The party that never happened
Head of Equity Strategy
Going into 2018 expectations were running high among investors and economists with strong financial markets and macro during 2017. In the beginning it definitely looked like the party would continue with strongest start in many decades with MSCI World delivering a bit more than 5% Inflation expectations were rising with the US tax reform and highest activity numbers out of Europe since 2007. Companies were increasingly confident about the future and investments were rising; even energy companies were back adding to growth. What could go wrong?
February started with the biggest 1-day volatility shock in decades even eclipsing the day after Lehman Brothers’ bankruptcy. For technical reasons driven by short-volatility funds the decline was brutal but markets came back quickly with especially US technology companies reaching new highs already in March. Then came the Facebook data scandal and louder voices arguing for increased regulation of technology companies clearly not living up to their responsibility of holding data on billions of people. The EU Commission circulated the idea of a 1-3% revenue tax on technology in what could look like a direct attack on US technology companies. But more to the truth the idea is a way to circumvent the harsh reality that a unified corporate tax rate cannot be applied throughout all member states in the European Union minimizing tax arbitrage behaviour. The EU technology tax is more an attack against Ireland’s vast tax arbitrage against other EU countries as billions of offshore currencies sit in Ireland as global companies use Ireland and transfer pricing to minimize tax payments in other European companies. As a result of the Facebook data scandal and increased concerns of coming regulation US technology companies nosedived 12% in less than a month dragging down the rest of the market.
Since late March global equities have been battling against mixed macro in China and very disappointing macro numbers from Europe while the US economy has been the wunderkind. The Q1 earnings season, despite very good numbers, failed to lift equities in general. Recently the US has imposed steel and aluminum tariffs on Mexico, Canada and Europe, and general tariffs worth $50bn on imported goods from China. Fears are increasing that the tit for tat trade policy tactics will escalate into a full-blown trade war that will sack the global economy. Today Daimler announced a downward revision to their profit outlook on slower SUV sales in China as these cars are produced in the US and imported into China on which the Chinese government has just slapped a 10% tariff. Increasing pain is also witnessed in the US agricultural sector with softs prices falling on especially soybeans. Add to all of this the relentless normalization of US interest rates causing stress in many EM countries. Recently the governor of the Reserve Bank of India said that EM countries could experience a USD funding crisis if the FOMC pushes ahead with higher Fed Funds Rate into 2019 as the US fiscal deficit will not be accommodated by QE as the Fed is winding down their balance sheet. Already now several countries from Russia, Turkey, Brazil, Argentina and Mexico are feeling the heat on their currency and things could easily get much worse in 2019 hitting the rest of the world as a boomerang.
Major equity indices performance year-to-date in %
So here we are with global equities up 2.5% translating linearly into a 5% return for the whole year if the current trend continues. Not bad, but on the either hand not stellar given expectations six months ago. As the chart above shows, US technology companies (NASDAQ 100) continue to perform splendidly, up almost 14% year-to-date. The technology sector has mostly avoided the dangers lurking around in global equities as these companies have zero debt leverage on their balance sheets and thus have no interest rate sensitivity. Couple that with the only real place for high growth and you have high valuations and strong returns for investors. This trend could easily continue for the rest of the year. The performance chart also shows that EM equities have underperformed, down 3% year-to-date with Europe just behind and down 1.5%. US equities are up 5% year-to-date, driven by technology stocks.
Our main view at this point is to be overall defensive on equities (underweight in an asset allocation framework – our model has a 24% weight on equities). But within the equity allocation be overweight minimum volatility stocks and technology. There is an increasing probability that 2019 will be the year of a global economic slowdown as the hangover from the US fiscal impulse hits financial markets. Mostly likely in the second half. As financial markets discount the future later this year investors will likely begin to learn that markets are discounting this potential scenario with equities topping out and credit deteriorating. The big questions left are 1) whether the European Central Bank has come out of negative rates before the slowdown starts, 2) can the euro project survive another downturn, 3) will the next economic slowdown be severe, 4) how will a not fully healed society cope with another economic slowdown, 5) will a lot of USD debt in EM countries go into distress and 6) will China finally make a policy mistake.
Finally, look at the chart below. Europe and emerging markets look like tired marathon runners willing to give up. Is there any hope? The one region lacks a dynamic technology sector, the other region is hopelessly greased in bureaucracy, old industry and too much foreign denominated debt. The winner looks to be the US for now, and especially the technology sector. But as with everything in life, the future never turns out as we expect it to...
Major equity indices performance the past five years in %