What are the key points to take from the first half of year?
The first half of 2018 has seen a rise in volatility, with sharp moves in both directions for equity markets. However, towards the end of the period we have witnessed a relatively moderate shift. Having fallen in the first quarter, by May the FTSE 100 Index had risen sharply. From the Q1 lows to the peak in May, the Index saw a 15% increase with the total return for the half year being just 1.6%. Most recently, the volatility in markets comes from fears over a trade war, the outlook for interest rates, moves in the oil market and political developments in Europe and elsewhere. None of these factors are likely to go away in the near term so we may expect continued fluctuations in markets as the year goes on. While volatility continues, it is important to remember that the global economy is broadly in good health and there are many reasons to be positive.
The fear of a trade war has caused more concerns in markets than anything else. The outcome is hard to predict, not least because of President Trump's habit of announcing policy by tweet based on his gut feeling. He also tends to take an extreme position and the outcome after negotiations are watered down. The tariffs he has placed on imports have been met by tariffs on goods sold into China and the European Union. When other countries respond, he raises the prospects of further tariffs on their goods sold in the US. US companies and the US consumer have been beneficiaries of globalisation of trade at the expense of some jobs moving overseas. Companies and trade organisations have complained about the policies and when the US consumer has to pay more for goods subject to tariffs, Trump's popularity may wain. Trump's team continue to talk of ongoing negotiations and in the end, it is in the interests of all concerned that the differences are resolved.
The US Federal Reserve continued to raise rates this quarter and indicated that rates may rise four times this year, which is one more than was previously talked about. The US economy is growing strongly and with additional stimulus from Trump's tax changes, they see room to raise rates faster. However, the impact of rate rises takes time to feed through and in the long run, we expect US interest rates to peak at a lower level than in previous cycles. In contrast, the Bank of England had been expected to raise rates in May but with weaker economic data for the first quarter, it has so far held off. There is a possibility that this weakness may have been linked to turbulent weather and, as such, there remains a possibility of another move in August. The European Central Bank (ECB) has announced that it will start to reduce bond buying later this year but does not expect to be raising rates until late next year at the earliest.
The oil price has risen substantially from the lows of last year. Trump is pulling the US out of the Iran nuclear deal and, as a result, sanctions may be re-imposed which could result in a reduction of supply. The Organization of the Petroleum Exporting Countries (OPEC) increased production but less than was hoped for or demanded by the US president. The US could increase production in response to the price rise but this takes time to come on line. With strong global growth, demand continues to grow despite the switch to alternative energy sources.
On the political front, we have seen the formation of a populist Eurosceptic government in Italy and Merkel having difficulties with her coalition partners over immigration. The yield on Italian bonds rose relative to other Euro government bonds. At the last European leaders' summit, Brexit was not the main concern and progress in the main sticking points, such as the Irish border, appears to be limited. Teresa May is having as much difficulty with her own party as she does with her European counterparties. These political moves and the prospect of more rate rises across the Atlantic have given rise to some weakness in the euro and pound relative to the US dollar.
Emerging markets suffered from the impact of trade restrictions and a rise in the dollar. In Brazil, the currency and stock market fell sharply on the back of a truckers' strike and uncertainty surrounding elections due for later in the year. Mexico has elected a populist left-wing leader and we will have to watch closely how this affects relations with the US leadership, particularly in light of renegotiating the North America Free Trade Agreement.
On a more positive note, the meeting between the US and North Korean leaders appears to have defused one source of political risk. However, it is early days and denuclearisation of the Korean peninsula is still a long way off. Chinese cooperation on this may give the US an additional incentive to avoid a prolonged trade dispute. As all these events swing in and out of focus, it is not surprising that we have seen a rise in market volatility. With all this noise we need to remember that developed market economies are doing well, particularly in the US. The full impact of Trump's tax cuts and the repatriation of overseas earning has yet to be felt. Rate rises are in response to this strength and should not necessarily be feared. Individual companies may not be impacted by these events and those with strong compounding earnings will continue to do well. Investors may have to become accustomed to greater fluctuations in equity markets and will need to look through to longer term returns. We continue to stress a selective approach to investment and remain wary of getting caught out chasing short term moves.
(Data source Bloomberg)
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