Following a strong rally in global equities during December 2017 and January 2018, the markets experienced a significant downturn in February as investors reassessed their outlook for the global economy.
In a period where riskier assets achieved returns far above their historical averages, the market was left looking vulnerable to a correction (which duly arrived). This was underpinned by factors including: strong global growth; low inflation; an accommodating monetary policy; stretched equity valuations; and a degree of complacency. Whilst the correction in itself was unsurprising, the nature and speed of the declines were concerning, and possibly exacerbated by the present structure of the markets. According to market commentators, this was the fourth-fastest decline into correction territory from an all-time high for the Dow Jones index.
This pick-up in volatility and sharp moves lower in equities signals a distinct shift in market psychology going forward. However, notwithstanding the recent turbulence in markets, global economic fundamentals remain strong and the threat of recession remains low.
The UK market was one of the worst performers during the quarter, falling 8%. The UK market has generally fallen out of favour with global investors, and the composition of the index has been detrimental to performance. The absence of large information technology companies in the UK and the dominance of ‘old-world’ industries such as financials, miners, and energy companies in the blue-chip index has led to some of this under-performance versus peers.
The relative strength of sterling was also a drag on performance during the quarter. Cautious optimism regarding Brexit negotiations and an expected interest rate rise in May were the main factors driving this. Given the danger of a disorderly break from the EU seemingly diminishing, UK companies are starting to look cheap versus US and European peers.
However, one sector in the UK most visibly struggling is retailers. A raft of companies went into administration during the quarter, including Toys“R”Us and Maplin. Whilst mismanagement and a failure to adapt to an increasingly online world have played a part in their downfall, UK households are still feeling the squeeze. Continued strong employment figures and positive real wage growth should help to alleviate this going forward.
US stocks were the best performers of the developed markets during the quarter, but ending the period in slightly negative territory. With the boost to US earnings derived from the recent tax reforms fully priced in, companies will need to meet lofty analyst expectations for the upcoming earnings season. According to Factset, the estimated earnings growth rate for the S&P 500 is 17.2%. If met, this will mark the highest earnings growth since Q1 2011’s 19.5%, and will represent a significant upward revision from the 11.3% figure estimated in December 2017.
Despite elevated valuations, US equities remain supported by this strong earnings momentum and continued fiscal stimulus measures. Whilst the overall backdrop for US companies remains positive, the recent trade tariffs imposed on Chinese imports will have a detrimental impact according to several large US retailers including Wal-Mart and Nike, which have warned that American households would suffer due to higher prices across a range of consumer products and household goods.
The US is putting particular pressure on China in its desire to reduce the enormous trade deficit it has with the Chinese ($375 bn last year). The US has also accused the Chinese of intellectual property theft, and recently blocked a takeover of US chipmaker Qualcomm on national security grounds. China has yet to take significant retaliatory steps, but if it were to, then US exporters would likely suffer. The industries most vulnerable to this would be aircraft makers, soy bean producers, and car-makers. Technology stocks experienced some weakness at the end of the quarter. Facebook sold off heavily after a backlash over the data harvesting of its users, which has brought into question the business models of other big technology firms in which the collection of data is central (targeted digital advertising, for example).
Japanese markets suffered during the quarter, with the Nikkei 225 index ending the period down by 7%. Portfolio managers have generally been running overweight Japanese equity positions due to strong corporate earnings and relatively low valuations. After strong returns last year, this has rendered Japanese equities vulnerable to profit taking/portfolio re-balancing and this has been in evidence this quarter, with persistent net selling by foreign investors. In addition, a strengthening yen on safe-haven demand, combined with the threat of trade wars, has put Japanese exporters under pressure. Sentiment has also deteriorated on the back of a cronyism scandal involving Prime Minister Shinzo Abe, weakening his position and putting in doubt his economic reform program dubbed ‘Abenomics’.
The Euro Stoxx 50 index, comprising the major Eurozone blue-chip names, also exhibited significant weakness during the quarter (down by approximately 6%). European stocks are particularly sensitive to global trade growth, and fears of trade wars and even ‘peak globalisation’ have taken their toll.
The worst performing of the major Eurozone markets was the German Dax (down by 6.7% on the quarter), whilst the less export-focused French CAC 40 index fell by less than 2.9%. As trade wars remain a clear and present danger to Eurozone growth, a fully-blown trade war event remains a low probability. Furthermore, the EU did secure an exemption from recent US tariffs on steel and aluminium. However, this may be a case of President Trump focusing on China first before turning his attention to other trading blocs.
Tech stock woes and trade war fears also weighed heavily on emerging markets. The tech sector is the largest component in emerging market indices, and these stocks took their lead from US tech names to finish weakly on the quarter. Debt concerns have also surfaced this year. As the US continues its ‘normalisation’ of monetary policy, questions have been raised as to whether or not the emerging world’s debt pile is sustainable, especially that of China. Despite this, political risk has lessened, and growth remains as strong as it has been since the financial crisis.
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