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Aon Retirement and Investment Blog

Third Quarter 2018 Market Review and Outlook

Key Highlights

  • Economic releases over the third quarter continued to reflect a theme of desynchronization seen in the previous quarter, with robust economic growth in the U.S. but not as much elsewhere.
  • Developed market equity performance was mixed on a regional basis over the third quarter but the relatively strong performance in the U.S. was a main feature.
  • U.S. bond yields marched higher over the quarter. There is still room for further increases but we do not anticipate increases in the magnitude of 1-2%, which would likely correspond to a bond market crash.
  • Credit markets recovered after a turbulent first half of the year. Nonetheless, we believe spreads are still below sustainable levels given where we are in the current extended cycle.
  • Widening interest rate differentials and stronger relative economic growth continue to support the U.S. dollar.  
Macroeconomic and Political Moves
Contrasting economic fortunes characterise the third quarter. NAFTA by a new name?

Riding on the wave of fiscal impulse, the U.S. economy remained very buoyant. Not only did real GDP growth hit 4.2% (year-on-year) but the Institute of Supply Management's (ISM) manufacturing index topped 60 once more in September. Moreover, record low levels of unemployment (falling to a 47-year low of 3.7%) appeared to drive wages higher (up 2.9% over the year to August). Against a backdrop of robust labor markets and accelerating wage inflation, consumer confidence in the U.S. surged to a 10-year high. Inflation, as measured by the core Personal Consumption Expenditures price index, was stable at the U.S. Federal Reserve's 2.0% target throughout the quarter.

While the foot seems firmly on the accelerator in the U.S., there are concerns over stalling momentum in the European economy. Although still in positive territory (above 50), the manufacturing Purchasing Managers' Index (PMI) in Europe decreased to 53.2. The slowing trend was not isolated to Europe as PMIs also fell in Japan and in Emerging Markets. Of particular interest in the latter category, the manufacturing PMI in China moved lower to just 50.2; only marginally in expansionary territory.

Aside from diverging economic releases, trade negotiation developments were keenly watched. A last-minute compromise in the U.S.-Canada trade negotiations late in the quarter looks set to pave the way for the U.S.-Mexico-Canada (USMCA) agreement to be ratified by all three member governments towards the end of this year. While uncertainty has been partially removed in North America, U.S.-China trade relations deteriorated further as the trade war intensified with further rounds of tariffs imposed by both sides.

In Europe, the UK government set out their so-called "Chequers" plan for Brexit negotiations which provided concessions on aspects such as regulations. However, the EU has categorically rejected key elements of the plan as it would infringe on the EU's four freedoms[1] and the integrity of the single market. Not much time remains for both sides to thrash out a deal which increases the likelihood of the UK falling out of the EU with no deal. It is further complicated by domestic political developments with building pressure from both the rival Labour party and internal tension within the Conservative party over the path Brexit is taking.  Our core view is that a deal will ultimately be reached but we recognise that risks are elevated.

Monetary Policy
U.S. monetary policy remains accommodative in all but name…

As widely expected, the U.S. Federal Reserve (Fed) tightened monetary policy by a further 25bps. While this rate hike now puts U.S. monetary policy above the Fed's preferred measure of inflation, the core Personal Consumption Expenditure price index, for the first time since the financial crisis, the real Fed funds rate (see chart below) is still very low historically and still broadly accommodative, despite the Fed removing its description of monetary policy as such. Whilst we cannot say that U.S. monetary policy is restrictive in any way yet, the tightening trend may well have a material impact on asset returns at some point next year. The first Fed dot plot for 2021 was also released at the latest Fed meeting, although expectations are that the Fed funds rate will be the same as in 2020.

Elsewhere, a rebound in economic growth from first quarter weakness prompted the Monetary Policy Committee (MPC) in the UK to hike interest rates to their highest levels since the onset of the financial crisis. Expectations have also grown for future rate hikes. 

The European Central Bank (ECB) reiterated its expectations that any tightening to conventional monetary policy would only take place in the second half of 2019. We are, however, drawing nearer to the end of quantitative easing in the Eurozone which could ease downward pressure on bond yields that has prevailed for several years and potentially remove support for risk assets.

With potential threats from trade war escalation and a slowing economy, the People's Bank of China (PBoC) took proactive steps to stimulate the economy, cutting the reserve requirement ratio and injecting cash through its medium-term lending facility. Elsewhere within Asia, the Bank of Japan increased their tolerance with regards to managing the 10-year yield as part of its yield curve control policy in order to increase its sustainability. 

Developed market equities gained over the quarter with notable outperformance from the U.S. and Japan in local currency terms 

Global equities generated a positive return of 4.8% in local currency terms and 4.4% in U.S. dollar terms over the quarter. As was the case in the second quarter, U.S. equities led the charge. In U.S. dollar terms, most markets posted modest gains but a number of regions affected by ongoing trade and political uncertainty. 

Equities, in general, have been on a strong bull run but we believe we have now entered a transition market environment where the sustained uptrend will give way to an overall flattening underlying price trend for risky assets with bouts of volatility. Moreover, the transition phase could well see change in market leadership at both the sector and stock level. Higher volatility and less conviction on returns in this transition phase reduce the reward for investors' risk bearing and so investors may wish to carefully consider risk asset exposure. 

U.S. 'tech' stock dominance surges on… but U.S. outperformance is not limited to just the FAANGs[2].

The combination of strong U.S. economic performance and robust corporate earnings growth elevated U.S. equity markets to new heights with the S&P 500 index hitting record levels. The Dow Jones Total Stock Market Index increased by 7.1%. Once again, the technology sector (9.5%) led all other sectors, but it is important to note that U.S. equities are not solely propped up by stocks such as the FAANG group. Yes, these tech stocks have surged c.28% since the start of the year, but even without their contribution the U.S. stock market would still be up 6%, as shown in the chart below.

 A very strong earnings season for mega-cap technology stocks, such as Amazon, Apple and Microsoft, supported U.S. large cap outperformance. The Russell 1000 index increased by 7.4% over the third quarter while the Russell 2000 (a small cap index) posted a more modest gain of 3.6%. While performance was worse across all sectors (with the exception of the Utilities sector), the poorer performance of Financial and Healthcare stocks were attributable to small cap underperformance. 

The Brexit clock keeps ticking, but no deal seems to be in sight
The UK government's Chequers plan did not seem to allay fears over a cliff-edge Brexit. Rancorous negotiations are likely to follow in the countdown to March 29 2019 (Brexit day) but we are of the opinion that a deal to stave off cliff-edge risks is likely to be reached. That being said, we are cognizant that there are very material risks of a collapse in negotiations and the UK falling out of the European Union. This option is expected to be sub-optimal and sterling-denominated risky assets could underperform. 

Pressures, both internal and external, keep a tight lid on European performance.

Although not the worst performer over the third quarter, European equities only modestly increased. Concerns over the Italian budget (risks that the populist government would increase the budget deficit further) and European banks' exposure to Turkey, which was exposed to a currency and debt crisis, weighed on the market. However, strong performance particularly from Swiss pharmaceuticals helped European markets gain 2.5% over the quarter. Much has been made of the UK's eventual exit from the European Union on UK assets, but investors should not be remiss of the impact from a disorderly Brexit on European risk assets. As mentioned above, this is not the most likely scenario for us but we feel it is important to highlight these risks to investors so adequate risk assessments are undertaken and protections made if necessary.

Meanwhile, further escalation of trade protectionism levied on Europe was partially averted with U.S. President Trump and EU President Juncker agreeing to work towards no tariffs between the U.S. and the EU for the non-auto industrial sector. However, trade war fears could easily resurface and damage future prospects for European stocks, particularly for the auto industrial sector. 

A stark contrast from the last quarter, as lower commodity prices drag commodity-heavy indices lower 
The decline in commodity prices detracted from both Canadian and Australian equity returns with the former also reeling from disappointing energy stock performance. Canadian equities dipped by 0.2% in local currency terms but returned 1.0% in USD terms due to U.S. dollar depreciation relative to the Canadian dollar.  

Yen weakness and better-than-expected economic data bolstered Japanese equities 
Japanese equities performed well in local currency terms over the quarter, with strong earnings growth supporting a 6.5% return for Japanese equities. The export-sensitive Japanese equity market also benefited from yen depreciation. Against the U.S. dollar, the yen weakened by 2.5% which translated into a 3.8% USD-return for Japanese equities. The economic contraction experienced in the first quarter of 2018 proved to be short-lived, as the Japanese economy rebounded by 0.7% in the second quarter. Moreover, recent measures of inflation seem to be more encouraging with headline, core and core-core[3] consumer price inflation increasing.

Emerging market equities broadly flat over the quarter but Chinese stocks suffer
Trade war escalations, a strengthening U.S. dollar and concerns over the Chinese economy–all prominent features from the second quarter–were mainstays over Q3. In particular, Chinese technology stocks which are a significant portion of the MSCI EM index, led the declines with a more than 7% decline in local currency terms over the quarter. We now think EM equities are close to the bottom in relative performance terms versus their developed market peers. Whilst further falls are possible, we recommend adding to EM equity allocations, if portfolio exposure is low or underweight to strategic benchmarks.

Government Bonds and Yields
Yields continue to march higher but the yield curve continues to flatten

The recent move in U.S. nominal government bond yields has primarily been driven by real yields, rather than market-implied expectations of future inflation. The 10-year U.S. treasury yield rose by 20bps to 3.05% with 18bps attributable to the increase in the duration-equivalent TIPS yield. The U.S. nominal yield curve continues to flatten with the policy-sensitive 2-year treasury yield increasing by 28bps to 2.81%, outpacing the upward movements for longer-dated yields. This flattening is very likely signalling bond market caution on economic growth prospects once the U.S. tax stimulus has flowed through.

Although U.S. yields have risen significantly in recent months and do not look far from fair value, we still see some potential for yields moving higher over the medium-term. The magnitude of possible future yield increases is, however, unlikely to mirror the movements seen over past months. We see few fundamental reasons, such as accelerating inflation, strong wage growth or a significant shift in the demand-supply balance, to trigger a game-changing move in Treasury yields of the 1-2% magnitude, at least not in the near term.

On the back of higher U.S. Treasury yields, the Barclays U.S. Treasury 20+ year total return index generated a return of -3.0%.

Credit markets bounce back after a turbulent first half of 2018 
Credit spreads whipsawed over the third quarter, as initial narrowing over July was offset by spreads blowing out in August, before contracting again in September. Overall, spreads were down over the three months supporting credit market outperformance over government bonds. In particular, the strong relative performance of high yield bonds persisted; spreads on the Bloomberg Barclays High Yield Index dropped by 35bps to 381bps, and primarily drove the 2.0% quarterly return. Global investment grade credit spreads narrowed by 16bps to 148bps. The greater contraction in spreads alongside the lower interest rate sensitivity of the Bloomberg Barclays Global High Yield Index meant that it outperformed the Bloomberg Barclays Global Credit Index (2.0% vs. 0.6%).

While a number of European government bond yields increased over the quarter, concerns over how the Italian budget may impact on the fiscal deficit propelled Italian yields ever higher. The yield on the Italian 10-year government bond rose to 3.18% over the quarter and with it the spread over German 10-year bund yields to 271bps – a five-year high. Other Eurozone bond yield movements were more muted in comparison. The Bloomberg Barclays Euro Aggregate Index slipped by 0.7% over the quarter in local currency terms but this translated to a 1.2% loss in U.S. dollar terms due to US dollar strength.

Although credit spreads retraced the previous quarter's widening, we continue to believe that, from a fair-value standpoint, spread levels on investment grade corporate bonds are below the sustainable levels that should be expected through a market cycle. As such, it is difficult to argue for any preference towards corporate bonds over U.S. treasuries from a risk-return standpoint. Headwinds in the form of the substantial expansion of leverage by U.S. corporate debtors still exist and, against a backdrop of rising interest rates and a likely eventual economic downturn, could pose further problems for credit markets.

The U.S. dollar continues on its upward path but remains short of its 2017 peak
As measured by the U.S. dollar index (DXY), the U.S. dollar continued on an upward trend albeit to a lesser extent compared to the previous two quarters. The DXY rose by 0.5%, increasing against most major currencies with the exception of the Canadian dollar. In the short term, tightening U.S. monetary policy, widening interest rate differentials and strong economic fundamentals are likely to provide further upward pressure on the dollar. However, given the high current account deficit and aging economic cycle, we believe the support is likely to wane and the U.S. dollar could well weaken.

Despite the UK base rate increase of 25bps to 0.75%, sterling continues to be buffeted by Brexit uncertainty, depreciating against a number of currency pairs with the exception of the poorly-performing Japanese yen and Australian dollar. As we head ever closer to the Brexit deadline and with no agreement yet to be made, it is likely that sterling will remain volatile over the period.

The Canadian dollar performed strongly against a wide range of currencies, most notably against the Japanese yen (an appreciation of 4.4% in Q3 2018). Uncertainty surrounding the future of the Canadian economy was allayed late in the quarter as concessions were made with the late save in the form of the USMCA agreement

U.S. supply glut drags down WTI oil prices while OPEC seeks to compensate for the loss of Iranian crude in global oil markets.
Higher oil prices helped the S&P Goldman Sachs Commodity Index (GSCI) return 4.3% over the quarter. Meanwhile, agriculture and industrial metal commodities, which are more impacted by global trade uncertainty, detracted from the overall index return.   Dollar strength also continues to exert downward pressure on commodities. Industrial metals were particularly affected with the price of copper dropping by 7.0% over the quarter to US$6,180/bbl. The uncertainty of the impact on U.S. sanctions against Iran and OPEC's response, helped send Brent crude oil prices higher. However, the glut of U.S. crude oil supplies dragged down the price of WTI crude oil to US$73.16/bbl – the price spread relative to Brent crude oil widened to just under US$10/bbl.

Given recent commodity market moves, our stance has not changed from last quarter, in that we do not believe there is much upside left at this time. However, we do think that commodities are a useful diversifier in a time of rising inflation and political risk

Equity Market Table

Click here for index descriptions.

[1] Core-core inflation measures the price change for all items excluding food and energy but including alcoholic beverages. Similar to the measurement of core inflation used in the U.S.
[2] Acronym used to define a collection of U.S. technology stocks: Facebook, Apple, Amazon, Netflix, Google (Alphabet)
[3] Set out in the Treaty of Rome: Free movement of goods, capital, persons and the freedom to establish and provide services
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