September 2019 - Staying Cautious Despite Recent Recovery
An increase in trade tensions led to a selloff in risky assets before they staged a recovery towards the end of the month. The MSCI All-Country World Index fell -2.6% on the month in $US terms, lowering YTD gains to 12.1%. Safer assets such as government bonds surged, with the 10-year U.S. Treasury yield dropping 52 bps and delivering total returns of 3.9%. Gold prices (+7.1%) also rallied on the flight to safety. While the equity market has risen over the last two weeks given the news that the U.S. and China will meet in early October, we maintain our cautious stance on risky assets as we don’t expect a quick resolution/deal. Although some technical indicators point to a near-term squeeze higher in the stock market, we ultimately think that the trade war uncertainty will keep hurting business and consumer confidence, and the ability of central banks to fully offset these headwinds will be limited. As such, we maintain our below target equity allocation, and are looking for future selloffs to offer better entry points.
The S&P 500 index dropped -1.8% in August, while the implied volatility on the index rose by 42% on average. Despite the sell-off, US stocks continued to outperform most global peers. On a sector basis, those that benefit from lower rates outperformed while cyclicals lagged. Specifically, Utilities and Real Estate rose by 4.6% while Energy (-8.7%) and Financials (-5.1%) and Materials (-3%) sold off the most. Tech remains the top performers YTD (28%) while Energy is the laggard (-0.5%). Recent economic data continues to confirm that the manufacturing part of the economy (which accounts for a relatively small share of GDP) is contracting while the consumer and services part (which account for c.70% of GDP) remain strong. We remain overweight U.S. equities but prefer sectors and companies that are more leveraged to the U.S. consumer and are resilient to global trade headwinds.
In Europe, the Euro Stoxx 50 index dropped by -1.2% in August in local currency terms, leaving YTD gains at 14.2%. Top performers within Europe were Switzerland (-0.2%) and Italy (-0.4%) while laggards were the UK (-4.4%) and Netherlands (-2.9%). The region’s manufacturing index remained at a low territory in August (at 47.0 from 46.5) and Q2 GDP growth came in only at 1.2% YoY. Although growth is still anaemic and negatively impacted by the slowdown in global growth, the European Central Bank is expected to cut rates by 10 bps this month and restart its asset purchase program. We maintain our marketweight stance on European stocks.
Elsewhere, Japanese stocks as measured by the Nikkei 225 dropped -3.8% on the month in local terms, driven by the stronger Yen and trade tension with South Korea. Japanese stocks continue to lag global peers (up only 3.4% YTD) and we remain underweight even as valuations are cheap. Elsewhere, Emerging market equities dropped -5.1% in USD terms, driven by the stronger USD, weaker commodity prices and trade escalation. The worst performers were Argentina (-51%), Turkey (-11%), Brazil (-10%) and Hong Kong (-8.6%) while the outperformers were Mexico and Qatar. Given the selloff which brought the average P/E in EM to 13.5 (a 27% discount to developed markets), we bring back our view to marketweight from underweight, and add Brazilian equities to our portfolios.
In fixed income, government bonds rallied sharply, and the U.S. Treasury yield curve inverted again. The stock of negative yielding bonds globally has risen to $17 trillion, and 30-year German bunds are now yielding -0.1%. The growing pie of negative yielding assets has sparked strong demand for positive yielding assets such as U.S. Treasuries, U.S. corporate bonds, and Emerging Market bonds. This has brought yields to unprecedented levels and is likely to continue in the near-term in our view as central banks continue easing policy and global economic data disappoint.
Given the rally in rates, US investment grade corporate spreads widened 11 bps in August to 125 bps with total returns of 3.0% (13.6% YTD). Top performing sectors were Financials and REITs while laggards were Energy and Metals & Mining. Technicals remain favorable with IG mutual funds seeing inflows of 1% of AUM in August. Supply volumes totalled $92 bn in August while the YTD total is tracking 12% higher YoY. We think US IG spreads will remain stable in the coming months given elevated supply volumes against the expected fall in hedging costs. We maintain our overweight view within our fixed income allocation. We prefer BBB credits with steep credit curves whose management is committed to maintaining an investment grade rating.
US HY credit returned 0.4% (11.1% YTD) and credit spreads wider by 15 bps at 408 bps. Spread volatility was high during the month, with spreads reaching 450 bps in mid-August before tightening in the last two weeks. Higher quality bonds continued to outperform, with BBs returning 1.1%, Bs 0.4% and CCCs 0.3%. The banking sector outperformed (1.8%) while the energy sector lagged (-2.6%). US HY funds suffered from outflows of $4.3 bn, bringing YTD inflows to $9.3 bn. In the primary market, corporations raised $9.7 bn in USD-denominated bonds in August and supply is set to pick up in September to the tune of $20 bn. In terms of defaults, the trailing 12-month default rate is around 4% and expected to remain around this level. We maintain our marketweight view on US HY given the volatility in equity markets and prefer higher quality credits with improving fundamentals. EUR HY outperformed US HY by delivering total returns of 0.7% (9.4% YTD) on the back of the 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 debt had mixed performance over the month, with the crisis in Argentina and stronger USD negatively impacting higher yielding USD bonds and local currency bonds. EM hard currency sovereigns returned 0.7% (4.2% for IG and -2.9% for HY) as spreads widened 34 bps. Argentina was the clear laggards with total returns of -51% following the surprising results in the Primary Elections which triggered a currency crisis and the beginning of a restructuring of sovereign debt. The current government has responded with capital controls, but volatility and uncertainty will remain high until there is more clarity regarding the new government’s intentions. EM corporates returned 0.1% (IG 2%, HY -2.4%), as spreads widened 55 bps in aggregate. EM local currency sovereigns returned -2.6% in $US terms, driven by sharp moves in the Argentine Peso, Brazilian Real and Colombian Peso. EM debt funds suffered from modest outflows in mid-August, only to recover by the end of the month. We expect the crisis in Argentina to have a limited impact on the rest of EM bonds, and view the spread widening in HY and large currency depreciation as attractive entry points for EM HY and local currency bonds.
Overall, the renewed escalation in trade in early August temporarily rattled global markets in an environment of slowing global growth. Policy makers in China and central banks are taking measures to offset these headwinds, but we think some of their tools will be limited. We remain defensive across our portfolios until we see the risk-rewards as tilted more to the upside. 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.