Despite fairly encouraging indicators confirming solid US growth and resilient activity in Europe and China, markets remained glued to watching the twists and turns on the Sino-US trade conflict.
- Equities fall sharply; emerging markets underperform
- Government bonds benefit from the flight to safety…
- … except Italian bonds, hit by renewed tensions between Rome and Brussels
As early as 5 May, a Donald Trump tweet revived the skirmishes with China over trade just as negotiations on a deal seemed on the right track. The US president said tariffs would be raised to 25% on USD 200 billion-worth of imports from China in the absence of an agreement by 10 May. A deal was not reached and the tariffs duly rose. He also threatened to introduce, by mid-June, a 25% tariff on USD 325 billion of products not previously targeted. China responded by announcing higher duties on USD 60 billion-worth of US goods, including farm products, from 1 June.
At the same time, Washington postponed the decision on a levy on cars from the EU by six months and reached an agreement with Canada abolishing tariffs on steel and aluminium. This had raised investor hopes, as did perceived – and later dashed – progress on a trade deal with China.
Relations soured when China indicated it would regulate rare earth exports to the US. Market sentiment headed south after the US announced a 5% tax on all products from Mexico as of 10 June and said these tariffs would rise gradually as long as illegal immigration continued.
Given Mexico’s close trading ties with the US, these decisions drove equity markets down around the world and government bonds rose amid a flight to safe havens. The US now tying trade policy to immigration indicates that protectionism is being used above all for domestic policy purposes as the Trump administration moves into campaign mode for the 2020 presidential election.
Exhibit 1: Shares abandoned, bonds being sought after
Equity markets fall across the board
After a shaky performance that tracked developments on the trade front, the MSCI AC World index (in USD terms) lost 6.2%, with emerging equities underperforming (-7.5% for the MSCI Emerging Markets index in USD terms), mainly in Asian markets.
In the main developed markets, Japan posted the biggest drop. Shares in exporting companies suffered from doubts about global growth and the yen’s appreciation (+2.5% against the US dollar) on the back of its status as a ‘safe-haven’ currency. The Nikkei 225 index fell by 7.5%. European and US markets shared roughly the same ride with a 6.7% fall in the EURO STOXX 50 and 6.6% in the S&P 500.
In the US, cyclical sectors (information technology, industrials, consumer cyclicals) were out of favour due to growth concerns linked to the trade tensions. The energy sector was the biggest detractor due to lower oil prices. WTI (-16.3%) finished below USD 54 a barrel, its lowest since mid-February, despite geopolitical tensions, the drop in production in Iran and Venezuela, and OPEC compliance with its production quotas. Fears about global growth weighed on crude, which also suffered from an unexpected rise in US oil inventories.
In the eurozone, banks dropped sharply on renewed concerns over the situation in Italy and the outlook for BTP (Italian government bond) yields.
German Bund benefits
In the flight to safety, the yield on the 10-year Bund fell from its low in July 2016 to -0.20% on 31 May. This fall by 16bp from the end of April (and by 50bp from the end of 2018) was seen in most government bonds. Worries about growth, lacklustre inflation and expectations of key interest-rate cuts by the Fed and the ECB explain the sharp fall in long-term rates since the beginning of the year. In May, this trend was exacerbated by the widespread drop in equities on the back of the renewed trade tensions and, with regard to Bund yields, by concern over Italian government finances.
The yield on the 10-year BTP reached its highest level since the end of February, at 2.75%. The spread over the German 10-year yield widened towards the end of the month to its highest level since December 2018. The European election parliament campaign had already given rise to dissent within Italy’s coalition government, and the broad victory of Matteo Salvini’s party revived tensions with the European Commission. Indeed, the League’s leader indicated that he wanted a ‘fiscal shock’ to boost the economy, citing the implementation of a ‘flat tax,’ one of his campaign promises, and rejecting EU rules on debt and structural budget deficits, which he considered ‘outdated.’ At the same time, the European Commission is concerned about the drift in Italian public finances (with debt at 132.2% of GDP in 2018) and is considering starting an excessive deficit procedure.
Investors deserted Italian bonds for the Spanish and Portuguese markets, where the 10-year yield finished the month at 0.72% and 0.81%, respectively, a fall of about 30bp compared to the end of April for each of the two rates, while Italian 10-year yields rose by 11bp to end the month at 2.67%.
Chart 2: New all-time low for 10-year Bund yield
It would be good to focus on anything other than the trade conflict (but it’s not easy)
After four months of stock market gains, May’s correction perfectly reflected a rise in risk aversion amid the renewed trade tensions. It seems illusory to try to predict what will happen next. On the one hand, it is becoming increasingly clear that domestic policy considerations are dominating US and Chinese statements and decisions. On the other hand, financial markets will monitor the trade policy developments closely and will swing this way or that depending how investors perceive the risks.
Moreover, the sharp fall in equities may, in itself, led the US and Chinese authorities to turn their positions around… In this context, a look at the fundamentals leads us to believe that the recent sell-off was excessive. Economic data, although fairly volatile, shows that activity is solid in the US and improving in the eurozone. Modest inflation should allow central banks to maintain accommodative monetary policies.
Risks and uncertainties have tended to rise again recently, requiring reactive tactical allocations and robust portfolio construction partly incorporating more adverse scenarios.
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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.