The market landscape in the third quarter was dominated by North Korean tension, a Brexit deadlock, central bank murmurs and a series of U.S. policy oscillations, all of which are influencing asset markets but have failed to materially budge market optimism.
Predominantly, currency markets are feeling the brunt of the political developments, with further gains for the euro and sterling combining with declines for the US dollar and Japanese yen. Of note, the euro has rallied year-to-date by 10.8% against the US dollar and 7.6% against the Japanese yen, causing the European Central Bank to express concerns about currency strength.
The euro strength is a defining feature of market sentiment that reflects a consensus that the European revival remains intact; despite the recent jitters in Catalonia and a mixed result in the German election. While the durability of this European optimism is still in question, it would seem to be supportive on the data front, with stronger economic growth figures, rising corporate earnings, falling unemployment and improving confidence surveys all acting as tailwinds.
Even emerging Europe excelled in the third quarter, with Russia turning around to surprise investors with its growing dividend allure and brushing off the sanctions saga to deliver its fastest economic expansion in four and a half years.
The U.K. undoubtedly faces different challenges to those outlined above. Many questions remain over the Brexit deadlock, with concerns over Theresa May’s leadership amid early signs of an economic slowdown. It certainly didn’t help the cause when European Union president Jean-Claude Juncker proclaimed that the UK’s Brexit position papers are “unsatisfactory” and “hesitates showing all its cards”. Such a dynamic also puts a lot of pressure on the Bank of England’s Mark Carney, who is hopeful to raise rates despite GDP annual growth most recently being revised down to a four-year low.
Equity Market Moves
Despite the political tension, it was another very positive quarter for equities generally, with gains across the majority of the globe. Emerging markets delivered stellar results once again, outperforming developed markets over the third quarter, although September saw a partial reversal and the breaking of an 8th month streak. Smaller companies also edged out their large-cap equivalents, enjoying the tailwind that has supported “risk-on” assets.
Such divergence was also evident at both a country and sector level too. China, Russia and Brazil have been buoyed by the strength in the energy and materials sectors, whilst US technology companies continued to attract investor attention despite lofty valuations.
Japanese and South Korean equities were notable laggards over the third quarter, clearly hampered by concerns over North Korea. While this fear is understandable, it ignores the appeal of the longer-term fundamental advances that stem from Japanese Prime Minister Shinzo Abe’s “Third Arrow”.
Fixed Income Markets
Against the backdrop of equity market strength and gradual central bank tightening, fixed income markets were generally flat. However, on a look-through basis there were some noteworthy developments. With hindsight, in the midst of the “risk-on” rally, it should not come as a surprise that emerging market debt continued to outperform developed market debt, nor should one be surprised that corporate debt outperformed government debt.
Yet, there may also be more than meets the eye. With corporate defaults hovering near historical lows, corporate bond yields have narrowed further relative to government bond yields. Part of this is attributable to central bank rumblings, especially in the US, with government bond yields grinding higher off a low base and the Federal Reserve set to deleverage its balance sheet. Inflation is also playing its part, yet there seems divided opinion about its durability amid low unemployment, low wage growth and a supply-led oil price recovery.
Broad Perspective
Going forward, we face an interesting situation whereby market optimism appears pegged to one of the longest, but slowest, economic expansions in history. With strong historical asset price performance behind us, it begs the question about what might happen going forward.
This is an area of intense speculation, with the threat of war and Chinese leverage often flaunted as the biggest dangers to equity market sentiment. Political uncertainty could also influence proceedings, especially as US President Donald Trump is thought to be contemplating a new Federal Reserve chairperson and could change the rate hiking course.
To provide context on the variety of opinions currently flaunted in the marketplace, the third quarter saw some respected pundits, including Jeremy Siegel, claim that equities are still a bargain relative to bonds, while others such as Alan Greenspan declared “we are moving into a different phase of the economy - to a stagflation not seen since the 1970s. That is not good for asset prices”.
We prefer to take a fundamental view of the markets, and while we must acknowledge a wide range of outcomes in the long-term, it is clear that the complexities of investing are growing. To provide further perspective, the earnings growth that has propelled markets has been mostly attributable to a rebound in profit margins among materials and energy companies.
This leaves us with a challenging opportunity set. On the one hand, there are pockets of opportunity that appear to warrant investor attention. However, the danger to our way of thinking, is that the broader market optimism could easily unwind. With valuations becoming stretched, this increases the chances of future weakness as prices accelerate beyond the fundamentals. From a portfolio construction standpoint, it also requires a level head and discipline as one navigates the course to deliver on the long-term goal.
