August 2019 - Another One (Tariff) Bites the Dust
Risk assets continued to climb higher throughout July, before selling off at the end of the month and beginning of August. The MSCI All-Country World Index returned 0.3% on the month in $US terms, bringing YTD gains to 17%. The rally in July was driven by stronger than expected corporate earnings from some large companies and expectation of monetary easing from the ECB and Federal Reserve. The Federal Reserve cut interest rates for the first time since 2008, but Chair Powell sounded a bit more hawkish in its press conference. Following the meeting, President Trump threatened to slap tariffs of 10% on $300 bn of Chinese goods, marking a significant escalation in the trade war. While the U.S. administration’s threat is likely driven by the desire to put more pressure on the Fed to cut rates and on the Chinese to make concessions, this escalation could result in some major damage to the global economy (which has already been slowing down) through the channel of reduced business and consumer confidence. China responded by allowing its currency to depreciate below 7 per $USD and halted purchases of U.S. agricultural products. We have turned more cautious on risky assets and view the risk-reward as tilted to the downside in the near-term. Accordingly, we have shifted portfolios to a more defensive stance, including a lower than strategic allocation to equities and higher allocation to safe haven assets.
The S&P 500 returned 1.4% in July, setting new highs on eight out of the 22 trading days during the month. Better than expected 2Q earnings from mega-cap companies helped boost the market. On a sector basis, Information Technology (3.3%), Communication Services (3%) outperformed while Energy (-1.9%) and Health Care (-1.7%) lagged. Tech remains the top performers YTD (30%) while Healthcare is the laggard (5.3%). The S&P 500 closed the month trading at a forward price to earnings ratio of 18.2x, which is above the post-crisis average but not as high as 20x reached in early 2018. We expect the index to remain volatile in the near-term given the escalation with China. In contrast to the first few rounds of tariffs, the new round would have a larger impact on consumer goods. Analysts estimate that the 10% tariff could hit earnings per share directly by 0.3-0.4% due to rising input costs, but the total impact would be larger due to weaker corporate and consumer confidence. We remain overweight U.S. equities but think that a more defensive stance is warranted in the near-term (i.e. avoiding sectors more exposed to the trade war).
In Europe, the Euro Stoxx 50 index delivered total returns of 0% in July, leaving YTD gains at 19.2%. Top performers within Europe were Belgium (4.3%) and the UK (2.2%) while laggards were Spain (-2%) and Germany (-1.7%). The region’s manufacturing index decelerated again in July (from 47.6 to 46.5) and earnings per share growth have declined in 2Q (-2.6%). Together with Europe’s exposure to global trade, these factors should drive equities to underperform U.S. equities. On the flipside, the European Central Bank is likely to cut rates and implement a new program of quantitative easing in September. We therefore maintain our marketweight stance on European stocks.
Elsewhere, Japanese stocks as measured by the Nikkei 225 rose 1.2% in July. Japanese stocks continue to lag global peers (up only 10% YTD) and we remain underweight even as valuations are cheap given bouts of Yen strength and slow growth. Elsewhere, Emerging market equities dropped -1.2% in USD terms, dragged lower by South Korea (-5.9%) and India (-5.5%). We shift our stance on EM equities to underweight from overweightgiven the escalation in trade which weighs on global growth, commodity prices, and local EM currencies.
In USD fixed income, 10-year U.S. Treasury yields were unchanged in July and credit spreads tightened amid strong demand. Treasury yields have dropped 25 bps in the first few days of August, and the market is now pricing in almost 3 rate cuts over the next 6 months.
US IG corporate spreads tightened 9 bps in July to 114 bps with total returns of 0.7% (10.36% YTD). Top performing sectors were Utilities, Tobacco and Metals, while laggards were Railroads, Banks and Retail. Technicals remain favorable with IG mutual funds seeing inflows of 0.9% of AUM in July and hedging costs for foreign investors dropping. Supply volumes totalled $104 bn in July while the YTD total is tracking -7% lower YoY. We think US IG spreads will keep their tightening bias given lower hedging costs for foreign investors. We move our view to overweight from marketweight within our fixed income allocation. We prefer BBB credits whose management is committed to maintaining an investment grade rating.
US HY credit returned 0.5% (10.7% YTD) and credit spreads tightened 14 bps. Higher quality bonds outperformed on the month, with BBs returning 0.6%, Bs 0.3% and CCCs -0.1%. The wireless sector outperformed (2.5%) while the energy sector lagged (-1.3%). US HY funds received inflows of $3.4, bringing YTD inflows to $13.7 bn. In the primary market, corporations raised $24.6 bn in USD-denominated bonds in July (a 64% YoY increase) with demand remaining strong. We shift our exposure on US HY to marketweight from overweight given the volatility in equity markets and potential impact of tariffs on consumer sectors. EUR HY outperformed US HY by delivering total returns of 0.8% (8.6% YTD) on the back of the ECB’s dovish meeting and ongoing search-for-yield. European HY credit should continue to perform well given the meagre yields available in government bonds and low default rates.
Emerging Market sovereign debt was the top performing asset class within fixed income in July. EM hard currency sovereigns returned 1.4% (11.7% YTD), led by Argentina and Ukraine. EM corporates returned 0.9% (9.1% YTD), led by Turkey and Brazil. EM local currency sovereigns returned 0.8% in $US terms, with weaker local currencies offset by a decline in yields. EM debt funds received another $2 bn of inflows in July, led by hard currency funds. We continue to like EM debt given the global reach-for-yield even though the escalation in the trade war may result in a softer tone in the very near-term.
Overall, risky assets had been rallying due to dovish central banks and decent corporate earnings. But the renewed escalation in trade has rattled global markets and represents a serious threat to global growth. We have turned a lot more defensive across our portfolios until there is more clarity on the looming tariffs. As always, risk-management combined with rigorous sector and geographical diversification will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.