Despite short-term market turbulence we continue to take a broadly positive stance towards markets. Pull-backs are a healthy way for investors to gain perspective and assess risk and reward. The recent volatility reflects an adjustment by investors to a world that just might be tinged with higher inflation than experienced in the last 10 years. Whilst we believe that inflation is unlikely to behave like a forest fire, it is not as supine as some investors have been thinking and, for this reason, we remain cautious on long term bonds. We may well have further ‘whipsaw’ days in equity markets in the coming weeks, but we believe it is unwise to sell out of risk assets at a time when there are reasonable valuations in a number of markets and a robust US economy is providing positive momentum.
Although equities started positively on the back of the United States-Mexico-Canada Agreement (“USMCA”) trade deal a number of factors drove markets sharply lower over the fortnight with many indices entering correction territory (defined as a drop of at least 10% from a recent peak). It is hard to identify any one reason for the correction, but factors included: strong economic data leading to a sharp sell-off in US bonds, concerns about a potential higher interest rate hiking path being set by the Federal Reserve, increased geopolitical tensions between the US and China, slowing global and Chinese growth, potential earnings volatility due to tariffs, and the strong US dollar. Despite this, we should note that October, especially in US mid-term election years, is historically a volatile month.
Markets were not immediately impacted by the International Monetary Fund (IMF) cutting global economic growth forecasts at the start of the period; the IMF cited trade war risks and tighter credit conditions as factors in their decision. However, strong September US non-farm employment payrolls and a bumper Institute for Supply Management (ISM) number led to the largest sell-off in US 10-year Treasuries since November 2016 (after the US election) and the highest Treasury yields in seven years. Initially, equities reacted positively to the strong economic news in the US, but subsequently the strong uptick in bond yields led to pressure on global risk assets as the market began pricing the potential for faster interest rate hikes by the US Federal Reserve. This, the market surmised, may lead to an even stronger US dollar which would in turn impact corporate earnings, as well as exacerbating the current pressure on emerging market countries. US Federal Reserve Chair, Jerome Powell, added to the bond sell-off with a bullish speech confirming his view of continued gradual rate hikes, saying interest rates were getting closer to a neutral footing and could even go “past neutral”.
Elsewhere, most developed and emerging market country equity indices are now negative for the year. The Peoples Bank of China (PBoC) tried to alleviate concerns of slowing economic momentum by loosening monetary policy through lowering the reserve requirement ratio (RRR) for the third time in 2018. However, Chinese equities still hit four-year lows over the period. Geopolitical tensions with the US were also high as Bloomberg reported that Chinese entities hacked thirty US companies and US Vice President, Mike Pence, said that there was no doubt that “China is meddling in America’s democracy”. However, on a more positive note, President Trump and Chinese leader Xi Jinping have reportedly agreed to meet at next month’s G-20 summit which has increased hopes of resolving the trade conflict.
Meanwhile, European risk assets also had to contend with continued geopolitical risk in Italy. A meeting of EU finance ministers in Luxembourg criticised Italy’s budget stance while Jean-Claude Juncker, the European Commission President, warned of needing to do everything to “avoid a new Greek crisis”. Italy’s Deputy Premiers, Luigi Di Maio and Matteo Salvini, defended their plan to increase the country’s budget deficit, with the latter even calling the leaders of the European Commission (EC) the “enemies of Europe”. By contrast, the Finance Minister, Giovanni Tria, said Italy was committed to “ensuring a constant reduction of the debt toward the objective agreed with the EU”. Despite this, Italian 10-year yields are at their highest levels since 2014 and the spread between Italian and German borrowing costs is at its widest since 2013.
In the UK, sterling was up over the period despite mixed Brexit headlines while equities traded down in line with other global markets. Prime Minister Theresa May delivered a confident speech at the Conservative Party conference which reduces the risk of an imminent leadership battle and it was initially reported that she was preparing to compromise on the Irish border situation by considering allowing regulatory checks on goods to take place between Northern Ireland and the UK mainland. In return for this concession, Theresa May appears to be aiming for the whole of the UK to remain within the EU’s customs union as the backstop agreement. However, members of Mrs May’s governing coalition partner, the DUP, spoke out against the proposal, with the the party’s leader, Arlene Foster, saying she opposes “any form” of border in the Irish sea and that post-Brexit checks on goods between Northern Ireland and the rest of the UK would be the “worst of one world” rather than the “best of both worlds.” Brexit Secretary Dominic Raab communicated on Sunday that Mrs May could not sign up to what is currently being offered by the EU while the EU’s chief Brexit negotiator, Michel Barnier, tweeted that “despite intense efforts, some key issues are still open, including the backstop for IE/NI to avoid a hard border.”
Within commodities, crude oil initially spiked to new four-year highs but soon fell back on signs of rising supply and general market unease. Gold and the Japanese yen, which are considered safe-haven assets, were some of the better performers in the risk-off environment.
Economic data released over the period was mixed. The IMF reduced global growth forecasts for both 2018 and 2019 to 3.7% from 3.9%. The US, however, continued to show robust growth (2.9% in 2018 and 2.5% in 2019). The September ISM manufacturing index fell from 61.3 to 59.8 versus 60.0 expected but was still the third highest reading this year, while the ISM non-manufacturing survey index rose to the highest reading since August 1997, at 61.6 versus 58.0. Employment data was strong, with the Automatic Data Processing Institute nonfarm payrolls for September coming in at 230k versus expectations of 184k, while initial jobless claims fell to 207k, close to the five-year low. The September new jobs report missed expectations at 134k versus 185k expected but the prior two months were revised up to a net 87k and the unemployment rate also fell to 3.7%.
The final September manufacturing PMI revision for the Eurozone fell from 54.6 to 53.2 versus the 53.3 flash print while the services PMI was confirmed at 54.1. Similar to the line taken by the IMF, Germany’s economy ministry also trimmed the growth forecast for 2018 to +1.8% from +2.3%, and for 2019 to +1.8% from +2.1%, citing “protectionist tendencies” and “international trade conflicts” as the key reasons for the cuts. Germany’s industrial production report disappointed with August activity -0.3% month-on-month versus expectations of +0.3%, while German exports also declined for the second month in a row.
In the UK, the final September manufacturing PMI surprised to the upside (53.8 vs. 52.5 expected) while August GDP growth was flat as against consensus of +0.1%.
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