Global Market Overview – 3rd Quarter 2019
The debate about where we are in the global economic cycle rages on, and the range of opinions appears to be widening not narrowing. The US Federal Reserve Chairman believes we are in a “mid-cycle adjustment” yet observers of the trade war between the US and China, the political unrest in Hong Kong or the Brexit situation closer to home, tend to feel more pessimistic. The US economic expansion following the financial crisis in 2008/09 is the longest since records began in 1857, now surpassing the ten-year boom of the 1990s. Post war expansions have been long because central banks have operated pre-emptive monetary policy to keep demand on track. If it wasn’t for central banks, economic cycles would be dominated by shorter term cycles linked to companies building up and then liquidating inventories. These mini cycles had an average life span of around three years and explain the recessionary false alarms seen in 2012 and 2015 when business confidence was at a low ebb. In both cases a lack of inflationary pressure allowed central banks to ease policy and trigger a recovery in the global economy and stock markets.The same fundamentals are in play today. Inflation is surprisingly muted despite a tight US labor market. The US Federal Reserve have embarked on a rate cutting cycle with a range of developed and emerging market central banks likely to follow suit, China included. A fresh round of monetary easing looks set to provide fuel for a renewed upturn in both global growth and stock markets into 2020. Not only are interest rates set to remain low for much longer, but they are falling from already historically low levels and adding yet more pain for cash savers.
In July, the United States stock market hit all-time highs and 10-year U.S. Treasury bond yields (interest paid by the price of the bond) stabilized. All was right with the world. This all changed in August as 30-year U.S. Treasury bond yields fell to a new record low, and 10-year yields inched up. What this means is investors are flocking to investments they think are “safe,” and they’re bidding up the price so much it’s driving the yield down. They’re paying more and more for less interest, just for the feeling that they’ll get their money back. So why does anybody care about Treasury yields? Well, big investors see those government bond yields as the ultimate economic indicator. They thought the August plunge meant trouble, and a recession would be right around the corner. Then trade tensions escalated between the U.S. and China. Plus, the U.S. stock market bounced around over 10 days in August, which was the most gloomy month since February 2018. After a difficult summer for risk assets, investors returned from their holidays in a bullish mood and drove equities higher in September, leaving global equities broadly flat for the quarter. The quarter was marked by a continued slowdown in the global economic data, offset by further monetary easing from the US and Europe.
The reasons for this can definitely be blamed partially on the depressing political climate in SA and consequently the slump in the economy which has entered a technical recession. Investors seeing the poor returns of the local equity market over the past 3 years are likely to think that they should ignore growth assets entirely and move more into xed interest asset classes and cash because there are better returns to be had and there is safety away from the local equity market which they believe could fall if the SA political environment worsens. The reality is that this may be true for the short term, however, if they make these changes to their long-term investments which are there to provide for their retirement in decades to come, they could be making a catastrophic mistake. It is a reality that growth assets like equity do return much more returns than lower risk asset classes over time (approximately 7 years or longer).
Not holding enough growth assets is, in fact, a much larger (opportunity) risk than the short term market volatility. A further reason for not going completely into local xed income assets only when investing for retirement is that xed income assets, in particular, SA cash is totally correlated to the rand and hence the SA political situation, while SA equities being dominated by many multi-national companies that earn much of their revenue outside of SA offer a great hedge to a potentially weakening rand.
In the US, the Federal Reserve (Fed) cut interest rates in July and September in an attempt to prolong the economic expansion in the face of a slowdown in the pace of growth and hiring. While the economy continued to add jobs, the pace of growth of aggregate hours worked in the economy has slowed meaningfully. Consumer confidence also declined from elevated levels. US equities delivered 1.7% over the quarter in USD.
In Europe, the European Central Bank (ECB) responded to the weaker economic outlook by cutting interest rates further into negative territory, restarting quantitative easing and committing to continue with asset purchases until it achieves its inflation target. This shift from a date- dependent to a state-dependent form of forward guidance is significant in that it could lead to a large expansion in the total size of assets purchased by the central bank over the coming years. While those asset purchases may have a limited effect on their own, if combined with fiscal stimulus from the economies that can afford it, they could help to support growth. But the timing of any fiscal stimulus from Europe remains uncertain.
The ECB’s policy easing came against a backdrop of weakening growth, with the business surveys for September painting a picture of an economy that continues to slow, particularly in the manufacturing sector. With growth pushing in one direction and monetary stimulus pushing in the other, European equities delivered 2.5% over the quarter.
In the UK, the seemingly never-ending Brexit saga dragged on, with parliament passing legislation that will force the government to ask for an extension if it can’t agree a deal with the EU. This sent sterling higher, before the prime minister suspended parliament, only for the suspension to be ruled unlawful. So, no let-up in the drama, with a highly unpredictable election remaining the most likely outcome if a deal cannot be reached in the coming weeks. UK equities delivered 1.0% over the quarter.
The Bank of England remained on hold as Brexit uncertainty continued to cloud the outlook for the UK economy. With wage growth at 4%, policymakers are conscious that if global and Brexit- related risks subside they may still need to raise rates, whereas if the downside risks highlighted by some of the business surveys materialise they will need to follow the Fed and lower rates. UK government bonds delivered 6.7% over the quarter.
In Japan, the consumption tax hike has just come into place, posing a risk to an economy that is already feeling the effects of the global slowdown in manufacturing. Faced with these risks, Japanese consumer confidence continued to decline this quarter. The Bank of Japan also resisted the temptation to join in the easing game, but said it would review the outlook at its next meeting, perhaps hinting at further easing to come. Japanese equities delivered 3.4% over the quarter.
China and EM
Of course, the trade war also continued to play a prominent role in financial headlines throughout the quarter. As things currently stand, further tariffs are due to come into place by the end of the year unless renewed talks between the US and China make sufficient progress. Failure to prevent further tariffs could hurt the global economy, so it’s set to be another quarter of carefully monitoring the developments on trade.
China’s economy continued to slow, with industrial production growing at 4.4%, down from around 7% at the start of 2018. Retail sales also slowed, to 7.5% from close to 10% in early 2018. However, with growth still comfortably above that in the US, and given that the US economy is also slowing as a result of the trade dispute and there is a US election next year, it’s far from clear that China will concede to US demands on trade. EM equities delivered -1.9% over the quarter ,helped by central bank easing and rising concerns about the global growth outlook.
Overall, the global economy faces several binary and highly unpredictable risks. Will the trade war escalate? Will a UK election lead to a no-deal Brexit? Will the recent tension in the Middle East escalate and cause another spike in the oil price? And will companies respond to slowing growth and profits by cutting jobs?The uncertainties surrounding the China/U.S. trade talks, and to a lesser extent Brexit, dominate the outlook. Manufacturing is contracting globally, trade is weakening and corporate profits are under pressure. The U.S. yield curve is signaling that recession risks are increasing, and Chinese economic indicators are weakening. There is a risk that global uncertainties generate a self-fulfilling cycle where rising pessimism leads to less private-sector spending and higher unemployment. This in turn would cause lower profits and equity markets—and ultimately, deeper pessimism. President Trump has a clear motivation to avoid a recession before the November 2020 election. China’s pain threshold is higher, but job losses and the threat of social instability provide an incentive to de-escalate the trade tensions and pursue domestic policy stimulus.
However, it may take further equity market volatility to prod both sides into action. We view the ongoing trade war as the most significant risk to the outlook. Although de-escalation makes sense for both sides, political uncertainties mean trade tensions have the potential to spiral out of control. Under that scenario, the yield curve will have correctly predicted a recession and equity bear market.On balance, we think it is more likely that the combination of trade-war resolution and policy stimulus will see the global economy recover in 2020 and why maintaining risk exposure will be important as “bull markets don’t die of old age they die because the Fed kills them” and this isn’t on the cards just yet.
The IZA Portfolios
The portfolios for the most part ended the quarter flat to slightly positive, with the rotation from growth to value in August and September being the biggest detractor on a relative basis to benchmarks . This while some property names subject to the volatility out of UK also provided a headwind. Given the very binary nature of Brexit, a decision has been taken by the Investment Committee (IC) for the Balanced Fund to consoliated all the UK single REIT names into an active global property fund called the Catalyst Global Property Fund , which has consistently added alpha over and above its benchmark and provides a more diversified exposure to the property space. This took place in September along with the addition of 5% to Gold ,for protection in the event of further geopolitical risk, hedge against any weakness in USD and a possible inflation surprise. Further cognisant of the rising risk as we surpass 10 years of a bull market the IC has decided to add further downside protection via the addition of 5% to the PIMCO Global Real Return Fund. This operates as bond proxy , rallying when real yields compress as markets seek safety while also allowing outperformance of nominal bonds if inflation does surprise on the upside. The Funds equity growth/quality bias meant the equity names underperformed the broader market during the quarter but believe this is yet another brief reversal as experienced in 2012 and 2016 before these high quality names gain ascendancy once more.