As we summarize the recent quarter and consider larger themes driving the global capital markets, we first reflect on the notable events of 2018 and how we got to this point.
In Q1, the year began with (1) aggressive and justifiably positive growth revisions following US tax reform. That set the trajectory for 2018. Then there was (2) a market-correction stemming in part from rising interest rates, but more to the point, from liquidity pressures related to the unwind of short-volatility funds staring at the threat of insolvency. Subsequently, there was (3) technical trend support bolstered by the reassertion of corporate growth fundamentals. In the aftermath of the correction, Q2 was marked by relative calm and a stark performance gap between the US and the rest of the world (“ROW”). Global economic growth decelerated to start the year, but while the US rebounded in Q2, the ROW lagged. Japan even contracted (in Q1) before resuming positive growth. Furthermore, divergent central bank policies plus $330 billion in post-tax-reform US dollar repatriation, prompted a 5% USD appreciation that amplified the performance gap (on a currency-translated basis), adding stress to Emerging Markets with external debt burdens.
In Q3, global themes persisted with escalating trade tensions adding to the mix. US growth again dominated, in both GDP and corporate profits, with the divergence driven by the ongoing effects of tax reform, deregulation, and positive sentiment. Reflecting all that, the S&P 500 Index gained +7.7% in Q3 compared to a modest gain of +1.4% for MSCI EAFE and further decline of -1.0% for Emerging Markets. Below the headline indices, results showed dispersion. For instance, MSCI Japan was the top-performer among non-US Developed Markets with a gain of 6.3% with economic activity rebounding (3.0% growth in Q2) and the Nikkei closing Q3 at an all-time-high of 24,120. MSCI China - comprising ~33% of the EM index - declined -7.7% as its Technology and Internet leaders reported earnings/revenue stumbles, but MSCI Brazil gained +6.2% in Q3 (growth rebound following trucking strike) and Mexico gained +7.0% (trade agreement with US). Energy-dependent MSCI Russia gained +6.6% as Brent crude rallied on energy production limits by OPEC/Russia.
Breaking down the markets and other observations:
- US GDP rose 4.2% in Q2 compared to 1.6% for the Eurozone. In Japan, GDP growth rebounded to 3.0% in Q2, but this followed a Q1 contraction. For Europe and Japan, the anticipated catch-up phase has been slow to materialize, despite strong employment trends and competitive trade advantages due to Euro/Yen weakness. Global trade fundamentals and policy concerns have been the main factors behind equity performance, but political issues across Europe have impaired sentiment (i.e. Brexit complexities, austerity-fatigue in Italy and Spain causing political conflict within the EU). Looking ahead, the Atlanta Fed is estimating US GDP growth of 4.1% for Q3. Last week, the Fed quietly raised its GDP growth projection for 2019 to 2.5% (and lowered its inflation estimate to 2.0%). At a conference on 10/2, Fed Chair Powell said “a wide range of data on jobs and prices supports a positive view” on the US economy.
- US tax reform’s impact on 2018 corporate profits has been pronounced. S&P 500 earnings gained ~25% in Q2 compared to ~11% for Europe and ~9% for Japan, and these results drove equity returns throughout the July/August reporting season.For Q3, S&P 500 earnings are projected to rise ~20%, according to FactSet. Expect more of the same for US earnings in Q4 - to be reported early next year. Beyond that, US after-tax profits will drop to more normallevels (absent the one-time boost from lower tax rates), but operating results should keep chugging along and this will be the main area of focus. Per FactSet, S&P 500 earnings growth is estimated at an above-average rate of ~11% for 2019. Bespoke Investment Group points out that these relatively high expectations make US equities vulnerable to earnings misses and revenue disappointments; not necessarily a prediction on their part, but something to consider and we concede the point. No doubt, investors will be watching intently for management guidance during the upcoming earnings season. Besides global trade concerns, perhaps transitory in our view, we are interested to see how recent structural reforms are impacting consumer/business spending behavior going forward.
- As noted above, US business and consumer optimism is robust. The NFIB Small Business Optimism index reached 108.8 in August, the best reading ever in the 45-year history of the survey. Meanwhile, the Conference Board’s Consumer Confidence Index reached 138.4 in August, the best level in 18 years and approaching an all-time-high. In our view, these sentiment measures are quite telling and reflect above-trend economic growth, strong employment trends, and a positive outlook based on pro-growth structural reforms (i.e. deregulation and lower tax rates). Again, we are curious to see how such optimism translates into (presumably increased) economic activity and growth momentum. As a base case, we expect enduringly positive effects.
- Divergent monetary policy is another factor contributing to the US-ROW performance gap. With the Fed methodically hiking interest rates, US dollar appreciation has detracted from returns for non-US assets on a currency-translated basis. Also, USD appreciation has added pressure to Emerging Markets with heavy external debt burdens, but that fundamental reality seems to be overly discounted in some cases and the negative perception has extended unfairly to certain EMs with strong sovereign balance sheets and growth attributes. After appreciating in Q2, the USD was essentially flat for Q3 (before a late September rally related to Italian budget concerns). Overall, and on a technical basis, dollar strength seems to be topping out against several currencies, so a trend reversal could be forthcoming. Moreover, (1) JPMorgan estimates that the bulk of the tax-related dollar repatriation has run its course, and (2) while the Fed says the US economic outlook is positive and it downplays the fact that it removed “accommodative” from its policy description, we attach some significance to the wording change and note that Eurodollar markets are pricing rate cuts by 2020. In other words, we see limits to the rate hikes on the not-too-distant horizon. Meanwhile, core inflation levels in Europe and Japan are hovering around 1% and plans for rate hikes and stimulus reductions keep getting pushed back. Nonetheless, we believe the policy divergence reached an extreme over the summer and could gradually narrow. Ultimately, a less-strong USD would stabilize currency markets, support global trade, and help turn sentiment and lift prices for Emerging Markets.
- Trade battles (or “family” skirmishes according to Kudlow in some cases) have persisted as the change-agent Trump strives to reform US trade agreements. Throughout most of Q3, this created a negative overhang for equity markets. So far, the global trade rebalance has been an obstacle for the ROW. Assets sensitive to global trade - and especially China-based equities - have been trading with a trade-policy discount. Regarding just the US, JPMorgan recently estimated a trade-policy discount of 5-7% for the S&P 500 Index, although some of that risk premium has evaporated with rising prices as unilateral trade deals unfold. Indeed, markets rallied earlier this week as the USMCA was announced. Actually, trade negotiations have been progressing fairly well (and quickly) with Mexico and Canada, the EU, Korea, Japan, and the UK. It is a reminder to investors that Trump’s rhetoric does not stop the Administration’s efforts at working to achieve tangible results. At some point, we expect the markets will figure this pattern out.
- On the other hand, relations with China are strained given geopolitical concerns and economic disputes, such as NOKO and intellectual property rights, but the on-again/off-again talks continue. With China, we see a more protracted process and for obvious reasons. For generations, the US and China have been a political, military, and economic rivals. Since 2001, China has benefited from its EM status as a WTO member, but given China’s profound economic development, Trump is now pushing for changes to remove preferential treatment. Ultimately, we see China adapting to some degree; the evolutionary process will take time, but the trade-policy discount on Chinese equities could evaporate quickly on any announced trade-negotiation progress. In the meantime, China is gradually deploying monetary stimulus, tax cuts, and infrastructure spending. Critics say stimulus levels are small, but we see the growth-oriented steps as moving in the right direction.
From our vantage point, two other factors deserve mention.
- Volatility and correlation dynamics have created opportunities for active managers and traders. After spiking above 50 (intraday) during the Q1 correction, implied volatility has steadily declined. The CBOE Volatility Index (“VIX”) closed Q3 at 12.12 and the VIX term structure remains in normal contango (upward sloping), which means the markets expect higher volatility ahead. Looking out six months, implied vol was 16.28 on 9/30. However, despite the decline from the February stress levels, the Spot VIX was up ~37% compared to last year based on a 2018 average of 15.16 (median of 13.47). More importantly, volatility-of-volatility was up ~220% this year. Furthermore, correlation levels are low. After peaking around 0.50 during the Q1 correction, rolling-three-month pairwise correlations for the S&P 500 have fallen to roughly 0.15, approaching the 2017 lows, according to Bespoke. Higher levels of volatility combined with lower correlations create a supportive environment for certain active management and trading-oriented strategies.
- For years, transformational structural reform has topped our list of global themes over an extended time horizon. From our recent CMO Weekly research briefing, we shared this view: “Despite escalating trade rhetoric, US leadership could drive a virtuous global cycle with the EU, Japan, and others competing to implement pro-growth structural reforms in the years ahead. Ultimately, China will comply. A byproduct of stronger global growth, however, could be rising inflation and interest rates, making fixed income vulnerable.” Obviously, the US-China trade negotiations are a near-term exception to the rule, but with trade agreements quickly unfolding and various markets enacting tax cuts (e.g. France, China), others are taking note. Kevin Muir, CFA and market strategist at Toronto-based East West Investment Management offered the following in his Macro Tourist blog dated 9/20:
“It’s probably fair to say that relative to the rest of the developed world, American fiscal policy has been easier, while monetary policy tighter. This is the complete opposite of the past decade’s recipe of tighter fiscal policy... and easier monetary policy... Yet that’s changed over the past couple of years with Americans taking the exact opposite tack. And what has been the result? Economic outperformance. Now, don’t worry if it is sustainable. Don’t worry if it is smart. Don’t worry if it is right. All you need to ask yourself is what are the consequences of this development? Do you think it likely Europe or China will look at America’s outcome and say, ‘you know what? We should really cut spending and push even more monetary stimulus into the system?’ Not a chance. The entire world will look at America’s success and copy them. What will that mean? More spending. Larger deficits. Most likely, higher interest rates. And strangely enough, probably a much stronger global economy... Don’t worry about whether it’s right or not. Don’t let your political views get in the way of your portfolio construction. Just worry about whether this trend will get more or less intense from here. My bet is that this is just the start...”
We believe this potential outcome is underappreciated. Near-term, there always will be uncertainties, volatility, and obstacles to overcome, but we focus on the areas offering growth potential. That said, we do not necessarily favor a long-only beta approach to investing. Some assets are fully-priced or expensive, while others offer more attractive value. We prefer a diversified mix of strategies up and down the risk/return continuum, including low-correlation relative value and idiosyncratic event-driven strategies focused on less efficient market segments.
For more information and actionable insights, please contact us.
Atlanta Fed GDPNow as of 10.1.2018
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.