Despite nervousness stemming from escalating trade tensions, stocks managed to post some reasonable gains during the second quarter of 2018. After a bruising first quarter, there was a rebound in global markets at the beginning of April, with most indices moving into positive territory for the year by mid-May. A flat period then persisted for the remainder of the quarter as markets were held back by geo-political concerns.
The US Administration stiffened their rhetoric on trade with China during the quarter (and to a lesser extent Europe), declaring that they were no longer willing to look the other way as China pirates intellectual property, subsidises its own exporters and maintains higher tariffs/barriers to entry than the US. On the face of it, they have a point. Chinese tariffs on global imports averaged around 10% while the US average was around 3.5%. US tariffs affect only about 40% of US imports from China, and those averaged about 6.5% while China imposed higher tariffs on items imported from the US.
The Trump Administration has proposed 25% tariffs on $50bn in imports from China in addition to the recent tariffs on steel and aluminium. The Administration is also considering an expansion of the tariffs and stricter limits on China’s ability to invest in US companies. The US believes it has a strong hand, given the unbalanced nature of trade between the two countries. In 2017, the US had a trade deficit of approximately $375bn with China. Therefore, the belief is that the Chinese can only go so far with any retaliatory tariffs. Imposing tariffs on all imports from China would of course hurt the US economy. Theoretically speaking, a 25% tariff on all imports from China would hit US GDP by something in the region of 0.7%. This is significant but not, on its own, likely to cause a recession.
Despite a stellar earnings season, US markets ended the quarter largely where they began. The Dow Jones was flat and the broader S&P 500 was up by around 2.5%. US markets had enjoyed a strong run after a string of upward earnings revisions, however, much of these gains were lost towards the end of June as trade fears escalated. The S&P 500 reported earnings growth of around 25% in the first quarter, with around 80% of companies exceeding their earnings estimates. Analysts are broadly positive for second quarter earnings also. According to Factset, during the first two months of the second quarter, such analysts increased earnings estimates for S&P 500 companies by 0.2%. Although this may seem insignificant, earnings estimates usually decrease in the first two months of a quarter, and by an average 2.7% during the last 20 quarters, as expectations are managed or ‘played down’. For Q2, the estimated earnings growth rate is currently 19%.
The best performing developed market in the second quarter was the UK, albeit recovering lost ground after a heavy sell-off in February and March. The blue-chip UK index ended the quarter up by around 7.5%, led by miners and oil companies. A weakening pound provided support to export-focused industries after the Bank of England declined to raise interest rates in the May and June meetings, citing a temporary soft patch in the data. This was contrary to market expectations.
Eurozone stresses returned during the period with the unstable political situation in Italy and softening macroeconomic data. Despite the political uncertainty, European markets generally posted modest gains for the period (with the exception of the Italian MIB index, which was down around 4.5%, largely on the back of a sell-off in Italian banks). Eurozone banks as a whole continue to trade at a significant discount to their US peers, suggesting that investors remain cautiously positioned within their European equity exposure.
Chinese stocks entered bear market territory (a decline of 20% from recent highs) towards the end of the quarter as a multitude of concerns hit home. In addition to the trade war threats, investors have become concerned about tighter credit conditions and a more restrictive regulatory environment in general, resulting in a slowing domestic economy. The June sell-off came after China’s inclusion in the MSCI Emerging Markets index in May. The expectation was that this would trigger large scale buying from global index funds and accelerate China’s opening up to global investors. However, this ‘forced’ buying may have masked an extended period of weakening, causing the sharp readjustment in June as this phenomenon dissipated.
Despite the potential headwind caused by an escalation in trade tariffs and the paradigm shift we are witnessing in monetary policy, we believe it is too early to be pricing in a possible US recession. The pessimism in the UK and Europe also appears to be overblown. In our view, the near-term outlook suggests caution, not alarm.