The Economy Trumps Trade Tensions

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Markets climbed above a wall of worry

• Solid economic fundamentals have powered the S&P 500 and the Nasdaq indices to new highs to brush trade tensions, geopolitics, and emerging market rout aside. Even as President Trump upended order at the G7 Summit, growth-oriented assets remain unfazed.
• We reiterate, once again, that economic fundamentals -- not market activity-- are the ultimate driver of asset returns. We see that the market has derived its resilience from solid growth accompanied by mild inflation.

US growth outpaces global since September 2017

• Although the historical correlation between global growth and US growth is high, the US has been performing better than the global aggregate since September 2017. For a global portfolio, this means US-based assets are going to play an increasingly important role in diversification.

Is the market correction over?

• Technically speaking, a market correction is over when the market reaches a new high since the initial drop (in this case, since 29 January). The S&P 500 has regained a lot of lost ground, but remained roughly 3.2% below its peak on 29 January, so it’s technically still in a correction. Some sectors have fully recovered from the market correction, with US technology stocks being the strongest example.
• As always, we recommend investors to continue to focus on economic fundamentals and let dollar cost averaging work in their favour

Markets climbed above a wall of worry

So much has happened since the the beginning of May. For a start, trade tensions between the US and China keep escalating. The US Congress had stepped up pressure on President Trump to punish ZTE for its violation of the Iran sanction, further complicating trade talks between the two global powers. Senior members of the Trump administration contradicted each other, and President Trump’s constant flip-flops have confused enemies and allies alike.

Outside of the US, markets were alarmed by the new populist coalition in Italy, where the Five Star Movement and the League parties stepped into power with a program that promises more fiscal spending and tax cuts. There are also proposals that defy European Union rules on fiscal policy, such as guaranteed citizen’s income and the scrapping of existing pension reform.

In emerging countries, there was also market turbulence. A combination of a rising US Dollar, rising inflation, worsening budget and current account deficits, and political uncertainty have all contributed to outflows of funds from emerging economies. Amid the exodus of international investors, the Turkish central bank was forced to raise its one-week repo rates rates from 8% (25 April) to 17.75% (7 June). Brazil was under similar stress, and by 8 June, the Real had declined 12.4% for the year. The central bank had to intervene in the currency market to provide some temporary relief.

So how did growth-oriented assets manage to outperform?

There were two economic-related factors that provided the game changers for growth-oriented assets. Firstly, the released minutes of the last Federal Reserve meeting have shown that the central bank is not overly concerned about inflation and the economy overheating. Next, the US payroll figures that were released on 1 June have shown continued improvement in the jobs market with controlled wage gains. These developments assuaged markets that the Fed will not hike faster than priced in.

Solid economic fundamentals are what’s powering the S&P 500 and the Nasdaq indices to new heights. Trade tension, geopolitics, and emerging market rout were brushed aside. Even as President Trump up-ended order at the G7 Summit, growth-oriented assets remain unfazed.

In general, US equities have outperformed other regions (Figure 1). Gains in US technology stocks were spectacular, with 9.8% of returns being delivered between 30 April and 11 June. The outperformance means that US technology stocks have fully recovered from the market correction that began on 29 January. The second-best performer is small-cap growth stocks in the US. The market appreciated the small-cap sector relative insulation from trade disputes, pushing the sector to gain 8.9%. In contrast, international equities did not fare well, with emerging markets and European equities losing 1.3% and 1.9% respectively.

Figure 1 - Asset Class Returns (30 April to 11 June 2018, USD)

Source: StashAway, Bloomberg

As reiterated previously, rate hike fears abated after the release of the Fed’s minutes. This has helped interest rate-sensitive asset classes, such as real estate investment trusts that gained 5.6%. The interest rate outlook has also helped protective assets, such as US government bonds, deliver some positive returns. Depending on the maturity on the bonds, returns for US government bonds ranged from 0.2% to 0.5%.

As we’ve said in past CIO Insights, the US Dollar, along with the Japanese Yen and Swiss Franc, can be viewed as a protective asset in turbulent times. Recent emerging market uncertainties have resulted in international investors repatriating funds which in turn kept major currencies such as the US Dollar strong. The greenback gained 0.7% on a trade-weighted basis and 2.2% against the Singapore Dollar.

Looking at another protective asset class, the consumer staples sector has been the worst performer in 2018 but gained 1.9% between 30 April and 11 June. The sector is sensitive to rising commodity prices, and there is also uncertainty regarding how trade disputes may impact the sector. Having said that, there are benefits in having some allocations to consumer staples. Aside from the cheap valuation, the sector has historically offered good diversification in economic contractions. Looking at all data from all recessions between January 1982 and December 2016, the consumer staples sector has posted an average annual return of +2.2%, offering a good mechanism to balance portfolio risk.

Growth in the US outpaces global growth since September 2017

Employment in the US continues to improve steadily with mild wage gains. This means that the inflation picture is benign, representing an economic environment where “real” (or inflation-adjusted) growth is solid. Historically, this is an economic regime that favors growth-oriented assets.

As the US is a big part of the global aggregate, the historical correlation between global and US growth is around 80%, based on monthly industrial production data between January 1982 and December 2017. However, as shown in Figure 2, there is a notable divergence between US and global growth since September 2017: the US remains solid, but there is some weakening in growth at the global level. For global portfolios, this means that US-based assets are likely to play an increasingly important role in providing diversification and risk offsets.

Figure 2 - US Growth Diverges from Global Aggregate

Source: StashAway Analysis.

Notes - growth is proxied by yoy percentage change in the industrial production of a country. The global aggregate is a proprietary index created by StashAway and includes countries such as Brazil, China, Denmark, Europe, India, Japan, Mexico, Norway, Poland, Russia, Singapore, South Korea, South Africa, Sweden, Taiwan, Turkey, United Kingdom and the United States.

Closing thoughts

We are technically still in a correction, but it looks like the markets have finally moved past 4 months of turbulent times, and we are now looking forward more positively. Investors who have continued to invest during the correction will have made strong profits, illustrating that all investors should continue to dollar-cost-average their investments as the markets move upward, downward, or sideward.

Economic data are very positive, and suggest growth-oriented assets will do well in the coming months. However, it remains advisable to have a diversified portfolio that includes protective asset classes such as bonds, consumer staple equities, and/or gold.