It has not been a good few weeks for investors. Markets had a risk-off start to October, with the S&P/ASX 200 down close to 5%. The S&P 500 and Euro STOXX were also similarly down about 5%. Technology and growth sectors dragged the indices lower as markets repriced growth on the back of higher yields. In early October, the US 10-year yield rose above 3.2%, sparking a one-day move of -4% in the growth heavy NASDAQ 100 index.
Yields rose globally as the US Federal Reserve hiked rates again. Australia’s 10-year bond is trading around 2.7%. The rising yields continue to feed through as negative returns for investors due to capital losses.
The Australian Dollar is hovering around 71 US cents as it continues its slide.
It’s US against the world as Trump continues to promote protectionism in the recent United Nations summit. While some comments drew laughter from his peers, Trump’s speech primarily centred around the criticism of other nations, adding to already strained geopolitical tensions. However, this was nothing new and markets took it in their stride.
Importantly, the US economic data continues to be strong, with consumer confidence continuing to soar, US GDP coming in at a strong 4.2% for the second quarter, unemployment down to 3.7% and wage growth starting to pick up with the latest monthly gains of 0.3%, or 2.8% year on year. The strong economy keeps the US Federal Reserve on track as it raised rates by 0.25% again and reiterated its intention to raise another 0.25% by the end of the year. This boosted US bond yields and forced a repricing of risk as we saw in February when the US 10-year bond yield rose over 3%.
Domestic data was less optimistic as the housing and construction sector remains a drag. House prices and building approvals fell again. The fall thus far has been orderly, and the consensus is that this will likely continue without impacting the broader economy too severely. However, the risks of a broader domestic downturn are building as global economic growth slows due to trade tensions which could cause a much sharper correction in asset prices. Indeed, the International Monetary Fund (IMF) has downgraded the global growth outlook for the first time since July 2016, from 3.9% to 3.7%.
The impact of trade tensions on the Chinese economy has been the elephant in the room. Latest economic activity indicators suggest that tariffs are taking their toll and slowing China’s rate of growth. China has responded with multiple easing measures and cut their reserve ratio requirement for the fourth time this year to provide some monetary stimulus to the economy.
With the third quarter earnings season back in focus until early November, economic and political news may take a back seat over the next few weeks. The US earnings are expected to show a strong 20% growth but forward guidance will be important in assessing the impact of tariffs on the complex business supply chains.
Global growth trading lower
As previously stated, the IMF has downgraded its global growth forecast for the first time in over two years. Trade tensions and emerging market stress were cited as the primary factors, many of which were inflicted by US policies, some were self-inflicted like Venezuela, and some were collateral damage due to risk-off sentiment and higher US Dollar like Indonesia. Global growth is definitely slowing and has been since the start of 2018.
Source: AIG, FactSet, Markit, J.P. Morgan Asset Management
Guide to the Markets – Australia. Data as of 30 September 2018
The Purchasing Managers Index (PMI) shown above provides an indicator for economic growth, where readings above 50 indicate expanding economic activity, and readings below 50 indicate contracting economic activity. Although PMIs continue to point to economic growth, the fall from December peaks indicates that this growth is slowing. If you look at the chart below, you can see that, similar to the PMI story above, trade volumes also started to fall around the same time.
Source: FactSet, J.P. Morgan Asset Management, Netherlands Bureau for Economic Policy Analysis World Trade Monitor
Guide to the Markets – Australia. Data as of 30 September 2018
Trade is an extremely important factor for global growth, especially for emerging markets which have been the recent driver for global economic growth. In turn, expected global economic growth is important for market sentiment. The fall coincided with escalating trade tensions in late 2017. When growth is expected to accelerate, the market tends to do well and vice versa, and is less dependent on how high growth is. A recent example would be 2016 where fears of slowing Chinese growth resulted in a global sell-off. At that time, Chinese growth was still close to 7% p.a.
Tearing down the great (trade) wall of China
Whilst many agree that China benefited from its protectionist policies while taking advantage of developed countries’ open economies, few believed that any single country could force China to relinquish the advantage given the centralised power, economic size and integrated global supply chains. Instead, the approach was for a united front to pressure China to slowly removing its barriers. However, the Trump administration has now overturned this approach and has decided to go toe-to-toe with China, leveraging the advantage of an already strong domestic economy, partly boosted by fiscal stimulus in the form of a tax restructure, and a big trade deficit, whilst Chinese economic growth was starting to slow. This has undoubtedly forced China to roll back its barriers more quickly as China now allows foreign companies to own controlling stakes in domestic joint ventures (JV) and lowered tariffs on many of its imports. BMW has already taken advantage of this to buy up a controlling stake in its Chinese JV, whilst China has announced tariff reductions that will reduce the average most-favoured nation tariff rate from 9.8% to 7.5%.
Unfortunately, these changes exclude the US, with bilateral protectionist policies between the two biggest economies only increasing since the start of the year, with the US now levying tariffs on $250 billion Chinese imports, and China levying tariffs on $110 billion US imports. Trump has since threatened to levy tariffs on the rest of China’s imports, and China has vowed to retaliate, although this will have to be via other means as it already has tariffs on virtually all US imports. Both economies have reiterated that they are willing to negotiate but since talks broke down in August, there has been no formal negotiations between senior officials of US and China. Most had thought a deal was done earlier in the year before Trump did a U-turn and announced the intention to proceed with additional tariffs instead. This has deterred China from further negotiations while Trump has ratcheted up his accusations to include political meddling.
These tensions look set to rise in the near term, and many expect that there will be fresh negotiations will not occur until after the US mid-term elections in November. With earnings growth likely to peak this year as the stimulus from tax reforms abate, trade will likely have more of an influence on investments moving forward.
If trade tensions are prolonged, the US market may see a sell-off and catch down to other markets as investors focussed on stellar profits and fiscal stimulus from tax reforms, and valuations remain above the long-term average. US equities have provided positive returns so far this year, while other equity markets have sold off. On the flip-side, emerging markets look like they have priced in further trade tensions as equity valuations have fallen back below the long-term average.
An agreement between US and China would likely result in a surge in risk-on sentiment with equities and commodities being primary beneficiaries, while global growth would also likely accelerate. This would likely see emerging market assets catch up to US performance. Either way, we expect an interesting and volatile final few months of 2018.
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