Markets Diverge on Geopolitical Unknowns

December 12, 2018

  • Volatility continued in November, with mixed performance across capital markets. U.K. and European stocks struggled amid ongoing Brexit uncertainty, while Latin American equities lagged all other regions; U.S. and Asia-Pacific stocks gained on the possibility of a U.S.-China trade-war ceasefire.
  • European leaders finally signed a Brexit agreement and the Federal Reserve released a financial stability report that named the greatest risks to the country’s financial system.
  • In such times of market volatility and geopolitical uncertainty, we believe that investors are best served by maintaining a diversified approach and focusing on their long-term investment strategy.

Economic Backdrop 

Volatility continued in November, with mixed performance across capital markets. U.K. and European stocks registered poor performance amid ongoing Brexit uncertainty, while Latin America reversed course as it posted the worst regional performance in November after outpacing the rest of the world last month. U.S. and Asia-Pacific stocks gained on a possible respite from trade-war concerns ahead of early-December talks between President Donald Trump and Chinese President Xi Jinping at the Group of 20 (G-20) summit in Argentina; the two leaders ultimately agreed to a temporary trade-war truce calling for the U.S. to postpone tariff increases in exchange for China’s commitment to purchase a substantial (but yet-to-be-determined) amount of U.S. agricultural, energy and industrial products in order to reduce the huge U.S. trade deficit with China.

Riskier fixed-income segments such as high-yield and emerging-market debt (foreign-currency) once again lagged the broader market along with investment-grade bonds. (Local-currency emerging-market debt performed well.) However, in a shift from the prior month, U.K. and EU government bond yields increased in November; the yield on the 10-year U.S. Treasury note moved lower for the month. West Texas Intermediate crude-oil prices tumbled further from their early-October peak, descending by 22% in November.

Despite a near-term view that is fraught with uncertainty, we continue to believe in diversifying portfolios with emerging-market exposure.

The Federal Reserve (Fed) released a financial stability report toward the end of the month, citing the biggest risks facing the U.S. financial system: increased asset prices; historically elevated debt burdens for American businesses; and rising issuance of higher-risk bonds. The report also noted that potential shocks to the U.S. economy—such as indirect effects of Brexit fallout, slowing growth in emerging markets (particularly China), or ongoing trade tensions—could further test the country’s financial system. The U.S.-China trade detente in early December came days after the Fed’s report was released.

Elsewhere, European leaders finally signed an agreement in November after more than two years of negotiations, officially outlining the terms of the U.K.’s divorce from the EU. If it passes EU and U.K. parliamentary votes next month, the two sides will enter a 21-month post-Brexit standstill on March 29 during which they will negotiate future trade and security provisions. The treaty also includes a solution to avoid a hard border on Northern Ireland, allowing it to remain in the EU’s single market and customs union. An additional non-binding document indicates an agreement to maintain strong economic ties between the U.K. and EU—yet prohibits U.K. manufacturers from gaining unrestricted access to the EU’s single market; it also calls for close security cooperation.

While reaching a divorce agreement was a significant breakthrough, U.K. Prime Minister Theresa May must still secure support from skeptical members of Parliament—a particularly difficult task as the treaty includes a range of compromises that have elicited criticism across political affiliations. Failure to secure backing from lawmakers before Brexit occurs, as scheduled, on March 29 could result in significant trade and security disruptions between the U.K. and EU.

Aside from the Fed, none of the world’s major central banks held monetary-policy meetings in November; each is scheduled to reconvene in mid-to-late December. The Federal Open Market Committee maintained its federal-funds rate and confirmed that inflation sits near its 2% target amid strong jobs growth and consumer spending, yet noted moderating business investment. The central bank remains widely expected to hike rates in December. The European Central Bank (ECB) released its meeting minutes from the prior month, which stated that recent economic data for the region remained in line with broad-based economic expansion despite weaker-than-anticipated reports; the minutes also reiterated the ECB’s intention to end net asset purchases before the end of the year.

U.S. manufacturing was depicted in mixed reports as healthy in November, either accelerating to an unusually strong pace or softening slightly to a still-solid rate of expansion. Services-sector growth appeared to moderate in November, according to preliminary reporting. The core personal consumption expenditures price index registered a lower-than-expected 0.1% gain in October, falling below the Fed’s target inflation level with a year-over-year increase of 1.8%. Payrolls increased in November, and average hourly earnings grew by 3.1% year over year, as the unemployment rate remained at a 49-year low. The U.S. economy grew at a slower but still-strong 3.5% annualized rate for the third quarter, according to an unrevised second estimate.

U.K. manufacturing beat expectations in November, expanding by two points from the 27-month low recorded in October, yet remained one of the slowest monthly paces recorded in the past two-and-a-half years. Construction growth also fared better than anticipated in November, hitting the highest point since July of this year. Labor-market conditions appeared mixed in the latest report: claimant-count unemployment increased by 0.1% to 2.7% in October; the July-to-September unemployment rate ticked 0.1% higher from the prior reporting period to 4.1%; average year-over-year earnings growth increased by 0.2% to 3.0% over the same three-month period.

Eurozone business activity softened further in November, with manufacturing growth picking up by less than expected (with output registering its worst reading in about 65 months) and services growth shrinking to a 25-month low. Unemployment increased so minimally that the rate held steady at 8.1% in October; joblessness in Italy surged, offsetting improvements France, Germany and Spain. The second flash report of overall economic conditions was unchanged, showing eurozone gross domestic product (GDP) expanding by 0.2% in the third quarter and 1.7% year over year—a deceleration over both periods and the slowest quarterly pace since the three-month period ending September 2014.

Portfolio Review 

U.S. equities finished in positive territory for November despite continued volatility and substantial risk aversion within the market during month, with large-cap stocks outpacing small-caps. Our large-cap strategy outperformed the benchmark on an overweight to the outperforming healthcare sector and selection within financial services; it also gained on exposure to value, which beat growth within the large-cap space. Our small-cap strategy lagged the benchmark primarily due to poor selection in industrials, healthcare and financials. Value-oriented strategies generally contributed, while momentum strategies detracted. In terms of holdings, weak selection in consumer discretionary and information technology as well as an overweight to energy detracted the most from relative performance; notable contributors included stock selection in materials and consumer staples.

Major Index Performance November 2018 (% return)

index performance nov 18

Sources: FactSet, Lipper

Further afield, emerging-market equities were also positive for the month—outperforming international developed markets, which registered negative returns in November, and U.S. stocks for the first time in months. Our emerging-market equity strategy trailed the benchmark on weak performance across multiple sectors, including consumer staples, energy, healthcare, financials (especially banks), industrials, technology and telecommunications. The real estate sector also detracted, due to an overweight to underperforming UAE real estate and an underweight to strong Chinese real estate. Regionally, the biggest detractor was selection in India and Vietnam. Selection was solid in consumer services and durables, but not enough to offset the weakness of other sectors. Our international developed-market strategy also lagged the benchmark during the month, primarily due to poor stock selection in industrials (capital goods), technology (software services), materials and financials. Europe was a significant regional detractor, mostly within Danish and Norwegian stocks.

U.S. investment-grade non-government fixed-income sectors underperformed comparable Treasurys in another challenging month, and our core fixed-income strategy performed in line with the benchmark. An overweight to the long end of the yield curve contributed, while a slight overweight to corporates subtracted from relative performance. The strategy benefited from its allocation to non-agency mortgage-backed securities (MBS), which continued to outperform on low inventories and advancing wages; it was hurt by an overweight to asset-backed securities (ABS), which were modestly negative for the month. The strategy’s higher-quality bias helped mitigate losses within commercial MBS (CMBS), which underperformed comparable Treasurys as lower-quality tranches registered dismal returns, while overweighting agency MBS was modestly favorable. An underweight to taxable municipals and U.S. dollar-denominated sovereign issuers contributed, as both sectors fell along with the broad selloff.

Our U.S. high-yield strategy underperformed the benchmark amid poor conditions for below-investment-grade fixed income in November. Security selection in basic industry, media and retail was the biggest detractor; modest contributors included selection in consumer goods and transportation. Within emerging-market debt, local-currency assets rallied during the month amid a decline in the U.S. dollar, while hard-currency assets fell on widening spreads. Our strategy underperformed the benchmark, primarily due to unfavorable positioning in certain countries; its allocations to local- and hard-currency assets essentially mirrored the benchmark over the period, and therefore had virtually no effect on relative performance. An overweight to Mexican bonds detracted, as the country’s assets sold off amid heightened trade talk between the U.S. and China as well as uncertainty about how the new president’s administration will fund large infrastructure projects. The strategy benefited from an overweight to Turkey, which benefited from the drop in oil prices and news that the U.S. lifted sanctions on the country in early November.

Fixed-Income Performance November 2018 (% return)

fixed income performance nov 18

Sources: FactSet, Lipper. See "Corresponding Indexes for Fixed-Income Performance Exhibit" in index descriptions, linked below.

Regional Equity Performance November 2018

regional equity performance nov 18

Sources: FactSet, Lipper. See “Corresponding Indexes for Regional Equity Performance Exhibit” in index descriptions, linked below.

Manager Positioning and Opportunities 

U.S. economic activity and corporate earnings have continued to increase, but there are indications that the current market cycle has already seen its greatest gains. Volatility may remain due to increasing inflation, rising interest rates and trade tensions. Our large-cap strategy continued to underweight some of the largest-cap stocks; there were a higher number of attractively valued opportunities further down the capitalization spectrum. We also remained underweight utilities due to their interest-rate sensitivity, high-debt balance sheets and low profitability. Within small caps, we maintained positive exposure to value and momentum, and continued to trim momentum at the margin in an effort to bolster value. Overseas, our emerging-market equity strategy remained underweight Asia (primarily to China and Korea), which was also our largest absolute regional exposure. Underweights to the Europe, Middle East and Africa (EMEA) region (mostly Russia and South Africa) and Latin America (namely Brazil and Mexico) were also retained. A structural underweight to certain countries impacted our sector positioning, including an underweight to technology-heavy Asian markets, resulting in an overall underweight to information technology. Our international developed-market strategy was overweight technology (generally within China, Taiwan and Korea) and financials, while it was slightly overweight to industrials (primarily professional services); defensive were underweights. Regionally, the strategy increased exposures to France and the U.K. and trimmed exposure to Brazil (financials and industrials) and China; it remained underweight emerging-market Asia, slightly underweight EMEA and overweight Latin America (largely Brazil, Colombia and ex-benchmark Argentina) and Europe.

Our core fixed-income strategy’s duration posture moved closer to neutral relative to the benchmark. Yield-curve positioning consisted of an overweight to 25- to 30-year bonds, an underweight to 15- to 20-year bonds, and neutral positioning in the short- and intermediate-term segments. We remained modestly overweight corporates with a preference for financials, and have been selectively adding as spreads have widened and issuance has been large. Overweights to ABS and CMBS were maintained, with an emphasis on limiting exposure to higher-risk segments (specifically, student loans within ABS and retail property within CMBS). An allocation to non-agency MBS and an overweight to agency MBS remained. Within high yield, we retained an allocation to bank loans and sizeable overweights to the leisure, media and retail sectors. We were significantly underweight energy, financial services, banking and basic industry. Our emerging-market debt strategy had a small overweight to local-currency assets; its largest country overweights were to Argentina, Egypt and Singapore, while its most significant country underweights were to Philippines, China and Hungary.

Global Equity Sector Performance November 2018

global equity nov 18

Sources: FactSet, Lipper. MSCI ACWI Index Components (as defined by SEI).

Our View 

The ratcheting-up of trade-war tensions between the U.S. and China has remained the number-one preoccupation of investors. And with good reason: Whatever happens between the two countries has global implications. China and the U.S. together accounted for 42% of world nominal GDP last year. So, when Trump and Xi agreed to a ceasefire, it makes sense that markets around the world breathed a collective (if temporary) sigh of relief—particularly in Asia and other emerging markets, which tend to have trade-dependent economies.

While China’s currency soared higher immediately after news of the agreement, it remains far lower than the U.S. dollar and versus a broader basket of currencies compared to its level before trade tensions arose. The weaker currency has partially offset the impact from tariffs already imposed by the U.S., while the competitiveness of Chinese exporters against other countries has improved as a result of this year’s devaluation.

The U.S. is still in strong shape economically—but nobody wins in a trade war. Even White House advisors with a pro-trade bias do not expect the U.S. to come out unscathed if tit-for-tat tariffs between the two countries resume after a 90-day ceasefire.

U.S. corporate margins have spiked in the past two quarters, reflecting the impact of the tax cute and acceleration of sales growth.

Despite a near-term view that is fraught with uncertainty, we continue to believe in diversifying portfolios with emerging-market exposure. The alpha opportunities (that is, the ability to achieve returns in excess of benchmarks) also are much greater given the economic and political idiosyncrasies inherent in the asset class. The price-to-earnings ratio for the MSCI Emerging Markets Index is still running at a discount to that of the MSCI USA Index (as of November 30, 2018).

Before the trade war with China appeared set to cool at month end, the Trump administration had already turned more conciliatory toward other countries with which it had picked fights. Broad agreement has been reached with Mexico and Canada on the new trilateral United States-Mexico-Canada Agreement (USMCA), which replaces NAFTA (notwithstanding Mexico’s stipulation of being exempt from steel and aluminum tariffs); the proposed new agreement is now pending approval by the U.S. Senate and House of Representatives. However, the threat of tariffs on European and Japanese autos and auto parts was reignited by the Trump administration ahead of formal negotiations due to start in January; we are hopeful that the White House realizes it’s better to gain allies in its battle against China than fight on multiple fronts.

Glossary of Financial Terms

Bull market: refers to a market environment in which prices are generally rising (or are expected to do so) and investor confidence is high.

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

Fundamentals: refers to data that can be used to assess a country or company’s financial health such as amount of debt, level of profitability, cash flow or inventory size.

Momentum: stocks whose prices are expected to keep moving in the same direction (either up or down) and are not likely to change direction in the short-term.

Price-to-earnings Ratio: Equal to market capitalization divided by after-tax earnings. The higher the price-to-earnings ratio, the more the market is willing to pay for each dollar of annual earnings.

Value: Value stocks are those that are considered to be cheap and are trading for less than they are worth.

Index descriptions

Legal Note

Disclosures
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.

There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.

Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company (SEI). Neither SEI nor its subsidiaries is affiliated with your financial advisor.