J.P. Morgan Asset Management is pleased to present the latest edition of Quarterly Perspectives. This piece highlights key themes from our Guide to the Markets, providing timely economic and investment insights.
THIS QUARTER’S THEMES
1. Global economy glides into protectionist turbulence
In 2Q 2019, we compared the global economy to a hang glider. The flying conditions entering 2019 were improving and ultimately delivered impressive returns across asset classes in the earlier part of the year. However, this glider hit some rough air in May, after the U.S. raised tariffs from 10% to 25% on USD 200billion of Chinese exports. This could delay a much needed recovery in exports and corporate investment plans. The good news is that central banks around the world are refocusing their policies to support growth. Overall, we expect a more challenging investment environment entering H2 2019. Building resilience with income-generating assets could help cushion Asian investors as they ride out this turbulence.
- Corporate investment sentiment weighed down by trade policy uncertainties.
Trade war clouds are gathering again
- Investor and corporate sentiment were slowly recovering in early 2019, aided by less hawkish central banks and the prospect of a U.S.-China trade agreement. Still, nothing was ever certain. U.S. President Donald Trump’s unexpected change in stance on Chinese export tariffs in early May shook market confidence. The U.S. also increased scrutiny of Chinese technology companies on national security grounds.
- We expect Beijing and Washington to eventually reach an agreement. Beijing wants to settle this dispute. Meanwhile, President Trump needs the U.S. economy to be in good shape entering the 2020 presidential election. Given the twists and turns in the past 18 months, however, an agreement may not deliver a swift recovery in corporate sentiment.
- Asia recovery delayed by trade tensions and weak electronics demand.
Slow export recovery, but room for new winners
- Asian exports have been slow to recover this year, and rising trade tensions will likely hinder the recovery. This is particularly challenging for Northeast Asian markets, such as Taiwan and South Korea, which are facing weak demand for consumer electronics alongside heightened trade tensions.
- However, as multinational companies re-strategize their production capacity within Asia, countries in South and Southeast Asia, such as India, Indonesia, Thailand and Vietnam, could potentially benefit. The passing of the election cycle in several of these economies means reduced political uncertainty, helping businesses to make long-term decisions.
- Have investors led the Fed in expecting rate cuts?
Central bank doves providing some lift
- Parallels can be drawn to 2018’s rise in trade tensions, but today’s escalation is accompanied by more accommodative central bank policies globally. The U.S. Federal Reserve (Fed) could opt for loosening later in the year. This has helped push U.S. Treasury yields and corporate borrowing rates lower. Investors seeking yield need to consider riskier parts of the fixed income market.
- The People’s Bank of China has reduced reserve requirements several times over the past year. Yet, it is mindful of flooding the economy with liquidity, for fear of starting another debt-fueled boom. Nonetheless, we expect China to remain supportive of economic growth, particularly via infrastructure spending.
Global growth is around trend but threat of deceleration looms.
Global economy stuck in a range?
- The risk of a recession in the U.S. is kept in check by low rates and a strong household balance sheet. A further rise in protectionism is a threat, but given the coming U.S. election cycle, we believe maintaining growth momentum will be a priority. Meanwhile, China will do what it can to stay within its growth target.
- That said, few upside surprises are expected for global growth. In Europe and Japan, room for a fiscal or monetary boost is limited. Tight labor markets in a number of economies could also limit growth. Overall, we see global growth constrained within a range around its long-term average.
2. Trade wars have no good outcomes
The past few months reminded investors that the U.S.’s turn toward protectionism is not just a one-country dynamic nor a hurdle that markets will be able to clear easily. Resumption of trade talks between the U.S. and China does not guarantee sustained peace even if an agreement is reached. These two economic heavyweights—the U.S. and China combined represent over 40% of world gross domestic product—have moved beyond standard tools, such as tariffs, to more narrowly targeting the economic practices of specific businesses. There is no easy path to resolving any of the current U.S.-led trade disputes. Investors need to think through how prolonged tensions in the global trading system could affect their portfolios.
- The most significant changes to U.S. trade policy have involved China.
It’s not all about China, but it’s still about China
- U.S. trade actions so far have covered a wide array of countries (including China, India and Mexico), as well as specific products (such as steel, aluminum and washing machines). Each of these actions could have a cooling effect on world trade, but the most significant front in this trade war is the U.S.-China conflict.
- Given the size of these economies, the depth of their economic relationship and a dramatic negotiation process, investor sentiment has been buffeted by every twist and turn in the trade conflict between the U.S. and China. Thus far, the U.S. has applied 25% tariffs on about half of the goods it imports from China, and threat to extend tariff to the remaining Chinese exports are on hold for now. China has responded by placing tariffs ranging from 5% to 25% on all of its imports from the U.S.
- These tariffs, plus additional tariffs against other trading partners, have the potential to move the U.S.’s effective tariff rate to a level higher than that of most emerging economies. Perhaps more importantly, non-tariff barriers to trade—like banning U.S. companies from exporting to certain foreign companies—are also on the rise. These barriers are likely to outlast any trade deal, suggesting those trying to appropriately price expectations for a resolution to trade tensions need to consider more than the tariff rates charged by the U.S.
- Uncertainty has damaging effects on its own.
Will a resolution to trade tensions prompt a market rally?
- While the U.S. is not a particularly open economy, companies headquartered there operate globally, and American consumers—whose spending underpins a significant portion of global economic activity—purchase goods largely manufactured elsewhere. Therefore, the rising costs associated with a more protectionist U.S. impact both domestic companies’ profits and inflation. Year-over-year growth in costs will look less dramatic as these tariffs remain in place, but higher costs will cut the purchasing power of consumers and squeeze business profit margins, just as the U.S. enters a period of milder growth.
- In some ways, whether or not threatened tariffs go into effect, or are subsequently repealed, does not matter. The uncertainty around trade is already impacting business decisions and keeping investor anxiety high.
- Trade sustains global economic growth.
Global trade matters for everyone
- Trade involves goods going both ways; the direction of exports and sources of imports differ country to country, building a complex web of economic links. This is why growth in global trade is one of the most important economic indicators for investors to watch. As the U.S. has turned sharply more protectionist, this indicator has slowed as well.
3. It pays to be prepared
The global growth outlook has become more challenging entering H2 2019. U.S. tariff policy is threatening more trade partners, raising business uncertainty and a reluctance to roll out capital expenditure. Economic forecasts are being revised lower, reflecting a decline in confidence that the U.S. Federal Reserve will lead the way in more accommodative policy or that Chinese stimulus will cause an acceleration in global growth. A dreaded recession is not looming, but investors should continue to protect themselves in the face of the latest round of bad news by boosting the resilience of their portfolios.
- Allocating to fixed income helps balance riskier assets in portfolios.
Searching for protection
- As often stated, the current economic expansion in the U.S. is close to being the longest on record. Timing the end has typically proven futile, but preparing for it has met with greater success.
- Geopolitical effects on the market are usually temporary and the escalating trade tensions may or may not be the event that ends this expansion. However, with trouble brewing around the world and expectations of the next downturn building, investors are likely to benefit from having some less risky assets in their portfolios.
- In our view, central bank policy can help reduce the odds of an economic slowdown. However, market sentiment toward risk assets could remain cautious. Fixed income may be able to help investors reduce volatility while generating income.
- The U.S. rate cycle has likely peaked.
Pondering rate cuts
- Bond prices have risen and yields have fallen on growth concerns. While valuations are challenging, bonds are not unattractive, as U.S. rates appear to have peaked for this cycle and yields could drop even further. The market has already priced in rate cuts by the Fed. We expect the Fed will be reluctant to move against this narrative to avoid disappointing markets on the back of multiple growth worries. Aversion to risky assets will likely continue until we get definitive signs of a formal trade agreement.
- With the potential for yields to move lower, high yield and emerging market bonds still look attractive given the renewed hunt for yield. Despite mixed economic numbers, we do not think growth will be so poor as to drive up default rates significantly.
- Gold isn’t cheap, but benefits from falling real yields.
Consider other asset classes
- Investor concerns about the end of the economic cycle raise the question of other diversification tools. Gold theoretically performs well in a falling rate environment with uncertain growth prospects since it is considered a counter-cyclical investment and is not dependent on interest rates. This has previously worked against it during the hiking cycle, but the rate story has shifted. We are now looking at a late cycle with growth uncertainty and rising expectations of rate cuts.
- Gold prices are still above historical averages. Nevertheless, gold’s correlation with most other asset classes is low and performance during times of equity peak-to-trough periods has been positive on average. These factors make gold attractive as late cycle concerns rise.
- Not only does gold tend to perform well in the late cycle, it could also outperform in the more pessimistic scenario of escalating trade tensions, where low growth would lead to more rate cuts. Gold may be a useful hedge in the event of an extreme market downturn.
4. Equities stumbling over a trade blockade
In 1Q 2019, equities were in a state of grace, boosted by stimulus measures from China, a moderation in the tightening intentions of central banks, hopes of resolution to the China-U.S. trade dispute and better-than-feared corporate earnings. However, an increasingly sour trade narrative, rising political disparity and a fragmented economic growth outlook resulted in a fall from grace for global equity markets. A near-term recession remains a low probability but the weight of pessimism on markets and retrenchment in corporate spending means a defensive hue should be applied to equity allocations, with a focus on quality and income.
- Valuations are back to long-run averages globally.
Fall from grace
- The surge in equities globally earlier this year outpaced both the economic and corporate earnings outlooks. The rise was driven predominately by the rebound in valuations and a re-rating in price-to-earnings multiples after 2018’s heavy losses.
- Markets moved to price in a rebound in economic growth, but the global economy has struggled to free itself from political quagmire and business surveys signal a very low level of corporate activity.
- Valuations have returned to long-run averages as markets have lost some of the gains. The prospects for rate cuts by central banks lower the discount rates applied in valuation metrics, which means equity multiples can remain higher than perhaps the economic landscape would suggest.
- Trade worries could weigh on an already subdued earnings outlook.
Back to reality
- The reality is both corporate profits and economic growth have long been expected to slow in late 2019. This deceleration is reflected in lower earnings expectations and more modest expectations for market returns. The outlook for returns from risk assets has become more muted but this is not the same as a return to last year’s extreme pessimism.
- While the corporate world may be struggling with uncertainty around earnings, rising levels of consumer confidence provide a counterbalance, strengthening the economic outlook. With little to signal an imminent recession, we believe it is premature to shift outright to a defensive position in equities. However, striking a better balance between income and capital appreciation may allow investors to buffer volatility on the downside, yet still participate on the upside.
- In automotive terms, more torque means faster acceleration. As the global economy downshifts late into the economic cycle, it is emerging markets that have more torque. Emerging economies routinely contribute more than half of global economic growth.
- This stronger growth profile is due in part to more favorable demographics, but, more importantly, to faster rates of technological adoption. This results in a sustained process of economic catch-up to more advanced markets.
- These deeper structural issues produce the secular themes for investing in emerging markets (technology, health care, education) that can withstand the shorter-term fluctuations in market performance.
- EM equities are more volatile; a longer investment horizon can help.
A hat for every occasion
- Swings in emerging equities are not unusual for this inherently volatile section of the global stock market. But long-term investors shouldn’t be deterred.
- “Emerging markets” fails to capture the individual characteristics of each economy referenced under this umbrella term. The current trade narrative is a case in point, weighing more heavily on those economies embedded in the global supply chain. However, the substitution effect as multinational companies reorganize supply chains and re-route production could benefit those markets less affected by the current shift to protectionist policies.
- While emerging equities may struggle to outperform given investor pessimism, near-term concerns are unlikely to outweigh the longer-term portfolio growth advantages of emerging equities or the regional diversification benefits.
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