US markets hold up in the face of global headwinds

By Zac Tate, Hottinger Investment Management

As we discussed recently, we have seen signs in the last couple of months that the global economy may have put the recent slowdown in activity behind it. Shipping volumes have picked up after cratering towards the end of 2018. There has been a big rise in Chinese export orders, which bodes well for Europe. The US dollar has remained strong, dampening the appeal of emerging markets as the Federal Reserve’s feet-dragging on rate cuts keeps the dollar attractive for global investors.

Figure 1 shows the dollar trade weighted index since May 2017. The index has generally risen during 2019. While emerging market currencies do not feature significantly in the index with the exception of Mexico, we find that the dollar has remained strong against key emerging market currencies such as the Chinese renminbi, the Brazilian real, the Indonesian rupiah, and the Vietnamese dong.

Leading economic indicators out of China have turned positive. According to the World Steel Association, China’s crude steel production for April 2019 was 85.0 Mt, an increase of 12.7% compared to April 2018, the fastest rate of growth since at least November 2017. Inventories of iron ore fell by almost 20% between mid-April and mid-May, possibly suggesting increased demands from industrial companies.

However, there are some signs of negative pressures. The CSI 300 index of leading Chinese stocks has struggled despite a good start to the year. We have also seen that MSCI World companies with high revenue exposure to China – especially semiconductor producers – have become more volatile as the trade war between the US and China intensifies, and they performed particularly badly last month.

Figure 2 shows how the trade war has affected firms with Chinese revenue exposure more severely, indicating that China is bearing the brunt of the stand-off. Past performance is no guarantee of future results.

In Europe, domestic factors have withstood the headwinds from a challenging global trading environment. Strong wage growth of 2.3% has been in excess of inflation and has therefore undergirded consumer spending and the domestic-facing industries. However, signs of strength may be misleading. The most recent German sales figures show a decline on the month (although still 4% up on the year).

We have discussed possible opportunities for value investing in Europe, given the attractive valuations of such stocks. Research suggests, however, that periods of value outperformance do occur but can be short-lived. Where they occur and persist, this is due to supportive macroeconomic policies that prioritise full employment over inflation control.

Therefore, with inflation expectations in the Eurozone trending towards 1% as measured by the 5y5y forward inflation swap, and with the prospect of a hawkish ECB governor following Mario Draghi later in the year, we don’t see conditions in which the long-favoured return of European value outperformance can be sustained, if indeed it happens at all.

We note that the market is pricing in 40bps of rate cuts in the US by the end of the year, the most aggressive expectation for monetary easing in this cycle. The Federal Reserve, however, remains neutral and will continue to respond to economic conditions. With core inflation falling in the US, growth and consumer spending decelerating, retail and auto sales weakening, and companies refraining from investing due to fears over the international trade, there is good reason to think that the Fed will comply with the market’s demands. However, it is moot whether the Fed will fully comply and cut interest rates twice this year, especially if inflation rebounds or is pushed higher by the effect of China’s retaliatory tariffs.

If the Fed fails to meet market expectations, negative sentiment could emerge and affect US equities, especially in the “Cyclicals” segment of the market, which has outperformed the “Defensives” segment in the last couple of months.

Nevertheless, the US remains an attractive market. The dollar is strong on a trade-weighted basis, defying market predictions for a move downwards. Persistently high relative US interest rates, coupled with America’s deep and broad capital markets, have kept the dollar strong. We have also seen that US markets have outperformed other global developed markets even once the popular Technology sector companies have been stripped out of the S&P 500 index.

Figure 3 shows how – since May 2016 – the US’s leading stock index, the S&P 500, stripped of its technology stocks, has outperformed the MSCI All Country World Index excluding US companies. Past performance is no guarantee of future results.

In the UK, we discussed how the flattening gilt curve seems to be impervious to domestic political risk, possibly reflecting a global trend towards fixed income products with 10-year gilt yields falling in line with German bunds and US Treasuries. The yield on German bunds has fallen to record lows below -0.2%.

However, our view is that with the situation in UK politics as it is, there could be considerable downside risk to buying long-dated gilts. We also believe that while there may be a significant value discount in UK equities, high payout ratios (implying low investment rates) and low dividend growth rates represent headwinds. Nevertheless, we think that sterling remains at a discount to fair value, especially against the US dollar and a favourable resolution of the Brexit question later this year will on balance provide impetus for the currency to strengthen towards its long-run median level.