Stock prices climbed across regions for the second consecutive month in February. Investor sentiment was buoyed by a combination of constructive US-China trade talks, a considerably more dovish stance from the US Federal Reserve and the implementation of Chinese stimulus measures.
US-China trade negotiations dominated the market’s attention. Areas of contention include tariffs, intellectual property and Chinese state-led subsidies for the technology sector. Although there was not a complete resolution on all of these aspects, there was enough progress in the negotiations to avert the increase in tariffs that was scheduled for 1 March. The ‘America First’ trade agenda remains a source of uncertainty for markets, not least because, following a report from the Department for Commerce, the US president has 90 days to evaluate whether to introduce higher tariffs on foreign-made cars. Such a decision could have a notable impact on Europe, and Germany in particular.
While the market is buoyed by the promise of Chinese stimulus, current economic data releases remain soft outside of the US. The downturn in capital expenditure (capex) is depressing industrial activity. As yet, consumer spending is looking more robust thanks to strong labour markets and the recent fall in the oil price.
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 28 February 2019
The partial government shutdown ended at the end of January as President Trump signed a bill funding the federal government through to the end of September. This did not include required funding for a wall on the border with Mexico, so the president declared a state of emergency to unlock funds.
Economic growth in the US remains on firm footing. The delayed release of fourth quarter GDP showed that growth had moderated from 3.4% quarter on quarter annualised in the third quarter, to a still above-trend 2.6% in the final quarter of 2018.
The shutdown had served to depress both household and corporate sentiment in January, but there were signs of a bounce back in February. The latest US composite purchasing managers’ index (PMI) improved to 55.8, which points to an ongoing robust rate of growth in the US economy of around 2%. However, the December retail sales report was very disappointing, registering a 1.2% monthly decline. It seems likely there were some distortions to this number given retail store earnings were more robust over this period. Inflation remains relatively muted. January core inflation was flat and headline inflation fell to 1.6% year on year.
The minutes of the January Federal Open Market Committee meeting confirmed the dovish shift in thinking at the Federal Reserve (the Fed), with “patience” remaining the operative word. The minutes of the meeting expanded on the Fed’s decision to maintain a larger balance sheet and therefore to end the process of quantitative tightening by the end of the year. This move has helped to push down longer-term bond yields. Over the past two months, when both equity and oil prices have bounced, the 10-year Treasury yield has barely moved.
Signs of weakening momentum persisted in Europe. The second estimate of quarterly growth in the fourth quarter remained at 0.2%, but growth in France was better than expected. By contrast, the German economy did not manage to grow at all in the final three months of 2018. The flash eurozone composite PMI improved to 51.4, but the manufacturing index fell below 50, indicating an outright contraction in manufacturing activity. Not all surveys of activity were as disappointing. Consumer confidence increased for the second month in a row and there are signs of a significant improvement in car registrations, which suggests the auto industry is beginning to adjust to the new auto emissions regime.
European Central Bank (ECB) chief economist Peter Praet warned that the slowdown in the eurozone had been “broader and more persistent”, and advised that the ECB will discuss the need for new liquidity instruments to assist the banks-through the use of targeted longer-term refinancing obligations (TLTROs)-at its March meeting.
The European political landscape continues to hinder appetite for European assets. The focus is now on Spain after the prime minister, Pedro Sanchez, announced snap elections having failed to secure support for a new budget. In Italy, recent regional administrative elections pointed to a fall in support for the Five Star Movement and an increase in support for the League-a situation that has the potential to increase frictions inside the governing coalition, although the market is likely to take comfort from the fact that this is a shift to the right of the political spectrum. The European Parliament released its first projection of the allocation of seats after the May European Parliament elections. The expected reduction in seats, and therefore influence, of the two main political groupings-the European People’s Party and the Progressive Alliance of Socialists and Democrats-could slow the process of European integration.
Brexit uncertainty continues to weigh on business sentiment as the 29 March deadline to leave the European Union (EU) draws closer. The UK services PMI fell to 50.1 and many businesses cited Brexit as the key reason for weaker demand. At the time of writing the prime minister, Theresa May, is trying to obtain some concessions from the EU on the backstop arrangement, which seeks to prevent a border between Northern Ireland and the Republic of Ireland after Brexit. If she can secure an amendment to the border agreement, she anticipates another vote on the Brexit deal in mid-March. Crucially, if that deal fails she has scheduled a vote to see whether the UK parliament would accept leaving the EU with no deal. Recent indicative votes in the House of Commons suggest there is a strong majority against leaving with no deal. The market is increasingly convinced that there is a higher chance of an extension to the Article 50 negotiation process than no deal, which has served to lift sterling 1.1% against the dollar over the course of the month.
Challenges for emerging markets persist. Activity is still weak, if not contracting, in many countries according to the composite PMI reports. However, a more dovish Fed and the resulting prospects for a weaker dollar, combined with the Chinese stimulus measures, is increasing investor appetite for the asset class.
Chinese policymakers are implementing a mix of fiscal and monetary measures to support growth. Total social financing—a key measure of lending—reached record highs in January and local government bond issuance increased, raising funds that will be directed at new infrastructure spending.
Outside of China there are still a number of emerging markets that are feeling the effects of former currency depreciation which is lifting inflation, particularly in agricultural products. In India, core inflation remains above 5%, while in Turkey inflation has climbed above 20%. This may constrain the ability of emerging market central banks to cut rates despite a weaker dollar.
While Chinese stimulus is helping to lift Asian equities, the new Brazilian president is having a similar impact on sentiment towards Latin American equities. President Bolsonaro’s ambitious pension reforms, if completed, could help solve Brazil’s fiscal problems and reduce government debt.
Japanese real fourth-quarter GDP growth rebounded, up to 1.4% quarter on quarter annualised (up from -2.6% in the third quarter). Growth was supported by a bounce in private consumption and capex. However, the underlying pace of activity remains subdued, with the latest manufacturing PMI falling to 48.5. The Bank of Japan remains far from meeting its inflation target and is likely to continue pursuing very loose monetary policy for the foreseeable future.
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 28 February 2019.
The US earnings season was relatively solid. 70% of S&P 500 companies beat expectations. Fourth-quarter earnings-per-share growth looks to have grown by roughly 13% vs. the single-digit growth registered by Euro Stoxx 600 companies. However, guidance was more cautious, with a number of companies citing margin pressure from increasing wages and tariffs.
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 28 February 2019.
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 28 February 2019.
More dovish tones from all the major central banks continue to exert downward pressure on fixed income yields despite the rebound in risk appetite. The 10-year Treasury yield remained broadly in a range between 2.6%-2.7%. Currencies have also been somewhat range-bound given interest rate expectations have fallen in tandem. The EURUSD exchange rate ended the month slightly lower than where it began, at 1.14 dollars per euro.
The stress in the Italian bond market has eased somewhat following the decision of Fitch to keep the Italian sovereign rating unchanged. The 10-year BTP vs. Bund spread declined to below 260 basis points. According to Fitch, while concerns remain over the level of debt and the absence of structural reforms, there are points of strength, such as Italy’s diversified economy and low levels of private debt.
On both the trade war and Fed policy the market has swung from extreme pessimism in the final months of 2018 to extreme optimism this year. This swing in sentiment has generated considerable changes in risk appetite and stock prices. Reports of Chinese stimulus are further lifting sentiment and this has benefited emerging market assets.
For this rally to continue we need to see a more complete resolution of the US trade disagreement with China and Europe, and evidence that the Fed is willing to tolerate higher inflation and rising asset prices. These factors will in large part dictate the outlook for corporate earnings. We remain sceptical that America’s trade agenda will move swiftly towards an amicable conclusion and so we only cautiously buy in to this recent bounce.
Exhibit 5: Index returns in February 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 28 February 2019.