At the start of 2018, we came up with the investment theme ‘Turning up the Heat’. Our outlook was based on two key views: 1) the global economy was reflating after years of sub-par growth and 2) equity markets would likely ‘melt up’ at least one more time before the current bull market expires. The former has clearly proven correct so far, with inflation and inflation expectations rising modestly, not just in the US but also in Europe, Japan and in certain parts of Emerging Markets.
On the latter, the global equity market is up around 5% since we published our ‘2018 Outlook’ report, and this despite a sharp 10% drawdown in February, which has clearly affected investor sentiment negatively.
Of course, President Trump has also been turning up the heat on the US’s major trade partners. The global economy’s pivot from globalisation towards protectionism is not new – we started highlighting this in 2017. However, we under-estimated the US President’s zeal when it comes to pursuing an aggressive trade policy, not just with China, but also with supposed allies, such as Europe and Japan. This has led to significant market volatility, especially within Emerging Markets which have also felt the pressure of a rising US dollar.
The key question here is what is the end-game? The answer to this question depends on your time horizon. For us, the longer-term picture – multi-year and, potentially, multi-decade – is more worrying than the shorter-term picture.
We are seeing a huge shift in relative economic power from the US to China. In terms of purchasing power, China’s economy has gone from being approximately a third of the US’s size in 1997 to becoming larger than the US in 2014. By 2022, it is expected to be almost 50% bigger than the US economy. This seismic shift in economic power is likely to come with increased military and geopolitical power, especially within Asia, but also globally. The US is unlikely to accept this change in the geopolitical landscape without a challenge, which means that tensions of one sort or another are likely to remain part of the landscape for a long time.
In the shorter-term, however, there are reasons to be optimistic, in my opinion. While the US President’s rhetoric remains fierce, we expect him to shift focus from creating a problem to working on a ‘solution’ to the problem. This view has received a lot of ‘are you living in cloud-cuckoo land?’ type of reaction. However, we believe the US President is focussed on two things: making deals and wide US public support, especially ahead of the mid-term elections in November. In this instance, the two seem to go hand-in-hand. Therefore, we expect trade rhetoric to diminish in the coming months, although this is unlikely to be a smooth process.
A gradual dialling down of the trade tensions would be positive for global equities. Indeed, we believe equity markets would have rallied a lot more, absent the uncertainties surrounding the trade policy outlook. Corporate fundamentals continue to improve, with expectations for 2018 earnings growth rising significantly since the start of the year in the US, Emerging Markets outside of Asia and, more recently, the UK. Meanwhile, in Asia, earnings growth is still expected to be around 12%, which is not too shabby.
Remove the uncertainty from the trade situation, while Euro area growth expectations stabilise to a more sustainable path and the US dollar peaks, and we believe the second half of the year could be good for equity investors. We continue to prefer more growth-focused areas of the market and would caution against concentrating on pure domestic plays in a world where trade tensions may ease, at least in the short-term. Our preferred sectors in the US are technology, energy and financials.
What could prove us wrong? Clearly Trump could decide that a full-blown trade war is a better US vote winner than the threat of rising tariffs, followed by a face-saving deal. In such an event, we would be more worried about Europe, if only due to the number of countries which will have to agree to any deal. China, in contrast, will likely be willing to strike a deal as long as it does not conflict with its ‘Made in China – 2025’ strategic objectives aimed at upgrading its industrial sector up the global technology value chain.
(Steve Brice is Chief Investment Strategist at Standard Chartered Private Bank)