9 Month Market Review – as at September 30, 2018

Q3 2018

Investors could be forgiven for pining for the halcyon days of 2017; those days of market calm, yet with stellar returns as far as the eye could see. For here in 2018, politics, it seems, has finally caught up with markets. The policies of the Trump administration remain the focus of global markets, and their effects can be felt far and wide. And dysfunctional political stalemates in Europe maintain a cloud of uncertainty over the continent’s future.

For the US at least, everything was fine up to the quarter end. The S&P 500 Index surged 7% in the third quarter of this year; it’s best quarterly performance since 2013. This was fuelled by buoyant earnings expectations, which were in turn fuelled by US tax cuts. Factset estimate third quarter earnings growth for the S&P of 19%.

Turbulence Begins

In the weeks after the quarter end, however, investors began to pay heed to predictions a little further out. For example, Factset predicts S&P earnings growth of 7.1% in the first quarter of 2019. And indeed the effect of the tax cuts will wane through 2019. Stocks tumbled in response; particularly as it became clear that the US Federal Reserve (the Fed) is convinced that the recovery is sufficiently robust to raise rates further. The Fed has already raised rates by two percentage points, and expectations are for another hike in December. Traders also realise that even intense criticism from President Trump should have little effect on how the Fed goes about its business. The response was steeply higher bond yields, with the US 10-year Treasury yield now trading at around 3.2%.

This turbulence may continue over the coming months. Technology and growth stocks led the charge over the third quarter, but they also accounted for much of the losses thereafter. A highly strung market also reflects the somewhat stretched valuation of the US market, which has significantly outperformed its global peers this year. The S&P 500 Index returned the investor over 8% for the past year, compared to, for example, losses of over 11% for the Euro Stoxx 50.

Divergent Paths

This divergence is to be expected given the relatively robust performance of the US economy. US GDP grew at annualized rate of over 4% in the second quarter of this year and the unemployment rate fell to 3.7%, its lowest level since 1969.

Contrast this with the risks plaguing Europe. Official squabbling over Brexit continues to subdue markets, with the UK’s FTSE 100 Index down 7% since the start of the year. British wages are growing at their fastest in nearly a decade, but the Bank of England is reluctant to act until it gets greater clarity on Brexit. So even with inflationary pressure building and unemployment at a 43-year low, UK rates are not expected to rise until after March 2019, when Britain is scheduled to leave the European Union.

European markets are also unsettled with the goings-on in Italy. The Italian government had a confrontation with the European Commission after the current (populist coalition) government presented a completely unrealistic (expansionist) budget. Tumbling Italian debt prices now mean that Italy has to pay approximately three percentage points more to borrow than does Germany. This will constrict activity in an already struggling Italian economy, and not help an already subdued European business confidence.

The imbalance in growth between the US and its peers has been a dominant investment theme, and indeed the International Monetary Fund (IMF) predicts that the US will be the only large developed economy that will expand more quickly this year than it did last year. An effect has been to keep the dollar strong, with the US currency appreciating by over 4% against the euro since the beginning of 2018.

Dollar Strength and the Oil Price

This strength in the greenback is causing a great deal of pain in emerging markets, since it makes the servicing of their dollar-denominated debt more expensive and amplifies the adverse effect of a surging oil price. (Brent Crude, trading around $80 per barrel at the time of writing, is priced in dollars). Consensus expectations are for the global demand for oil to weaken further. But it’s usually supply factors that - at the margin - influence the direction of the oil price. On the supply side, OPEC and Russia are finding it difficult to increase output at a rate that will offset the fall in Venezuelan production and the drop in Iranian oil sales. Politics plays a significant role here, with US sanctions on Iran due to begin on November 4th and Iranian exports already having fallen considerably since its announcement.

China Crisis

But it’s trade negotiations between the US and China that are of most concern, with tension escalating by the week. The tit-for-tat tariffs are likely to hurt China far more than the US, at least in the near term. Indeed, the Shanghai Shenzhen CSI 300 Index is down by around 23% over the last year on trade tension and data indicating a slowdown in the economy. US trade policy is squeezing China’s exports at a time when Chinese growth is faltering and the when country is trying to deleverage. An important offsetting factor for China however is the depreciating yuan. The Chinese currency is already nearly 7% weaker against the dollar so far this year, and should help Chinese growth in 2019.

We retain our neutral outlook overall while we wait and see how far the relationship between these two major trade powers is allowed to deteriorate. If this turns out better than we expect, then maybe the market may decide it can prosper in an environment of tightening monetary policy. Global politics, of course, may lead us to a darker place. But now that political uncertainty is affecting asset prices, we can expect a bumpy ride while this plays out.