Trade continues to “HOG” the spotlight as the quarter ends on a wobbly note

Brian Nick

The last week’s market highlights:

Quote of the week:

“Without forgiveness, life is governed by an endless cycle of resentment and retaliation.” – Roberto Assagioli, Italian psychiatrist
Each week, we present our featured topics in the context of the major themes listed below from the Nuveen Midyear Outlook:
  • U.S. economy: Running ahead of its peers.
  • Global economy: Trade a bigger concern outside the U.S.
  • Policy watch: Central banks aren’t all on the same wavelength.
  • Fixed income: Starting to prefer higher-quality assets.
  • Equities: Earnings are supporting prices, but expect plenty more volatility.
  • Asset allocation: Remain risk on, but focus on quality.

U.S. economy/equities: The dollar, Treasury yields, and small caps all rise in the first half of 2018

The U.S. dollar has rallied and found its feet.
During the first quarter of 2018, expectations for a steady pace of Federal Reserve rate hikes pushed up the yield on the 2-year Treasury to 2.27% by the end of March. At the same time, growing inflation concerns and forecasts for increased Treasury issuance to fund tax cuts and deficit spending lifted the yield on the bellwether 10-year note to 2.74%. In contrast, short-term interest rates in Europe remained negative, with 2-year German debt closing at -0.59% on March 29. Longer-term yields were only marginally higher. The 10-year German bund offered just 0.50% by the end of the first quarter.
Considering the extra income provided by U.S. government debt, capital should have flowed stateside, strengthening the dollar versus the euro. Higher yields, after all, tend to attract foreign funds. That didn’t happen, though. Instead, the euro fluctuated between $1.20 and $1.25 for most of the quarter, notching a number of three-year peaks along the way. Market participants bet that the eurozone’s economy would power ahead after outperforming the U.S. in 2017.
But that currency dynamic reversed course in the second quarter. The euro began falling in mid-April amid a series of disappointing economic releases and was pressured further in June when the European Central Bank (ECB) decided to postpone raising interest rates until next summer at the earliest. The euro closed at $1.17 on June 29 and was down 2.7% versus the dollar for the first half of the year.
From a “dollar positive” viewpoint, the second quarter saw the U.S. economy reclaim its title as the world’s primary growth engine, even as consumer spending undershot expectations in May and was revised lower for April. The manufacturing and services sectors remained healthy, and the housing market continued to show signs of strength. Moreover, the Fed stayed on a tightening path, in contrast to the ECB’s cautious stance. May’s 2% year-over-year increase in the core PCE index—the Fed’s preferred inflation barometer—should bolster the case for two more rate hikes in 2018.  
Reflecting a more hawkish Fed, the 2-year Treasury yield jumped 25 basis points during the quarter, to 2.52%. Meanwhile, the bellwether 10-year note closed at 2.85% on June 29. This was down from a mid-May high of 3.11% but up 11 basis points for the period overall. Longer-dated Treasuries have rallied over the past few weeks thanks to strong demand from pension funds and a “flight-to-quality” triggered by rising trade tensions.
In equity markets, small-caps (+7.7%) easily outpaced all major asset classes during the first half of the year, as their domestic tilt provided a cushion against trade policy uncertainty, slower global growth, and a stronger dollar, which makes exports more expensive in overseas markets.
Not all “risky” sectors outperformed, though. After climbing 8.3% in January, the MSCI Emerging Markets Index fell 15% over the last five months. Chinese stocks, which make up about one-third of the index in terms of market capitalization, have struggled as China’s economy has decelerated.
A strong dollar has hit emerging-market (EM) shares hard in 2018. For example, the greenback has surged 17.1%, 8.9%, and 20.9% against the Brazilian real, Russian ruble, and Turkish lira, respectively. Gains of this size have made it more costly for EM countries to service and roll over dollar-denominated debt, leading to higher borrowing costs. Moreover, rising yields on “risk-free” assets such as U.S. Treasuries have dimmed the allure of investing in EM securities.

Global economy: As synchronized global growth falters, protectionism poses new challenges for China

After considering a little-used statute to crack down on direct investment from China, on June 27 the Trump administration opted instead to employ a softer approach that would be less disruptive to trans-Pacific financial markets and the U.S. and Chinese economies. The threat of a trade war has left China’s President Xi Jinping contemplating “self-defense measures” in response to an initial round of U.S. tariffs on Chinese imports scheduled to take effect on July 6. With the possibility of additional levies on hundreds of billions of dollars’ worth of Chinese goods later this year, China’s ability to maintain its economic growth target of 6.8% could face headwinds.
Against this backdrop, the Chinese yuan fell by 5.2% versus the dollar in the second quarter. The rapid slide in the yuan poses additional challenges for China’s government, which must strike a careful balance between allowing a currency that’s low enough to maintain a competitive advantage for the country’s exporters, but high enough to stave off the possibility of capital outflows. 
At the start of the year, we believed China was well positioned for growth given the synchronized global growth environment that seemed in full swing. President Xi and central authorities appeared to be (1) containing credit growth through monetary policy and financial regulation and (2) supporting GDP growth through fiscal policy. As 2018 has progressed, however, global growth has become more disjointed, with the U.S. taking the lead while Europe and China have slowed. The Chinese government’s much-needed deleveraging campaign led to a sharper-than-expected slowdown in fixed-asset investment, as well as reduced construction and mortgage activity.
As a managed economy, China has an arsenal to draw from to help shore up growth. The 50-basis-point required reserve ratio (RRR) cut, announced on June 24, will provide approximately $100 billion in additional liquidity to small- and medium-sized banks that directly serve the private sector. This should offset some of the anticipated drag on GDP growth caused by the current trade dispute. Perhaps equally important, however, is the markets’ interpretation of future economic growth prospects. The yuan’s steep decline, combined with a rapid drop in Chinese equities makes this point clear. The Shanghai Composite Index shed $1.8 trillion in market value after moving into bear market territory during the previous week. Despite a solid rally on the last trading day of the quarter, the Shanghai Composite fell by 1.47% for the week ended June 29.
As this year’s global trade “noise” continues to escalate into a louder trade “din,” its potential impact on China’s economy and equity market for the remainder of 2018 will bear watching.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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