July 2018 - Preparing for a Stronger Second Half
Updated: Jul 10, 2018
The first half of 2018 has been driven by a much different backdrop than the one which prevailed in 2017. The synchronized global growth setup, which peaked last year, has given way to a mild slowdown in momentum. Coupled with a drawdown in global liquidity as quantitative tightening takes liquidity growth negative over the next six months, global risk assets have not been immune. Indeed, the MSCI All Country World Index is down 0.25% compared to its 12.4% advance last year over the same period. At the same time, inflation, especially in the U.S. is moving into a new and higher range, putting pressure on bond markets. Heightened trade risks have raised uncertainty though we continue to believe that solid fundamentals are underpinning economic growth.
Over the last six months, global growth has entered a moderate slowdown and has accounted for some of the underperformance of risk assets. That said, we believe momentum will pick up for a number of reasons. First, US activity remains robust and is driving global growth. Meanwhile, the world’s second largest economy, China, remains solid with production remaining strong despite recent volatility across the country’s currency and equity markets. In the U.S., increases in wage growth against a firm labor market are expected to drive consumer spending while capital expenditure picks up. In the Eurozone, GDP is expected at 2.1% or better while US GDP should grow around 2.8%. China, despite its recent volatility, should see growth around 6.5%-7% range, well within the official policy target. This is all occurring against a withdrawal of policy stimulus from the world’s major central banks though we continue to expect this to be a slow process with policymakers sensitive to any weakness in economic activity.
As global growth improves, the equity market should perform better in the second half of the year though with higher levels of volatility relative to 2017. Within equities, the U.S. market has outperformed given current growth momentum and the S&P 500 composition towards technology stocks which stands at around 24% versus 8.6% for Europe. The total return year-to-date for S&P 500 at the end of June was 2.65% compared to Eurostoxx50 return of -3.32%. We continue to prefer equities over bonds given the late cycle nature of the current expansion and the low probability of recession over the next six months.
Emerging markets have also seen a different 2018 versus the prevailing backdrop in 2017. During the first half of the year, emerging markets experienced various levels of stress with stocks down almost 8%. This was driven by large moves across currency markets including the Argentina Peso which fell by 30% and Turkish Lira by 17 %. These moves were driven by the stronger U.S. Dollar as its appreciation versus emerging market currencies increases foreign denominated liabilities and puts stress on countries with large current account deficits. Indeed, the MSCI emerging market equities index is down almost 8% this year, while global equities are flat year-to-date. Within emerging market debts, local currency debt have fallen 6% and dollar denominated debt are down 5% compared to the increase in 2017 by 14.2% and 9% respectively.
Within corporate credit, U.S. high-yield has remained relatively resilient, up 0.24% versus -0.30% for U.S. investment grade during the month of June. Going forward we continue to prefer short duration credit given expectations for rising interest rates against a backdrop of higher inflation. We also believe short-term U.S. government bonds provide some diversification benefit given yields on the short-end of the U.S. Treasury curve have moved significantly higher than the longer end (“bear flattening”) and are proving income with low levels of volatility.
Undoubtedly, the market is dealing with a number of moving pieces ranging from politics to trade against a backdrop of less liquidity, higher rates and a slowdown in the momentum of growth. Risk assets have responded in kind. Still, the fundamentals remain encouraging and recessionary risk remains low this year. On this basis, we continue to advocate a strategic long position in equities given our belief in the underlying economic picture. In our view, generating positive returns requires increased flexibility and the ability to look through periods of higher volatility. In that context, risk-management combined with rigorous sector and geographical selection 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.