U.S. and Mexican negotiators neared a deal to revise their portion of the trilateral North American Free Trade Agreement, leaving the U.S.-Canada component to be resolved amid ongoing negotiations at month-end. The EU expressed willingness to lift tariffs from all U.S. industrial products—including automobiles (which have been a sticking point with President Donald Trump’s administration)—provided that the U.S. does the same. Meanwhile, the U.S. Chamber of Commerce, a business-focused lobbying group with unrivaled influence on conservative politics, launched a pressure campaign to highlight the economic pitfalls of relying on tariffs to conduct trade policy.
The British government released a set of contingency plans in late August detailing how segments of the U.K. economy should prepare for possible failure in striking a Brexit deal with the EU before the autumn deadline; the French government announced intentions to do the same as divorce negotiations persisted. U.K. cabinet-level ministers asserted throughout the month that the only two realistic negotiation outcomes include one that closely adheres to Prime Minister Theresa May’s so-called Chequers plan or one that reaches no deal at all. The EU’s chief Brexit negotiator, Michel Barnier, said at the end of August that he is holding out hope for a one-of-a-kind trade partnership between the EU and U.K., while also ruling out single-market access.
U.S. equities jumped higher, providing the only positive performance among major developed markets for the month. British shares tumbled in August, delivering the poorest performance among major developed markets, and European shares declined on notable weakness in peripheral countries like Greece and Italy. Hong Kong and mainland China shares fell, as did South American equities. A double-digit decline in Brazil was overshadowed by a meltdown in Argentina, where the government was forced to take extraordinary measures—including hiking the central bank’s benchmark rate to 60%, securing a stabilization loan from the International Monetary Fund, and announcing austerity measures—all in an effort to keep the Argentine peso from dropping further. Turkey also faced deep destabilization starting in early August, when the announcement of U.S. sanctions caused a re-evaluation of the country’s ability to service its heavy foreign-debt load, sending the Turkish lira into freefall.
Yields on U.S. Treasurys and U.K. gilts declined, except for those with the shortest maturities, while euro-area government bond yields fell universally across all maturities during the month. The Federal Open Market Committee took no new actions on monetary policy, according to its statement on the first of August. Meeting minutes released later in the month revealed that most members think another rate hike would probably be warranted in the near future given bright prevailing economic conditions. Federal Reserve (Fed) Chairman Jerome Powell offered a measure of accommodation at the central bank’s annual summit in Jackson Hole, WY, saying that its policy-setting committee would try to avoid overreacting with rate hikes if faced with inconclusive economic data. The Bank of England’s Monetary Policy Committee voted unanimously in early August to increase the bank rate by 0.25%, its second such hike of the current cycle. Bank Governor Mark Carney expressed willingness to remain on the job past his planned departure next summer to help provide stability as the U.K. grapples with its exit from the EU. The European Central Bank (ECB) and Bank of Japan had no meetings in August; both kept their policy paths steady following late-July meetings, and the Japanese central bank said it plans to offer more specific forward guidance on policy rates in an effort to influence its inflation target.
U.S. manufacturing reports for August depicted consistently strong new-order growth, while services-sector growth slowed. Prices for core personal-consumption expenditures (the Fed’s preferred inflation gauge) edged up to 2.0% in July, precisely in line with the central bank’s target inflation level. Economic growth was adjusted higher by 0.1%, to an annualized 4.2% second-quarter rate.
U.K. services sector growth jumped in August, exhibiting healthy conditions, while manufacturing growth slowed to more modest levels. July’s claimant count (the number of people claiming unemployment benefits) held firm at a 2.5% rate. Unemployment for the April-to-June period fell by 0.2% to a rate of 4.0%, although average year-over-year earnings growth ticked down to 2.4%. Overall economic growth registered 0.4% for the second quarter, improving by 0.2% from the final reading of the prior quarter.
Eurozone manufacturing growth softened during August, while services strengthened; however, both measures were at healthy levels of expansion despite remaining far below their respective peaks at the beginning of 2018. Economic sentiment continued to trend lower on slowing economic growth. The eurozone unemployment rate was 8.2%, unchanged from June’s downward-revised figure. Total economic growth was adjusted higher by 0.1% for the second quarter (to 0.4%) and for the 12-month period ending June (to 2.2%).
U.S. equities produced significant positive returns in August, with small-cap stocks outpacing large caps. Growth-oriented stocks substantially outperformed value-oriented stocks; this weighed on the performance of our large-cap strategy given its value tilt. Other detractors included an underweight to and stock selection within information technology, the top-performing sector for the month. Our small-cap strategy performed well on the strength of selection in information technology, consumer discretionary and telecommunications. Offshore equity markets faced a challenging environment, but our international developed-market strategy generally fared well. An overweight to technology companies and selection within materials and financials contributed, while selection in consumer staples and an underweight to Japan detracted. Emerging-market equities had a sharper decline than developed markets, and our strategy struggled. Specifically, positioning in metals and mining stocks detracted, as did selection in transportation and Chinese industrial stocks.
Treasurys outperformed U.S. investment-grade, non-government fixed-income sectors in August; this restrained the performance of our core fixed-income strategy. Duration positioning was modestly positive as yields declined. A yield-curve-flattening bias also contributed as long-term yields declined by more than short-term yields. Slightly overweighting corporate credit detracted despite a concentrated positioning in financials, the best-performing sub-sector. An allocation to non-agency mortgage-backed securities (MBS) contributed, while a slight overweight to agency MBS detracted. Asset-backed securities (ABS) outperformed, benefitting the strategy’s overweight, but a higher-quality bias within commercial MBS held back returns. An underweight to taxable municipals contributed. U.S. high-yield bonds were the best-performing non-government fixed-income sector for the month, and our strategy slightly trailed the benchmark. Security selection within technology and electronics and an allocation to Puerto Rico were the largest contributors; an underweight to and selection within banking also helped. An allocation to bank loans and selection in basic industry and media detracted. Emerging-market debt sharply underperformed the rest of the fixed-income universe, with steep losses in local-currency-denominated debt. Our strategy underperformed, largely on overweights to both foreign-currency-denominated and local Argentine debt. An overweight to the Turkish lira (which was reduced during August) and an overweight to Turkish foreign-currency debt also detracted.
Manager Positioning and Opportunities
The economic environment and earnings trends remain favorable, but markets may exhibit continued volatility due to high valuations, rising interest rates, trade tensions, and potential geopolitical instability. High valuations have been coming primarily from a narrow set of expensive high-growth stocks, which our large-cap strategy was underweight due to unusually wide valuation spreads. Furthermore, we remained positioned to seek to benefit from the long-term premium available to those with the patience to tilt toward value. Within small caps, we retained positive exposure to value and momentum—but were trimming momentum in an effort to avoid a major drawdown, and using this as an opportunity to add to value. Our international developed-market strategy increased an overweight to the technology sector due to attractive opportunities in Japan and Germany. Industrials remained overweight, and we trimmed holdings in the materials and consumer discretionary and consumer services sectors. We took profits in Hong Kong and reduced exposure to the Italian auto sector, while adding to Japanese names. Traditional defensive sectors remained underweight. Our emerging-market equity strategy maintained an overweight to technology, and made small increases in energy, healthcare and industrials stocks. We slightly increased exposure to Korean and Indian assets due to company-specific opportunities, and trimmed positions in Turkey as the country’s situation continued to decline. We favored private banks in India (due to their competitive position) as well as Greek banks (due to their massive upside potential), but were underweight Chinese banks due to quality problems. We were underweight utilities given their limited growth opportunities and interest-rate sensitivity.
The duration posture of our core fixed-income strategy has continued to drift lower since the middle of the second quarter, but maintained a yield-curve-flattening bias (which has moderated with the flattening curve). Our corporate positioning still favored the banking sector; we plan to continue adding selectively to corporate holdings as September tends to be a large month for issuance. Overweights to ABS and commercial MBS (CMBS) will likely remain as these bonds tend to offer competitive risk-adjusted yields; however, we selectively reduced risk in student loans within ABS and retained higher-quality exposure to CMBS given retail-property troubles. We also retained positive exposures to agency and non-agency MBS. Our high-yield strategy maintained a bank-loan allocation and significant overweight to the retail, media and leisure sectors, offset by a large underweight to energy and smaller (but significant) underweights to financial services, banking and services. Within emerging-market debt, our strategy had equal weighting to foreign- and local-currency debt. Top country overweights were to Argentina, Mexico and Egypt, while top underweights were to Romania, Philippines and Taiwan.
Make no mistake about it: headwinds blowing in the face of risk assets have accelerated. Growth in business activity has slowed somewhat, especially in Europe. Monetary policy has tightened in the U.S. and is set to become less expansionary in Europe. Inflation has ticked higher across the major economies, driven by synchronized global growth and a contracting of labor markets and industrial capacity in the U.S., Germany, the U.K., China, and elsewhere in Asia. A jump in oil prices has pushed headline consumer-price-index readings to their highest levels in several years; the Organization of the Petroleum Exporting Countries and Russia have shown a fair degree of discipline in constraining the supply of crude oil at a time when demand is strong and inventory levels have fallen. Some developing countries have been forced to raise their policy rates dramatically in an effort to defend their currencies.
Most important, the stoking of trade-war tensions by the U.S. has threatened to undermine the very foundation of the system that has supported the global economy since the end of the Second World War. Although actual trade actions to date have been modest, the impact on global supply chains bears close watching.
Economic fundamentals that drive the stock market nevertheless appear solid, even in places like Europe and developing economies. Plus, interest rates remain at levels that are accommodative to global economic growth. Key risks—escalating trade tensions and the polarization of electorates over issues like immigration and fiscal sovereignty—appear more political in nature. The positives include a still-solid global economy, strong momentum in corporate-profits growth, and persistent equity valuations that seem reasonable against the backdrop of still-low (albeit rising) interest rates.
If one believes, as we do, that the global economy is sound and political uncertainties will be contained, then the proper course (in our view) should be to remain exposed to equities and other risk assets and ride out the short-term ups and downs.
American investors, businesses and consumers have much to applaud despite fears of a trade war pitting the U.S. against foes and allies alike. The country’s corporate tax reform, tax cuts for households, and reduced or modified regulation of various industries have led to record-high consumer and business confidence.
But saber-rattling between the U.S. and China has deteriorated into actual skirmishing, and the latest back-and-forth suggests this spat will get worse before it gets better. To be blunt, the Trump administration’s strategy of waging a trade war with China could prove to be the equivalent of cutting off one’s nose to spite one’s face.
In the U.S., a trade war will likely lead to higher prices for consumers and hurt the bottom lines of companies that sell imported goods and those that depend on global supply chains in their production process—resulting in a net loss for its society. A small group of American producers will probably benefit substantially from the trade impediments, while most consuming industries and households suffer declines in purchasing power—declines that may be small at the level of the individual but add up to an enormous loss across the affected economies. With any luck, the Trump administration will shy away from further ratcheting tensions. But we must admit that doesn’t seem to be in the cards in the near-term.
The economic data coming out of Europe has been hugely disappointing this year. Instead of building upon the improved business activity of 2016 and 2017, there has been a widespread deceleration. At SEI, we have been reluctant to get too bearish on Europe’s fundamentals, but there’s no denying that financial-market participants are disbelievers.
ECB President Mario Draghi and other bank governors decided to conclude net asset purchases by the end of this year because they view deflation risks as having moderated significantly. Since the ECB will no longer be a price-insensitive buyer of eurozone debt, we could see yield spreads rise as investors demand a risk premium for those countries with a heavy debt burden relative to the size of their economy. Italy’s new government wants to institute several expensive propositions that would blow a hole in the government’s budget, likely causing the country’s bonds to be further discounted by investors—with other periphery countries’ bond yields rising in sympathy (yields move inversely to prices).
Recent U.K. economic data reports, like those of other countries in Europe, suggest that Great Britain is wending its way through a soft patch. Underlying growth nevertheless appears solid, indicating the U.K. economy is in stable condition; although the trade sector looks to be a problem spot.
The biggest source of uncertainty facing the U.K. is its looming withdrawal from the EU. The Conservative Party’s internal fight over the country’s future relationship with the EU has stalled progress toward a clear post-Brexit status. Maybe it’s sheer coincidence, but sterling versus the U.S. dollar is almost where it was the day after the Brexit vote on June 23, 2016. The recent trend has been to the downside, as currency-market participants worry about the rising odds of a hard Brexit and more-thorough disruption of U.K. trade with the EU. We would not be surprised to see further downside volatility in sterling as we draw closer to the EU exit date.
A confluence of events has conspired to hurt the performance of emerging-market assets. An extensive trade war that disrupts multinationals’ supply chains would interrupt the flow of raw commodities and semi-finished materials from developing economies, which depend on these exports for economic growth. Rising U.S. interest rates, resulting in another period of sustained U.S. dollar strength, is a second threat. The soft patch in Europe and recent signs of deceleration in China’s economic growth is a third.
But while emerging-market stocks and bonds have come under pressure this year, we’ve yet to see any widespread deterioration in economic performance or financial conditions. On balance, we think most emerging markets have the ability to weather the storm—again, assuming the disruption to global trade does not devolve into something more encompassing.
A broadening of the trade war with China or a U.S. departure from the North American Free Trade Agreement would likely have a severely negative impact on the profitability of U.S. manufacturers, prompting us to reassess our still-positive view. Impediments to trade also could lead to a higher inflation rate as U.S. companies use the tariffs umbrella to raise their selling prices. The Fed may feel compelled to lean against this threat to price stability, thereby aggravating any economic shock arising from the disruption of global supply chains—which is how a bear market could develop.
This is not our base-case scenario. We still think this old bull has some life left in it, but the risks to the equity market now seem more balanced than skewed to the bullish side.