Signs of a breakthrough on the US/China trade impasse and expectations for lower interest rates resulted in many equity markets ending the second quarter at or near all-time highs. Wall Street led the way with a rise of almost 4% followed by the eurozone and Japan. Asia and emerging markets lagged in dollar terms, though a near 3% depreciation in sterling to $1.27 increased returns from international markets to over 6% for UK investors. This was well ahead of the FTSE 100 which was up 146 (approximately 2%) to 7,425.
The fall in global bond yields meant sovereign debt, particularly longer-dated conventional and index-linked gilts, also produced positive returns. Brent crude eased to $66 as US oil production offset softer demand, OPEC discipline and growing tensions in the Persian Gulf. Gold’s safe haven status helped the price rise 9% over the quarter.
Despite accommodative financial conditions, central banks once again appear to be on the cusp of coordinated easing. The Federal Reserve is expected to cut rates by at least 25bp in July, the ECB is likely to follow and restart quantitative easing later in the year while the Bank of Japan will extend its guidance by maintaining low rates until late 2020 and may resume asset purchases. China has taken further measures to implement the fiscal package aimed at boosting infrastructure.
The Bank of England had been holding fire, ostensibly to give it scope to respond to a disruptive Brexit. However, the recent sharp decline in UK construction suggests this timescale may be revisited.
Bond yields fell steadily over Q2 – the US 10 year yield was back down to 2% while the prospect of more quantitative easing pushed German and Japanese government bonds deeper into negative territory. UK yields dipped below 1% again and could test the 2016 post-referendum low of 0.5%. While it is hard to justify these levels on fundamentals, with central bank policy continuing to target unrepresentative inflation measures, further record low yields are possible. The rise in the gold price suggests some investors are looking for alternative safe havens, particularly now the opportunity cost versus bond yields is near zero.
The good news from the G20 meeting in late June was that the US and China agreed to re-open trade discussions and postpone another round of higher tariffs. The US is to loosen some restrictions on high-tech exports and China will increase purchases of agricultural products. The bad news is the uncertainty continues and there appears to be little progress on key sticking points including the speed of existing tariff removal, enforcement of transfer restrictions on intellectual property, and trade deficit reductions.
Global GDP fell to 3% in the second quarter from a peak of 4% a year ago but trade tensions have so far had a relatively modest impact. There is still a significant differential between advanced and emerging economies albeit most face slower growth. Erratic policy decisions are disrupting global supply chains and investment plans, resulting in a decline in manufacturing business sentiment. It is unclear at this stage if the cost of tariffs can be passed on – with a potential impact on inflation – or whether an extended period of uncertainty will feed through to employment and consumption.
China’s response to trade tariffs has been measured and, with GDP above 6%, the authorities seem prepared to weather the storm. Stimulus measures are once again being targeted at infrastructure but strong consumption supported by jobs growth is becoming increasingly important. Although India’s growth rate of just below 5% is a five year low, the challenges are largely political and self-inflicted. The global trade slowdown continues to affect other Asian exporters such as Taiwan and South Korea.
The Q2 acceleration in US consumption – supported by strong employment growth and wage increases – has more than compensated for lower business investment. A number of historically reliable measures are highlighting the risk of recession but the cycle is being severely distorted by protectionist measures. Projected 2019 GDP growth of 2.6% is well above average.
Other advanced economies are not faring as well, with Japan struggling in the face of planned consumption tax increases that could result in a technical recession early next year. Eurozone exporters continue to suffer disproportionately from the slowdown in China, weaker global trade, threatened US tariffs and a disruptive Brexit, although the resilience of the domestic economy should support 1% GDP growth. Spain remains a highlight reflecting loose fiscal policy, strong job creation and a substantial increase in the minimum wage. Italy is the complete opposite with zero real GDP growth and deteriorating government finances.
Global headwinds, the unwinding of Brexit stockpiling and continuing political uncertainty mean Q2 GDP growth in the UK is expected to be very weak. The new Prime Minister will face the same problems and the threat of a “no-deal” to force concessions from the EU appears foolhardy given the erosion of the wafer thin Conservative majority. This means tensions could escalate during the summer and a general election with further delay to Brexit cannot be ruled out. Although sterling appears cheap on a real effective exchange rate basis, this has not stopped speculators building up short positions.
Analysts continue to revise down estimates for corporate profits growth as the spike caused by pre-tariff stockpiling fades and corporate profitability reverts to trend. The revisions are similar in scale to the 2015/16 global growth slowdown with the largest downgrades concentrated on the US followed by Japan and the eurozone. Energy and information technology have been the most affected sectors.
The Q2 results season is expected to be fairly flat which indicates that a meaningful improvement will be needed in the second half of the year to meet the current 4% growth estimate. In a low growth environment, companies with above average sales and the ability to generate strong free cash flow to support dividends and share buybacks have consistently outperformed. Many are technology and consumer focused whereas the laggards have tended to be traditional ‘value’ companies, typically industrial cyclicals and financials. While the latter are not universally unattractive, it may take more than erratic policy decisions for performance leadership to change.
We remain mildly optimistic on the economic outlook and financial conditions are supportive of a continuing improvement in corporate profitability. However, equity markets are at the upper end of their recent trading range and valuations of 16x estimated 2019 earnings do not look obviously cheap so a period of consolidation would not be surprising.
