For much of this year, equity markets have enjoyed a healthy climb, assisted by a dovish tilt from central banks, as well as the possibility of a trade deal between the US and China. As we entered May, the S&P 500 was at an all-time high. However, just six days into the month, investors were tested by the announcement that the US would be moving ahead with tariff increases on US imports from China. Equity markets performed poorly over the month, with Asia ex-Japan, emerging markets and the S&P 500 all losing more than 6%. US Treasury yields fell, with markets now pricing in more than 3 Federal Reserve (Fed) rate cuts by the end of 2020, and so US Treasuries returned a positive 2.4% over the month.
Exhibit 1: Asset class and style returns in 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. Past performance is not a reliable indicator of current and future results. Data as of 31 May 2019.
Trade negotiations between the US and China broke down, but the impact so far has been felt more in equity markets than the economy. From 10 May, the US increased the tariff rate on USD 200 billion worth of Chinese imports from 10% to 25%, and announced that it may impose a 25% tariff on the remaining USD 300 billion worth of Chinese imports. This led to China retaliating by increasing the tariff range from 5-10% to 5-25% on USD 60 billion worth of imports from the US.
Rising import tariffs could affect the US economy as well as China. In the US, inflation could rise, and growth for 2019 is likely to be lower as a result. The worry from here will be that capex intentions fall further due to ongoing trade uncertainty, which could begin to filter through into job losses and falling consumer confidence. The flash numbers for the US manufacturing purchasing managers’ index (PMI) fell in May. The headline index fell 2 points to 50.6, while the new orders component fell below 50, into contractionary territory, for the first time since 2009. US consumer confidence is holding up for now, though, with May’s reading rising to a very healthy 134.1 from 129.2 last month.
April’s headline personal consumption expenditure index (PCE), the Fed’s preferred measure of inflation, was just 1.5% year on year (y/y). In the minutes of the 1 May Federal Open Market Committee meeting, policymakers concluded that the current inflation shortfall is transitory, suggesting the Fed is comfortable with rates being on hold rather than delivering the cuts that markets are currently pricing in. However, recent comments from vice chair Richard Clarida suggest the Fed would be willing to cut rates if the data indicated a material deterioration in the economic outlook.
While it is good news for corporates with higher levels of borrowing that rates remain on hold, the subdued level of inflation due to limited pricing power is a possible cause for concern. May’s US jobs report saw the unemployment rate fall to 3.6% and wages growing at 3.4% y/y. The prospect of rising costs through higher wages, combined with limited revenue growth due to the slowdown in global growth and subdued inflation, had led analysts to forecast that US earnings for the first quarter would fall by around 3% vs a year ago. Reporting season concluded with no earnings growth over the same quarter last year for S&P 500 companies—better than the expectations for negative growth, but much weaker than the over 20% earnings growth seen last year.
Exhibit 2: World stock market returns in local currency
Source: FactSet, FTSE, MSCI, Standard & Poor’s, TOPIX, J.P. Morgan Asset Management. All indices are total return in local currency. Past performance is not a reliable indicator of current and future results. Data as of 31 May 2019.
The re-emergence of trade tensions is likely to have economic and policy implications for China. The failure to agree a trade deal with the US increases the risks to the growth outlook. With the introduction of further tariffs, the renminbi fell against the US dollar by 2.5% in May, which could offset some of the impact of the tariffs on exports to the US. However, the tariffs introduced so far could drag on China’s GDP growth by around 0.8% points across this year and next. Of course, these estimates could worsen in the event of further tariffs on the remainder of the exports to the US, or they could improve if a further policy response is delivered by the Chinese authorities.
So far, the policy response to the slowdown in Chinese growth has been significant but measured. May saw reserve requirement ratio cuts, albeit on a smaller scale than those made earlier this year, amounting to roughly 20 basis points. The announced tax cuts on personal and corporate incomes also show the appetite from the authorities to help stabilise growth. While, more recently, it looked like these stimulus measures were beginning to take hold, the latest data was much weaker than expected. Retail sales and industrial production (IP) data was particularly weak, with IP falling to 5.4% year on year in April, from 8.5% the month before. There were some distortions in these releases due to the Lunar New Year, but the weaker data does mean that, against a backdrop of increased trade tensions, the authorities are likely to continue to increase stimulus measures. The extent of the stimulus delivered will, of course, be important for the Chinese economy, but also for broader emerging markets and Europe.
Elsewhere in the emerging world, India saw the conclusion of its six-week long general election, with Narendra Modi’s Bharatiya Janata Party (BJP) winning an absolute majority in the lower house. This provides some clarity on the policy outlook, and focus will now shift to unlocking the potential for long-term growth in India, which will be one of the key challenges and priorities for the BJP.
Exhibit 3: Fixed income sector returns in local currency
Source: 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. Past performance is not a reliable indicator of current and future results. Data as of 31 May 2019.
Eurozone data in May was somewhat mixed. The flash manufacturing PMI fell to 47.7, indicating contraction, while the employment component also dipped below 50. There were some positive signs in the data, though. The new export orders component, while still below 50, did tick higher, and eurozone consumer confidence picked up in May to its highest level this year. The initial estimate for Q1 GDP also beat expectations, with annualised growth of 1.6% over the last quarter.
The concern in Europe, much like the US, is that trade uncertainty filters through to the labour market and starts to hurt the service sector, which has so far proved more resilient. The latest employment growth numbers in Europe have been solid, though. The first estimates of employment growth for Q1 show a pickup to 1.4% quarter on quarter, annualised.
Stimulus in China could help Europe in the second half of this year, and another positive factor for the region is that the US has put the discussion over global auto tariffs on hold for up to six months. Europe ex UK equities fell by 4.8% over the month.
The European Parliament elections, which took place from 22 to 26 May, yielded a generally positive result for the European project. Populist or eurosceptic parties gained seats compared to the last election in 2014, but they underperformed expectations. The centrist parties of the EPP and S&D remain the largest two parties in parliament despite losing their combined majority. For now, the results are more likely to have bigger implications at the national level, particularly in Italy, Greece and the UK.
Exhibit 4: Fixed income government bond returns in 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. Past performance is not a reliable indicator of current and future results. Data as of 31 May 2019.
The votes from the European Parliament election, together with recent polling, make it clear that the UK population remains just as divided on Brexit as it was during the referendum in 2016, with neither the leave nor the remain camps gaining any significant ground. The prime minister, Theresa May, announced that she is stepping down on 7 June as the factions in parliament refused to back her deal. The market interpreted the news as increasing the likelihood of either a hardline Conservative Brexiteer leading the UK towards a “no deal” exit from the European Union (EU), or a general election that could pave the way for a potentially less market-friendly Labour government. Despite the increased market concerns over a no-deal Brexit, we don’t think the likelihood of no-deal has increased given there still isn’t a majority for it in parliament, in the UK population (not everyone who wants to leave wants to leave without a deal) or in the EU. Sterling fell 3.3% vs the US dollar over the month and the FTSE 100 outperformed the FTSE 250.Conclusion
The calm market environment was disturbed in May, with politics again taking centre stage. Investors will be watching how trade negotiations develop, with a close eye on the G20 summit at the end of June. Beyond politics, we should remember to focus on the economic fundamentals. China is aiming to steady the ship with its stimulus, and success here could provide a tailwind for growth elsewhere in the world.
It is unlikely that valuation expansion will continue to drive markets as it did in the first quarter. The outlook for growth and earnings is hence crucial for the direction of markets over the rest of the year. May’s uncertainty has reminded investors that there are two-way risks to growth and markets from here. That outlook argues for a balanced portfolio that builds in some protection, including government bonds in markets where there is room for rates to be cut, value and quality stocks, as well alternatives with low correlations to risk assets.
Exhibit 5: Index returns in May 2019 (%)
Source: MSCI, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Data as of 31 May 2019.