In July, investors were once again forced to keep a watchful eye more on political events than on economic factors. As had been the case for several months, financial markets were driven by statements from Washington and reactions from the US’s trading partners.
After a first half of the month in which the trade situation appeared to worsen – particularly following new US announcements on 10 July, which triggered a reaction from China and led the president of the European Council, Donald Tusk, to call on parties “to avoid conflict and chaos” at a Beijing summit – hopes were raised by the surprise agreement on 25 July between the US and the European Union. While many uncertainties remain regarding the very vague communiqué establishing a working group in favour of freer transatlantic trade, this decision does seem to reduce the risk that tariffs will be slapped on European cars. Investors appreciated this in particular and bid up global equities by 2.9% in July (as measured by the MSCI AC World in US dollar terms), pushing them into positive territory over the year to date (+1.3%).
After a lacklustre first half, developed market equities managed to gain from a robust economic environment, despite the prevailing protectionist threat. In July, the MSCI Emerging Markets index in dollars inched up by 1.7% and is now down by 6.1% over the year to date. This latest monthly underperformance was driven mainly by the Chinese markets, which were hit by the escalation of the tiff over tariffs with the US and a slight slowdown in the Chinese economy, with GDP up by 6.7% year-on-year in the second quarter (after 6.8% in the first).
Exhibit 1: Emerging market equities continue to underperform relative to their developed market peers
Source: Bloomberg, BNP Paribas Asset Management, as at 31/07/2018
In its World Economic Outlook update released on 13 July, the IMF pointed out that growth was more uneven and stated explicitly that an escalation and prolongation of trade measures could “derail the recovery”. Even so, there were no downward revisions to global growth, which the IMF still expects to come in at 3.9% in 2018 and 2019, while the latest available information showed no major shifts in trend.
In the US, growth was robust in the second quarter, with GDP up by 4.1% at an annualised pace (after 2.2% in the first quarter), driven by consumption and investment. Initial indicators for the third quarter suggest that growth was even stronger. European economies continued to disappoint, with GDP up by 0.3% (after 0.4% in the first quarter) and sluggish business survey data. Based on the flash estimate, the PMI composite, which reflects the opinions of purchasing managers in manufacturing and services, dipped slightly in July (at 54.3 vs. 54.9 in June). In Japan, the Bank of Japan’s Tankan survey, released in early July, showed that activity had slowed, in particular for major manufacturers, which are more vulnerable to global trade trends. In July, the PMI manufacturing index fell to a 20-month low.
Monthly performance of developed equity markets
Concerns over the Japanese economy may be the reason why the Tokyo Stock Exchange (Nikkei 225) rose by just 1.1% in July and why sectors exposed to domestic demand declined.
In the eurozone, the EuroStoxx 50 rallied by 3.8%, driven by the financials sector against a backdrop of higher long-maturity bond yields, energy and manufacturing stocks (carmakers in particular, after the Washington agreement).
In the US, the major indices rode the solidity of the economy and a promising start to the earnings reporting season, with an extra boost from corporate tax cuts. The S&P 500 rose by 3.6%, with an outperformance by defensive sectors (healthcare and consumer staples), while tech stocks moved in different directions after the release of earnings results of various quality.
Exhibit 2: US equities maintain their lead over other developed market equitiesSource: Bloomberg, BNP Paribas Asset Management, as at 31/07/2018
US Treasury bonds under the influence of the Bank of Japan
The 10-year US T-Note yield rose by 10bp between the end of June and end-July, making a foray above 3%, its highest level in just over two months, and ending at 2.96%. Most of this occurred in the second half of the month, after relative stability in the first half at about 2.85%.
Upward pressure was seen in the wake of the 19 July announcement of a reduction in securities purchases by the Bank of Japan (BoJ) and several rumours that fed expectations of an adjustment in monetary policy in Tokyo as early as the July meeting. Despite denials by Governor Kuroda and the findings of a report on the financial system that revealed no special difficulties for banks arising from negative key rates and the yield curve control policy, the BoJ cautiously moved forward on 31 July.
The 10-year JGB yield range, which is still centred on 0%, may now go as high as 0.20% vs. 0.10% previously. Although Governor Kuroda prefers to refer to this as an adjustment towards greater flexibility rather than normalisation, and although BoJ is still very cautious on inflation (forecast at 1.5% for the fiscal year ending in March 2020), the possibility of higher long-maturity Japanese bond yields weighed on the US bond market.
Exhibit 3: Moderate rises in long-term bond yields in JulySource: Bloomberg, BNP Paribas Asset Management, as at 31/07/2018
Investors must watch out for the protectionist threat
Despite the July equity rally, financial markets remained agitated at the start of summer, as investors remained unsettled on many fronts. The prevailing nervousness has been driven by statements by the US president (regarding NATO partners’ financial commitment, Iran, Russia and China) and, of course, US trade policy.
In addition to comments on this topic, which drove daily shifts both up and down in equity prices, global economic growth faces threats created by the implementation of tariffs on Chinese products and the prospect of further announcements (new taxes, reprisals and WTO appeals) in the coming months.
With this in mind, China’s measures to support its domestic economy (and thus address US threats more defensively rather than through escalation) is good news. Likewise, the US-EU agreement, which clears the way for new talks on several sectors, is a constructive response after weeks of tensions. The same goes for the trade agreement between Japan and the European Union.
The protectionist risk is nonetheless still present. It has been emphasised in particular by central banks, which, nonetheless, have chosen to stick to their recent decisions to continue, or begin, normalising their ultra-accommodative monetary policies. Even the Bank of Japan has taken measures along these lines, even though it continues to face very weak inflation.
The global economy looks solid enough to withstand the headwinds that have arisen, but it is not unsinkable. Other pitfalls (the highly confusing Brexit situation after the resignation of hardliners, and noisy bargaining over Italian fiscal decisions) have emerged and investors will have to avoid them. Although the world has become a little less ideal than in 2017, fundamentals remain favourable, as seen in solid corporate earnings reports.
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