Review of markets over May 2018 - J.P. Morgan Asset Management

Review of markets over May 2018

Contributors Tilmann Galler, Global Markets Insights Strategy Team

Markets were again plagued by volatility in May, largely due to heightened political risk. The US administration’s approach to global trade, North Korea and Iran remain uncertain, while Italy’s new populist government added to market concerns. Risk-off sentiment contributed to a significant rise in the value of the US dollar, which strengthened 2% vs. a basket of major currencies.

Despite the noise, the macro backdrop is still relatively supportive. The ongoing strength of global growth was evident in corporate earnings reports. Moreover, inflation remains benign, and so any interest rate normalisation looks set to be gradual. Therefore, despite significant intra-month swings, developed world equity markets rose over the month by more than 1% and broad fixed income markets were down around 1%.

Exhibit 1: Asset Class and style returns (local currency)

Source: Barclays, Bloomberg, FactSet, FTSE, MSCI, J.P. Morgan Asset Management. DM Equities: MSCI World; REITs: FTSE NAREIT All REITs; Cmdty: Bloomberg UBS Commodity Index; Global Agg: Barclays Global Aggregate; Growth: MSCI World Growth; Value: MSCI World Value; Small cap: MSCI World Small Cap. All indices are total return in local currency. Data as of 31 May 2018.

US data was strong across the board. April consumer confidence is still close to the 17-year high reached in February, and the flash manufacturing purchasing managers’ index (PMI)—the key business survey—increased in May, indicating an acceleration in the pace of activity into the second quarter. The tailwind to growth from tax reform and the energy sector should more than offset any drag to consumption caused by higher gasoline prices.

The positive effects of growth and tax cuts contributed to a strong Q1 earnings season in the US. The first quarter saw record profits, with S&P 500 earnings per share growth of 24% year on year (y/y) and revenue growth of 8% y/y. Profit margins improved to a new record of 11%, and over three quarters of companies reported better earnings than expected. US companies appear well on track to meet the 20% earnings growth expectations for this calendar year. Looking to next year, it is unclear to what extent rising wage growth and interest costs will eat into corporate margins. The market currently expects 10% earnings growth next year, which we believe is comfortably achievable.

Fears about a much more aggressive pace of tightening by the US Federal Reserve eased over the month. Although headline inflation picked up slightly, wage growth remains benign. And although the Fed is still expected to increase interest rates by a quarter of a percentage point at its June meeting, its recent communication has been on the more dovish side of expectations. The US two-year yield fell 6 basis points (bps) over the month, and despite reaching 3.1% within the month the US ten-year yield ended the month 9 bps lower than at the end of April.

European data was more mixed. The labour market still looks strong, and eurozone unemployment fell to 8.5% in April after an upward revision of March’s figure to 8.6%. This is supporting consumer confidence, which remains close to a 17-year high. However, concerns about global trade and a higher oil price appear to be weighing on corporate sentiment. The flash eurozone manufacturing PMI for May declined for a fifth consecutive month from a peak of 60.6 in December. Nevertheless, the recent level of 55.5 still corresponds to growth in excess of 2%, which is high by eurozone standards. Strong growth has translated into relatively robust, above-expectations earnings growth, in the region of 10%.

Exhibit 2: World stock market returns (local currency)

Source: FactSet, FTSE, MSCI, Standard & Poor’s, TOPIX, J.P. Morgan Asset Management. All indices are total return in local currency. Data as of 31 May 2018.

Higher oil prices helped lift eurozone headline annual consumer price inflation to 1.9% according to the flash estimate. But core inflation still remains well below the ECB target at 1.1%. The cocktail of weaker growth, subdued underlying inflation and ongoing political tensions should keep the ECB firmly in accommodative mode. We continue to believe that any policy tightening in the eurozone will not occur until at least the second half of next year. Government bond markets were driven predominantly by political developments in Italy, with a strong rally in German bunds sending the 10-year yield down from 0.56% at the beginning of the month to 0.34% at the end.

While German government yields were falling, Italian yields rose on the month as Italy struggled to form a government. The spread of the Italian 10-year government bond yield vs. that of Germany, widened above 2% for the first time since June 2017, and will likely stay elevated for the time being. At the time of writing, Five Star Movement and League are forming a government, after days of political uncertainty and market volatility following the president’s veto of their proposed finance minister (an outspoken critic of the euro). The president has now approved the formation of a government after a less eurosceptic compromise was reached on ministerial positions. It is important to remember that these populist parties have retreated from anti-euro rhetoric that was linked to them in the past, because the majority of the Italian electorate are in favour of the single currency. Tensions with its European partners may increase if Italy wants to deploy more generous fiscal policies, since government debt is already 130% of GDP. But we do not view this as a systemic risk for broader European markets.

Exhibit 3: Fixed Income sector returns (local currency)

Barclays, BofA/Merrill Lynch, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. IL: Barclays Global Inflation-Linked; Euro Treas: Barclays Euro Aggregate Government - Treasury; US Treas: Barclays US Aggregate Government - Treasury; Global IG: Barclays Global Aggregate - Corporates; US HY: BofA/Merrill Lynch US HY Constrained; Euro HY: BofA/ Merrill Lynch Euro Non-Financial HY Constrained; EM Debt: J.P. Morgan EMBIG. All indices are total return in local currency. Data as of 31 May 2018.

Exhibit 4: Fixed Income government bond returns (local currency)

Source: FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. All indices are J.P. Morgan GBIs (Government Bond Indices). All indices are total return in local currency. Data as of 31 May 2018.

The UK showed the rather puzzling combination of very strong employment data and yet relatively weak business sentiment. GDP grew by just 0.1% in the first quarter. It is unclear how much of this weakness is due to unusually cold weather in the first four months of the year. The housing market is also weakening. Home prices saw the biggest monthly price drop in eight years, with London seeing the sharpest slowdown, but this data is volatile. On a quarterly basis, aggregate house prices fell just 0.1%. As the post-referendum weakness in sterling is no longer boosting import prices, inflation is falling; the annual rate of headline CPI fell to 2.4% for April. With annual wage growth now running at 2.9%, real wages are finally rising in the UK, which may support consumer spending going forward. Weaker growth and ongoing uncertainty about the future of the Brexit negotiations kept the Bank of England on hold at its May meeting. Only two members of the Monetary Policy Committee voted for a rate hike, while seven members voted for no change.

The strength of the dollar and rising risk aversion weighed on emerging markets in May. Emerging market equities underperformed developed markets by 3.6 percentage points in local currency terms and 4.2 percentage points in US dollars. But the outlook for the emerging economies varies greatly, and investors are distinguishing between the strong and the weak.

The countries in the emerging world that are most vulnerable in this environment are those that have large external balances (most commonly oil importers) with relatively limited currency reserves. The higher interest rates needed to defend currencies will precipitate a domestic slowdown. Countries such as Argentina, Turkey, South Africa, Indonesia and, to a lesser degree, India appear most exposed on that criteria.

However, other countries have reduced their external leverage significantly and built up domestic reserves following the experience of the “taper tantrum” in 2013, and the market is showing some ability to differentiate. While the Argentine peso and Turkish lira are both down more than 15% year to date, the Malaysian ringgit and Thai baht are both up on the year and many other Asian currencies are broadly stable.

Some emerging economies will also benefit from the recent increase in the oil price, which hit USD 80/barrel for the first time since 2014 in May. The rise in the oil price reflects strong global demand, a supply reduction by OPEC, and a more cautious approach from potential suppliers in North America. All three factors have helped to reduce the supply glut that depressed oil prices in 2015/16. The decision by the US administration to withdraw from the Iran nuclear deal on 8 May sparked fears about the reduction of Iranian supply into the global market, but Saudi Arabia and Russia have since hinted that they are willing to increase supply in the near future to make up for the collapse in Venezuelan output and potential reduction from Iran. Oil prices have since retreated slightly to USD 78/barrel. Going forward, we expect further supply increases out of North America to limit the upside for oil.

Overall, the calm markets of 2017, which saw both bond and stock prices drifting gently upwards on a monthly basis, seem firmly behind us. Geopolitical risk is likely to continue to be felt most keenly in currency markets. We continue to believe that over the long term a combination of a large trade deficit and rising government debt should weigh on the value of the dollar. But in the near term, geopolitical risk is likely to coincide with dollar strength.

Looking through the noise, we still expect a benign growth environment—characterised by above-trend growth, relatively low inflation and accommodative global monetary policy—to be supportive for earnings growth and equity markets. But a more unpredictable US administration and the re-emergence of political risk in Europe serve for caution in the degree of risk taken at this stage in the cycle.

Exhibit 5: Index returns in May (%)

Source: MSCI, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. Data as of 31 May 2018.

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