As of the close of August 23rd the S&P 500 is -4.4% MTD and +13.6% YTD, and the MSCI World is -4.25% and +11.2% YTD.
August has historically been a volatile month and this year is clearly no different. A lot of noise these past weeks (geopolitics, tweets, Fed, trade wars, recessions, yield curves) in summer-like volumes drove choppiness in global markets. As markets bounced around without much direction, it appeared that it wasn’t really a period to read too much into price moves…or at least until the latter half of Friday of last week. This drove some pretty ugly price action with S&P ending Friday of last week, -2.6%.
- Investors will most certainly be reading into the market moves after the events of China tariffs on $75bn of goods and Trump’s inflammatory tweets and further decision to retaliate raising tariffs to 30% on $250 billion on Chinese imports starting October 1st. In total around $550 billion of imports from China are now subject to import tariffs.
- The US/China trade war is a major geopolitical struggle that is as much about future technological supremacy and national defense as trade deficits. Additionally, the August escalations have crossed two red lines: consumer tariffs and a currency war. In this regard and given the growing geopolitical rivalry between China and the US, it seems that the trade war will last indefinitely. Their “no pain, no deal” framework requires severe negative feedback from markets, the economy, or politics at home in order to motivate a deal. Until then, a risk is mutual escalation becomes the only feasible outcome.
- This escalating US-China trade tensions and yield curve inversion was offset with better US retail earnings and a slightly more dovish Fed in Jackson Hole.
- As deciphering varying messages from the Fed also continues to keep investors busy, all eyes were on Jackson Hole last week. While Fed Powell’s much anticipated appearance was overshadowed by the tariff escalation, his overall tone—while measured—was on the margin more dovish. As Chairman Powell acknowledged today in Jackson Hole, “fitting trade policy uncertainty into [the Fed’s] framework is a new challenge” in an environment where global growth, business investment, and manufacturing are deteriorating yet the US consumer remains resilient. Powell’s speech reiterated a commitment to sustaining the expansion and removed any reference to a “mid-cycle adjustment” but gave no definitive indication of the Fed’s rate path. This was welcome after more hawkish commentary from the Fed minutes signaling the July rate cut was merely a mid-cycle adjustment.
- All in all, geopolitics clearly remain critical (Italian elections, Brexit, Trump’s trade war with China and eventually Europe) where small mishaps can restart December 2018 - like price action and small victories can catapult assets to new highs… and global data continues to be closely watched for any signs of what the Fed will do or read-throughs for the global growth picture.
- World equity markets are off their highs (even after the resilience exhibited in the month of July, as the S&P 500 touched an all time high of 3027 on July 26th, 2019 versus the closing of August 23rd, 2019 of 2847, a correction of around 6%), fears of slowing global growth are alive as well, rates are setting off warning signals, and the blame game on trade tensions remains in full swing.
- As far as the Fed goes, the July 31st 25 bps cut to 2.25% was the first rate cut in 11 years. The risk off environment has led to markets pricing in a 100% probability of a 25bps cut in September and a 33% probability of a 50bps cut. Several economists now expect successive cuts of 25bp at the Sept and Oct FOMC meetings, which will bring the total monetary policy easing up from 50bp to 75bp this year.
- The narrative is confusing and the market isn’t sure how to react. If the Fed doesn’t ease as much because things aren’t that bad – is that good? If the Fed joins the rest of Central Banks around the word in a race to zero and beyond because the economy is at risk – is that bad?
- In our view, another cut will be coming and this, combined with additional ECB stimulus, gets tough to fade in the near team. Yet, you could argue, with the escalating trade rhetoric and potential action, Central Banks may not have enough ammunition to offset what could be a meaningful catalyst to push a weakening globally economic backdrop into recession.
- Last week EU PMIs beat expectations (albeit still in contractionary territory), German data was in-line, while US Markit PMIs disappointed to the downside (50 vs 51 cons).
- Overall, US economic data in August was relatively solid especially those forward looking ones. The CPI beat was the second upside surprise in a row here, kicking off some debate related to firming inflation pressures. That combined with above consensus prints from both the Empire and Philly Fed surveys and stable jobless claims presented a benign economic backdrop. Perhaps the biggest was the strong Retail Sales numbers, in particular strong earnings from retailers as Target, Lowes and Home Depot, which continued the trend of consumer data being firmer than the producer side. However, the UMichigan survey suggested the latest trade tensions have started weighed on consumer sentiment.
- Recent flows of $313bn into bonds and $197bn out of equities YTD according to the most recent Bank of America Merrill Lynch analysis, show that perhaps equities are nowhere near overbought, which could be positive for the equity markets :
- As 2Q19 reporting nears its close, most of the S&P 500’s market cap has now reported. This earnings season served as a confirmation of the lower growth trend that began in 1Q19; however, the numbers still came in better than expected, with YoY EPS growth estimated to finish -78bps for 2Q vs -3% at the start of the quarter. This is the second consecutive quarter of negative growth. Interestingly, cautiousness seems to have been embedded into investor expectations, as the companies that missed on both earnings and sales were “punished” less severely than in past quarters (down only -1.5% vs the average of -3.0% since 2010).
- Taking a step back amid subdued volumes (less liquidity), choppiness in markets, and tight client positioning, we would like to point out an underlying risk in the markets that we have highlighted in past — credit risk. The most interest rate sensitive parts of the economy have failed to rebound even though rates have fallen sharply over the past year. Housing related stocks have not been able to outperform since April as rates collapsed and last week's accelerated move lower in the performance of cyclicals / defensives was as striking as the blow off move in bonds, suggesting the market is likely getting more convinced of the recession outcome.
- Another interesting point highlighted last week was a commentary from last week’s University of Michigan consumer sentiment survey, which many investors may have initially overlooked. It said: “The main takeaway for consumers from the first cut in interest rates in a decade was to increase apprehensions about a possible recession. Consumers concluded, following the Fed’s lead, that they may need to reduce spending in anticipation of a potential recession”.
- This means the Fed may be between a rock and hard place on policy at this point. If they try to reassure the markets by going with a 50bps cut, they run the risk of sending the consumer into a spending strike which may be all we need to send the economy into an economic contraction. If they fail to deliver 50bps, the markets may continue to exert pressure until they get what they want. This too can be disruptive to financial conditions, and therefore confidence. With so much of domestic economic growth attributed to the strength of the US consumer, such anecdotes are sure to put recession watchers on notice.
- The health of the US Consumer looks to be on solid footing based on the following: 1) debt service remains low, 2) refinancing are up, 3) personal savings rate are up and 4) wage growth remains solid. What would make us cautious would be a significant rise in unemployment rates and a rise in jobs hard to get. However, a plunge in consumer confidence could cause us to get defensive.
As of the close of August 23rd the Eurostoxx is -3.8% MTD and +11% YTD, and the MSCI Europe is -3.9% and +9.5% YTD.
- Looking to Europe, it seems sentiment towards the region has worsened and it is now even more unloved than it was before—who thought that was possible? European net exposure (measured by European equity long/short hedge fund exposure) is at its lowest point in 7 years, having dropped 13% points in 6 weeks from 32% to 19%. The current level is now lower than Q4’18 and the lowest level since July 2012. None of this is truly surprising given the complexity of and uncertainty around the geopolitics in the region. There are a whole host of concerns at the macro level that sometimes looking beyond them to the single stock level becomes difficult. But for those who have a view there are ways to express that view through the FX markets, indices, and single stocks.
- Euro area growth has been weakening since last year. The inflection point came around the start of 2018—which is to say, it predated rising global trade tensions. As those tensions escalated in the second half of 2018, investors increasingly focused on disappointing euro area growth data.
- Importantly, though, acute growth weakness has been isolated to a couple of pockets of the euro area economy. Manufacturing has been hit especially hard—no surprise, given the slowdown in global industry and trade. Germany, a bellwether of the global economy, has borne the brunt of this weakness, given its outsize manufacturing sector and strong trade linkages to the slowing economies of China and Turkey. Moreover, the German auto industry continues to grapple with idiosyncrasies like tightening national emissions standards.
- It is also important to recognize that much of the euro area economic slowdown reflects a cooling from the extraordinary, unsustainable global growth boom of 2016- 17, to which the euro area, with its large external trade sector, is highly levered.
- The current pace of growth seems near trend, which is estimated to be just above 1%. Last week’s release of the euro area composite PMI implies an annual growth rate of 1.2%, and suggests manufacturing weakness may have bottomed. Exports have deteriorated somewhat, but have not collapsed. The services sector remains robust. Consumer and business sentiment have slowly retreated from the unsustainable exuberance of 2017, but remain at elevated levels. Businesses continue adding jobs, reducing economic slack and helping wage growth to pick up a bit. And banks continue to lend at a solid pace, which in the euro area especially is a strong leading indicator of future economic growth.
- The need to manage downside risks and re-anchor inflation expectations has led market participants to expect that the ECB, at its next monetary policy meeting on September 12, will deliver a whole package of stimulative measures. Here are the possibilities: First, to cut by 10bps the policy deposit rate. The current level, -0.4% since 2016, had been considered an effective lower bound, since banks cannot easily borrow from depositors at negative rates, but “tiering” bank deposits (subjecting only a fraction of deposits to paying this rate), should allow the ECB to lower overnight lending rates without creating a new drag on bank profitability. If the tiering experiment proves successful, a more aggressive series of cuts is likely to follow. Second, anticipate enhanced forward rate guidance. And third, anticipate that quantitative easing (QE) bond purchases, which ended at the start of this year, will resume at a pace of €30 billion per month for sovereigns and nonfinancial corporate issuers, in addition to a smaller program for small- and mid-sized entities (SMEs). The ECB’s self-imposed limit against purchasing more than one-third of any sovereign issuer’s debt will not be immediately binding and we see scope to relax this constraint.
- The fiscal stance, meanwhile, has been expansionary in recent quarters. In Germany, where weak growth has been especially acute, there is considerable space to increase government spending—by about 1% of GDP— while staying within a constitutional budget constraint. But one should not necessary expect significant further fiscal stimulus from Germany, or any major euro area member, barring a more significant deterioration in realized growth.
Europe / UK
- Looking specifically at Brexit, it appears that the probability of an end-October no deal Brexit is increasing, reflecting the new UK government's determined stance. And after recent polarization, it is probable that there is less chance of a deal (20%) and more chance of the polar options of staying in the EU (40%) or leaving with no deal (40%). UK assets are for the most part already pricing for a disruptive Brexit outcome.
- The most immediate economic impact of a disorderly or disruptive Brexit, would be the supply chain disruption as firms face customs processing and EU manufacturers seek to source component parts from EU companies that officially comply with EU regulations. The sectors most likely to be affected are food & agriculture, chemicals & pharmaceuticals, and transport & transport services. The fall in sterling and subsequent rise in inflation would squeeze real incomes and put downward pressure on consumer spending. This would be compounded if business confidence declined and firms chose to cut back on staff. The recent weakening in the global backdrop will not help in this regard. One key uncertainty is the EU’s treatment of UK financial services. While the UK will lose its passporting rights, there may be an agreement to enable the UK to continue providing financial services via some form of ‘equivalence’ (essentially permission to provide some services as long as UK regulators were deemed to set regulations to at least an equivalent standard to those set by the EU). It helps greatly that the BoE is held in such high regard internationally for its regulatory competence. If an agreement on financial services was not forthcoming then no deal risks a broader European financial contraction, which would exacerbate a downturn on both sides of the channel. There may also be serious challenges for the UK if international investors questioned the ongoing dominance of UK financial services, not least with regards to the sustainability of the UK’s public finances (given 28% of all income tax comes from the top 1% of earners in the UK).
- In order of likelihood, from most likely to least, this is how JPM sees the situation as at 1 November: 1) Following resistance from parliament, the prime minister has called an election and accepted a short technical extension to Article 50 to facilitate the process 2) The UK and EU have agreed a revised deal 3) The UK has left the EU without a deal.
- With such a binary outlook – sterling at either 1.40 or 1.10 versus the US dollar – it does not make sense to assume large positions in sterling assets in either direction at this stage. ‘Do or die’ may be seen as an acceptable political strategy. It is not a strategy we would deploy.
Asia and Emerging Markets
As of the close of August 23rd the Topix -4% and 0.55% YTD, the MSCI Asia ex-Japan is -5.1% MTD and +1.54% YTD, and the MSCI Emerging Mkts. is -6.1% MTD and +0.8% YTD. These later two indices are down over 11% from their peak on March 30th, 2019.
In addition both the Topix and the MSCI Asia ex-Japan are still down
-20% and -15% respectively since the end of 2017.
- Looking at China, the CSI 300 is only -0.38% in August, and continues to be +26.9% YTD. The Hang Seng Index has not fared as well; -7.6% in August and -0.6% YTD. Clearly the Hong Kong market has suffered from the internal political problems and the impact of the anti-extradition bill protests, that seem to have gone out of control of the authorities, affecting this economy.
- Amid all this, most Asia-focused investors have been watching the most recent China Internet earnings, where the picture was rosier. eCommerce remains resilient despite concerns around China’s economic growth. Alibaba (BABA US), beat on both revenues and profit thanks to solid core commerce growth (ongoing penetration to less-developed areas) and disciplined cost control. JD (JD US) is up 15% last week after beating earnings and raising full year net profit guidance. Tencent (700 HK) beat on earnings but missed on revenues due to weakness in Advertising / FinTech & Business Services.
- Our views on the “rest of the world” EMs have not changed since last month’s decision to slightly reduce our weighting to EMs. Our reasoning remains that even though EMs will probably benefit from the looser monetary policy in the DMs, the current trade conflict could extend longer than expected causing a bearish outlook and sentiment for growth in the EMs.
- Don’t forget about Argentina, where equities suffered their own ‘Black Monday’ on August 13th, 2019. The Argentine Equity market fell around -45% in a single day, which is twice what the Dow fell (-22.5%) on Black Monday in 1987. This was caused by an unexpected election results where its current leader, President Mauricio Macri, was defeated by a left-wing opponent in the country's primary elections by a greater than expected margin.
- This is the 2nd largest single-day decline in history, only rivaled by Sri Lanka’s bourse tumbling more than 60% in June 1989, as the nation was engulfed in a civil war. Heavy positioning into the event (especially in fixed income) and a small exit door helped exacerbate the correction. If you want an interesting fact…Lehman Brother CDS on Sept 10th, 2008 were at 610pts vs. current Argentina 5-yrs CDS at 2250pts.
- The MSCI EM Latin America (MXLA) has now lost all its yearly gains in August (-11%) and is now -1.3% YTD.
- In US Fixed income - The yield curve has continued to change shape. The spread between 3-month treasuries and the 10-year is now inverted. With Fed Fund rates at 2.25%, current 2 year rates are at 1.53%, 5 year rates at 1.4% and 10 year at 1.53% and 30 year at 2%. The yield curve is not anymore inverted in the 2-10 year maturities.
- In European Fixed income - the yield on Germany’s benchmark 2-year bond is -0.9% and the 10-year, is now -0.67%, Weak German growth data, low inflation numbers and the continued belief that China weakness is bad for German growth, remain the main drivers for negative interest rates in Europe.
- The expansion of negative yielding debt, and indeed its acceptance as part of the current financial system, compounds the asset allocation problems facing investors in the future. Above all, it heightens the worry that a major accident could be around the corner. An entrenched world of negative yields upends the important role played by government bonds in providing insurance or ballast for portfolios that generally favor equities and credit.
- As fixed-rate coupons disappear, and as bond investors rely ever more on price appreciation to hit return targets, holding bonds becomes little different from holding stocks. The bond-market milestones reached this month are truly stunning. US Treasury yields out to 30 years fell below 2 per cent for the first time as about $16tn of negative-yielding debt around the world acts as a powerful magnet towards the long end of the curve. The entire German Bund market went one step further and dropped below zero (the 30 year bond is -0.14%). Bond markets in Japan, Switzerland and Sweden sit in negative territory, alongside half of global investment-grade debt sold by companies (outside the US).
- The distorting influence of negative yields across global fixed income has emerged in recent years as central banks have become major holders of bonds as they try to boost economic growth and inflation. But such activities have failed to offset long-term trends depressing bond yields such as ageing populations and rapid technological change, which respectively boost savings rates and dampen inflationary pressure.
- What the August bond shock reveals is that a key part of the financial system expects no relief from these secular forces, well into the next decade and beyond. There has clearly been pressure among insurers and pension funds to buy long-dated bonds that can offset the cost of their future liabilities. Bond markets are also dominated by investors who typically follow a benchmark, which means that as yields drop and prices rise, so does the need to increase the pace of buying. Lagging the benchmark runs the risk of losing clients, and this creates a powerful herding trend — and one which is exacerbated by the rise of fixed-income focused exchange traded funds over the past decade.
- This means that holders of bonds with low and negative yields are painfully exposed to even a modest rebound in growth and inflation expectations, which should naturally cause yields to rise. But as the global economy feels a squeeze on manufacturing and waits for signs of a genuine truce in the US-China trade war, bond prices, for now, reflect expectations of weaker growth and the hope that central banks will repeat their previous doses of extraordinary monetary policy.
- Buyers of negative-yielding debt are only rewarded via a further appreciation in price. Thus, the risk of owning bonds converges with the risk of owning equities. The short-term potential for capital appreciation — nominal or real — diminishes, while the potential for vicious losses increases dramatically. As of now, diversified investment portfolios have benefited from the tailwinds of the bond rally. A global index of government bonds, for example, has returned some 8 per cent over the past 12 months, compared with a drop of 2 per cent for the FTSE All World stock index. An index of US Treasury bonds with a maturity of more than 20 years has appreciated by more than one-fifth this year alone, with price performance enhanced by the August grab for long-dated paper.
- The financial system is thus left exposed to any abrupt rise in bond yields while having little scope for strong price appreciation, given the extreme moves that already reflect plenty of bleak growth and inflation data down the road.
- What should really worry people is how a prolonged episode of negative and lower-yielding government bonds intensifies the challenges facing bank profitability. There are also red flags fluttering over valuations for pension funds and the viability of insurers, as bond coupons shrink. Herein resides ammunition for the next episode of financial market distress, which played a major role in torpedoing the global economy in 2001 and 2008. That is the worrying long-term message of this August market shock.
- Asset class implications – Swings in sentiment expressed in the news are becoming quite sharp; they have retreated from the optimism of the IC at the end of April, when the S&P 500 made new highs, to a much more pessimistic tone in May, to another optimistic scenario now in June and to a more pessimistic now. The more dovish tenor of the Fed underscores the expected support that monetary policy could provide to the economy and markets this year. The countervailing pricing of growth and policy is a recipe for continued volatility around a muted equity market trend in the coming months. In contrast, sources of carry, like credit, make more sense on a risk adjusted basis (except if we enter a recession).
- We continue to overweight U.S. equities over the rest of the world. It seems to us that the S&P could absorb a lot of the good news on trade, if and when it occurs, as well as further interest rates cuts. Europe, Japan and emerging markets are still in the shadow of potential future trade disputes, and less margin for monetary stimulus. However we clearly prefer Europe over Japan and EM equities.
- For the reasons given before, we remain cautious on duration – prefer short duration fixed income instruments. We believe long duration can be extremely painful if the curve moves higher and steeper, as the sensitivity of longer duration fixed income assets will be extremely high. We do not want to make any fixed income duration bets when now over $16 trillion of sovereign credit is negative yielding.
- Bonds may be telling a more gloomy story than the equity markets. So who should we believe ? We would acknowledge that it is becoming harder to balance the marginally more positive tone being set by economic data and stabilizing earnings against the clear tail risks arising from trade tensions and geopolitics in general. Harder still is filtering out the more extreme expressions of optimism or pessimism that nowadays seem to accompany relatively small shifts in price action. Absent a further escalation in trade tensions (Trump cannot sacrifice his election prospects by creating a recession), the backdrop of stable, trend-like growth will eventually regain primacy. And with it, the volume of those voices suggesting a “melt up” in asset prices may well rise again. But looking beyond the fear and greed that tends to fuel sentiment, the fact is that the global economy remains in late cycle.
- Over the longer run, our base case remains that there will be some de-escalation of trade rhetoric, sufficient to calm markets.. As a result, we expect the second half of 2019 to be characterized by trend-like, but weaker growth, easy policy, muted inflation and limited near-term risk of recession. And as the 2020 election campaign draws nearer, we would also anticipate a rather more reassuring tone for the economy and markets from the administration.
- In this environment, we continue to believe that credit can perform. A diversified exposure to credit, like we have, should be maintained. We do see a better outlook for equities at the margin, with negative news already priced in equity prices, earnings revisions trending a little better and expectations for the rest of 2019 now quite achievable. Nevertheless, the level of headline risk associated with the prevailing trade rhetoric leaves us in no hurry to rush into a large equity position.
Bank of America Merrill Lynch, Global Research Highlights, August 23, 2019
Financial Times, August shock raises fears of big accident around the corner, by Michael Mackenzie, August 24, 2019
Global Reflections, by Nick Savone, Morgan Stanley, Aug. 17 & 24, 2019
JPM Multi Asset Solutions, Michael Albrecht, August 26, 2019
JPM On the minds of investors, Karen Ward, August 2019
NDR Surging Online Retail Sales Aug. 22, 2019