Investment Outlook 09.2018
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
Global contagion risks?
August was a very volatile month. US and Japanese equities performed positively, up 3.0% and 1.4% respectively. Emerging markets sold off, due to concerns about the impact of the trade dispute on Chinese growth as well as the crises in Turkey and Argentina. Emerging markets equities lost 3.3% and local currency bonds 6.1% in August. In Europe, concerns about Italian finances, banks’ exposure to Turkish debt, and the potential impact of US tariffs, weighed on markets. As a result, the equity index, MSCI Europe, fell 3.1% and banks especially came under selling pressure.
The safe-haven environment led to declining government bond yields. European 10-year yields fell 12 basis points and US yields 10 basis points. The yield spread of Italian 10-year bonds over their German equivalents climbed to roughly 2.5%. High-yield and emerging market bond spreads widened in August by 15 and 65 basis points respectively.
REITS had a strong month, the global REITS index rose 1.6%.
The Bloomberg Commodity index fell 1.8% in August, mainly driven by falling prices for agriculture (-6.0%), industrial metals (-4.3%) and precious metals (-3.1%). Only energy prices rose, with an increase of 3.8%.
UCITS hedge funds had another weak month with the broad hedge fund index falling 1.1%.
Emerging markets currencies had a terrible month. The Turkish lira fell about 30% and the Brazilian real 8% against the USD. The USD rose 0.8% against the EUR. The CHF appreciated 2.9% vis-a-vis the EUR.
In Q2 US GDP grew 4.2% QoQ annualized, which is the strongest growth for many years. This compares with growth of 1.6% in the euro area and 1.9% in Japan.
The IMF estimates that tax cuts and fiscal stimulus in the US will add 0.7% to GDP growth this year and 0.8% next year.
There is a big question mark regarding the growth outlook for China. President Xi has recently cut interest rates and brought forward fiscal spending to support the economy. However, it appears unlikely that China will introduce strong stimulus packages similar to those of 2009 and 2015, since the Chinese administration has declared its focus to be on deleveraging and structural reforms.
The US PMI climbed to a very strong 61.3 in August after 58.1. The EMU PMI stagnated and fell slightly to 54.6 after 55.1.
US inflation was at 2.7% in August, slightly down from 2.9% in the prior month. Core inflation also fell to 2.2% after 2.4%. EMU inflation was at 2.0% down from 2.1% and core inflation remained at 1.0%.
US non-farm payrolls rose more strongly than expected. The US economy added 201,000 jobs in August. Average hourly earnings increased 2.9% from a year earlier, the strongest wage growth since 2009.
Fed chairman Jerome Powell, speaking at the annual Jackson Hole Economic Symposium, reiterated that “a gradual process of normalization remains appropriate”. In our view, this suggests that the Fed will be hiking rates by 25 basis points each quarter going forward. The futures market is still not fully pricing such a hiking path.
On September 13 the ECB kept rates unchanged and clarified its planned tapering measures, which were in line with expectations and did not surprise markets.
Market participants were worried that the situation in China, Italy, Turkey and Argentina could become contagious and drag down other markets. Most worrying to us appears the situation in China and Italy. China is a major concern due to its sheer size and since it is very connected economically and financially. The country has become the biggest importer of many commodities. A slowdown could have a large negative impact on many commodity-producing economies. It is also an important market especially for European exporters.
The Italian government is a major debtor and Italian government bonds sit in large amounts on European banks’ and insurers’ balance sheets. Distress in Italy would certainly also lead to serious concerns about the sustainability of the European union.
In contrast, we regard the situation in Turkey and Argentina as less contagious for global finances. While there are sizeable amounts of Turkish debt on balance sheets of European banks, overall it does not look too worrying. The stark depreciation of the Turkish lira had a short-lived effect on financial markets
The Argentinian economy is relatively small and far less connected to the rest of the world. Therefore, we see only moderate contagion risks there.
However, we continue to monitor the situation in China and Italy. Currently we see only a slight chance that the situation could trigger a strong and lasting market correction in the next couple of weeks.
We still see an escalating trade war as the major risk, followed by an overheating US economy, which could scare the Fed policy committee and lead to aggressive monetary tightening. It seems, however, that markets have recently become more sanguine regarding the potential impact of additional tariffs.
While the US economy is clearly firing on all cylinders, the inflationary impact has so far been limited. However, we continue to monitor US inflation risk, since this is the single most important variable which could make the Fed more hawkish.
We reduced interest-rate risks in the portfolios and have lowered our exposure to credit risks, since credit risks are priced to perfection in our view. We maintain a slight overweight of US equities and energy.