Market Insights: Review of markets over the first quarter 2016 - J.P. Morgan Asset Management
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Market Insights: Review of markets over the first quarter 2016

Contributors Michael J. Bell, Global Markets Insights Strategy Team

Last year’s volatile market ride has continued in the first quarter of this year. Equity markets in the US and UK are now close to where they started the year, with Europe slightly down. But that comes after much fretting over global growth, China and the fall in the oil price in January and February. These fears started to ebb in the latter part of the quarter, when we also saw more stimulus from the ECB and dovish noises from Federal Reserve (Fed) chair Janet Yellen. This has all helped to restore some composure to markets.

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

 

Source: Barclays, Bloomberg, FactSet, FTSE, MSCI, J.P. Morgan Asset Management. 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 March 2016.

The start of the year was plagued by concerns that the US might be heading into recession, as the trend in initial US jobless claims edged upwards. Historically, initial jobless claims have tended to trough several months before the unemployment rate starts to rise. This triggered fears that the steady fall in the unemployment rate that has supported the recovery could be coming to an end, dragging stocks down.

However, initial jobless claims are more volatile than the unemployment rate and can give false warning signs. Since February, the trend in initial jobless claims has in fact improved again, calming market fears about the US labour market and adding to positive news from the household labour force survey and strong job openings data. We expect unemployment to keep falling for the time being.

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 March 2016.

Another source of concern at the start of the year was the continued weakness in US manufacturing, with the Institute for Supply Management (ISM) manufacturing survey signalling contraction since the latter part of 2015 and industrial production actually contracting. Recently, however, the new orders component of the ISM manufacturing survey has bounced back into positive territory and regional manufacturing surveys have also shown some signs of improvement.

Manufacturing only accounts for 14% of US GDP and, importantly, the non-manufacturing new orders component of the ISM survey continues to indicate expansion in the much larger services sector. However, it would be unwise to dismiss manufacturing weakness entirely, given that manufacturing has sometimes offered early warning of trouble in the broader economy. Although still positive, service sector growth has been slowing recently, and it will be important to monitor this closely in the months ahead.

We saw a similar divergence between manufacturing and services surveys in 2012, when manufacturing eventually rebounded rather than dragging services down with it. History could be repeating itself. As then, manufacturing production excluding metals and machinery continues to expand. This is important because contractions in metals and machinery manufacturing have happened historically without causing a recession, whereas contractions in the whole manufacturing industry have tended to coincide with recessions.

Exhibit 3: Fixed income sector returns

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 EMBI+. All indices are total return in local currency. Data as of 31 March 2016.

In March, as a result of this uncertainty around the outlook for the US economy, the Fed lowered its median projected expectation for the pace of further rate rises, following its December increase. Instead of four more 0.25% increases this year, the dot plot now suggests only two, in line with our expectations.

Core CPI inflation in the US is now above 2% year on year (y/y) and the Fed’s preferred core PCE inflation measure has also picked up sharply to 1.7%. Despite rising inflation and a low unemployment rate, Yellen continues to emphasise the need for a cautious and gradual pace of policy tightening. That is because the Fed’s “ability to use conventional monetary policy to respond to economic disturbances is asymmetric".1 . Put simply, policymakers are more worried about tightening too fast than too slowly, because if they make a mistake, they have much more room to raise rates than to cut them.

Over in Europe, the European Central Bank (ECB) delivered a significant easing package in March to bolster its chances of raising inflation back to target and support the recovery. In addition to increasing the amount the ECB will purchase by EUR 20 billion per month, ECB president Mario Draghi also announced that the central bank will buy non-financial investment grade corporate bonds. This could have a significant effect on corporate bond prices in the eurozone and make it cheaper for companies to raise money in the market, at the margin.

Potentially even more significant was the ECB’s new scheme for encouraging bank lending directly. Banks that can show they have increased their private non-mortgage lending will be able to borrow at negative interest rates—in effect, the central bank will be paying them to lend money out to the broader economy. This echoes previous efforts to stimulate lending directly in the UK, and could mark a bold shift in European monetary policy. Taken together, these measures should help support the eurozone economic recovery.

The unemployment rate has been falling steadily in Europe, and purchasing managers’ indices remain consistent with steady if not spectacular growth. However, consumer confidence has been falling since the beginning of the year. This, coupled with signs of slower service sector activity, would be cause for concern if the data continued to weaken. It will also need careful monitoring

Exhibit 4: Fixed income government bond returns

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 March 2016.

In China, the latest data continues to show the economy transitioning away from manufacturing and towards services and consumption. The rate of economic growth is slowing gradually, but the economy is not collapsing. Industrial production growth has slowed to 5.4% y/y and retail sales continue to grow rapidly at over 10% y/y. The reality is probably that China is growing at a slightly less spectacular pace than previously. That does not make for exciting headlines, but it is very different from a much talked-about “hard landing”. The recent rapid growth in Chinese money supply suggests that Chinese growth is unlikely to collapse in the near future and could even surprise to the upside in the short term.

Overall, we continue to expect moderate positive growth from both the US and Europe, and growth in China in the region of 5-6%. We do not think there is a higher than 30% chance of recession in 2016. However, the risk is greater than it was in 2015 and there will be a rising probability of a recession over the next few years as this economic cycle gradually approaches maturity.

Exhibit 5: Total returns from markets in March (%)

Source: MSCI, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management; data as of 31 March 2016.

Brexit and beyond

With the referendum looming in June, it is difficult for UK investors to focus on much beside Brexit risk at the moment. What can we helpfully say about the risk of Britain leaving the European Union (EU)?

First, the bookies and punters don’t think the UK is going to vote to leave: the current implied probability from betting markets of the UK leaving is only about 35%.

Second, we estimate that if the UK did vote to leave, UK growth could be reduced by as much as half over the coming few years. Rather than growing at about 2% a year the UK would probably only manage about 1% growth for a few years, as uncertainty around the eventual outcome of negotiations about the UK’s future relationship with the EU discouraged or delayed investment and trade. Other things equal, this would mean interest rates would go up less quickly than otherwise, because the economy would be weaker. Sterling would fall, perhaps quite significantly, and the Bank of England would have to take this into account in its deliberations. But on balance we think UK policymakers would be likely to look through the one-off upward impact on inflation caused by the weaker currency.

Third, it is safe to assume that the uncertainty around the upcoming vote is causing some investors, both domestic and international, to wait until the result is known before buying any additional UK equities. That suggests a vote to remain in the EU could provide some welcome certainty and bring some money that is currently waiting on the sidelines into the market, particularly given that the dividend yield on UK equities is attractive in an international context, at over 4%.

If the bookies turn out to be right that the UK will stay in the EU, any UK equity market pullbacks prior to the result could prove, in retrospect, to have been attractive entry points for investors.

Exhibit 6: Difference in polls between remaining and leaving

Source: Essex Continuous Monitoring Survey, What UK Thinks, YouGov, J.P. Morgan Asset Management. Essex Continuous Monitoring Survey data: 2004 to January 2015, YouGov data: February 2015 to August 2015, average polls from YouGov, ICM, Survation and ComRes: September 2015 to February 2016.

1 The outlook, uncertainty, and monetary policy, Janet Yellen, Economic Club of New York, 29 March 2016

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