06 May 2019
Tilmann Galler, Global Markets Insights Strategy Team
After a strong first quarter, risk assets continued their rally in April. Equity markets climbed across the regions, while high yield spreads narrowed further. This year’s rebound has been driven by accommodative central banks, the expectation of a recovery in Chinese growth, and the anticipation of a resolution to Sino-American trade negotiations. Further support for the markets came from a solid start to the Q1 US earnings season. After earnings expectations had been revised sharply lower since the beginning of the year, with Q1 2019 estimates even falling into negative territory, companies were able to deliver positive surprises. This renewed optimism in the equity markets is also reflected in the outperformance of cyclicals vs. defensives in April.
Exhibit 1: Asset class and style returns in local currency
Source: Barclays, Bloomberg, FactSet, FTSE, MSCI, J.P. Morgan Asset Management. DM Equities: MSCI World; REITs: FTSE NAREIT All REITs; Cmdty: Bloomberg UBS Commodity Index; Global Agg: Barclays Global Aggregate; Growth: MSCI World Growth; Value: MSCI World Value; Small cap: MSCI World Small Cap. All indices are total return in local currency. Past performance is not a reliable indicator of current and future results. Data as of 30 April 2019.
The government shutdown and cold weather in January and February distorted economic data in the US at the beginning of the year, leading to increased recession fears in the market. The March labour market report helped to calm near-term recession fears. The 196,000 payroll gain exceeded consensus and was much better than the 33,000 gain reported in February. The unemployment rate stayed at 3.8%, which confirms the view that the 10-year economic expansion is losing momentum but not faltering. Wage growth of 3.3% year on year (y/y) can be viewed as positive in two ways. First, it is high enough to support real wage growth and therefore consumption, and second, it is not too high to raise concerns about rising inflationary pressure at the Federal Reserve (Fed). The disinflationary trend in consumer prices continues to be a headache for the central bank. Core CPI was lower than expected at 2.0% y/y in March, and has continued to trend down since the high of 2.4% in July 2018. The relationship between inflation and unemployment—the Phillips curve—continues to be broken.
Meanwhile, purchasing managers’ indices (PMIs) showed diverging momentum in the US economy. While the Institute for Supply Management’s manufacturing index surprisingly increased to 55.3 for March, the non-manufacturing index decreased to 56.1 after the boom-like reading of 59.7 in the previous month. However, index levels for both sectors of the economy correspond with an economy growing at or slightly above trend, and not with an economy heading into recession.
The first estimate of US Q1 GDP growth was much higher than expected at 3.2% annualised. This indicates that the US economy is still growing at an above-trend pace. However, investors should take this surprisingly strong showing with a pinch of salt. Of the 3.2% growth in Q1, 0.7% came from rising inventories and 1.0% came from improving trade, but real domestic final demand has decelerated. Trade is a notoriously volatile component of GDP, and elevated inventories tend to correct in future quarters, so it seems likely that real GDP growth in the coming quarters will be lower. Let’s not forget the fading tailwind from fiscal stimulus that sets in next quarter. The US economy is still on course to slow from above-trend to trend growth by the end of the year.
In China, the manufacturing PMI disappointed expectations, falling back from March’s reading to 50.2 for April, but still an improvement from a multi-year low of 48.3 in January. The service sector PMI increased for March. China’s GDP grew 6.4% y/y in 1Q19, above market expectations and flat from 4Q18. Industrial production growth rose from 5.3% to 8.5% growth y/y in March, and retail sales growth inched up, delivering more evidence that fiscal and monetary stimulus is feeding through to the real economy. Monetary conditions also show signs of improvement. New yuan loans rose well above the level in February and the consensus forecast, while Q1 aggregate total social financing, at RMB 8.2 trillion, easily surpassed credit expansion in the previous years. The recent surge in credit growth and improving sentiment from a possible trade agreement between China and the US should support economic activity in the coming quarters.
Chinese equities lost some momentum in April after a strong rally in Q1, in part on worries the government might begin dialling back stimulus in light of improved growth. Although this is a fair assessment, it should also be noted that Chinese policymakers remain vigilant and will provide support if the economic data softens again. The future success of the policy measures will also depend on China’s ability to sign a trade agreement with the US administration in the coming months. China imports, at -7.6% y/y for March, still haven’t shown any major improvement, which would be a precondition for a broader recovery in economic activity in the region.
Emerging markets continue to face several challenges. Activity in the large Asian economies of Korea and Taiwan is still due to pick up. Manufacturing PMIs improved in March, but at 48.8 and 49.0 respectively, the Korean PMI and the Taiwanese PMI are still signalling continued weakness in economic activity. In particular, the new export orders sub-component continues to be depressed. Both export-dependent countries would benefit from the success of the China stimulus and a recovery in global trade.
Supply concerns and the announcement of the planned end to the US administration’s waivers on oil sanctions on Iran sent the oil price higher in April, on top of the 27% price increase in Q1. While economic activity and equity markets in net oil-exporting countries such as Russia, Saudi Arabia, Qatar, and UAE benefited from this development, it is an increasing headwind for oil-importing and inflation-prone countries. Argentina and Turkey, in particular, showed worrying signs of macroeconomic instability last month, with the Turkish lira falling by more than 5% and the Argentinian peso by more than 2.5% vs. the US dollar.
The US dollar remained relatively strong vs. most of the EM currencies, which continues to be a headwind for the region.
In the eurozone, manufacturing continues to be the weak spot, with the manufacturing PMI only improving slightly to 47.8 in April. The new orders component picked up a little but remains in contractionary territory. More positively, the employment component stayed above 50, at 50.8—an indication that poor activity data has not yet had a negative impact on the labour market. The unemployment rate fell slightly to 7.7% in the March labour market report. This is consistent with relatively stable data from the service sector and the consumer. The services PMI improved to 52.5 and consumer confidence fell to only -7.9, which is lower than in the previous month (-7.2) but still far above the long term average of -11.7.
In the April meeting of the governing council, the European Central Bank (ECB) left interest rates unchanged, as expected. The ECB expects rates to remain at their present levels at least through the end of 2019, since the slower growth momentum is expected to extend further into this year. The eurozone bank lending survey for the first quarter of 2019 suggests that overall bank lending conditions remained favourable. The new series of targeted longer-term refinancing operations (TLTROs) that the ECB announced in March will help to safeguard favourable bank lending conditions. This will be crucial for Italian and Spanish banks, which are the largest borrowers of the existing TLTRO-II. Details on the precise terms of the new TLTRO-III series will be communicated at one of the forthcoming meetings. March flash CPI in the eurozone drifted lower to 1.4% y/y and core CPI slowed to 0.8% y/y, its lowest level for a year. This provides further justification for the ECB to remain accommodative until the inflation target is achieved.
Standard & Poor’s affirmed Italy’s BBB rating, two levels above junk, but retained a negative outlook. Although this was widely expected, it removes a major risk factor for the markets. Growth in Italy and Spain surprised to the upside and helped to lift eurozone Q1 GDP to an annualized 1.5% growth speed, which is close to trend growth. Periphery bonds outperformed German government bonds in April.
Exhibit 2: World stock market returns in local currency
Source: FactSet, FTSE, MSCI, Standard & Poor’s, TOPIX, J.P. Morgan Asset Management. All indices are total return in local currency. Past performance is not a reliable indicator of current and future results. Data as of 30 April 2019.
The EU granted the UK a flexible Brexit extension until 31 October, removing the threat of a no-deal exit. The UK is obliged to hold elections for the European Parliament on 23 May if it has not ratified the Withdrawal Agreement by that point.
Despite the political uncertainties, UK economic data surprised to the upside last month. The manufacturing PMI jumped to 55.1, its highest reading in a year, and retail sales increased for a third consecutive month in March. The consumer is largely supported by a robust labour market. The unemployment rate stayed at 3.9%, the lowest rate since 1975, and basic wages rose 3.4% y/y.
Exhibit 3: Fixed income sector returns in local currency
Source: Barclays, BofA/Merrill Lynch, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. IL: Barclays Global Inflation-Linked; Euro Treas: Barclays Euro Aggregate Government - Treasury; US Treas: Barclays US Aggregate Government - Treasury; Global IG: Barclays Global Aggregate - Corporates; US HY: BofA/Merrill Lynch US HY Constrained; Euro HY: BofA/Merrill Lynch Euro Non-Financial HY Constrained; EM Debt: J.P. Morgan EMBIG. All indices are total return in local currency. Past performance is not a reliable indicator of current and future results. Data as of 30 April 2019.
Exhibit 4: Fixed income government bond returns in local currency
Source: FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. All indices are J.P. Morgan GBIs (Government Bond Indices). All indices are total return in local currency. Past performance is not a reliable indicator of current and future results. Data as of 30 April 2019.
A solid start into the reporting season, promising economic data from China and the hope of receding trade risks propelled risky assets higher in the first four months of the year. The low risk-free interest rates provided by accommodative central banks continue to support risky assets fundamentally. However, investors should be aware that a lot of optimism is already in the price. Given the lack of earnings growth, most of the equity rally can be attributed to multiple expansion. The risk of disappointment of investor expectations has risen recently. Despite improving newsflow from Sino-American trade negotiations, political uncertainties regarding trade remain. If, in the coming weeks, the US administration declares car imports a national security threat it will likely overshadow any positive outcome between China and the US. Therefore, it still makes sense to be making gradual shifts in portfolios to add more resilience and to look to strategies that can more dynamically shift their exposure to risk assets.
Exhibit 5: Index returns in April 2019 (%)
Source: MSCI, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Data as of 30 April 2019.
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