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Quarterly Overview: Patiently Watching Growth Unfold

Summary

In Q2, the most pronounced theme was the performance gap between the US and the rest of the world. The gap was amplified by investor sentiment and fund flows.

Current trends could moderate with Europe and Japan poised to show improved growth; currency stability could support Emerging Markets.

Globally-diversified portfolios, by design, already account for short-term fluctuations.

Trump trade policy has been somewhat clumsy, but he is pressing for concessions and better terms for the US. Despite contentious rhetoric, US leadership could ultimately set the pace for a virtuous global growth cycle as other countries follow.

Offering a macro view of the global capital markets provides important context. Our goal is to deliver timely perspectives and avoid lengthy platitudes. Ultimately, our purpose is to inform and equip decision-makers, so they are able to implement efficient portfolio allocations.

In Q1, the main themes were (1) positive growth revisions, then (2) a sharp market-correction related to rising interest rates and the unwinding of short-volatility strategies, followed by (3) technical trend support and the reassertion of corporate growth fundamentals. In the process, equity market volatility normalized at elevated levels with the CBOE Volatility Index (the VIX) running ~50% higher this year compared to 2017 (~16% versus ~11%).

In Q2, perhaps the most prominent theme was the performance gap between the US and the rest of the world (ROTW). In terms of economic data, virtually all global markets showed positive, but decelerating growth metrics in early 2018. The US stabilized with growth inflecting higher in Q2[1], but in Europe and Japan, the deceleration persisted. Along with divergent central bank policies, investor sentiment and fund flows rotated away from the ROTW. Due to USD appreciation of +5.3% in Q2, the pain was especially acute for Emerging Markets, where several central banks raised interest rates to defend currencies and protect against capital flight (at the risk of stifling economic growth). Some of the dollar-induced pressures could subside, however, as the pace of USD repatriation - a post-tax-reform factor which exaggerated fund flows and dollar strength in the first half - should fade in the second half, according to JPMorgan. Thus, current trends could moderate in the second half with Europe and Japan poised to show improved growth, supported by now-weaker currencies. Indeed, Markit PMI data through June shows continued global expansion with modest improvement versus one year ago. A growth rebound in Europe and Japan could help stabilize currencies and lessen US dollar strength, which would likely benefit Emerging Markets[2]. Moreover, the PBOC recently reduced reserve requirements by an estimated $100 billion and China could initiate further growth stimulus in the months ahead.

Assessing Global Growth: Have growth fundamentals shifted significantly over the last six months? Not in our estimation. Aside from an unsustainable boost from US tax reform, growth trends look firm over an 18-month horizon and should accelerate into year-end.

  • In 2017 global GDP grew at 3.8%, the fastest pace since 2011 per the IMF
  • Moreover, the IMF reaffirmed in April its view that economic growth would accelerate this year and next based on its global GDP projection of 3.9% for both 2018 and 2019
  • 2017 was the best year for global earnings since 2010 per JPMorgan
  • According to IBES[3], EPS growth for the S&P 500 is estimated at 22.6% in 2018 and 10.2% in 2019; analyst revisions and corporate guidance continue to show an upward bias
  • EPS growth for the Eurozone and Japan is estimated at 7.3% and 2.3% in 2018, respectively, and 9.5% and 5.1% in 2019, respectively
  • EPS growth for MSCI Emerging Markets is estimated at 15.9% in 2018 and 11.6% in 2019

“Advanced economies will grow faster than potential this year and next,” according to the World Economic Outlook published by the IMF in April 2018. “Aggregate growth in emerging market and developing economies is projected to firm further, with continued strong growth in emerging Asia and Europe and a modest upswing in commodity exporters after three years of weak performance.” Of course, identifiable risks and “downside concerns” are present. We concur with the IMF list of issues that includes “possibly sharp tightening of financial conditions, waning popular support for global economic integration, growing trade tensions, and risks of a shift toward protectionist policies, and geopolitical strains.” Markets already are on alert for these. However, the IMF sees potential for policy and structural improvements: “The current recovery offers a window of opportunity to advance policies and reforms that secure the current upswing and raise medium-term growth to the benefit of all.” Thus, despite all the contentious rhetoric that has dominated in recent months, we believe US leadership could ultimately set the pace for pro-growth structural reforms and trade policies, perhaps creating a virtuous global growth cycle as other countries follow. Furthermore, we see this upside risk as being underappreciated.

Therefore, our perspective on Q2 is this: A modest divergence in the pace of growth between the US and the ROTW has been amplified by investor sentiment and fund flows. This phenomenon plays out on a regular basis, whereby, directional asset class performance begins with a rational set of fundamental and/or policy factors; investor sentiment then responds accordingly and builds momentum, but then tends to overshoot (especially when technical trading programs get triggered). Admittedly, sentiment can become self-fulfilling in some cases and the overshoots can last longer than expected. When that happens, a series of data points in the other direction are required in order to validate fundamental value and persuade investors to rotate back into positions they exited. In other words, we are describing the normal ebb and flow of the daily-liquid public markets. Market prices track fundamentals over time, but they do not necessarily reflect fundamentals perfectly in the short-term.

Portfolio Structure Considerations: Globally-diversified portfolios, by design, already account for much of the short-term fluctuations (defined as less than six months) described above. The precise mix of geographical exposures and return sources will vary with one’s unique investment objectives and market views, but as a reference point, the MSCI ACWI (global equities index) is ~53% USA, ~34% Developed Markets ex-USA, and ~13% Emerging Markets. Certainly, there is a role for advisors, wealth managers, family office and institutional CIOs, and other allocators to engage in active repositioning and tactical rebalancing, but this can be difficult to execute over short time-horizons in the absence of clear visibility on fundamental or policy catalysts. Where price dislocations are pronounced, however, allocators enjoy the luxury of rebalancing portfolios and waiting for value-realization catalysts to emerge. All that said, tactical maneuvering over short periods is often best delegated to active/opportunistic fund managers with demonstrated trading skill, who specialize in certain market segments.

Global Trade Considerations: Obviously, trade policy has been a prominent issue since Trump was elected. Rhetoric has become bolder in recent weeks. Assessing potential outcomes on trade policy is difficult. First of all, exactly how much of the proposed tariffs and trade restrictions gets implemented is unclear. Secondly, the duration of any policies could be short-lived, assuming trade agreements are eventually reached. Moreover, global supply-chains have created highly-integrated economies, whereby policy changes can be counterproductive. In other words, a portion of US imports are components that are funneled into the end-products of US companies. Disruptions can be costly and this reality ultimately will limit the actions by the Administration. Finally, international trade entails multiple levers, which add complexity. For instance, currency fluctuations come into play; the China yuan has depreciated ~6% in recent weeks, offsetting costs associated with increased tariffs on US imports of China goods.

Patience is a virtue but is often hard to find in the capital markets. In early June, business leaders Jamie Dimon and Warren Buffett published an Op-Ed in the Wall Street Journal, calling for public companies to abstain from issuing quarterly profit guidance. Their point was that “short-termism is harming the economy” because a pre-occupation on immediate results often interferes with strategic planning designed to deliver long-term gains. The same might be true with the Trump Administration’s trade policy. Trump is a disruptor. His trade policy has been clumsy, sometimes inaccurate on details, or simply exaggerated for effect, but essentially, Trump is pressing for concessions and better terms for the US. Time will tell, but the public negotiations are unsettling and the rhetoric seems to be reaching a tipping point. We see growing risk that policy uncertainty could negatively impact capital investment behavior. We are hopeful cooler heads will prevail. Based on various research sources we track, asset prices have already priced-in modest trade barriers. Thus, the implementation of more restrictive policies could bring a sell-off, but fading trade tensions could bring a relief rally, especially for effected assets.


[1]US GDP rose at 2.0% in Q1. As of 7/6, the Atlanta Fed estimated Q2 growth of 3.8%.

[2]US dollar depreciation of ~5% might drive a gain of ~20% for Emerging Markets equities per JPMorgan as of 7/6.

[3]As reported by JPMorgan, Global Equity Strategy, July Chartbook, July 2, 2018.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: This overview is for informational purposes. The data referenced has been taken from sources deemed reliable, but there is no guarantee of its complete accuracy.