David Roberts

Trade, Italy and QE unwind will remain key in second half of 2018

David Roberts

If you remove US technology stocks and oil, investors lost money pretty much everywhere in the first half of 2018.

Asset class

H1 return

Why?

West Texas Crude

40%

Oil was oversold, Opec helped and the world economy grew around 5% (annualised, nominal)

Nasdaq

10%

Tech heavy, certain names lifted the index

Global bond index

-1.5%

Bonds too expensive as Quantitative Easing (QE) ends and no protection from yield

Dow Jones

-1.5%

Trade wars, part 1

EuroStoxx 50

-3%

Italy and threat of European Central Bank (ECB) ending QE create volatility and downward pressure

Shanghai Shenzhen

-15%

Trade wars, part 2


Source Bloomberg, as at 30.06.18, returns rounded

If we ignore alpha and sectoral themes, the big three factors driving returns in the first half were global trade, Italy and an end to QE – and we see little to suggest these will not also lead the way over the coming six months.

There are, of course, always unknowns that might pop up to surprise us but everything points to these same three drivers deciding the fate of core markets for the remainder of the year.

My best guesses are below:

Italy

Bull case – 30% probability

Bear – 10%

Base – 60%

Fiscal restraint in budget, debt/GDP stable or declining, no election until 2019 and an ongoing fall in unemployment

Real face off with EU in respect of fiscal rules and migration, further election based on continued EU membership panics market

Six months of “he said, she said” creating a bit of negative volatility but no real direction

 

 

 

Global trade

Bull – zero probability

Bear – 40%

Base – 60%

Trump has access to twitter blocked, we are all friends again and the past 70 years of working together is seen as a good thing. Assume no impeachment.

Escalation, tit for tat. US leaves the World Trade Organisation and we see an increase in military and political tensions. Confidence collapses and recession results

Six months of “he said, she said” creating a bit of negative volatility but no real direction

 

 


Quantitative easing

Bull – 20% probability

Bear – 40%

Base – 40%

Inflation remains benign, the Fed raises a couple of times and the market continues to believe Draghi is of sound mind.

Inflation continues to rise, the Fed raises aggressively that kills emerging markets and the ECB is recognised as being behind the curve. Investors lose faith in the Euro.

Six months of “he said, she said” (actually he said he’s going to say and do nothing) creating a bit of negative volatility but no real direction.

I spot a theme.

 

 

So, if I’m right, the same three themes dominate and, in each case, my base scenario is for more of the same impact on markets. A bit dull, of course, but sometimes markets are like this.

In terms of what this means for asset class returns, point forecasting is a bit of a mug’s game. However, active managers are paid to have a view, so based on my probabilities above:

Asset class

H2 return

Why?

West Texas Crude

-10% (I’m a contrarian at heart)

No expert, I’m a contrarian and personally have owned energy funds for two years. After 100% rally, I’d take profit. Plus Mr Trump is keen Opec increases supply.

Nasdaq

0% (a proxy for “no idea”)

Again, no expert. Too old fashioned to try to value prospective earnings/alpha in “disruptor” industries.

Global bond index

-2% (Yes, QE is ending)

The Fed and ECB are each reducing support. Yields are generically below inflation. That is not good.

Dow Jones

-5% (strong USD is a fact)

The market is expensive, trade wars do no one any good and, as the USD rallies, overseas earnings are worth less.

EuroStoxx 50

5% (weaker Euro, Italy a damp squib, better starting point)

The ECB has given a green light to markets to rally and said it will ignore (strong) data. Stupid, stupid, stupid but supports risk assets.

Shanghai Shenzhen

-10% (confluence of negative events)

For most of the above reasons, emerging markets just look wrong in the short term. Currencies need to weaken, which they are doing, but if this is at too fast a pace it will threaten debt affordability. I’m nervous still.

 

Summary

  • The same three drivers will dominate the second half of 2018: trade wars, Italy and QE unwinding
  • Equites are vulnerable to higher discount yields and lower global trade revenue
  • Bonds, especially ex-US, are not priced for QE reduction or continued inflation momentum
  • This, quite possibly, is a toxic combination for emerging markets
  • Beta doesn’t look great


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Key Risks & Disclaimer

Please remember that past performance is not a guide to future performance and the value of an investment and any income generated from them can fall as well as rise and is not guaranteed, therefore you may not get back the amount originally invested and potentially risk total loss of capital.

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Tuesday, July 10, 2018, 9:24 AM