After a tricky first quarter, most equity markets have had a better second quarter. This has been helped by data confirming that the first-quarter weakness in US consumption was a temporary blip. US retail sales grew by over 6% year-on-year in May and unemployment fell to 3.8% – the lowest level since 1969.
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. Data as of 30 June 2018.
A strong US economy gave the Federal Reserve (Fed) the confidence to raise interest rates again in June and signal two further hikes to come this year, followed by three more next year. In contrast, after a string of disappointing data and still low core inflation, the European Central Bank (ECB) announced that interest rates will not be going up until at least the summer of next year, although they did confirm that eurozone quantitative easing would come to an end by the end of this year. At the end of last quarter, markets were convinced that the Bank of England would raise rates in May. However, May and then June came and went with no action. Nevertheless, a bounce back in UK retail sales, combined with the lowest unemployment since 1975 and surveys indicating firming wage pressure, suggest that rates will rise this year and next unless Brexit negotiations prove disruptive. Against this backdrop, government bond returns have been broadly flat other than in Italy.
Exhibit 2: Fixed income government bond local 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 30 June 2018.
Unfortunately, the recent weakness in the euro has not benefited European equities. A sharp increase in Italian government borrowing costs, in reaction to the potential risk of fiscal largesse from the new government, has left Italian equities as a notable underperformer this quarter. On the plus side, contagion to other European bond markets has been minimal. The Eurobarometer survey for March showed that support for the euro in Italy has actually risen, with only 29% in favour of leaving the euro, 61% in favour of staying and the rest unsure. As a result, we think Italian politics is unlikely to become a systemic issue for European markets but it could remain a source of volatility in the near- term.
The dollar has not just rallied against the euro this quarter but against most currencies, and this has had important implications for equity markets. Sterling’s weakness against the dollar has helped the FTSE 100 to deliver strong returns in local currency terms, as foreign revenues are repatriated. In emerging markets, a stronger dollar has often proved a headwind to equity performance and that was certainly the case this quarter. The direction of the dollar is likely to remain important for relative equity performance going forward and unfortunately is currently particularly difficult to predict, with different factors pulling the dollar in different directions. In the short-term, the outperformance of US growth and interest rates may support the dollar, but at some point ever-rising levels of government debt and a large current account deficit will likely weigh on the currency.
Exhibit 3: 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. Data as of 30 June 2018.
The trade concerns have also weighed on equity markets, with markets outside the US most affected. This has dragged on Chinese and emerging market equities. European equities have also been affected, with auto companies suffering on fears that US tariffs could be applied to car imports. The conclusion of this scuffle is hard to predict, but the longer this drags on the greater the risk that it starts to impact sentiment more broadly. In addition to trade concerns, the most vulnerable emerging markets, with large current account deficits (external funding requirements), such as Turkey and Argentina, have come under significant pressure with sharp currency and equity market falls. Further US interest rate rises or dollar strength could put additional pressure on the most vulnerable emerging market economies. However, the market has shown some ability to distinguish between the weak and the strong, with Indian equities up over the quarter.
Exhibit 4: 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 EMBIG. All indices are total return in local currency. Data as of 30 June 2018.
A notable theme this quarter has been the widening in investment grade credit spreads. With corporate leverage elevated in the US investment grade market and interest rates rising, we remain cautious on the outlook.
Overall, growth still looks healthy and corporate earnings are growing strongly, but there are a number of potential political risks to markets over the second half of the year. The strength of the US economy is also causing the Fed to gradually remove the punch bowl from the party. The US fiscal stimulus should keep growth going strong into 2019, but once the fiscal sugar rush wears off at around the same time that tighter monetary policy could start to bite, the economy could be left nursing a hangover heading into 2020. The currently healthy economy, balanced against political risks and the late stage of the US economic cycle, argues for a slightly more balanced approach to risk. As we progress deeper into the late stage of this economic cycle and get closer to the end of the party, it probably pays to dance a little closer to the cloakroom.
Exhibit 5: Index returns for June 2018 (%)
Source: MSCI, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. Data as of 30 June 2018.