July 2019: Markets in context
An escalation in trade tensions, an about-turn in the Federal Reserve’s interest rate policy and heightened anxiety in the markets: Chris Lewis takes an in-depth look at the first half of 2019
In the long term, financial markets are remarkably rational and efficient processors of information. Over this timeframe the actions of informed and objective investors generally cause assets to be priced fairly in proportion to their risk based on the available information and economic data. In the short term, however, market efficiency has a tendency to break down. This often results in heightened volatility and notable shifts in investor sentiment.
The second quarter of 2019 was a good example of this. While the fundamental picture remained largely unchanged, with softer economic data in Europe and the US reconfirming the trend towards slower global growth, market movements were driven by political and central bank rhetoric and expectations of the potential impacts on asset prices.
Having enjoyed a healthy climb for much of 2019, global equity markets fell in May, with the MSCI All Country World index returning -2.7% in sterling terms. It is worth noting that given sterling weakness during May these figures hide the extent of the moves, with 75% of global equity markets experiencing a correction of more than 5% in US dollar terms.
The S&P suffered its worst May returns since the "flash crash" of 2010
In fact the S&P 500 US dollar return of -6.4% represented the worst May performance figure for the US equity market since the flash crash of May 2010 and before that May 1962.
This was due to rising global growth concerns, fuelled by escalating US trade tensions with China and Mexico, the potential for renewed US conflict with Iran and worries about fading support from central banks, which had been a key driver of risk appetite in the first quarter.
In the UK, the market interpreted the news that Theresa May would be stepping down as Prime Minister as increasing the likelihood of either a hardline Conservative Brexiteer leading the UK towards a “no deal” exit from the European Union, or a general election that could pave the way for a potentially less market-friendly Labour government. Heightened investor concerns translated into weaker sterling (falling by around 3% against both the US dollar and the Euro), falling equity markets (with the FTSE All Share returning -3% in May) and lower government bond yields (resulting in a +2.7% return from the FTSE All Stock Gilt index).
Concerns about the impact of worsening US-China trade relations on global growth were not limited to investors, with central banks too seemingly recognising the potential threat it posed. This was clearly signalled at the June Federal Reserve meeting, where a readiness to ease policy before the end of the year was made clear. While recent US data has been mixed, it is clear that the policy shift was at least partly aimed at managing risk by pre-emptively easing in the face of elevated trade uncertainty.
The idea behind these “insurance cuts” is that instead of waiting for an actual deterioration in economic data, policymakers should proactively push rates below the levels implied by the baseline outlook when the economy passes through a period of unusually elevated uncertainty—such as the renewed trade conflict with China—in order to protect against an unfavourable outcome.
The Fed's about-turn on rates
We have seen a remarkable pivot in the Fed’s stance from just six months ago, when it hiked the policy rate and predicted two additional rate increases over the course of this year. Since then, investor expectations have flipped from expecting two rate hikes in 2019, to expecting three cuts before the end of the year. In addition, the Fed’s downward revision of 2019 inflation forecasts combined with the persistently low projections for long term real rates, further supports investor expectations of looser rather than tighter policy going forward. The impact of these expectations on asset prices has been notable, with risk assets rallying on the assumption of continued central bank support, and global government bond yields moving lower in anticipation of inflation remaining at current levels.
Central banks become defensive and pre-emptive
The interplay between central bank policy and geopolitics are likely to continue as we move into the third quarter. If the trade risk dissipates, pre-emptive Fed rate cuts beginning in July would arguably not be justified by the underlying economic fundamentals. Financial conditions have not tightened materially, growth is still in positive territory and recent weakness in US core inflation has been influenced by transient effects which we expect to pass through leading to higher core inflation towards the end of the year.
In this scenario, policy disappointments increase the risk of an equity market sell-off, especially given the strong performance in June, which was at least in part due to expectations of easier monetary policy.
This assumes that we see a resolution to the trade dispute in the coming months. While not reaching some form of resolution would be costly for both the US and China, it would not be surprising if the Trump administration continues to use the threat of tariffs as a bargaining chip to force the Fed to cut rates in the short term, something which the President has repeatedly called for.
The uncertainty over how the trade dispute may develop and how the Fed might choose to respond is likely to ensure that investor sentiment remains poor. We continue to see the potential for heightened volatility in financial markets.
This uncertainty has more recently been reflected in the performance of gold, which has returned 7.3% in June. Strong performance has been driven by both geopolitical risks as well as concerns about the impact of potential rate cuts on the Fed’s future ability to stabilise the economy when faced with a meaningful economic slowdown. Any likelihood of a return to quantitative easing is taken as positive for gold.
An additional consideration for investors as we move into the third quarter is the fact that the valuation opportunity we saw across many global equity markets at the start of the year has closed (with perhaps the exception of Japan). This removes another important support for market levels if we were to see concerns over global growth, whatever the cause.
Increased political uncertainty will likely remain a feature of the economic landscape for the rest of this year. But the underlying fundamentals, which continue to point to positive (albeit slowing) global economic growth, do not yet suggest that we are moving into a recession.
 Performance figures are GBP denominated and total return
 JP Morgan Asset Management
 Performance to 27th June denominated in sterling