The unusually hot weather and the football World Cup provided plenty of excitement in July but markets were just as interesting. Trade tensions remained acute but ultimately the phenomenal strength of corporate earnings was enough to push equity markets higher across the developed world. Over the course of the month, the S&P 500 gained nearly 4% and European equities rose 4% and are now up on the year. Good economic news also propelled the 10-year US Treasury yield to 3%.
Exhibit 1: Asset class and style returns (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 31 July 2018.
The US continued to report above-trend economic data and markets responded to a raft of strong company earnings reports. Consumers remain optimistic about the future and are spending with gusto. Retail sales grew 6.6% year on year for the month of June. This is the fastest pace of spending growth since 2012. The strength of the labour market is undoubtedly playing a role in boosting household sentiment. 213,000 nonfarm jobs were created in June but because 601,000 people joined the labour market in the same month the unemployment rate rose to 4%. Businesses are similarly optimistic: the manufacturing purchasing managers’ index (PMI) held strong for the month. GDP in the second quarter rose at an annualised pace of 4.1% over the previous quarter. Inflation rose to 2.9% in June, well above the Federal Reserve’s (Fed’s) target, though some of this strength is attributed to the rise in oil prices and should prove temporary. It is unlikely that growth will remain this strong, but given that both inflation and employment are near the Fed’s target we expect it to continue normalising interest rates at a pace of roughly 25 basis points (bps) per quarter.
US equity earnings in the second quarter were very strong. Almost 90% of companies beat expectations in July. Full-year earnings-per-share (EPS) is still tracking well in excess of 20%.
Stubbornly low inflation and signs of a moderation in growth are once again posing a challenge for the Bank of Japan (BoJ). It is unclear what further ammunition the central bank has. Already there are concerns that negative policy rates and a 0% 10-year government bond yield target are proving counterproductive by damaging the profitability of the banks. There was some speculation that this policy would be altered at the July meeting but seemingly for want of alternatives the policy was held broadly in place.
Exhibit 2: Fixed income government bond returns (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. Data as of 31 July 2018.
Brexit continues to dominate the UK headlines as the deadline for an agreement approaches. The prime minister Theresa May assembled her cabinet at her Chequers country house to try to agree a common position for her to begin the formal negotiations on the UK’s future relationship with the European Union (EU). Two cabinet members – David Davis and Boris Johnson – did not support the plan and tendered their resignations. A white paper, which sets out the UK’s desired future relationship, aims for a customs partnership, which is the only clean solution for avoiding a border between Northern Ireland and the Republic of Ireland. The UK government has acknowledged that it will have to respect the regulatory framework imposed and overseen by the EU. While this may look like a concession on the UK’s ambition to restore sovereignty, it is worth remembering that regulatory agreement is an important bedrock for trade. The government maintains that it must regain control of migration. This could compromise the UK’s ability to reach a broad agreement on free trade in services, but our core assumption is that there will ultimately also be a deal on services.
The market clearly remains nervous about the prime minister’s ability to strike a deal with Europe that will be sufficient to appease her own party. Whilst this is certainly a delicate tightrope for her to walk, our core assumption is that the threat of losing office ultimately holds the party together and that the EU will provide some concessions to support her. A ‘no deal’ scenario is risky for both sides given the economic ties.
Sterling fell 0.6% over the month against the dollar, although this in part was due to broad-based dollar strength. The FTSE 100 rose 1.5% over the month and the FTSE 250 rose 0.4%.
Exhibit 3: 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 July 2018.
Europe’s recovery appeared to falter in the spring as growth eased from the heady levels seen in the fourth quarter of last year. However, surveys in July suggest activity is stabilising at a level that is still consistent with growth of around 2%, which is above what we would consider to be trend.
In July, the eurozone’s composite PMI eased slightly to 54.3, after a brief uptick to 54.9 in June. However, the headwinds of higher oil prices and trade tensions eased over the month, which may support business sentiment over the remaining months of the year. Germany’s manufacturing PMI in July has already showed encouraging signs of improvement, which was surprising given the industrial exposure of the economy to any proposed tariffs on autos. The stabilisation in the activity data helped lift the exchange rate. The euro ended the month at 1.17 against the dollar, up 0.2% on the month.
The European Central Bank’s (ECB’s) Monetary Policy Committee meeting in July was uneventful. All key interest rates remained unchanged and the ECB reaffirmed its intention to end quantitative easing by the end of the year but hold interest rates at their current levels at least through the summer of 2019.
Trade tensions de-escalated between the US and EU after EU President Jean-Claude Juncker visited Washington. They agreed to work together “toward zero tariffs, zero non- tariff barriers, and zero subsidies on non-auto industrial goods”. Plans for new tariffs on other EU goods – including autos – are on hold while talks take place. This is a step in the right direction, though we are mindful that efforts to negotiate between the US and China ultimately broke down. But for now European markets were cheered by the news, and the MSCI Europe ex-UK rallied after the announcement to end the month 4.0% up.
Exhibit 4: Fixed income sector returns (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. Data as of 31 July 2018.
China and Emerging Markets
In contrast, trade relations between the US and China deteriorated further. On 10 July, the US Trade Representative listed 200 billion US dollars’ worth of Chinese goods that could be eligible for 10% tariffs. Several days later, China announced tariffs on US agricultural products. In response, the US said it may be prepared to further increase the tariffs on the full range of goods imported to the US from China (approximately 450 US billion dollars’ worth). The US is now consulting on its proposal. Businesses are becoming increasingly vocal about the detrimental impact of potential tariffs, which may limit the administration’s final actions. But as we head towards the US mid-term elections in November it is unclear how these policies will play into the political rhetoric. For this reason, we maintain a degree of caution.
In the first week of July, the 50 bps cut in the Reserve Requirement Ratio (RRR) previously announced by the People’s Bank of China became effective. This will encourage bank lending. A significant package of fiscal policy was also announced by Beijing’s authorities. This included tax reductions and expansion of R&D deductible policies for a wide range of Chinese companies. The yuan fell 2.9% against the dollar over the course of the month.
Elsewhere in the emerging world, the news remained mixed. The Central Bank of the Republic of Turkey surprised markets by not raising its 17.75% policy rate. Markets and economists were expecting a 75bps – 125bps increase given runaway inflation and the weakness of the lira. This raised concerns about the credibility of the authorities in Turkey and their commitment to economic stability.
Turkey is one of the economies that is vulnerable to rising US interest rates and a strong dollar, given its large current account deficit and recent growth in external debt. Argentina and South Africa are similarly exposed. These economies’ currencies have fallen significantly against the dollar over the course of the year, by 32% and 7% respectively.
The football World Cup has concluded but there is unlikely to be a shortage of market excitement in the final months of the year. The US mid-term elections will be particularly important, so some consideration of the likely outcomes and market impact is a worthy exercise in these quiet summer weeks. Whether growth outside the US reaccelerates will also be an important factor shaping markets in the second half of the year.
Given fiscal stimulus will continue to boost US growth in the coming quarters, corporate earnings will continue to be well supported. We also expect a modest improvement in growth in Europe – so we remain pro-risk. But with some trade tensions still unresolved and later cycle risks looming on the horizon, a more balanced approach to risk is appropriate. Investors should think about adding fixed income and alternatives selectively to provide downside protection but without increasing the vulnerability of portfolios to rising interest rates.
Exhibit 5: Index returns in July 2018 (%)
Source: MSCI, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. Data as of 31 July 2018.