Trade uncertainty returns to drive-up market volatility
Market volatility picked-up in May after a period of calm earlier in the year. This followed President Trump’s decision to raise current tariffs on $200bn of US imports from China to 25%, from 10%, and a threat of more tariffs on US$325bn of additional Chinese goods that have remained untaxed until now.
The move to apply more pressure on the Chinese to resolve trade issues, such as intellectual property protection and forced technology transfer, comes after US Trade Representative Robert Lighthizer said that Beijing was reneging on prior commitments. The tariff hikes may also reflect US frustration with North Korea’s latest round of (short-range) missile tests, which may be viewed as having carried Beijing’s blessing. A simmering in US- China political tensions over US freedom of navigation in the South China seas and Taiwan Strait, as well as the US demand that China halts imports of Iranian oil in line with America’s sanctions on the Middle East oil producer, has not helped matters either.
It is unclear whether Trump’s high stakes gamble with China will work. The risk is the Chinese could walk away from trade talks on the expectations that rising trade tariffs leads to US job losses in states that Trump needs to win if he is to be re-elected in the November 2020 presidential election. Beijing could then use more policy stimulus to cushion any downturn in the Chinese economy from trade headwinds.
Should the US and China fail to agree a trade deal and tariff rates are raised on both sides, it could lead to a material slowdown in international commerce and global growth. Nevertheless, despite the trade tariff hikes annual global export volume growth accelerated to a 2% rate in March, up from a low of -1% last December. This suggests that the underlying fundamentals behind the global economy and markets remain fairly resilient.
US productivity recovery continues
Back in our August 2018 Investment Outlook, we outlined how US de-regulation and tax cuts would provide a growth tailwind against trade protectionism fears. That seems to be playing out with labour productivity (real GDP per hour worked) up 2.4% from a year ago in the first quarter, the fastest pace for 9 years.
Although market concerns that the tax boost to growth in 2018 is wearing off, the de-regulation drive is still intact. One way to measure the magnitude of deregulation is to count the number of pages in the Federal Register of regulations. At the end of the Obama presidency in 2016, the number of pages peaked at 97,000 pages, but in 2017-2018, the number of pages fell by 32,000 pages, the biggest two-year contraction on record. Less red tape provides a boost to business confidence and encourages employment. Even 10 years into the business cycle, the US job engine continues to motor. In April, US non-farm payrolls rose by 263,000 and have now expanded for a record 103 months in a row.
Importantly, there is scant evidence to show that the economy is overheating. In the first quarter of 2019, unit labour costs (ULCs, or hourly compensation relative to productivity) were flat over the past year. Subdued ULCs generally correlate with a low inflation environment, suggesting the Fed can continue to be patient with regards to tightening monetary policy, and that companies can continue to sustain elevated profit margins to drive corporate profits.
Downgrades in European growth
The European Commission published its spring economic forecasts for its member states. Germany, at the heart of Europe, saw its 2019 annual real GDP growth downgraded to 0.5% from 1.1% forecast in February, largely due to deteriorating business sentiment and order inflows tracking the downturn in the global manufacturing cycle. For the Eurozone as a whole, the 2019 GDP growth is forecast at 1.2%, down from 1.9% in 2018 and 2.4% in 2017. Despite these fairly downbeat economic projections, some timely macro indicators (e.g industrial production) suggest that the Eurozone economy has at least troughed and is being supported by a combination of job creation, China policy stimulus that should boost European trade and modest fiscal stimulus. On the latter point, Germany intends to reduce its structural surplus by 0.8% of GDP between the end of 2018 and 2020, which should add to economic growth.
Nevertheless, the Eurozone faces numerous structural risks, including;
- i) a failure to fully recapitalise its banks (see the top chart in the market highlights section);
- ii) having a seemingly unworkable monetary/currency union without a fiscal union (e.g. common taxation);
- iii) sluggish demand growth led partly by EU limits on government borrowing; iv) a divergence in living standards within the EU.
For example, Germany’s real GDP per capita (a proxy of living standards) grew at an annualised rate of 1.3% per annum since the euro’s inception in 1999, or 10 times the growth rate of Italy; and v) rising nationalism, as evidenced by the rising share of the “populist” vote in the recent European parliamentary election. Given the backdrop of fairly sluggish growth and structural risks, the Eurozone equities are likely to underperform other markets.
Over the last 6 years US equities have outperformed their European peers by around 40%. A large proportion of this outperformance can be attributed to each region’s dominant sectors – in Europe, the banks, and in the US, technology. If we look at the performance of six major European banks, (Banco Santander, BNP Paribas, Ingenico Group, Deutsche Bank, Unicredit and Banco de Sabadell) relative to the big US technology names (Facebook, Apple, Amazon, Netflix, Google and Microsoft) we find that US tech outperformed European banks by around 85% over the same period. For European equities to recover on a relative basis we would need to see a reversal of this trend – something we think looks unlikely given the strength of earnings in the tech sector and the economic headwinds continuing to face the Eurozone.
This month saw the 10 year US Treasury bond yield fall to levels not seen since December 2017. Yields have tumbled by more than a percentage point since the high of over 3.2% in November 2018, for a combination of reasons; a change in rhetoric from the Federal Reserve, as it moves from a tightening bias towards a rate cutting stance, falling inflation expectations, and increasing concerns around trade between the US and China. A broad index of Treasury bonds increased by 5.8% in May in GBP terms.
FX and commodities
The ongoing trade dispute between the US and China has weighed on the performance of emerging market currencies. The US dollar relative to a basket of emerging market currencies on trade-weighted basis, as published by the Federal Reserve, increased by nearly 2% in May. Market participants will be very focused on the G20 summit in Japan on the 28 – 29 June when US President Donald Trump will meet his Chinese counterpart Xi Jinping in the hope of making progress towards a trade agreement.