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Aon Retirement and Investment Blog

Second Quarter 2018 Market Review and Outlook

Key Highlights
  • Economic releases over the second quarter pointed to contrasting fortunes with strong US data while indicators rolled over in other regions.
  • Developed market equities rebounded although trade turmoil has dented investor sentiment.
  • Yield curves continue to flatten although upward pressure on US term premia is likely.
  • Credit markets took a hit as spreads widened. Despite recent movements, we believe spreads are still below sustainable levels.
  • Widening interest rate differentials and stronger economic data sent the US dollar higher. 
 
Macroeconomic and Political Moves Diverging paths between the US and the rest of the world while the post-WWII era of trade liberalism is under threat
Despite the current economic expansion reaching the second longest in post-war history (currently at 108 months), US economic momentum showed no signs of abating during the second quarter of 2018. The Institute of Supply Management's (ISM) manufacturing index topped 60 in June, while the unemployment rate declined further to 3.8%. The lack of slack in the US labour market has started to translate into higher inflation with the core Personal Consumption Expenditures price index hitting the US Federal Reserve's 2.0% target for the first time in six years.
However, there was less upbeat news elsewhere with a number of economic indicators coming off current cycle peaks in Europe. While still in expansion territory (above 50), the manufacturing Purchasing Managers' Index in Europe decreased to 54.9 – a marked shift from the late-2017 readings that were above 60. This trend was not European-specific as readings in Japan and Emerging Markets reflected similar deceleration in the respective economies (see chart below). Concerns over the health of the Chinese economy resurfaced over the quarter, as investment slowed and the housing market continues to cool.
After some political wrangling, a populist coalition of the Five Star Movement (MS5) and the Northern League (NL) formed a government in Italy. The policies set out by these two political parties engendered fears of a potential Italian exit from the European Monetary Union as well as concerns of greater fiscal deficits, which was reflected in the poor performance of European financial markets. 
On the other side of the Atlantic, the US administration set out plans for rebalancing global trade with the imposition of tariffs on members of NAFTA, the European Union and in particular, China. The latter has sparked fears of escalations into a full-blown trade war.  It is still possible for the US and its rivals to back down and reach an agreement to prevent further escalation but the risk that more tariffs will be imposed has certainly increased with latest action and statements.


 

Monetary Policy The Fed continues on their hiking path while easy monetary policy continues elsewhere
Reflecting their diverging economic fortunes, the Fed has been tightening monetary policy at a faster rate than its peers with an additional 25 basis point (bp) rate hike in June, in tandem with the continued unwinding of the Fed's considerable balance sheet. The Fed's expectations of future rate hikes were also revised upwards, based on the latest Fed dot-plot. A confluence of tight resource utilisation and rising input prices are likely to exert upward pressure on inflation and potentially US monetary policy.
In Europe, the situation was somewhat different. In the UK, a rate hike was widely anticipated in the months leading up to May's Monetary Policy Committee (MPC) meeting, but members of the MPC decided to refrain tightening policy citing weak domestic economic data as one of the reasons for their change in stance. Meanwhile, the European Central Bank (ECB) announced that its quantitative easing programme would end in December 2018 whilst also insisting that any tightening to conventional monetary policy would only take place in the second half of 2019.
Within Asia, the People's Bank of China (PBoC) loosened monetary policy as it cut the reserve requirement ratio – the proportion of deposits required to hold as central bank reserves – for domestic banks twice over the quarter. Moreover, the PBoC did not increase the reverse repo rate after the Fed's rate increase in June – a departure from their previous moves following a US rate hike. While the Bank of Japan left its monetary policy unchanged over the second quarter, they did abandon the pledge to hit their 2% inflation target in 2019. 
 
Equities Developed market equities bounced back over the second quarter, buoyed by higher energy prices and resilience in earnings. Emerging markets were hardest hit by a stronger US dollar and a retreat from trade liberalism
  Whilst a strong initial start to the second quarter helped global equity markets to rebound from the previous quarter's decline, equity market momentum (as measured by the MSCI All Country World Index) faltered over the remaining period, culminating in a flat return over June. Building headwinds, namely trade turmoil and slowing growth (with the exception of the US), led to an increase in risk aversion amongst investors which dampened returns. Global equities, nonetheless, generated a positive return of 2.9% in local currency terms and 0.7% in US dollar terms.
The valuation adjustment required and risks from a change to economic conditions are starting to loom larger. Foregoing some return opportunity is reasonable after such strong performance over a long period. This is not a call for large equity sales, but rather a view that market conditions are favorable for de-risking, where affordable and practicable.
  The technology sector continues to lead the way for US equities while bond proxy sectors lag behind
Against a backdrop of lingering trade concerns, the resilience of US economic and corporate earnings supported US equity performance over the quarter with the Dow Jones Total Stock Market Index up 3.9%. Sector performance was quite diverse with traditionally interest rate sensitive sectors underperforming as yields marched higher while IT companies continue to impress.
  With a more domestically-focused revenue stream, US small cap companies were not buffeted a great deal by elevated trade tensions. The impact of US tax reform, enacted late in 2017 and disproportionately benefitting smaller companies, continues to provide a tailwind. The Russell 2000 index surged by 7.8% over the quarter while the Russell 1000 index lagged behind with a return of 3.6%.
  UK equity performance benefitted from the upturn in commodity prices as well as the weakening of sterling
While Brexit uncertainties persist, UK equities rebounded strongly following a particularly weak start to the year. The tailwinds of sterling depreciation, higher energy prices, and a degree of reversion from being oversold in the previous quarter drove a 9.4% return for UK equities in local currency terms. Once translated into US dollar terms, however, this gain falls to just 3.0%.
  Re-emerging political risks intensify headwinds for European equities
Receding political uncertainty within the Eurozone during 2017 seems very distant now with a coalition between the MS5 and NL In Italy, and a new government in Spain following a no-confidence vote for former Prime Minister Rajoy. This, alongside economic data coming off slightly, led to Europe's relative underperformance; a quarterly return of 2.9% in euro terms. The financial sector, in particular, underperformed due to exposure of weak performing banks. Against a backdrop of slowing economic momentum, cyclical stocks also underperformed.
  Canada and Australia benefitted from the strong commodity upturn
Both Canadian and Australian equities benefitted from the increase in commodity prices over the quarter, returning 7.0% and 9.3% respectively in local currency terms.    
  Weak economic data provided strong headwinds to Japanese equities
Japanese equities were the weakest performers over the quarter, returning just 1.2% in local currency terms. Economic data largely disappointed with a worse than expected contraction in the economy over the first quarter of 2018; an annualized decrease of 0.6% in Japan's output. Measures of second quarter manufacturing and industrial production growth also showed signs of slowing.
  Emerging market equities hit hardest by increased protectionism
Emerging market equities were hardest hit by the trade turmoil as they returned -3.4% in local currency terms. The strength of the US dollar compounded the issue, with unhedged US investors returning -7.9% from EM equities. EM countries more exposed to tightening liquidity came under pressure with the Turkish central bank forced into an emergency rate hike to stem currency weakness. 
 
Government Bonds and Yields Yield curves continue to flatten with persisting negative term premiums
US term premiums continued to move in a downward direction over the quarter and the slope of the US yield curve is the flattest it's been since the Global Financial Crisis (measured by the difference between the 10 and 2 year US treasury yield). The 10-year US treasury yield rose by 11bps to 2.85% while the policy-sensitive 2-year treasury yield increased by 26bps to 2.5%. While there may well be factors at play which will continue to exert downward pressure on yields, namely institutional demand for government bonds and higher risk aversion, we believe lower central bank purchases against a backdrop of larger fiscal deficits will lead to a greater net supply of government bonds and drive US term premiums higher.
From a medium-term perspective, US yields no longer look significantly out of line with what might be deemed 'fair value'. Near-term, yields could easily overshoot our targets, keeping us still wanting to be somewhat short on duration for the time being, but we are approaching a more neutral stance.
Despite the upward movement in US treasury yields, the Barclays US Treasury 20+ year total return index generated a positive return, although only a modest 0.4%.
 
Credit Market volatility and credit deterioration sends credit spreads higher
Credit underperformed government bonds for a second consecutive quarter, suffering from bouts of volatility. Global investment grade credit spreads widened by 22bps to 164bps while high yield spreads increased by 58bps to 416bps. Despite the greater spread movement, the lower interest rate sensitivity of the Bloomberg Barclays Global High Yield Index meant that it marginally outperformed the Bloomberg Barclays Global Credit Index (-2.2% vs. -2.3%).
Spreads over German 10 Year bunds widened for most Eurozone countries but was particularly the case for Italian government bonds which increased by 90bps over the quarter; a 238bps spread over German bunds. The Bloomberg Barclays Euro Aggregate Index slipped by 0.5% over the quarter in local currency terms but this translated to a 5.5% loss in US dollar terms.
From a purely yield perspective, non-US investors would be attracted by the higher yield on offer from US bonds. However, the additional yield pick-up is all but eliminated if currency risks were hedged.
The fact remains that even after recent spread moves, from a fair-value standpoint, spread levels on investment grade corporate bonds are still below the sustainable levels that should be expected through a market cycle. This makes it hard to argue that corporate bonds should be preferred over treasuries from a risk-return standpoint, even allowing for those slightly higher yields. There are additional headwinds in the form of the substantial expansion of leverage by US corporate debtors which could be problematic in time given rising interest rates and an increasingly possible eventual economic downturn.
 
Currencies The 'greenback' recovers strongly after a tumultuous 2017
A combination of tighter monetary policy and global trade turmoil led the US dollar posting its best quarterly performance since 2016. The US dollar index (DXY), which measures the US dollar against a basket of major currencies, rose by 5.2%. We see the ongoing tightening of US monetary policy and widening interest rate differentials as providing sufficient impetus to sustain the US dollar rally, at least in the short term. Over the medium term, our view on the US dollar is moderately negative given the high current account deficit and aging economic cycle.
Conversely, sterling depreciated against a number of currency pairs as mounting Brexit uncertainties continued to undermine UK economic prospects and knock back the currency. In particular, sterling depreciated by 5.9% against the US dollar but fared better against the euro which was buffeted by greater political risks in the bloc.
As the furore in the Korean peninsula abated, so too did the safe haven buying of Japanese yen. The reversal of the trend seen over the first quarter led to a 4.0% weakening of the yen against the US dollar. 

Commodities OPEC + Russia looks to restore balance to crude oil markets from dwindling US inventories.
Crude oil prices have risen on the back of strong global growth and a supportive supply-demand balance. The reintroduction of US sanctions against Iran and imposition of additional sanctions on Venezuela provided additional support to crude oil prices with the price of WTI crude oil increasing by 14.3% to US$74.13/bbl. Higher oil prices helped the S&P GSCI return 8.0% over the quarter while agriculture commodities detracted from the overall index return.  
We believe that the US capacity to increase its oil production tends to limit the upside potential for prices. Conversely, the appreciation of the US dollar is likely to reduce upward pressure on oil and commodity prices over the medium term (see chart below).
Given recent movements in commodity markets there is not much upside left at this time from a fair value stance. Even so, we take the view that as a diversifier to equity risk that may come from rising inflation, commodities may still be worth persisting with for somewhat longer.

Equity Market Table  
 

The information contained above should be regarded as general information only. That is, your personal
objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs. Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal, tax or investment advice. Please consult with your independent professional for any such advice. The information contained within this blog is given as of the date indicated and does not intend to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information since the date of publication, or any obligation to update or provide amendments after the original publication date. The blog content is intended for professional investors only.

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs. Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal, tax or investment advice. Please consult with your independent professional for any such advice. The information contained within this blog is given as of the date indicated and does not intend to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information since the date of publication, or any obligation to update or provide amendments after the original publication date. The blog content is intended for professional investors only.


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