Monthly markets review - August 2018

Highlights

• Global equities, as measured by the MSCI World index, gained in August but there were significant regional differences amid persistent US-China trade tensions and Turkey’s currency crisis.
• US equities gained ground and significantly outperformed other major regions, as economic growth remained extremely robust.
• Eurozone equities declined. Banks were under pressure amid concerns over exposure to emerging markets as well as uncertainty over whether Italy’s 2019 budget proposal will comply with EU fiscal rules.
• The UK’s FTSE All-Share fell over the period. The Bank of England (BoE) announced a further 0.25% increase in base rates to 0.75%.
• Japanese equities saw negative returns with trade tensions continuing to dominate the global headlines.
• Emerging market equities lost value amid a currency crisis in Turkey and further escalation in US-China trade relations. Countries exposed to global liquidity tightening experienced currency weakness, notably South Africa.
• In bond markets, the wider risk aversion caused the US 10-year yield to drop from 2.96% to 2.86%. 10-year Bund and gilt yields also fell while Italian yields rose.

US

In a month that saw geopolitical developments weigh on share prices in most major regions, US equities rose in August. The S&P 500 returned 3.3%. Escalating US-China trade sanctions, the currency crisis in Turkey, a reinstatement of US-Iran sanctions as well as ongoing Brexit negotiations hurt sentiment in most major equity markets. However, the resilience of the US economy continues to encourage participation on Wall Street.

GDP data released in late July showed that US economic growth accelerated to 4.2% on an annualised quarterly basis in Q2, its fastest pace in nearly four years. Strong household spending was the key driver of the pick-up in growth, supported by the US administration’s drive to lower taxes and increase spending. A surge in the volume of exports from the US ahead of the scheduled implementation of new tariffs also helped.

The S&P 500 stock market index also retained momentum from July’s slew of strong corporate earnings results. The index’s current bull run – broadly defined as a rise over time without falling more than 20% from its peak during the period – became the longest in history on 21 August.

Over the month, the consumer discretionary and technology sectors were among the strongest performers, buoyed by robust gains in Amazon and Apple (the latter becoming the first company to surpass a $1 trillion market cap on 2 August). The energy sector was weaker, with US oil companies hurt by uncertainty surrounding China’s inclusion of US crude oil in its tariff-targeted products.

Eurozone

Eurozone equities registered declines in August with the MSCI EMU index returning -2.7%. Financials, notably banks, underperformed. In particular, lenders with exposure to Turkey came under pressure as the Turkish lira fell sharply and bond yields rose. Meanwhile, the Italian banks were also impacted by rising domestic bond yields amid worries that the new Italian government’s 2019 budget may come close to breaching EU fiscal rules. The budget is due to be finalised in September and presented to the EU in October.

Elsewhere, automobile stocks fell in August amid ongoing trade worries. German tyremaker Continental reduced full-year forecasts for sales and profit margins, citing slower sales as well as higher costs and warranty claims. The information technology and real estate sectors delivered positive returns.

On the economic front, growth for the second quarter of 2018 was revised up to 0.4% quarter-on-quarter, compared to the initial estimate of 0.3%. The forward-looking composite purchasing managers’ index1 pointed to steady expansion with a reading of 54.4 in August versus 54.3 in July. The German Ifo business climate index2 improved to 103.8 in August from 101.7 in July while expectations also saw an upward move.

Outside the eurozone, Norway’s central bank kept rates on hold at 0.5% but restated that the first increase in seven years will be forthcoming at September’s meeting.

UK

The FTSE All-Share fell against the backdrop of increased risk aversion in global markets as US-China trade relations deteriorated and fears rose over the stability of emerging markets (EM). Sterling fell amid ongoing uncertainty around Brexit and following further strength in the US dollar. The decision by the Bank of England (BoE) to increase base rates failed to have a stabilising effect on the currency as the bank stressed that the path of future tightening was likely to be gradual.

The BoE judged the slowdown in the UK economy in Q1 as temporary and weather related, a prognosis vindicated shortly after by preliminary GDP data from the Office for National Statistics, which revealed growth had bounced back to 0.4% in Q2. However, the bank left its growth projection for 2018 unchanged at 1.4%. Meanwhile, a build up of inventories in the economy raised some questions around the sustainability of the rebound in Q2.

EM-exposed areas of the market performed poorly, including Asian financials and the mining sector, with the latter negatively impacted by disappointing Chinese macro-economic data. Meanwhile, the tobacco sector also performed very poorly, giving back all of the gains it achieved in July. Merger and acquisition activity was a rare bright spot in the month after Whitbread recommended an offer from Coca-Cola of the US for its Costa coffee chain for an enterprise value of £3.9 billion.

Japan

The Japanese stock market was weak in the first half of August before a partial recovery, resulting in a return of -1.0% for the month as a whole. Despite ongoing global uncertainty, the yen moved in a relatively narrow range against the US dollar. The reversal in market direction produced a very mixed sector picture. The pulp & paper sector was the strongest performer as product prices remain at relatively high levels, while the construction sector moved sharply lower. There was an unusually wide spread between defensive sectors such as foods and pharmaceuticals which have previously tended to move together.

The other notable feature within the market was the sharp underperformance of small caps in August following a similar but less pronounced move in July. The trigger for these moves is not clear and this may be a natural short-term correction after the sustained outperformance by small caps over the past two years. However, the timing of the change, following closely after the Bank of Japan’s last policy meeting, suggests that some investors may be making assumptions about the extent and impact of any change in the central bank’s policy for ETF purchases.

External factors continue to be the short-term driver of investor sentiment. Although trade related issues dominated headlines throughout August there was almost no substantive news on which to base long-term decisions either for investors or Japanese corporates. Economic data also provided little direction particularly given the need to discount for extreme weather conditions across Japan last month. Meanwhile, after weathering financial scandals earlier this year, Prime Minister Abe now seems to have a reasonably clear path to the LDP leadership election on 20 September.

Asia (ex Japan)

Asia ex Japan equities posted a marginally negative return, with China and Hong Kong among the weakest countries. Previously announced US tariffs on $16 billion of Chinese goods took effect during the month and China responded with similar measures. The two sides held fresh talks in August with little progress achieved, increasing the prospect of further sanctions. Chinese economic data was weak, notably fixed asset investment growth. Singapore also underperformed, with consumer discretionary stocks among the weakest names.

By contrast, the ASEAN3 markets of the Philippines and Thailand posted positive returns and outperformed. In the Philippines the central bank hiked its key policy rate by 50bps to 4% as inflation ticked up to 6.4%. Meanwhile Thailand, together with large index markets Taiwan and South Korea, outperformed peers given strong current account surpluses and foreign-exchange reserves.

Emerging markets

Emerging markets (EM) equities registered a negative return with US dollar strength a headwind, despite some moderation later in the month. A currency crisis in Turkey contributed to risk aversion amid concern over contagion to other EM. Uncertainty over US-China trade relations also weighed on sentiment. The MSCI Emerging Markets index decreased in value and underperformed the MSCI World.

Turkey was the weakest index market amid a sharp depreciation in the lira. The currency fell as geopolitical tensions with the US exacerbated ongoing concerns over its wide current account deficit, above-target inflation and central bank independence. Those EM exposed to global liquidity tightening experienced currency weakness, notably South Africa which lagged the index by a wide margin.

Latin American equities underperformed with currency weakness a headwind, particularly in Brazil where domestic political uncertainty weighed on the real. China trailed the index as the US moved closer to imposing more significant tariffs on Chinese goods and domestic macroeconomic data disappointed.

By contrast, Thailand and Korea posted positive returns and outperformed. Both markets held up better than peers given strong current account surpluses and foreign exchange reserves.

Global bonds

A degree of risk aversion returned to bond markets in August amid ongoing trade tensions, political uncertainty and idiosyncratic events, which saw a precipitous fall in emerging markets. Economic data remained strong, especially from the US.

US 10-year yields retraced to end-June levels, dropping from 2.96% to 2.86%, with the yield curve flattening as two-year yields dropped from 2.67% to 2.63%. In Europe, 10-year Bund yields dropped from 0.44% to 0.33%, while Italian 10-year yields rose from 2.72% to 3.23% and Spain’s ticked seven basis points higher to 1.47%.

UK gilt yields were slightly lower on the month. This was despite a well telegraphed rate hike by the Bank of England, as Governor Mark Carney suggested that the economy required only a “modest” pace of rate hikes. UK assets also continued to be driven by Brexit related risks, with rhetoric suggesting the increasing possibility of a “no deal”.

Global investment grade4 (IG) corporate bonds produced positive total returns, led by US dollar and sterling; euro IG underperformed. Services and other financials made good returns, while automotive and transport, more sensitive to trade tensions, were lacklustre. Higher-rated credit outperformed.

Global high yield (HY) corporate bonds saw a small negative return, reflecting weakness from the euro-denominated market. In the US dollar market, HY outperformed IG, continuing its strong run of performance, and sterling HY was in-line with IG. Services, media and healthcare did relatively well across markets. Euro subordinated insurance and retail were notably weak.

Emerging market bonds saw renewed weakness, with fears over Turkey and Argentina again to the fore. Local currency returned -6.1%, hard currency and corporate bonds returned -2% and -1% respectively.

Global convertible bonds, as measured by the Thomson Reuters Global Focus Convertible Index, showed a positive return of 0.9%. Convertible bond valuations continued their downward trend with US bonds becoming cheaper in August. Japan and Asia ex Japan remain cheap regions for convertibles.

Commodities

The Bloomberg commodities index posted a negative return in August. The agricultural and energy components both recorded negative returns. Among soft commodities, coffee and soybeans fell on currency weakness in key producer countries and favourable weather. Industrial metals prices moved lower, with the US-China trade dispute weighing on the demand outlook. The energy component was supported by Brent crude, rising on the prospect of reduced supply from Iran due to US sanctions initiated during the month. Gold (-1.8%) and silver (-7.2%) both lost value.

1The eurozone purchasing managers’ index is produced by IHS Markit and based on survey data from around 5,000 companies based in the euro area manufacturing and service sectors. A reading above 50 indicates expansion.

2The Ifo Business Climate is based on around 9,000 monthly survey responses from firms in manufacturing, services, trade and construction.

3The Association of Southeast Asian Nations (ASEAN) is a regional grouping that promotes economic, political, and security cooperation among its ten members: Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam.

4Investment grade bonds are the highest quality bonds as determined by a credit ratings agency. High yield bonds are more speculative, with a credit rating below investment grade.