Central banks to the rescue?
In June, the central banks came to the rescue. Confronted by weaker economic data, risks to the trade outlook and still low inflation, the Federal Reserve (the Fed) and the European Central Bank (ECB) indicated that the cavalry is coming in the form of further monetary stimulus. So bad economic news was good news for markets.
Risk assets, such as equities and credit, rallied along with traditional safe haven assets, such as developed market government bonds, gold and the yen. Reversing the weakness in risk assets in May, June’s strong performance has made it a good quarter and certainly a good start to the year, almost irrespective of what you were invested in. Developed market equities were up nearly 4% over the quarter and 17% year to date. Credit has also had a good quarter and start to the year. Most government bond indices are also up about 5% year to date, having rallied this quarter.
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 30 June 2019.
It may seem counterintuitive for risk assets and safe haven assets to rally at the same time. However, markets have been pricing in Fed and ECB rate cuts and the potential for further ECB quantitative easing (QE), all of which is supportive of developed market government bonds. Rate cuts and further QE can also be supportive for risk assets if they are successful in preventing the current slowdown from turning into an economic downturn. So current market pricing reflects expectations that central bank stimulus will keep the economic expansion going.
Manufacturing surveys have weakened around the world, with a notable decline in the US business surveys and continued weakness in China, Japan and Europe. Germany’s manufacturing sector in particular, looks to be struggling.
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 30 June 2019.
One risk is that this weakness in the manufacturing sector could lead to job cuts and falling consumer confidence. May’s rise in German unemployment would therefore have been a concern to the ECB. Data in early June also showed a slowdown in the pace of hiring in the US and the conference board’s measure of US consumer confidence declined. It is this rising risk to the employment and consumer outlook that has probably been a key driver of the shift towards further stimulus from the Fed and ECB. The market’s attention is therefore likely to be focused even more sharply than usual on the labour market data in the coming weeks and months.
Faced with greater downside risks to the economic outlook and falling long-term inflation expectations, the Fed backed up the dovish rhetoric that has been emanating from various members in recent months by indicating that eight out of seventeen members think rate cuts are warranted this year. Helped along by Fed chair Jerome Powell’s comment that “an ounce of prevention is worth a pound of cure”, the market now expects more than 0.5% worth of rate cuts by the end of this year, in sharp contrast to the 0.5% increase in interest rates it was expecting for 2019 back in of September. US 10 year yields have fallen to about 2%.
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 30 June 2019.
Not wanting to be left out and also concerned about the downside risks to the economic outlook, the ECB also came out with fighting talk. ECB president Mario Draghi said that monetary policy would be loosened unless the economy improves, tried to convince markets that the ECB still has plenty of ammunition left if further QE is required and that interest rates could fall even further into negative territory if needed.
The G20 meeting resulted in the US and China agreeing to keep talking about trade, with no escalation in tariffs but also no significant signs of progress in addressing the key sticking points in the negotiations. While the lack of further escalation avoids the worst case scenario for now, the ongoing uncertainty and potential for a further breakdown in negotiations could continue to weigh on business sentiment.
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 30 June 2019.
In the UK, the news has been dominated by the Conservative Party leadership race. The polls and odds suggest that Boris Johnson is a strong favourite to be the next prime minister. Whoever is prime minister, parliament is still likely to prevent a no deal Brexit, unless a general election or referendum takes place and provides a strong mandate from the population for such an outcome. At the moment, polls suggest only about 30% of UK voters want to leave the European Union without a deal. How the new prime minister hopes to unite the Conservative Party and solve the Brexit impasse remains to be seen.
The Bank of England (BoE) has been less dovish than the Fed and ECB, given concerns around the limited spare capacity in the UK economy and wage growth that has accelerated significantly over the last couple of years. After the BoE meeting, the Confederation of British Industry’s reported retail sales measure for June came in at the weakest level since the financial crisis. If a broader swathe of economic data deteriorates, the BoE could well join in the easing party by cutting interest rates.
In short, the market has been willing to ignore the bad economic data in the hope that central bank stimulus will help avoid a recession. If the data remains weak, delivery of the hoped for stimulus seems highly likely. Whether the stimulus will be enough to extend what is now the longest economic expansion in history, only time will tell.
While we wait to see whether global growth reaccelerates or slows further, investors may want to hold only a neutral allocation to risk assets and avoid overweights to small caps and low quality, expensive stocks. Treasuries can provide some hedge to equities in the event of an economic downturn, while it may make sense to move up in quality within credit. Within alternatives, flexible strategies, such as global macro funds (which have historically provided some cushion to portfolios during market declines) and core global infrastructure, may also help to diversify portfolios.
Exhibit 5: Index returns for June 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 30 June 2019.