Following the steep falls in October, a degree of stability returned to markets in November, but not without some considerable volatility during the month. Late in the month a more dovish speech from Federal Reserve Chairman Powell, together with hopes of some thawing of the US-China trade wars helped markets to post gains, led by emerging markets in Asia, up 5.2% in November, and the US, up 2.0%. This enabled the MSCI World Index to produce a gain of 1.1% and the MSCI Global emerging markets to gain 4.1% for the month.
The progressive removal of post crisis ultra-loose monetary policy, especially by the Fed, and the increasing evidence of a slowdown in global trade and growth, were the main drivers of markets. The US economy has remained buoyant, but the key housing sector is showing clear signs of slowing, with home sales down for the 6th consecutive month and other indicators pointing in the same direction. As the Fed has tightened policy the cost of finance has risen – the 30-year mortgage rates have increased by 1.5% over the past 2 years to around 5.0% – and has had a direct impact on costs to home buyers. Capital goods orders have also been softer, hurt by concerns about weaker growth globally.
Once again, the month of October delivered a torrid time for investors, leaving the goldilocks environment of 2017 dead and buried. In a sharp reversal of fortunes, which began at the end of September, very few asset classes produced a positive return in October. The classic safe-haven assets including government bonds, gold and the Japanese Yen produced positive returns, with the notable exception of US Treasuries posting a negative return of 0.5%. The equity market suffered the brunt of the selling, led by the Asian equity market falling over 10% in the month, while most other regions fell 7-9% in US Dollar terms. Despite a bounce in the final days of the month, the MSCI World Index declined 7.3%, a slightly smaller fall than the 8.7% decline in Emerging Markets.
After the sharp falls in emerging market currencies and markets in the previous month, a degree of stability returned in September. With the US equity market up 0.5% and indexes reaching new all-time highs, investors might be forgiven for thinking all was well. The MSCI World Index was up 0.6% with all regions producing gains, with the exception of Asia ex Japan equity market, which fell 1.4%. Emerging market equities were down modestly, falling 0.5%, dragged down by the poor performing Asian market. Emerging market currencies recovered by 1.6% in aggregate following the significant falls in August and emerging market bonds produced strong returns of 2.8%. However the modest headline moves and low volatility in the month hid a number of worrying undercurrents.
Perhaps August will go down as the month when the vulnerabilities to a US monetary tightening cycle and trade wars became abundantly clear. Although emerging markets have been under pressure since the peak in late January there was a marked deterioration during August, led by the most vulnerable countries, Turkey and Argentina. A toxic combination of factors in the current macroeconomic environment has resulted in contagion spreading. While some of the problems were self-inflicted a common theme as contagion spread was the high levels of offshore debt, built up in the era of very low interest rates and the majority being in US Dollar. Countries exposure to global trade has made them vulnerable to trade wars, and having high fiscal and current account deficits has raised uncertainty over their economic sustainability. In August, the Emerging Market Currency Index fell by 6.2%, notably the Turkish lira and Argentinian peso both fell by 25% (Figure 1). The Venezuelan bolivar devalued by 95%, however, Venezuela is known for being a basket case due to their low international debt and hardly having any impact on the financial stability of the global economy. However, the collapse of oil production has played a key role in putting upward pressure on Brent Crude. This volatility has dragged down emerging market bonds, with local currency bonds down 6%. Hard currency emerging market debt has fallen 3.1%, and subsequently resulted in a 7.3% fall YTD. Emerging equity markets fell sharply, the fall of 2.7% in the global index masking much bigger falls in Latin America, Russia, South Africa and Turkey. From the January peak emerging equity markets are down 16% and several are in bear market territory with falls of over 20%.
After a difficult few months risk assets generally performed well, with most equity and credit markets producing positive returns. The MSCI World advanced 3.1% in July, with Continental European equities producing the strongest returns of 4.1%, closely followed by the US up 3.7%. Emerging markets were up 2.2%, recovering some ground from the losses experienced in June. Developed markets continue to outperform emerging markets; with the flat Asian market returns partly explaining this underperformance by emerging markets.
The current risk-on environment has resulted in US Treasuries falling 0.5% in July, and notably falling 1.6% year-to-date. In July, the 2-year US Treasury yield rose 14 basis points to 2.67% and 10-year US Treasury yields rose 10 basis points to 2.96%.
It was a flat month for developed equities and safe-haven government bonds, with the MSCI World index and US Treasuries returning zero in June. Notably, the market action came in emerging markets; where the MSCI Global Emerging Market equities declined 4.2%, EM bond yields fell by 1% and EM currencies came under pressure. Emerging market currencies vulnerable to a strong dollar and rising interest rates were put under considerable pressure. The Shanghai market fell by 8% in June, taking its fall from the peak in January into bear market territory, down over 20%.
Underlying these moves in the emerging market asset classes was a more hawkish tone from the Federal Reserve and escalating trade tensions. The Federal Reserve hiked rates by 0.25% in June which was widely expected by the market, following strong macroeconomic data. However, the Federal Reserve changed their forward guidance to include two additional rate rises in 2018 and then another three next year. If implemented this would take rates up from the current 2.0% to 3.25%, this would be the first time for a decade that US dollar cash would offer a positive real return.
The stand-out event during the month was the fall-out from the indecisive Italian election in March. An unlikely coalition of the anti-establishment Five Star movement and the far right League was finally able to form a government in May, only to have their nomination for Finance Minister overturned by the President on the grounds of the anti-euro views of the proposed minister and the perceived risk to stability. Investors, increasingly nervous about the populist, anti-euro views of the coalition parties and their policies of radical economic reform, took fright as it seemed the coalition would use this as an opportunity to push for another election, in which the populists could substantially increase their voting share, potentially increasing the risks of
Italy exiting the euro. Eventually a compromise was reached and, with a different finance minister, the coalition formed a new government. However, the damage to Italy’s bond markets and perceived credit worthiness was still apparent. With a government debt to GDP ratio of 130%, one of the highest in the world, Italy remains vulnerable, despite the better performance of its economy in the past year, while many Italians reject the budgetary constraints imposed by what is seen by some as an over reaching Brussels bureaucracy. The conundrum for the Eurozone remains; a single currency without full banking and fiscal unification is inherently unstable and prone to bouts of stress, leading to recent calls for reform.
While geopolitics dominated the headlines in April, it was economic factors that primarily drove markets during the month and underpinned the recovery in most risk assets after sharp falls in previous weeks. Developed market equities rose 1.1% while fixed income markets witnessed declines in credit spreads with gains in high yield bonds despite weakness in government bond markets. However, the most notable and important moves came in an acceleration in the recovery of the US Dollar and a rally in oil prices.
From its low point in mid-February, the US Dollar had already been recovering, but the trend accelerated in April with the Dollar rising by 2.1% on a trade-weighted basis. The trend has been supported by continuing optimism around the US economy, despite a relatively subdued Q1 GDP growth reading of 2.3% and increasing evidence of an upturn in inflation. In response to the uptick in inflation, the Federal Reserve appeared mildly dovish in its April meeting, indicating it was prepared to tolerate a period of overshoot in inflation above its 2.0% target, however investors are anticipating a further rate increase in June and another before year end. This pushed the yield on two-year Treasuries to 2.49% by month end, its highest level since mid-2008.
After a broad sell-off across many asset classes in February, volatility continued into March, with equity markets declining and government bonds rallying. Risk markets were impacted by the prospects of a US-China trade war with President Trump continuing to push his ‘America First’ philosophy. Emerging market and developed market equities fell, with emerging markets marginally outperforming. US equities fell 2.6% during the month, taking Q1 2018 returns to -0.9%. A key contributing factor seemed to be President Trump’s imposition of tariffs on imports of Chinese steel and aluminium and proposals for further tariffs on a wide range of goods.
China immediately responded, imposing tariffs on several US imports, including wine. This led to worldwide concerns of a potential trade war, which could have implications for global growth. In addition to this, tech stocks, among the strongest performers in 2017, suffered sharp share price declines. This followed a serious data breach at Facebook which led to a series of governments seeking to tighten the loose regulation of companies in the sector, while tax authorities are seeking to impose more effective taxes.
Financial markets had a turbulent and more volatile month in February, with almost every asset class falling while the US Dollar rose on a trade weighted basis. Notably, after a record streak of fifteen consecutive monthly gains, the S&P 500 fell 3.7% in February. After a particularly strong January, global emerging market equities underperformed developed markets, although emerging market equities continue to outperform developed markets year to date. Global bonds suffered with yields generally rising amidst a better than expected jobs report in the US.
US markets fell sharply early in the month, with the S&P 500 falling 6.2% in the first three days of trading. This followed a strong jobs report, with wage growth beating expectations at 2.9%. With the tightness in the labour market yet to feed into wage growth and subsequently headline inflation, investors have been focusing on wage growth figures in anticipation of the trend reversing. The better than expected data indicated this may finally be the case and investors adjusted their inflation expectations and subsequently their forecast for the timing of future US rate hikes. This initially put bond markets under pressure, before concerns spread to equity markets.
