Not long ago, even ardent fans conceded that Tiger Woods was likely to finish his career with 14 major championships. After four back surgeries and a personal life that took too many detours through the tabloids, Tiger’s body, mind and his game were surely played out.
What about now? After steady improvement this year and competitive appearances in the last two 2018 majors, Woods claimed victory on September 23 for the first time in five years. Maybe that impressive portfolio of 14 major titles isn’t done growing after all. Despite a few worrisome signs, we think the same of the U.S. economic cycle. While the current cycle approaches record length, we see scope for optimism with further bright days ahead.
In September, BMO’s global multi-asset team convened in London for our annual secular forum, where we evaluate the world from a longer-term perspective to formulate our market expectations over the next five years. The team discussed several topics currently occupying the minds of investors, such as the escalation of the so-called trade wars and the potential for a U.S. recession in the next one to two years. We offer our views on these topics below along with our perspective on market-moving events in other key regions.
Trade wars: Everyone loses but some lose more
Fears of a global trade war intensified in the third quarter. In September, President Trump announced additional tariffs on $200 billion of Chinese goods at a 10% rate (potentially rising to 25% in January 2019). Predictably, China responded with 25% tariffs on $60 billion of U.S. goods. While it is true that the ability of the U.S. to impose tariffs on China is much larger than China’s ability to reciprocate, the U.S. has more to lose than the trade numbers suggest. The U.S. sells many more goods to China through subsidiaries, as evidenced by the fact that China represents General Motors’ largest market — larger even than its U.S. market. Additionally, foreign direct investment from the U.S. into China is three times the amount of investment from China into the U.S.
Even so, equity markets are implying that a trade war will damage Chinese firms more than U.S. firms. Relative equity performance demonstrates this. Since the beginning of the year, Chinese companies with high U.S. sales have significantly underperformed U.S. companies with high China sales.
On global trade, we continue to have a more benign view than consensus, reflected in the modest risk-on stance in our portfolios. While concerning, the direct impact of the tariffs implemented and proposed thus far remains small. We believe that the U.S. and China will come to a deal in the medium term. In addition, we’ve yet to see “second-order” effects from tariffs, such as lower consumer/business confidence and reduced spending, which would cause greater concern.
Emerging markets: How dangerous is the selloff?
Emerging markets (EM) continued their sharp selloff during the quarter. Fears of contagion increased as economic weakness in Turkey intensified and a few EM central banks raised rates significantly to support their currencies. China was not immune from the EM weakness, in part due to the trade dispute with the U.S. Chinese equities have sold off nearly 20% since the end of January.
We are closely monitoring emerging markets for signs of stability. Our base case is that the pockets of weakness are idiosyncratic and country-specific and we do not think they will initiate a crisis in EM. Certain countries — most notably Turkey and Argentina — have suffered from a dangerous combination of negative current account balances, high externally denominated debt and high inflation. However, broadly speaking, emerging-market economies appear relatively healthy with better fundamentals as compared to historical crisis periods.
Japan: Resisting the tightening tide
In defiance of a global trend towards monetary policy tightening, the Bank of Japan (BOJ) continued to aggressively purchase assets and maintain a yield target of “around zero” on 10-year Japanese government bonds (JGBs). To help bond markets function better, the BOJ did tweak policy during the quarter, allowing 10-year JGBs to fluctuate by as much as 20 basis points in either direction. The change allowed JGB yields to increase marginally, causing a temporary steepening of yield curves in the U.S. and Europe. With inflation still well below the BOJ’s 2% target, we expect policy will remain largely stimulative in the coming quarters.
Prime Minister Shinzo Abe was overwhelmingly re-elected for a three-year term as head of the Liberal Democratic Party. His re-election was not without controversy due to recent scandals, but we believe stability and continuity in the political arena is a positive for the Japanese market.
Europe: Lower growth and persistent political risk
The economic growth outlook continued to be somewhat challenging in Europe in the third quarter as PMIs trended weaker and the European Central Bank (ECB) revised down its forecast for GDP growth in 2018 and 2019. However, ECB President Mario Draghi noted late in the quarter that he expects a “relatively vigorous” pickup in inflation as a tightening labor market pushes up wage growth. The ECB will halve its bond-buying program starting in October and is due to end the program altogether in December. Despite Draghi’s more hawkish comments, an interest rate hike is not expected until mid-to-late 2019.
The long-awaited Italian budget arrived on September 28, with the government announcing a plan that set the deficit at 2.4% of GDP, which is below the 3% EU limit but still represents a significant increase. This followed a tense battle with Italy’s technocratic economy minister. We continue to believe that the Italian coalition may be short-lived as it will have difficulty delivering on election promises.
It was a tough quarter for U.K. Prime Minister Theresa May and her Conservative Party. The resignations of Foreign Secretary Boris Johnson and Brexit Secretary David Davis showed a government in turmoil, and at a September summit in Salzburg, May was caught off guard by the EU’s denunciation of her “Chequers” plan. The prime minister must also contend with the main opposition Labour Party’s dismissal of Chequers, which may leave the door open to a second Brexit referendum. While we still expect a deal, time is running out and the probabilities of “no deal” and “hard Brexit” likely increased during the quarter.
U.S. midterm elections: Noisy but unlikely to derail the economy
U.S. midterm elections often reflect voters’ response to the president’s first two years in office. While things looked bleak for Republicans in 2017, the picture has moderated somewhat, in part due to the U.S. economy’s persistent strength and a resulting bump in the president’s approval rating. Our base case is for the Democrats to gain control of the House of Representatives but not the Senate, where they must play defense in 26 of the 35 elections.
We do have some concerns regarding a split government, as equity returns tend to underperform during these periods, especially if there is an economic downturn. However, the U.S. economy is on firm footing and we do not see the outcome of these elections disrupting U.S. economic growth over the medium term. Gridlock and posturing will dominate Congress while both parties position for the important 2020 elections.
U.S. wage growth: Look at least twice before you leap
In late January, a higher-than-expected reading of U.S. wages led to a brief but sharp equity selloff as market participants scrambled to price in additional hikes by the Federal Reserver (Fed). Investors feared the long-awaited (and long-forecasted) pickup in wages had finally arrived to herald the end of the cycle. However, that reading of average hourly earnings was subsequently revised down to a number in line with the original expectation, reminding us all of the market’s tendency to overreact, even when the economic data is likely to be revised.
Again in September, the same reading of wages came in above expectations at 2.9%. The market response was to bring U.S. rate hike expectations closer (but still below) the median Fed expectation. Given the low level of unemployment, wage growth will continue to be one of the most influential variables for financial markets in the coming months. We have a modestly hawkish view on U.S. inflation (inclusive of wages) and our portfolios are positioned for a gradual increase in interest rates.
Much has been written about the relentless flattening of the U.S. yield curve, where short-term rates have risen at a much faster pace than long-term rates over the last five years. The yield difference between the 10-year Treasury and the 2-year Treasury is now approaching the point of inversion, typically a harbinger of recession. We prefer to watch the difference between the 10-year Treasury rate and the 3-month Treasury rate, which better measures current Fed policy and has historically provided a more accurate recession prediction. According to this measure, the yield curve looks steeper and Fed policy less restrictive.
U.S. equity earnings: Going beyond the stimulus boost
When the fiscal stimulus package in the U.S., including a large corporate tax cut, was announced in late 2017, most equity analysts forecast a one-time boost to U.S. equity earnings. However, earnings have remained exceptionally strong, with second-quarter results even managing to slightly outpace those of the first quarter.
Earnings are expected to fall from this elevated pace later in the year, but they are expected to remain near 20% through the end of 2018. Even with the escalation of trade protectionism by the U.S. and China, S&P 500 companies with more global exposure actually reported higher earnings and sales growth in the second quarter as compared to their domestic-focused counterparts. While our “behavioral” assessment of U.S. equities has been very strong, we feel the bar for corporate earnings has been set relatively high. In light of very strong recent performance, we are considering modestly reducing our bias toward U.S. equities.
We continue to favor a modest overweight to global equities, funded by underweights to rates and credit. Within equities, we retain a preference for U.S. equities relative to international developed equities; however, we are considering reducing positions modestly in response to very strong relative performance. While we remain tilted toward developed-market equities relative to emerging-market equities, we believe that we may be nearing the trough for EM and that the longer-term outlook is relatively positive. Within fixed income, we retain an underweight position to both sovereign bonds and credit. On currency, our core view is that the U.S. dollar will experience broad but modest strength, particularly against the Canadian dollar, and weaken modestly versus the yen.
More to come: Our five-year outlook
BMO’s global multi-asset team is in the process of updating our five-year outlook and we look forward to sharing our longer-term conclusions with you in the coming months.