Since the global financial crisis, August has regularly proved difficult for financial markets. This summer was no exception. Investors had to digest the reintroduction of US sanctions against Iran, new tensions between Turkey and the US, a deterioration of trade talks between the US and China, and volatility in the Italian government bond market. Most equity markets and risk assets sold off, with the notable exception of the S&P 500, where extraordinarily strong macro data, and a general absence of any inflation concerns, once again pushed the index higher. Amid the geopolitical turmoil, the search for a safe haven helped push government bond prices up, with the 10-year US Treasury yield falling by 10 basis points (bps) to 2.86%.
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 August 2018.
Second-quarter GDP growth was stellar, both in magnitude and the nature of growth. Net trade and consumption both grew strongly and all indicators point to another robust print in the third quarter.
As yet, trade tensions appear to be having little impact on business sentiment within the US. The August flash Purchasing Managers’ Index (PMI) eased slightly from July’s levels but business investment spending looks robust according to the July durable goods report. Capital goods orders and shipments (excluding defence and aircrafts) increased at an annual rate of 8.5% and 7.5% respectively in July. Moreover, the NFIB index, which tracks the sentiment of small- and medium-sized enterprises in the US, rose to a 35-year high. Almost a third of the companies surveyed are planning to increase capex.
Consumption should also continue to support GDP growth in the third quarter, as retail sales rose more than expected in July (monthly growth of 0.5% vs. consensus expectations of 0.1%). Consumers continue to benefit from the tailwinds provided by fiscal reform and the strong labour market.
The labour market goes from strength to strength. The U6 unemployment rate – a broader measure of unemployment than the headline rate - dropped to 7.5% in July, its lowest level since 2001. This is considered to be one of the best measures of unemployment since it accounts for underemployment, such as those working part time that wish to work more, and those currently discouraged but considering re-entering the labour market. Such a low rate of unemployment could trouble markets. But wage growth remains modest and productivity appears to be picking up (most wage measures continue to grow at an almost 3% annualised rate, while second-quarter non-farm productivity growth came in at a seasonally adjusted annual rate of 2.9%).
The Federal Reserve (the Fed) looks set to continue raising rates in a gradual fashion. The policy rate was held steady in August but the minutes of the meeting, along with Jerome Powell’s speech at Jackson Hole, indicate that the Fed is likely to continue to raise rates at a pace of 25 basis points per quarter.
In Europe, August provided some further evidence that the soft patch in economic activity seen at the start of the year was temporary. Some rebound in the second half of the year appears likely.
Second-quarter GDP growth has been revised up to 2.2% annualised. The flash harmonised index of consumer prices (HICP) report for August estimates that headline inflation rose by 2.0% year on year (y/y), but core inflation remains stubbornly low at 1.0% y/y. Therefore, the European Central Bank is likely to keep interest rates on hold until this time next year, at least.
Following the recent easing of trade tensions with the US, most sentiment indicators improved in August. The composite PMI increased by 0.1 point to 54.4 thanks to the strong PMI recorded in Germany (up 0.7 to 55.7) and France (up 0.7 to 55.1). Moreover, the German Ifo business climate index rebounded strongly to 103.8, its highest level since March.
However, as is often the case in Europe, politics overshadowed these good fundamentals. The dramatic collapse of a bridge in Italy, and new migrant arrivals in the Mediterranean, caused tensions between the new Italian government and European Union (EU) officials.
Markets are anxious about the new Italian government’s budget plans, which are due to be released by the end of September and submitted to the EU on 15 October. If Italy’s budget deviates from the objectives of the stability and growth pact, the European Commission could be forced to reactivate the excessive deficit procedure against Italy. The country’s credit rating could also be at risk – Moody’s and Standard & Poor’s have both scheduled a review at the end of October.
The 10-year Italian government bond yield touched 3.20% by the end of the month, 290bps above that of Germany. European assets sold off in August, with the MSCI Europe ex-UK Index down 2.0%. The euro fell 0.6% versus the dollar.
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 August 2018.
Brexit continues to dominate the UK headlines as the deadline for an agreement approaches. The government published a number of technical notes on the implications of a “no deal” outcome. But this should not be interpreted as a statement of intent, or a signal of the current state of the negotiations. These papers have been planned for release for many months as a prudent part of the negotiation process.
Many of the headlines over the course of the month suggest negotiations are proceeding reasonably amicably. The new Brexit secretary – Dominic Raab - and Michel Barnier, the EU’s chief negotiator, said that their respective teams will be “negotiating continually” from here on, although it may take until November for talks to conclude. Barnier signalled that the EU could be flexible in the negotiation around the Northern Ireland Border and that “he was confident that the negotiations can reach a good outcome”. He also stated that the EU was willing to offer the UK an unprecedentedly close relationship after Brexit.
The Bank of England (BoE) delivered its well anticipated 25bps interest rate rise in August. We do not expect the BoE to raise rates again until the Brexit outcome is clear. But given we expect a relatively soft Brexit deal to be reached by year end, we anticipate more rate hikes than currently priced by the market next year.
On the economic front, GDP growth for the second quarter came in at 1.5% on an annualised basis, which was in line with expectations but a bit lower than the BoE’s forecasts. Inflation also came in a bit lower than the BoE’s forecasts, with the consumer price index (CPI) and core CPI of 2.5% y/y and 1.9% y/y, respectively, in July.
Sterling fell 0.9% over the month against the dollar, although this was largely due to broad-based dollar strength. It fell 0.4% against the euro. The FTSE 100 dropped 3.3% over the month and the FTSE 250 dropped 0.6%.
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 August 2018.
After a difficult start to the year, the Japanese economy seems to have stabilised in the second quarter at a cruising speed of roughly 1% on an annual basis. The details of the second-quarter GDP report were encouraging as private consumption rebounded strongly (2.8% quarter on quarter), supported by surprisingly strong wage growth, which came in at 3.6% y/y in June, its highest level in over 20 years.
However, even though CPI rebounded to 0.9% y/y in July, core CPI excluding fresh food and energy - the Bank of Japan’s (BoJ) preferred inflation measure - remains low at 0.3% y/y, showing that the underlying inflation trend remains anaemic and below the BoJ’s objective.
The BoJ decided at the start of August to tweak its policy framework by introducing forward guidance on its policy rate and by increasing the flexibility of its yield curve control by doubling the range of fluctuation around its 0% target, from 10bps to 20bps. This has led to a temporary steepening of the JGB yield curve, which has spread to other developed market government bond yield curves. The aim of these measures is to reduce the negative side effects of the BoJ’s monetary policy on the Japanese banking system, since a flat yield curve can adversely impact commercial banks’ profitability.
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 August 2018.
China and Emerging Markets
Trade tensions and a strong dollar continued to dominate the headlines in emerging markets. At the start of August trade relations between the US and China deteriorated further as the US threatened to apply a 25% tariff on USD 200 billion of Chinese goods (these goods were already going to be subject to a 10% tariff). This sits on top of the 25% tariff on USD 16 billion of Chinese imports, which came into force on 23 August. Moreover, the US president signed the National Defense Authorization Act on 13 August in order to better regulate inbound foreign investments, a move not directly targeting China but which would still restrict the ability of the country to invest in the US.
These trade tensions appear to be already affecting trade and output in China. Exports to the US from China fell 2.5% in July vs. June and fixed asset investments came in much weaker than expected, rising only 5.5% on the year for July.
The Chinese authorities are aiming to counter this with measures to stimulate domestic demand. The banks’ reserve requirement ratio was cut by 50bps at the end of June. There are also few signs, so far, of stress as Chinese FX reserves increased modestly in July to USD 3.19 trillion, which suggests that capital outflows were limited.
In contrast, the signs of stress were more evident in Turkey. The country was already in a difficult situation since the beginning of the year due to a widening of its current account deficit to 6% of GDP. This already fragile situation deteriorated further at the start of August after the US decision to increase tariffs on Turkish steel and aluminium imports as a consequence of the imprisonment of a US citizen in Turkey. The Turkish central bank has not acted with sufficient force to support the currency. The lira is now down 42% against the dollar since the start of the year and is at an all-time low on a real effective exchange rate basis.
In the context of trade tensions and a potential balance of payments crisis in Turkey, emerging market assets sold off in August. But the market is differentiating between regions. The MSCI EM index fell 0.5% compared to a 4.1% fall in the main Turkish stock index. Turkey only accounts for 0.6% of the MSCI Emerging Market Index and contributes less than 2% to Global GDP.
While trade uncertainties may continue to weigh on emerging market economies and markets, there are also reasons to be optimistic, as shown by the trade deal reached between the US and Mexico on 28 August.
All in all, the economic data for August points to a global economy that is still growing above trend, which should support corporate earnings globally. But geopolitical headlines continue to create considerable volatility around this generally positive trend. In this context it seems reasonable to remain pro-risk in balanced portfolios, while seeking at the same time lowcorrelation assets to provide some protection as the cycle ages.
Exhibit 5: Index returns in August 2018 (%)
Source: MSCI, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. Data as of 31 August 2018.