federal funds target range of 1.75-2.0%. It further indicated rate hikes once a quarter for at least the next 12 months. We are carefully monitoring the development of core PCE inflation, since a clear overshoot above 2.0% could trigger additional Fed rate hikes.
On 14 June the ECB kept rates unchanged and signaled the end of asset purchases in December. It is unlikely that the ECB will hike rates before summer of next year. The ECB can afford this “dovish tightening” policy stance since core inflation continues very stable around 1.0%.
The Bank of Japan remains committed to its yield curve control policy. As a result, the Bank of Japan may end up as the last central bank performing quantitative easing.
Mid-April we reduced our equity allocation to neutral, and thus reduced portfolio risks. Since we remained underweight in bonds, we increased the cash position in the portfolios.
We have kept our more defensive stance, as trade war risks remain elevated. However, if we were to see trade war risks abating, we would consider a more pro-risk portfolio stance, as growth and earnings dynamics remain strong and valuations have become less demanding.
Nevertheless, down-side risks have clearly risen, especially since central banks and governments are much less likely to bail-out financial market investors in times of stress. Rising US inflation, driven by an economy running at full capacity, further boosted by substantial fiscal stimulus and rising trade tariffs, will prevent the Fed from easing monetary policy measures. In Europe inflation is only gradually evolving, but the ECB has shifted its policy stance and is likely to continue its shift towards policy normalization. In China, the government has become concerned about oversupply and leverage and is focusing on structural reforms and deleveraging. Monetary easing has, therefore, become less likely, even if markets should come under stress. However, the Chinese government may start, or may even have already started, to soften monetary conditions by weakening its currency.