Chief Investment Strategist
July was a good month for international equity markets as strong global economic and corporate profit growth outweighed the escalating trade tensions. In local currency terms, the US market was the best performing, with the S&P 500 gaining 98 points to 2,816, just short of the all-time high reached at the end of January. The tech-heavy Nasdaq Composite performed even better, ending the month up 161 points up at 7671, again close to the new all-time high. The FTSE Eurofirst shrugged off earlier trade fears gaining 47 points to 1534 and the FTSE 100 rose 112 to 7748, both little changed since the start of the year. The Nikkei 225 and emerging market indices also rose over the month, though both are down year-to-date. Bond yields rose over the month, most decisively across the curve in the US with the 10-year ending near 3% but less decisively in the UK – up 8bp at 1.33% – and in Germany where yields remain negative out to six years maturity. Production control and political worries kept Brent crude close to recent highs at $74.
Estimates for global growth remain unchanged at just under 3.5% for this year and next, with China and the US being the two largest contributors. The growth momentum in China is slowing and US tariffs of 25% could reduce GDP growth by as much as 75-100 basis points. The muted response so far by the Chinese has been accompanied by mild currency depreciation and a raft of domestic policy initiatives to maximise growth from the substantial domestic economy and increasingly self-sufficient industrial capability. Exports to the US remain significant – and are still expanding – but are less critical than previous cycles which explains why GDP forecasts are little changed year-to-date at 6.5%.
In the advanced world, economic data has surprised on the upside in the US, picked up in Japan and stabilised in Europe – including in the UK. Temporary strength in net-exports and inventories – reflecting stockpiling ahead of potential trade disruption – bolstered US Q2 GDP growth to 4.1% and the economy is expected to grow above trend in the second half of the year, at around 3% annualised. The unintended consequences of trade sanctions will likely be offset by continuing fiscal stimulus for the foreseeable future. Business investment is very strong, housing should improve despite the dampening impact of higher mortgage rates, jobs are plentiful and unemployment falling. Retail sales increased at 6.6% in the year to the end of June and consumer confidence is high. While there are some signs of wage pressures building, productivity improvements should constrain inflation, currently 1.9%. The Federal Reserve will continue to normalise policy with two further rate rises expected this year, the next in September. Tightening financial conditions will eventually slow activity but maybe not until 2019.
The Japanese economy has recovered from the temporary dip in Q1 and is expected to grow above trend at 1.1% this year and next, supported by exports and business investment. A tightening labour market has resulted in modest wage growth but consumer spending is lukewarm. Eurozone growth has stabilised with indicators such as the purchasing manager composite showing the first rise in five months. Germany’s manufacturing output and exports have picked up and the construction sector is booming although retail sales are mixed. Germany is more sensitive to Chinese growth and global trade sanctions than most so it is unsurprising business optimism has dipped. President Macron’s rating is deteriorating and resistance to structural reform in the transport sector may explain the decline in industrial output but overall business conditions have stabilised and household income should rise on the improving labour market. A slowdown in exports is the main reason behind the weaker H1 growth in Italy rather than political risk or tightening financial conditions including widening of bond yield spreads. The Spanish economy has maintained momentum with GDP growth of 3% supported by a fiscal policy boost and strong exports on the back of improved cost competiveness. Strong nominal GDP growth has reduced the budget deficit to below 3% of GDP and taken the country off the EU’s excessive deficit procedure after 10 years. However the political balance remains uncertain and the latest wage deal with trade unions has been set at 3% annually. Strong employment growth and improving private consumption is helping Ireland to grow at a similar rate to Spain albeit there are Brexit and international tax competitiveness challenges ahead.
The UK is experiencing moderate and broad based GDP growth of around 1.4%. The inflationary impact of sterling depreciation from the EU referendum is unwinding but the anticipated boost to disposable incomes is being partially offset by the rise in energy costs. While business investment is depressed exports are strong, jobs vacancies high and unemployment low. Wage growth is not accelerating as anticipated by the Bank of England but that didn’t prevent the MPC – by unanimous vote – raising rates to 0.75% in early August. The summer recess of Parliament offers a temporary respite from the ongoing Brexit process. Given that the outcome remains extremely uncertain we are not recommending any major portfolio moves.
While a disruptive exit cannot be ruled out, the negotiations this autumn are most likely to result in an extended withdrawal and transition agreement resulting in continuing uncertainty and moderate growth. While there are obvious risks to sterling – which could take another step down – the outcome for equites and gilts is less certain. Our equity recommendations tend to be ‘global’ not ‘local’, even for UK quoted companies. Gilt yields could jump if foreign monies were withdrawn or UK inflation moved permanently higher, but a disruptive exit followed by recession could lead to disinflation and lower yields. We continue to recommend a modest exposure to gold as event risk insurance and for non-correlated return potential.
While trade tariffs remain the focus of attention on the newswires, markets are largely ignoring the potential adverse consequences with implied volatility back to low levels across currency, bond and equity markets. The latter are supported by a strong Q2 corporate results season which reaffirms the estimates for 16% growth in 2018. US companies lead the way with 22% growth followed by emerging markets at 15%, then Asia, Japan and Europe all around 10%. UK profits match Europe at a headline level but this drops to under 3% excluding the exceptional gains in the energy sector. Rising earnings and the consolidation in share prices means valuations have improved and are at the lower end of their recent trading range at 16x global price/earnings. Forward guidance from companies is understandably guarded – the US is seeing most of the upgrades – and some input pricing pressures are being reported. Next year’s estimate of 9% growth doesn’t appear overly optimistic however. Healthcare, energy, IT and industrials continue to see upgrades whereas telecom and consumer staples lag.