The global economy continued to pick up steam in October, with the global purchasing managers’ index (PMI) for manufacturing rising to its highest level in two years. October’s reading of 51.9 suggests around a 3% annualised growth rate in global manufacturing. Not only is this a significant improvement from the roughly 1% growth rate of the past year and a half, but it represents a shift in some key themes. In particular, as we enter the last two months of the year, there appears to be far less concern surrounding deflation, Chinese instability and potential global growth deterioration. Politics still dominates media headlines, whether it is the Brexit process or US elections. Oil (Brent crude) continues to rise, ending October at USD 48.6 a barrel. Government bonds remain at the mercy of developed market (DM) central banks, and as yields bumped up DM sovereigns lost nearly 3% on the month. Equity indices remained fairly range-bound over October, with the exception of Japanese equities, which posted the highest DM returns (in local currency terms), up 5.3%.
Exhibit 1: Asset class and style returns (local currency)
Source: J.P. Morgan Asset Management, Barclays, Bloomberg, FactSet, MSCI. 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: MSC World Small Cap. All indices are total return in local currency. Data as of 31 October 2016.
UK & Europe
The UK continues to wade through the political and economic implications of the referendum. At the beginning of October, prime minister Theresa May stated the UK would invoke Article 50 by March 2017, which set the tone for an action-packed month in UK asset markets. Sterling fell to new lows in October, including a flash crash on 7 October after the UK Conservative Party conference, and ended the month at 1.22 against the US dollar. Partly in response to the weaker currency, the FTSE 100 gained some ground to add to its impressive 15% year-to-date return. UK GDP data showed the economy was able to withstand the post-referendum period, with solid services growth of 0.8% quarter on quarter (q/q), leading to total economic growth of 0.5% q/q for the third quarter. On the last day of the month, Bank of England governor Mark Carney announced his intention to serve in his position until summer 2019.
Exhibit 2: World stock market returns (local currency)
Source: J.P. Morgan Asset Management, FactSet, MSCI, Standard & Poor’s, TOPIX; data as of 31 October 2016.All indices are total return in local currency.
Across the channel in Europe, the European Central Bank (ECB) endured an exercise of managing expectations, while the Comprehensive Economic and Trade Agreement (CETA) deal between the European Union and Canada was finally signed. In the flash estimate, eurozone GDP growth held steady at 0.3% q/q. Consumption was the biggest contributor to the overall growth rate. Out of the 19 nations, some stood out as healthier: Spain - which had once been one of the region’s weakest economies - grew a healthy 0.7% in the third quarter, while Germany’s composite PMI impressed, jumping 2.3 points to 55.1, indicating a resurgence of the bloc’s powerhouse. Inflation in Europe was muted: consumer prices in the 12 months through October rose 0.5%, up from 0.4% in the 12 months through September.
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 October 2016.
The ECB’s Mario Draghi told markets that a “tapering” of quantitative easing (QE) was not discussed at its October meeting and reiterated that asset purchases would continue as long as they needed to. But what exactly a QE extension will look like will be revealed in the ECB’s December meeting. Spanish, German and Italian sovereign bonds weakened over the month.
The first estimate of third-quarter real GDP showed the US economy expanded at an impressive annual rate of 2.9% last quarter. Consumption led the charge, but growth was also boosted by significant contributions from both inventories and exports. This report represents a nice rebound from the weakness seen in the first half of the year, and supports our view that the Federal Reserve (Fed) will feel comfortable hiking rates in December.
Exports were the highlight of this report, surging 10% in the quarter and contributing nearly 1.2% to overall growth. This was the strongest export growth seen since the fourth quarter of 2013, and suggests that the "dollar drag" may be behind the US. However, US dollar strength made a comeback in October, with the trade-weighted US dollar gaining 14.5% over the month. With markets pricing in a nearly 70% chance that the Fed will raise rates at its December meeting, a significant deterioration in macroeconomic data would need to occur in order to knock the central bank off course.
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 October 2016.
The US 2016 election campaign continued, with three widely-televised presidential debates and several revelations making headlines, including Hilary Clinton’s email practices and Donald Trump’s comments towards women. While the S&P 500 lost nearly 2% in October, the third-quarter earnings season beat expectations. With most S&P 500 companies reporting for the third quarter, a higher-than-normal 75% of companies beat earnings expectations. While the year-on-year earnings-per-share (EPS) growth rate is likely to fall from the 14.5% pace it is currently tracking, we do expect overall operating EPS (as defined by Standard and Poor’s) to be up sharply from a year ago.
Though growth and inflation data were still muted in Japan, Japanese equities (the TOPIX) beat peers for monthly returns, as the yen weakened from 101 to 105 per US dollar. Chinese data held steady for the third quarter and confirmed the nation’s rebalancing story, shifting from investment-led to consumption-led growth. GDP grew 6.7%, retail sales were up 10.7% and industrial production increased by 6.1%. While consumption growth is strong, if investment lessens over the next few quarters it will be harder to hit the 6.5%+ GDP growth targets. However, policy from Beijing appears to be focused on stabilising and supporting growth and investment through public spending, which was evident in October’s fixed asset investment growth rate of 8.2%. While the Chinese debt buildup remains a worry for investors, the earnings expectations for “new China” (including technology, consumer and healthcare) companies looks robust.
Exhibit 5: Index returns for October (%)
Source: MSCI, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management; data as of 31 October 2016.
KEEP IN MIND FOR THE REST OF THE YEAR: RAISING EXPOSURE TO EMERGING MARKETS
Emerging market (EM) equities have been the best-performing asset class in local currency terms year to date, with tremendous performance for euro- and sterling-based investors. As we look ahead to next year and beyond, the case for increasing exposure to EM seems to be compelling. There appears ample evidence that the economic performance of most EM has now stabilised after a difficult few years. The recent negative sentiment towards their countries has driven EM currencies down to competitive levels. This - along with the stabilisation in commodity prices—has promoted a brighter growth environment. The “growth alpha” of EM - the amount by which their GDP growth exceeds that of the developed world - has now stabilised after shrinking since 2011. This usually signals the start of a period of brighter performance of EM securities relative to those in the developed world. As currencies have stabilised, inflation rates are now starting to subside, leaving room for central banks across the EM world to reduce policy rates. This should further support growth and sentiment, while also directly boosting both equity and fixed income markets.
How best to play the improving EM story? There is no shortage of options for investors. The first consideration would be EM debt. After a period of economic stress, it’s usually better to initially engage with debt as it is higher up the capital structure than equity. EM debt has started to see inflows this year but the yield on the safest sub-category - hard currency government debt - remains around 5%. Yields are even higher when considering corporate or local currency government debt securities.
EM equities could also be worth a look by investors. EM equities represent more than 12% of global equity capitalisation, so investors with less than this in their equity bucket should ask themselves if the significant underweight that they have been running remains warranted in the current environment. Valuations are relatively compelling, and - with a dash of active management - yields of around 5% of an equity portfolio are achievable. With research from a variety of sources in recent years pointing to lower and lower-trend returns ahead from developed asset markets, the need for long-run growth drivers in a portfolio is greater than ever. EM equities are predicted to provide investors with higher returns over a multi-year horizon, although only investors able to bear the potential volatility of those returns should consider them a real option. The recent strength of the US dollar and the looming election are reminders that events well outside of EM pose risks to the performance of their asset markets.