J.P. Morgan Asset Management: Review of markets over February 2018

After fifteen months of equity markets grinding steadily higher, volatility returned abruptly at the beginning of February. Volatility – as measured by the VIX index – increased to levels last seen in 2015, when the market was concerned about the strength and stability of China. Risk asset prices fell sharply, but swiftly recovered much of the early losses. The S&P 500 ended the month 3.7% lower, the FTSE 100 was down 3.4% and the MSCI Europe ex UK fell 3.5%. The Global Aggregate Bond Index fell by a more modest 0.9%.

Exhibit 1: Asset Class and style returns (local currency)

Source: Barclays, Bloomberg, FactSet, FTSE, MSCI, J.P. Morgan Asset Management. 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. Data as of 28 February 2018.

Strong macro data most likely played a role in preventing a more sizeable market correction. Data released over the month showed that for the fourth quarter of 2017 the annual pace of real GDP growth rose to 2.7% in the eurozone. Moreover, growth was broad-based across the region. Growth looks set to continue at an above trend pace given that the composite Purchasing Managers’ Index remains at an elevated level of 57.5 for February, despite moving lower from the prior month’s figure of 58.8.

In the US, the annual pace of GDP growth was broadly steady at 2.5% in the fourth quarter. The labour market remains strong, with jobless claims continuing to trend lower. Strong job prospects and tax reform are supporting consumer confidence, which this month reached its highest level since 2000.

In Japan, fourth-quarter GDP growth eased but remained positive, with annualised quarterly growth of 0.5%. Chinese growth was stronger than expected, at 6.8% year on year, for the fourth quarter. The fact that China has maintained rapid growth despite a renewed push by the authorities to rein in loan growth has eased some concerns about the country’s ability to grow out of the debt it has accumulated in recent years.

The key concern among investors is that as the recovery proceeds, economies start to reach the limit of their resources; that as unemployment grinds lower and factories reach capacity, inflation reasserts itself, causing central banks to reassess their easy monetary policy.

The market volatility seen in February demonstrates the sensitivity of investors to the prospects of a swifter pickup in inflation. In the January US labour market report, the annual pace of wage growth rose 0.2 percentage points to 2.9%. The market priced in a faster pace of Federal Reserve tightening and the ten-year government bond yield quickly rose towards 3%, which in turn caused the equity market to wobble.

In our view, there is still not compelling evidence that inflation is picking up meaningfully. Brent crude oil prices fell 4.7% over the month of February whilst core inflation remains below the central banks’ target of 2% in many areas, including the US and the eurozone. Inflation in some emerging countries is trending down, highlighting a process of convergence between the emerging and developed world.

Inflation is most stubbornly low in the eurozone. Mario Draghi, in his speech to the European Parliament, argued that the European Central Bank (ECB) must remain patient and persistent with regard to monetary policy in order to create conditions for inflation to pick up to the stated target of below, but close to, 2%.

Exhibit 2: World stock market returns (local currency)

Source: FactSet, FTSE, MSCI, Standard & Poor's, TOPIX, J.P. Morgan Asset Management. All indices are total return in local currency. Data as of 28 February 2018.

In the US, Janet Yellen handed over the baton of Federal Reserve Chair to Jerome Powell. Markets do not anticipate many changes to policy as a result of the handover. The minutes of the January Federal Open Market Committee meeting suggested that the committee remains optimistic on the outlook for the US economy but believes policy needs to be normalised very gradually.

In Japan, the government confirmed Haruhiko Kuroda as the Bank of Japan’s (BoJ) Governor for a further five years. The progress towards lifting inflation in Japan remains slow and Kuroda reaffirmed the need for ‘powerful monetary easing’ when he spoke in front of Parliament in February. It seems likely that the BoJ will keep its 0% yield target for ten-year government bonds in place in the near term. This in turn is likely to continue to weigh on global longer-term yields.

In contrast to communications from the BoJ and ECB, the Bank of England (BoE) sent a notably more hawkish signal at the February Inflation Report press conference, suggesting that interest rates would need to rise “somewhat earlier and by a somewhat greater extent” than they anticipated in November. The market now sees it as more likely than not that the BoE will raise the base interest rate by 25 basis points in May.

Politics played a very minor role in market developments through February. The imminent election in Italy is a very important event for the country but is not troubling broader European markets. The Italian political picture is still fragmented. A centre-right coalition is expected to obtain the most votes, according to recent polls, but possibly without reaching a majority. A prolonged period of negotiation to form a coalition seems likely. Although this is not good news for Italy given its need for reform, the election result is unlikely to raise major questions about Italy’s role in Europe. Germany announced a new grand coalition that, if ratified in the Social Democratic Party’s referendum, could be supportive of further European integration.

Exhibit 3: Fixed Income sector returns (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 EMBI+. All indices are total return in local currency. Data as of 28 February 2018.

US Treasuries remained under pressure and the 10-year yield reached a level of 2.86% by the end of the month. The US government passed a package of fiscal stimulus that amounts to roughly 400 billion US dollars of public spending in the next two years. This could see the fiscal deficit rise to more than 5%. The return of the US twin deficits (fiscal and trade) likely explains the ongoing weakness of the US dollar despite the increasing yield differential between the US and Europe. The US dollar/euro exchange rate reached a peak of 1.25 over the course of February.

Exhibit 4: Fixed Income government bond returns (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. Data as of 28 February 2018.

At the end of the month, equity markets were edging higher again. We expect further modest price gains over the course of 2018, given the strength of the macro picture and healthy earnings momentum. Earnings growth for the current year has already been revised up in many countries compared to the start of the year. In the US, 2018 earnings per share are expected to grow 19%, thanks in part to the tax reform. Earnings for the MSCI Europe and TOPIX are expected to grow 11% and 7% respectively.

Exhibit 5: Index Returns for February 2018 (%)