Stock markets showed resilience in the second quarter, however an undercurrent of risk-averse sentiment flowed around the world. Trade-war rhetoric was a key focus of weakening sentiment, with emerging markets under significant pressure as investors pulled money out of the region.
This affected emerging stock markets and their currencies, but the fundamental thesis and economic progress were largely unchanged. The divergence in equity market performance was evident in mid-year returns, with Asian and Latin American markets particularly feeling the brunt of the change in investor sentiment.
For some time, investors have had to face the implications of rising interest rates. This theme has continued to impact returns, as most central banks – excluding those in Japan and some emerging markets – have made it clear that they are either unwinding, or planning to unwind, the monetary stimulus that has persisted for the best part of a decade.
This “normalisation” process has muted the performance of traditional bond markets, especially government bonds with longer duration, whilst inflation-protected bonds continue to be shaped by a rollercoaster of changing inflation expectations. Corporate bonds have also had to deal with a modest rise in bond yields, albeit from a low base, which has hampered relative performance.
Europe Beset with Political Uncertainty
Meanwhile, European investors have nervously watched Italy’s precarious political situation and a closing deadline on Brexit. This recently dampened risk appetite in the region, as investors contemplated the possible repercussions on the European banking system and any associated contagion risk. Brexit tensions have heightened again, although U.K. multinational corporations have generated stronger investor interest, especially as sterling has fallen recently. Similarly, a stronger U.S. dollar) is helping bolster foreign returns for non-U.S. investors in the quarter.
Developments at an Asset Allocation Level
Despite the dual headwinds of European political vulnerabilities and escalating trade-war fears, broad equity market returns have been reasonably robust in the first half of 2018. Strong earnings growth has certainly helped, with companies, especially in the U.S, continuing to post stellar profit results. Solid fundamentals have seemingly led investors to higher-quality investments, regardless of price.
In addition to strong fundamentals, country and sector dispersion is alive and well, such as the circa 20% performance differential between the U.S. technology sector and emerging-markets financials over the past quarter alone. More broadly, strength in technology, healthcare, and consumer staples was offset by weakness in telecoms and financials. Similarly, at a country level, resilience in the U.S., Japan, and Russia was offset by significant price falls in Brazil, China, and Turkey.
Our Valuation Views
We believe that the U.K. remains an interesting proposition, especially among large-caps, as poor sentiment amid Brexit uncertainty sees retail money leaving this market. The underlying investment case for emerging-markets equities also remains largely intact, especially in emerging Europe, and to a lesser extent Asia, built around improving earnings and attractive valuations.
Additionally, Japanese equities appear reasonably priced, with the continued focus on their corporates improving shareholder outcomes by increasing dividends/buybacks and improving profit margins.
By contrast, the U.S. remains far less compelling because of price. Lastly, we believe emerging-markets debt continues to offer very attractive yields, and U.S. bonds increasingly offer better value.
Keeping a Long-Term Perspective
It may be tempting to attribute recent market falls in some major markets to a single factor and extrapolate some form of expectation for the near future. For instance, a full-blown trade war between the U.S. and China is a potential minefield with no clear winner. However, trying to predict such matters would be a fool’s errand, and positioning on such speculation would be a mistake.
Inevitably, the market will redirect its attention to the difference between price and the underlying fundamentals. Opportunities tend to reside in unloved pockets where the margin of safety is at its widest. Therefore, we continue to build portfolios with a bias to these typically unloved assets, with a constant eye on maximising reward for risk in a long-term context.
