Developed and Emerging Markets
The escalating tension between the U.S. and North Korea has been the dominating geopolitical event risk and unsurprisingly took center-stage for a couple of days during August. Investors turned cautious and were reducing the level of risk-taking in their portfolios by turning their attention to safe havens such as Gold, government bonds, high-quality corporate fixed income, defensive equity sectors and/or the Swiss Franc and Japanese Yen. Although this risk-off phase proved to be short-lived, it offered a brief glimpse on the direction markets are willing to take in the event of stress.
The geopolitical topic subsided only to be replaced by U.S. homegrown, racially charged violence in Charlottesville, Virginia, and the subsequent inability by US President Donald Trump, to issue a clear statement of condemnation against racism and more specifically the white nationalism movement. Business leaders who were part of the two White House business councils that Trump has assembled (and now disbanded), expressed their dismay over his response to the Charlottesville riots and decided thereupon to withdraw their participation in the councils. It has become apparent that Trump’s unpredictable behavior has raised reputational and business risk for Corporate America to remain attached to the President. More importantly, Trump’s lack of competencies to promote and push business-important legislative agenda items such as easing regulatory constraints, cutting and simplifying taxes, pushing infrastructure investments and the imminent debt ceiling adjustment through Congress has become a political liability.
Elsewhere, White House Strategist, Steve Bannon, offered unhelpful comments by stating that the “U.S. and China are at economic war”. These comments provoked a response by China’s foreign ministry saying that the relationship was “mutually beneficial” and that “there could be no winner from a trade war”. It went on to voice the hope that “people will not use 19th and 20th-century perspectives and measures to address 21st-century problems”. S. Bannon was ousted from office shortly after his comments. In summary, investors became increasingly concerned about the dysfunctional U.S. Administration and its potential to disrupt global confidence in its economy.
The risk-off sentiment led to a short-lived strengthening of the usual safe-haven currencies such as the Swiss Franc and the Japanese Yen. While the U.S. Dollar remained volatile in the light of persistent political confusion, the Euro had to digest ECB comments on its stimulus program and concern over the Euro’s strength.
Energy and other commodities
The general flight to safe havens also affected Gold which hit a two-month high during August. Meanwhile, oil slightly weakened as OPEC members failed to meet output cutback targets for another month as Saudi Arabia and others still have not trimmed as much supply as promised.
Global Bond Markets
Fixed Income markets held firm across the month, as political tensions escalated and we witnessed a flight to safe haven assets. News of further fallout within the current US administration and the subsequent exit of a prominent adviser to Donald Trump, highlighted once again the lack of progression within the government since taking office in January this year. Despite all of the above, leading indicators suggest no sign of the US economy slowing down although yields remain depressed. Growth and output improved during the second quarter but productivity remains under the long-term average. Many economists note the change could be come from the speculated tax reforms and infrastructure bills, which have yet to be formally proposed (and could be delayed until sometime in 2018). On a more global scale, central bankers attended the annual Jackson Hole (US) event towards the end of the month, focusing on world and domestic economic issues. Investors were heavily sceptical regarding the outcome of the conference as data readings and dovish rhetoric has not signaled any significant in the near-term. US Treasury Bonds and German Bunds were sought after, closely followed by Japanese sovereign debt, as indicated by yield curve shifts to the downside. The anomaly being 1-month and 2-month US Treasury Bills, showing yields offered at a level of over 1% and similar to that of 6-month risk, as the chance of a US Government shutdown around this period is increasing. The European Central Bank’s President Draghi now has to work on reducing the impact of a strong Euro, which would potentially slow a European recovery and in turn, downplay a reduction of the current stimulus program. Peripheral European bonds gave back some gains from last month as the risk mood diminished slightly. The Bank of Japan has trimmed its purchases of domestic bonds and continue to manipulate the government yield curve, however, this did not deter those in search of havens as yields trended to levels unseen since May. Across the Emerging Market Universe, sovereigns out performed from both the Central and Eastern European region and also Latin America. High Yield credit markets were negatively affected as investors positioned themselves within the higher credit quality grades. The mid-point of the maturity curve for core high quality sovereigns continues to be the most attractive to investors, during more volatile periods.
Global Equity Markets
August and September represent the “quite period” during a calendar year. Second quarter earnings have been published and investors are judging if they should increase their risk-asset position toward the end of the year or lock in unrealized gains. During this challenging season, events (e.g. geopolitics, conflicting news about the U.S. administration, congressional debates on debt levels etc.) that are unrelated to corporate fundamentals but have the potential to disrupt the confidence in equity markets sometimes take center-stage.
By mid August, global equity markets corrected significantly amid fears of open hostilities over North Korea’s nuclear program. Adding to these geopolitical tensions, there has been an undercurrent of concern by many investors that bond and equity markets are becoming richly priced. This has been aggravated by the confusion surrounding the U.S. President’s erratic behavior and his decision to disband the business councils after a large number of participating CEOs resigned. By mid August, the European STOXX-600 headed for the worst week since the U.S. Presidential election in November and the U.S. S&P-500 followed suit as the CBOE Volatility Index climbed to the highest level year-to-date. Towards the end of the month however, risk-assets rose as political tensions cooled and market and economic fundamentals were back in focus again. U.S. and European equity markets closed almost unchanged for the month.
Not ignoring geopolitical risks such as the U.S./North Korean tensions and the political turmoil created by the widening gap between U.S. Corporate CEOs and the U.S. President, we would still advocate that remaining reasonably realistic and keeping an eye on economic and corporate fundamentals never proved to be wrong. The global macro backdrop remains favorable for equities and other risk assets. In addition, bond yields have remained well anchored, which has supported the rally in global equities.
Looking ahead, we anticipate that a backup in yields will moderate the equity advance and increase volatility. We remain moderately pro-risk in terms of our investment stance, although the near term could be volatile given heightened geopolitical risks and seasonal influences.
Core sovereign yields across the Eurozone will fluctuate in the coming months as expectations of a reduction in stimulus are high. The ECB should manage communication to the market, taking care to remember the 2013 taper-tantrum, incited by the US Federal Reserve. US Treasury yields remain range-bound and the yield curve should flatten further as the current administration fails in implementing tax reforms, new healthcare bills and possible infrastructure plans. The ongoing environment for globally low rates forces investors further down the credit quality matrix, increasing risk in order to achieve acceptable yields and should therefore be supportive for the High Yield spectrum and Emerging Market region. Risks to the above would be a dramatic change in rhetoric from the major central banks in a race to interest raise rates, which we believe to be highly unlikey, in tandem with an unexpected and consistent up-tick in global inflation.
Our equities portfolio remains balanced in terms of the relationship between cyclical and defensive stocks. Regionally, we still favor an overweight in European relative to U.S. equities and stay completely outside of Japanese and U.K. names. We are still convinced our investments in companies which feature above average profitability combined with sound balance sheets and superior business models are positioned to benefit from the supportive fundamental environment.
The period of persistent economic disappointments in the U.S. has ended. The U.S. dollar is now oversold and speculators are no longer positive on the currency. Such a combination usually coincides with a bounce or consolidation in the U.S. Dollar/Euro cross rate. However, a strategy of progressively downgrading the U.S. Dollar and embracing various European and EM Asian currencies might be warranted.
Commodities potentially face greater headwinds. They are unable to solely rely on the weakness of the US Dollar, nor can the asset class depend on China, the largest commodity-consuming region, which is becoming more self-sufficient in its own commodity production. Oil trends around mid-40s to late 50s in USD/pb but could receive a temporary boost from operational closures during the US hurricane season. The recent move in Gold has been due to geopolitics and sustained by a weaker US Dollar, which should continue in times of uncertainty.
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