Q3 Market Commentary: Global Shares Come Full Circle as Rates Fall into Autumn

7 October 2019

We have leaned toward an optimistic view on equities and other risk-oriented assets for the past 10 years. We believe that staying invested has been a sound overall strategy.

Snapshot

  • Equity markets, which plummeted in early August after climbing through July, largely recovered into mid-September around most of the globe. Government bond rates declined across all maturities in the UK, eurozone and US during the three-month period.
  • Prime Minister Boris Johnson faced sharp resistance from the outset of his tenure: Conservatives defected in view of Johnson’s willingness to follow through with a no-deal departure from the EU, and the UK Supreme court reversed his attempt to suspend Parliament.
  • Although maintaining exposure to equities and other risk-oriented assets can feel uncomfortable during such periods of uncertainty, we believe that investors with long time horizons should avoid timing the market or making outsized sector or regional bets.

Equity markets, which plummeted in early August after climbing through July, largely recovered into mid-September around most of the globe. UK shares sold off especially sharply in August and didn’t bounce as significantly as peers in other major developed markets, but continued to recover straight through the end of September.

European, US and Japanese shares generally tracked the pattern of global equities. However, US stocks were notable in that they drifted to all-time highs in late July, dropped as a consequence of US President Donald Trump’s escalating trade-war measures, and failed to break new highs despite recovering in September.

Mainland Chinese shares rebounded faster and earlier in the quarter than the rest of the world’s equity markets, and then slid back down toward the end of the period. The early September bounce in Hong Kong shares was modest by comparison, and essentially reversed in late September.

Government bond rates declined across all maturities in the UK, eurozone and US during the third quarter. Long-term rates dropped by more than short-term rates in the UK and eurozone, leading to flatter overall yield curves. In the US, shorter- and longer-term rates both declined by more than medium-term rates, compressing the difference in rates across all maturities. After remaining negative since May, the 3-month-to-10-year Treasury spread—a widely-watched recession indicator — turned positive for a single day in late July, but tumbled deeply into negative territory by late August before recovering to less negative levels by the end of the quarter.

Oil prices followed the path of global equities for much of the three-month period. They jumped abruptly in mid-September on news of an attack that targeted energy-processing facilities in Saudi Arabia that account for about 5% of global oil production. However, the spike in prices was reversed by the end of the quarter as output quickly returned to sufficient levels.

Prime Minister Boris Johnson faced sharp resistance from the outset of his tenure: Conservative members of Parliament defected to support a vote eliminating the prospect of a no-deal departure from the EU on 31 October, and the UK Supreme Court reversed the Prime Minister’s attempt to suspend Parliament. A general election remained out of reach for Johnson despite all of his setbacks, as opposition parties opted to wait until the no-deal threat was taken off the table.

US-China trade negotiations came to a halt on 1 August with President Trump’s announcement of new tariffs (10% on $300 billion of Chinese goods) and China’s subsequent promise of retaliation, provoking a disconcerting depreciation in the yuan’s exchange rate with the US dollar. Both sides applied new and higher tariffs beginning 1 September: The US imposed a 15% tariff on $112 billion worth of Chinese goods, while China resumed 25% tariffs on American cars and added 5%-to-10% tariffs on $75 billion worth of other American goods. As a new round of negotiations materialised for October, the US delayed a tariff measure scheduled for 1 October (an increase from 25% to 30% on $250 billion worth of Chinese goods).

The US and Japan struck a narrow trade agreement in late September, which reduced tariffs on US agricultural exports and Japanese industrial exports, and set guidelines for digital trade between the two nations. Elsewhere, after months of demonstrations, protesters in Hong Kong saw some success when a proposed law that would have allowed for extradition to mainland China was withdrawn. Protests continued, however, amid a reported increase in China’s police presence and undercover activity.

Major Index Performance in Q3 2019 (Percent Return)

Major Index Performance in Q3 2019 (Percent Return)

Gold=Fixed income. Orange=Equities. Sources: FactSet, Lipper. See “Corresponding Indexes for Major Index Performance Exhibit” in the Index Descriptions section for more information.

Fixed-Income Performance in Q3 2019 (Percent Return)

Fixed-Income Performance in Q3 2019 (Percent Return)

Sources: FactSet, Lipper. See “Corresponding Indexes for Fixed-Income Performance Exhibit” in the Index Descriptions section for more information.

Central Banks

  • The Bank of England’s Monetary Policy Committee took no new actions at either its 1 August or 19 September meeting, retaining a bias toward less accommodative monetary policy. However, its statement now notes that Brexit must occur smoothly and global economic conditions must improve before taking new tightening action.
  • The European Central Bank (ECB) sought to provide fresh stimulus following its mid-September meeting by reducing its deposit rate from -0.40% to a record low of -0.50% — and adopting a new system to offset possible consequent bank-reserve losses. The ECB also reintroduced its asset-purchase programme at €20 billion per month, to start in November and continue indefinitely. Finally, it modified its latest round of targeted longer-term refinancing operations to allow for lower bank-borrowing rates and a maturity extension from two to three years.
  • The US Federal Open Market Committee (FOMC) reduced the federal-funds rate by 0.25% in mid-September — only the second decrease in 11 years, two months after a July cut of the same size — bringing the rate to a target range of 1.75% to 2.00%. The FOMC’s late-July announcement also included an accelerated end to quantitative tightening by letting US Treasurys and mortgage-backed securities (MBS) mature without reinvesting proceeds. With the end of the program, the central bank has resumed reinvestment activities — focusing on moving its securities portfolio toward Treasurys and away from MBS. On a separate note, in an effort to stabilise short-term borrowing rates, the Federal Reserve Bank of New York undertook temporary repurchase agreements (known as repo operations) in September for the first time since the global financial crisis, and maintained them through the end of the quarter; a shortage of bank reserves caused by increased Treasury issuance, corporate tax payments, and a range of other factors led to a sharp spike in secured short-term rates, forcing the need for intervention.
  • The Bank of Japan left its monetary-policy orientation unchanged following its September meeting. Minutes revealed discussion about communicating the central bank’s willingness to use more stimulus if needed, in light of concerns about slowing economic growth.
  • The People’s Bank of China (PBOC) allowed the yuan to depreciate past the psychologically significant 7-to-1 ratio with the US dollar in early August following a statement by President Trump that the US would impose far-ranging new tariffs on 1 September. The PBOC revealed in August that it made an adjustment to the calculation of China’s loan prime rate, which is expected to result in a gradual reduction in Chinese borrowing costs. The central bank also provided Chinese banks with additional relief in September by cutting its reserve requirement ratio by 0.50%, with a potential additional 1% reduction for qualifying banks in October and November, freeing about $125 billion of banking-system liquidity.

Economic Data

  • The contraction of UK manufacturing activity entered its fifth consecutive month in September. Growth in the UK services sector essentially ground to a halt in the same month after a mild rebound in July and August. The broad UK economy shrank by 0.2% in the three-month period ending June, but expanded by 1.3% year over year, according to the final reading of second-quarter gross domestic product growth. The UK claimant-count unemployment rate held at 3.2% in July before edging upward to 3.3% in August. Average year-over-year earnings growth jumped to 4.0% for the May-to-July period (from 3.7% and 3.4% in the three-month periods ending June and May, respectively).
  • Conditions in eurozone manufacturing continued to deteriorate in September, the eighth straight month of contracting activity. Services sector activity also slowed in the month, falling below the healthy pace it had maintained for the prior few months, but remaining in expansion territory. The eurozone unemployment rate edged down to 7.4% in August from 7.5%, where it was stuck for the three months prior. The eurozone economy slowed to a pace of 0.2% in the second quarter — half that of the prior quarter — and to 1.2% year over year (a modest 0.1% decline).
  • Multiple reports of US manufacturing indicated that activity slowed throughout the third quarter, showing signs of contraction in September and falling to the lowest level in more than a decade according to one measure. Activity in the US services sector bounced to healthy expansion levels in July, decelerated sharply to near-breakeven levels in August, and grew slightly in September. The US unemployment rate remained at 3.7% in September for the fourth straight month, although the labour-force participation rate continued to increase in the same period. The final second-quarter reading of overall US economic growth eased by 0.1% to an annualised 2.0%.

Regional Equity Performance in Q3 2019 (Percent Return)

Regional Equity Performance in Q3 2019 (Percent Return)

Gold=Countries. Orange=Regions. Sources: FactSet, Lipper. See “Corresponding Indexes for Regional Equity Performance Exhibit” in the Index Descriptions section for more information

Global Equity Sector Performance in Q3 2019 (Percent Return)

Global Equity Sector Performance in Q3 2019 (Percent Return)

Gold=Defensives. Orange=blends. Red=Cyclicals. Sources: FactSet, Lipper. MSCI ACWI Index Sector Components (Cyclicality determined by SEI).

Our View

We have leaned toward an optimistic view on equities and other risk-oriented assets for the past 10 years. When markets corrected sharply in price — as several US equity indexes did in 2011, 2015 and late last year — we viewed the pullbacks as buying opportunities. We believe that staying invested has been a sound overall strategy. Today, while we still doubt that a true bear market is on the immediate horizon, we are surprised by the resilience of the stock-market averages during the third quarter in the face of numerous economic and political uncertainties, both in the US and globally.

The US economy remains in reasonably good shape and appears to be in little danger of contracting any time soon. Granted, the manufacturing and agricultural sectors are being stressed by the trade war with China. But we think there is a limit to how far this deterioration in economic activity will go. Few economists would dispute that the US consumer sector is in great shape.

Traders in the federal-funds futures market expect more rate cuts on the heels of the FOMC’s July and September cuts. The central bank is also no longer letting its securities portfolio contract now that it halted quantitative easing. If the economy were to weaken in a serious way, it could ramp up its purchases of Treasurys again.

Looking at the US stock market, the forward-earnings trend has flattened in recent quarters. Periods of flat-to-down earnings over several quarters occurred in the 2014-to-2015 period, and in 2011, 2007 and 1998, each coinciding with flat-to-declining stock prices, increased volatility and moderate-to-severe market corrections.

Growth and momentum styles continued to outperform quality and value for much of the third quarter. However, September saw a sharp reversal in this trend for the first time since the beginning of 2018 as value outperformed. It’s hard to say whether this reversal will be sustained, although SEI’s equity managers have been positioned for such an eventuality.

A trade truce between China and the US would be a relief, but it would be only one piece of a larger mosaic that must first come together.

A trade truce between China and the US would be a relief, but it would be only one piece of a larger mosaic that must first come together. Getting the world back on a faster growth track will depend on an economic rebound in the domestic economies of China and Europe.

Our expectation of an economic revival in China rests on the assumption that all the fiscal and monetary-policy measures put in place over the past year will overcome the major challenge posed by the trade war. The latest tranches of import duties are aimed at Chinese goods like apparel and toys, which usually have thin profit margins, are labour-intensive, and can be more easily produced in other low-wage nations than higher-tech products. We therefore believe that Chinese President Xi Jinping has an incentive to get a deal done with President Trump. The last thing Xi needs is a sharp rise in unemployment and corporate bankruptcies as profit margins get eviscerated.

China’s currency has weakened further in recent months, reaching an 11-year low against the US dollar in September 2019 that amounted to a cumulative decline of 12% since April 2018 — thereby offsetting a little more than half of the imposed or announced tariff increases. The Chinese government is reluctant to encourage additional currency depreciation, fearing that capital could flee the country. Rather, there is evidence that it is getting more aggressive when it comes to pulling the monetary and fiscal levers.

Slowing growth in China, the US and the eurozone does not bode well for other economies. On a positive note, many developing countries have been able to cut interest rates in recent months. Meanwhile, capital-market conditions in emerging countries still appear benign. Spreads on US dollar-denominated debt remain in the middle of their range for the past eight years.

Despite all its economic and political problems, European-wide equity markets have done rather well this year in local-currency terms. The MSCI Europe ex UK Index (net, total returns) climbed 21.1% year to date, actually matching that of the MSCI USA Index. The United Kingdom Index (net, total returns) was the laggard, gaining only 13.8% — still something of an achievement considering the messy political situation in the UK.

How does one explain the rather robust performance of European equities? It can largely be attributed to the lack of an alternative option. For example, now that Germany’s sovereign yield curve is negative all the way up to 30 years (just one year after yields were positive beyond six years), its investors have no hope of building wealth in less risky fixed-income assets and are therefore forced into equities and other risk-oriented investments. Investors globally face similar challenges, even if not quite to the same extent.

While Germany’s overall economy is not clearly in a recession, its manufacturing sector almost certainly is—the 6.4% decline in industrial production from the peak in November 2017 through July 2019 was worse than Italy’s 2.5% contraction over the same period. Considering that manufacturing represents almost 23% of the country’s GDP (much higher than the average for developed countries), it is easy to understand why the country is in a funk.

We will find out soon whether a no-deal exit from the EU actually takes place or is delayed (for a third time) beyond the 31 October deadline. The political carnage caused by Brexit is already breath-taking. The Conservatives lost their working majority in the Parliament following the expulsion of 21 members of Parliament from the party in the aftermath of a vote to wrest away Brexit negotiations from the government.

The battle between the Prime Minister and the Parliament already led to a constitutional crisis when the UK Supreme Court declared Johnson’s move to suspend Parliament as invalid. If he defies the will of Parliament and takes the UK out of the EU without a trade agreement, that crisis will deepen. More likely, there will be an additional delay, with a new Brexit deadline. That would allow for a general election and, hopefully, a new mandate from the electorate. But the political landscape in Great Britain is in flux. The outcome of the next election could be an unstable coalition.

Despite the rather solid financial position of UK households, both consumer and business confidence are nearing levels consistent with recession.

Despite the rather solid financial position of UK households, both consumer and business confidence are nearing levels consistent with recession. Confidence measures in the eurozone, while off the highs of 2017, have not fallen to the same degree.

Japan is also focused on home-grown uncertainty: The consumption tax hike effective 1 October. And despite a tight labour market with an almost record-high number of available jobs per applicant, the decline in earnings growth from last year is surprisingly steep. Regardless of all their efforts, Prime Minister Shinzo Abe’s government and the Bank of Japan have been unable to spur a lasting reflation of the economy.

Like Germany, Japan has been hurt by the slowing growth of China and the general malaise affecting Asia as a whole. To make matters worse, Japan’s political relationship with South Korea has frayed badly in recent months. Both countries have expanded economic sanctions, including tit-for-tat tariff duties and consumer boycotts. Even more worrisome is the breakdown in direct military intelligence sharing at a time when China is pushing its weight around in the East and South China Seas.

In all, Japan’s outlook appears to be one of stasis. In the meantime, investors will likely continue to view the country as a safe haven owing to its low volatility. We believe the yen will remain well-bid under this scenario.

In view of the uncertainties facing investors presently, the prediction game is arguably even more challenging than usual. Accordingly, as always, we believe in a diversified approach to investing. Although maintaining exposure to equities and other risk-oriented assets can at times feel uncomfortable, it is our view that investors with long time horizons should avoid timing the market or making outsized sector or regional bets. We think it is best not to assume, for example, that the S&P 500 Index and growth stocks will always be the only games in town. The recent volatility and sharp style rotations in the past quarter should serve as reminders that trends do not last forever. 

All references to performance are in US dollar terms unless otherwise noted.

Glossary of Financial Terms

Federal-funds rate: The federal-funds rate is the interest rate at which a depository institution lends immediately-available funds (balances at the US Federal Reserve) to another depository institution overnight in the US.

Index Descriptions

S&P 500 Index: The S&P 500 Index is an unmanaged market-capitalisation-weighted index comprising 500 of the largest publicly-traded US companies and is considered representative of the broad US stock market.

Legal Note

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