Having already passed the halfway mark in 2019, this is perhaps an apt time to take stock of some of the key trends in the global markets and what this means for the rest of the year. Market behavior and psychology was to a large extent dictated by central bank action as well as the unfolding US-China trade war. While these macro developments are not new, they still haven’t run their course and in our minds are likely to continue to play an outsized role in shaping market dynamics going forward.
Against this backdrop, we will initiate this note with a “top-down” view of the global economy and then move on to look at the performance of the major asset classes over the first half of this year. The final part of the report will provide a guide in terms of some of the potential themes to watch as we move through the remainder of this year.
1. H1 2019 marked a worsening of the global macro backdrop…
Global markets have had a lot to contend with during the first half of 2019. Of particular note has been the slowdown in world growth. Indeed, global growth momentum continued to slow through the first half of this year, while at the same time most of the major economies have progressed towards more advanced stages of the business cycle. Additionally, the synchronized deceleration in global industrial production continued unabated, with the share of major countries with expanding manufacturing orders dropping below 50% for the first time since 2015 (see Chart 1). Global trade growth, meanwhile, also moved into recession territory, weighed down by both the manufacturing slowdown and trade policy friction, particularly between the US and China.
Against this backdrop, our sense is that global economic momentum has peaked and could yet take a leg lower. That said, we think that recent talk of an outright recession is wide of the mark. For one thing, policymakers across both developed and emerging economies have signaled an easing bias and this could serve to backstop global growth for the time being at least. Separately, the current slowdown of the global economy is largely confined to the manufacturing sector, while the services sector of the economy, particularly in the US, has held up much better. This is, in part, thanks to the fact that the labor markets in countries, such as the US, have continued to be resilient which has helped to cushion consumer spending – a mainstay of such economies. Going forward, a key concern is the extent to which the industrial slowdown and rising tide of protectionism at the global level could spill over on to the services/consumer side of the economy – a development which would certainly make the policy response on the part of the authorities that much more difficult.
2. But markets continued to eke out positive returns
Investors began 2019 cheering the global rally in risk assets that followed a dramatic late-2018 market plunge. The tough fourth quarter caused the Fed to stop raising rates despite a strong US economy, aligning the Fed more closely with other major central banks that are keeping rates low. However, as 2019 progressed the markets turned more volatile in the face of a more fragmented economic environment with multiple pain points:
- Investors – who are known to cherish certainty and policy predictability – found themselves caught up in the disruptive fire of the US-China trade war, which is turning into “tech cold war” that threatens to disrupt global supply chains.
- Europe is still vulnerable to Brexit uncertainty and, with established leaders such as Mario Draghi of the ECB and Germany’s Angela Merkel on the way out, this may slow critical decisions within the bloc.
- The US has continued on the late-cycle path with growth easing back to around 2% and expectations growing of a recession in 2020. Indeed, these fears have grown with the recent inversion of the yield curve, which has in the past served as a reliable signal of an impending recession.
Despite these growing headwinds, markets – both equity and fixed income – recorded positive performance in the first half of this year as outlined in Chart 2 below. Of particular note here is the fact that developed market equities, on the whole, outperformed their emerging markets peers by a fairly comfortable margin over this period. Meanwhile, within the fixed income space, despite worries over high valuations, returns were pretty respectable at around 7% on average.
The fact that both the equity and fixed income markets (particularly government bonds) rose in tandem during the first half of this year is rather unusual, but there are two differing explanations for this phenomenon:
- The equity markets have taken the view that with central banks willing to come to the rescue of their respective economies, this will help to insulate slowing economies and thereby boost the prospects of the corporate sector.
- Conversely, the sovereign fixed income markets have interpreted the recent economic slowdown as being more durable in nature. This, coupled with muted inflationary pressures, will according to this viewpoint likely keep the monetary authorities in a prolonged easing bias, thereby increasing the appeal of safe-haven assets such as US Treasuries.
While the jury is still out in terms of which of these two schools of thoughts will ultimately prove to be correct, the key point to note is that uncertainty going into the second half of this year has ratcheted up somewhat and this will in our view provide the basis for greater market volatility during the remainder of 2019.
3. Key investment themes ahead
Notwithstanding the broad-based nature of the market rally outlined above – which has been dubbed the “everything rally” – its sustainability as alluded to above remains in question. To this end, we are of the view that following themes or considerations will be of key importance going forward.
a) Fed policy action
An accommodative Fed has been central to the upward trajectory in risk asset during the first half of this year. As such, all eyes will be on it and other major central banks in terms of their policy actions and how markets respond to them going forward. Our sense is that the Fed – which cut rates at its July meeting – will do so again at least once more this year in order to keep the markets on-side and to avoid unwanted tightening in financial conditions.
- Interest rates now seem likely to remain “lower for longer”. With markets already pricing several rate cuts, investors expect continued low returns for traditional bonds, though they are likely to prove to be an attractive option if recession risks continue to rise.
- Contrary to expectations, the US dollar continued to rise during the first half of this year despite the Fed signaling an easing bias. While a further strengthening of the US dollar cannot be ruled out, we believe that it may peak in value during the remainder of this year. Such a scenario would offer further relief to emerging market assets in particular.
b) US/China trade war
Amid the heightened trade tensions between the US and China, Trump has not just resorted to the imposition of tariffs on Chinese goods but has also singled out leading Chinese companies, such as Huawei, for engaging in “intellectual property theft” and other such unfair trading practices. Such action could run the risk of upending global supply chains if countries are forced to choose between Chinese and American tech ecosystems while the two countries vie for leadership in big data and artificial intelligence.
- The “tech cold war” could undo the globalized low-cost, high margin supply chains of many US and Asian tech companies.
- With large American tech firms already under fire for privacy issues, new US-China tensions could cause their valuations and expected returns to decline.
- Cybersecurity and defense stocks may benefit from rising geopolitical hostilities.
c) Earnings concerns
With concerns over the health of the global economy at the front and center of investors’ minds, the question doing the rounds is to what extent this will impact corporate profitability. Here the point to note is that the earnings growth of S&P 500 companies declined by some 0.2% in Q1 of this year according to data from FactSet. If a negative reading is confirmed for Q2 as well, it could mark the onset of an “earnings recession” that could drag on for a while longer given the increasingly parlous state of the global economy and the strength of the US dollar, both which could stand to impact large companies in particular thanks to their international orientation.
- In light of the anticipated slowdown in corporate profitability, investors may be more minded to shun so-called “cyclical sectors”, such as industrials and materials that are deemed to be sensitive to the economic cycle, in favor of those that are more “defensive” in nature e.g. the pharmaceutical and utilities sectors.
d) Gold & other safe-haven assets likely to be in the ascendency
With global central banks, in the quest to cut rates, embarking on a “race to the bottom” and geopolitical tensions on the rise, risk aversion has been the order of the day so far this year. As such, gold and other safe-haven asset have been bid-up and this is set to continue in the second half in our minds.
- Gold’s rise will not just be underpinned by investors demand the yellow metal as global uncertainty rises, but will also be supported by global central bank purchases of the commodity. Indeed, this already appears to be happening with the likes of the Chinese and Russia central banks stepping up their purchases of the metal in order to diversify their foreign exchange reserves away from the US dollar.
- As investors continue to pile into so-called safe-haven assets, such as US treasuries, this will further depress global bond yields and will add to the value of negative-yielding global bonds which have already topped the US$15bn mark (~30% of the global bond market).
4. Taking stock/concluding thoughts
Global markets notched up a pretty impressive performance in the first half of this year, led by the equity markets. Notwithstanding the slowdown of the global economy and the intensifying US/China trade war, we expected this positive performance to continue in the second half as central banks step up to the plate with further stimulus. That said, in an environment of macro uncertainty and ongoing trade tensions, we think that safe-haven assets, such as government bonds and gold, will outperform equities in the second half of this year.
Source from: MERatings