With 2018 half over, we are seeing broad payback for the strong returns and low volatility of 2017. So far, most of the asset classes in our investment universe, even bonds, have underperformed cash. Within equities, the United States is leading with a gain of 2.7% year to date and 0.6% for the month, in far contrast to negative returns elsewhere.
The economy and financial markets have priced different paths for the rest of the year. U.S. current economic activity indicators have rebounded since 1Q18, reflecting stimulus from tax cuts and strong corporate earnings. The rest of the world has a far more challenging outlook: leading indicators have moderated from late 2017 levels and have yet to perk up. Certain high frequency indicators are signaling downside risk from here. Add in the uncertainties of trade wars with the U.S. and electoral geopolitics, and we see a formula for a stronger U.S. dollar and weaker non-U.S. equity markets. The markets have priced in a far more sinister scenario for the rest of the world, especially the emerging markets (EM).
Trade concerns dominate the financial market narrative, with no visibility over which way matters will turn. We see three potential outcomes over the next few months. First, President Trump may back down after exacting nominal concessions from China and others. This would be the most market friendly outcome, but it looks less likely with the lapse of the July 1 deadline for a NAFTA deal. Second, the Trump administration may take on China’s unfair trade practices and follow through with multiple rounds of tariffs. The news suggests this is likely the path the administration is taking — the least friendly to China and EMs. If China retaliates — as is likely — over time, growth will slow and inflationary pressures will firm. Third, the U.S. may engage in global protectionism, imposing tariffs against China and auto imports in addition to other protectionist policies. This would be the most unfavorable economic outcome and the most adverse for financial markets. Developments are still unfolding and July is a key month for these actions (Figure 1).
Figure 1. Economic Policy Uncertainty Looms as a Critical Factor in Market Expectations
Baker, Bloom and Davis Economic Policy Uncertainty Index1
Source: Bloomberg, Voya Investment Management, data as of 6/30/2018.
Figure 2. P/E Multiples are Moderating outside the U.S., Particularly among Emerging Markets
Source: FactSet, Voya Investment Management, data as of 6/30/2018.
Figure 3. Investor Sentiment Indicators are Trending to Oversold Readings
Source: Credit Suisse, Voya Investment Management, data as of 6/30/2018.
Market performance and alpha generation have been unusually poor in the first half 2018. A period of such sweeping weak equity and bond returns is unusual — especially when, despite numerous country-specific stresses, corporate profits look robust. We remain mostly long growth assets but have rotated some EM equity exposure into U.S. equities and cash. The yield available on shorter term debt has become a viable investment option with higher rates. We view this as a tactical move until clarity emerges on fundamentals for the rest of the world and the likelihood of the various trade war scenarios.
Our models have been vacillating between mid- and late- business cycle readings over the course of this year. The relative strength of domestic data has flipped the U.S. back to mid-cycle, which corresponds with equity returns that should outpace bonds handily. However, models cannot pick up all measures of geopolitics and trade wars. If the high frequency activity indexes moderate enough — as a result of uncertainty and corporate retrenchment due to a wait and see approach on tariffs — our indicators would move to late-cycle rather quickly. It is a risk that we are monitoring closely. Late-cycle does not necessarily mean financial assets are set up for a swift fall, but it would lean us toward the narrative that equity markets in the U.S. are getting closer to a broad topping process. In our view, we are not there yet.
There are key risks besides trade conflict, such as complicated U.S. politics with the mid-term elections, inflation overshoots triggering faster Fed tightening and Italian politics throwing into question the efficacy of the eurozone project. Markets have priced in a lot of bad news, as illustrated by the paltry year-to-date returns in U.S. equities despite two back-to-back quarters of over 20% earnings growth. Our investor sentiment indicators are not at panic levels yet, but getting there (Figure 3). If the fundamentals hold up and the rest of the world starts to improve, the second half of 2018 can be quite different from the first.
1 The Baker, Bloom and Davis Economic Policy Uncertainty Index is based on newspaper archives from Access World New’s NewsBank service. The NewsBank Access World News database contains the archives of thousands of newspapers and other news sources from across the globe. While NewsBank has a wide range of news sources, from newspapers to magazines to newswire services, analysis is conducted using only U.S. newspaper sources. These newspapers range from large national papers like USA Today to small local newspapers across the country. The index is constructed based on the number of articles that contain at least one term from each of three sets of categories. The first set contains the terms “economic” or “economy.” The second contains the terms “uncertain” or “uncertainty.” The third set contains the terms “legislation,” “deficit,” “regulation,” “Congress,” “Federal Reserve” or “White House.”
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