In July, countries across the world celebrated the 50th anniversary of the first manned mission to land on the Moon. The US National Aeronautics and Space Administration (NASA) streamed footage of the mission online, giving younger generations the opportunity to view the historic event that had been watched by over 500 million people in 1969. NASA also outlined ambitious plans to take humans to the Moon once again by 2024.

Financial markets made a series of small steps in July, as US equities, represented by the S&P 500 and NASDAQ indices, reached new highs, but investors were unable to make a giant leap over the quarter as a whole. Indeed, there were signs that the mood among investors was darkening, with a growing number of indicators hinting at the prospect of a downturn, while policymakers’ ambitions to revive economies came under increasing scrutiny. For the first time since its inception in 2014, a global survey of asset managers has put the likelihood of a recession occurring in the next year at over 50 per cent.1

Continued US-China trade fears were the spark for renewed volatility at the start of August as China’s currency weakened sharply to breach a key threshold of RMB7 per US dollar, triggering an angry response from US President Donald Trump, who used a series of tweets to accuse China of currency manipulation. Data for the second quarter showed that China’s economy had expanded by 6.2% year on year, its slowest pace in nearly 30 years.2

Uncertainty over how the long-running trade dispute is likely to play out (Trump struck a much more conciliatory tone later in the month) is one factor that may have driven demand for government bonds over the summer. The yield on the 10-year US Treasury fell sharply in August, while the inversion of the US yield curve (a phenomenon which sees long-term bond yields fall below those of short-term instruments, and which has been a precursor to every US recession over the last 50 years) became deeper than at any time since the beginning of the global financial crisis. In Switzerland, borrowing costs on 50-year bonds fell below 0% in July, meaning that the country’s entire government bond market was trading with negative yields.3

Spread between 2-year and 10-year US Treasuries
(
percentage points)

treasuries

Source: US Treasury, August 2019

A profusion of other developments served to worry market participants, including data which indicates the sharpest global manufacturing downturn in more than six years, with the car industry in particular experiencing a dramatic slowdown. The oil price, which jumped to as high as $71 per barrel following drone attacks on Saudi Arabian oil facilities in mid-September, has since fallen back to around $60, where it had been languishing for much of the summer, arguably revealing the weak demand environment. The price of gold, traditionally a refuge in difficult economic times, has reached six-year highs, while the safe-haven US dollar has made gains against many other currencies.

Faced with the challenges of weakening growth and low inflation, markets have become accustomed to central-bank support, and this quarter the authorities, ostensibly at least, did not disappoint. The US Federal Reserve (Fed) followed up a 25 basis-point cut to its main interest rate in July – the first reduction since the financial crisis – with a further 25 basis-point decrease in September, but took a more hawkish line than markets had expected, with the Federal Open Market Committee (FOMC) forecasting that rates would fall no further by the end of 2020.4 Meanwhile, the European Central Bank (ECB) cut interest rates further into negative territory, and pledged to revive its €2.6 trillion asset-purchase programme for “as long as necessary”.5 However, highlighting the stretched nature of monetary policy in the eurozone, outgoing ECB President Mario Draghi urged governments to support growth through increased public spending, stating “now is the time for fiscal policy to take charge”.6

In fixed-income markets, prices moved higher as yields declined over the third quarter. In the UK, the FTA Government All Stocks Index (gilts) returned +6.2% over the quarter (+11.2% over the nine months to the end of September), while the JPM Global Government Bond Index (excluding the UK) returned +4.3% (+10.0%). Corporate bonds also made gains over the summer, with the BofA ML Sterling Non-Gilts Index returning +3.7% (+10.2%).7

In spite of the significant volatility experienced in August in particular, most equity markets produced modest positive returns over the quarter. North American equities delivered a quarterly return of +4.9% to UK-based investors (and an impressive +24.8% over the nine-month period), boosted by the weakness of sterling. Japan returned +6.6% (+14.6% over nine months); Europe ex UK equities returned +1.6% (+19.4%); and UK equities returned +1.3% (+14.4%). Meanwhile, a negative local-currency return for Asia- Pacific ex Japan equities over the quarter was reversed by the weakness of the pound, as these equities delivered a flat return of 0.0% (+13.0% over nine months), while emerging markets were marginally negative at -0.5% (+11.4% over the year to date).8

The price of gold rose by +4.5% in US-dollar terms over the quarter (+14.8% year to date), while the return in sterling terms was even stronger: +8.0% (+19.2% year to date).9

In light of the significant fall in Treasury yields and the inversion of the yield curve over the summer, the US Federal Reserve had been looking for clear signals regarding the economy ahead of its September meeting. However, there was little conclusive in domestic economic data. Consumer spending has remained strong, and the unemployment rate has held steady at 3.7%, its lowest level since 1969. However, US job growth slowed to its weakest level in three months in August, while data from the Institute for Supply Management showed that the country’s manufacturing sector unexpectedly contracted in both August and September. Concerns that US manufacturing is being hit by China’s retaliatory tariffs may have been a factor in the US’s decision in early September to begin a new round of talks with China, following the rapid escalation of the trade war in August.

toolkit

At the Jackson Hole symposium of central bankers on 23 August, Fed Chair Jerome Powell highlighted the challenges the Fed faces, saying there are “no recent precedents to guide any policy response to the current situation.” He added that the Fed is questioning “whether we should expand our toolkit” in a landscape that has changed significantly since the global financial crisis a decade ago.10 

In the event, the Fed’s decision to cut US interest rates at its September meeting was accompanied by rising disagreement on the FOMC, with two of the committee’s 12 members voting to keep rates unchanged, and one preferring a bigger cut of 50 basis points. President Trump also voiced his displeasure that the reduction had not been bigger by tweeting “Jay Powell and the Federal Reserve Fail Again. No “guts,” no sense, no vision!”11

regional-overview2

In the UK, scientist Alan Turing was chosen by the Bank of England in July as the face of the new £50 bank note. Turing was a pioneer of modern computing, and played a pivotal role in helping to crack German military codes during the Second World War. During the third quarter, however, no computer or individual appeared able to break the UK’s Brexit impasse. As a result, the pound remained under pressure throughout the quarter, its trajectory linked to the ups and downs of increasingly fraught Brexit negotiations.

With new Prime Minister Boris Johnson pledging to take the UK out of the European Union on 31 October “deal or no deal”, the IMF ranked a no-deal Brexit, alongside US trade policy, as one of the chief threats to the global economy.12 Data from the Office for National Statistics showed that the UK economy contracted during the second quarter of 2019, for the first time since 2012, with manufacturing output falling back after the pre-Brexit stockpiling seen during the first quarter slowed.

At its September meeting, the Bank of England’s Monetary Policy Committee voted unanimously to keep interest rates on hold, hinting that it might look to cut them should Brexit-related uncertainty persist in a weak global economy.13

While the European Central Bank’s decision in September to launch fresh stimulus was initially welcomed by investors, not everyone was delighted by the move. German tabloid Bild branded ECB President Draghi as a ‘Dracula’ who has sucked billions of euros from German savers, while in a surprising move, the governors of the Austrian and Dutch central banks, among others, suggested that the latest easing package could be a mistake.

regional-overview

Draghi noted that the eurozone was facing “more protracted weakness” than previously anticipated,14 and suggested that fiscal easing in the form of tax cuts and additional spending was required in order to avoid a fresh crisis. He also called for fiscal transfers between eurozone member states. Such rhetoric may have been targeted particularly at the bloc’s largest economy, Germany, which has continued to operate a budget surplus. Germany’s economy shrank in the three months to June as its manufacturing sector, heavily reliant on exports, was hit by trade tensions.

Germany – quarterly change in GDP

chart-bar

Source: Federal Statistical Office of Germany, August 2019

Organisers of the Rugby World Cup in Japan have been surprised to find they are set to make more money than the previous record- setting tournament held in England in 2015, owing to unprecedented interest from fans in the host nation. However, Japan’s economic backdrop appeared less healthy than the finances of this major sporting event. At its September monetary policy meeting, the Bank of Japan (BoJ) warned that it was concerned about increasing downside risks to the global economy. Although the central bank decided against further monetary expansion, it pledged to review interest rates at its next meeting.15

world-cup-2

The BoJ was the first bank to introduce a zero- interest-rate policy back in 1999, and has more recently targeted long-term interest rates through a yield-curve control policy. The central bank faces a challenge as its peers – such as the Fed and ECB – cut interest rates, which could potentially lead the yen to appreciate and further harm the country’s exports. Exports fell for the ninth month in a row in August, and manufacturing activity declined to a seven-month low, although the country’s GDP grew by a faster-than- expected pace during the second quarter. A rise in Japan’s consumption tax from October presents a further short-term threat to domestic demand, while a diplomatic dispute with South Korea, which escalated over the summer, puts trade at risk.

Over the last 12 months, China has announced various measures to stimulate its economy in response to slowing momentum. However, these efforts have so far failed to prevent the deceleration of the country’s economy, which is widely viewed as the engine driving global growth. A recent survey conducted by the People’s Bank of China has shown that consumers in the country are increasingly likely to save rather than consume or invest, while car sales have continued to decline.

Following the failure of Baoshang Bank in May, August saw another bank – Hengfeng – bailed out by China’s sovereign wealth fund. There is also increasing evidence that liquidity is becoming a systemic issue within the banking sector, which is likely to impede the ability of the Chinese financial system to generate the credit required to generate a meaningful improvement in the country’s economic growth trajectory. While investors are focusing on recent cuts to banks’ reserve requirement ratios as a sign of supposed easing, at best the country’s central bank appears to be treading water. The banking system faces a funding shortfall, and the People’s Bank of China is still having to retire domestic liquidity, which indicates that it remains in tightening mode.

China – GDP growth

Source: CEIC, National Bureau of Statistics China, July 2019

Major central banks may once again be in easing mode, but interest-rate cuts have not translated into a material improvement of financial conditions in markets or economies, and signals such as purchasing managers’ indices and falling consumer confidence are indicating that the global economy is slowing down. While the US-China trade war has undoubtedly influenced investor sentiment, global trade had peaked well before the introduction of trade tariffs. Furthermore, significant structural barriers to growth remain. Recent analysis has shown that the world’s major economies now have average debts of more than 70% of GDP, a level that has only been exceeded previously during the Second World War.

A breadth of evidence over recent months has pointed to a tightening of US-dollar liquidity, the essential foundation for global growth and trade. Primary dealers (banks approved by the Fed to trade US government bonds) have been increasing their inventories of Treasuries, while the Fed had to intervene on several occasions during September to address a funding squeeze in US money markets. Historically, similar situations have occurred when financial-market conditions have become stressed. Meanwhile, in China’s financial system, the lack of liquidity remains a systemic issue, despite countless attempts to stimulate the economy.

In the uncharted waters of extraordinary monetary policy, there is no certainty as to whether the inversion of the US yield curve heralds a recession, as it has done in the past, but history would suggest that this is not a time for complacency. Moreover, as central banks and governments around the world talk increasingly about the introduction of fiscal stimulus and untested policies, the consequences for different asset classes and sectors could be significant.

Against such an uncertain backdrop, it is as critical as ever that investors thoroughly assess the risk and reward characteristics of the securities they evaluate and hold.

Average debt of world’s major countries
(as % of GDP)

Economies include Australia, Canada, France, Germany, Italy, Japan, Netherlands, Spain, Sweden, Switzerland, UK, US. Source: Deutsche Bank, September 2019.

We believe caution and a defensive posture are warranted, but with both investor and policymaker sentiment capable of rapid shifts, an ability to be flexible and opportunistic is, in our view, an increasingly valuable quality.

We can only see a short distance ahead, but we can see plenty there that needs to be done. 

Alan Turing, Computing Machinery and Intelligence, 1950

1 https://www.ft.com/content/10a85b94-dbbd-11e9-8f9b-77216ebe1f17
2 https://www.ft.com/content/1eb6d9ac-be6e-11e9-b350-db00d509634e
3 https://www.reuters.com/article/switzerland-bonds/swiss-50-yr-yield-falls-below-0-entire-swiss-curve-now-negative-idUSL8N24Q31B
4 https://www.federalreserve.gov/newsevents/pressreleases/monetary20190918a.htm
5 https://www.ecb.europa.eu/press/pr/date/2019/html/ecb.mp190912~08de50b4d2.en.html
6 https://www.ft.com/content/9b2c29c0-d53d-11e9-a0bd-ab8ec6435630
7 Bond market returns sourced from FactSet, 01.10.19 Equity market returns sourced from FactSet, 01.10.19
8 Equity market returns sourced from FactSet, 01.10.19 (All sterling total returns, FTSE World Index)
9 Gold bullion return sourced from FactSet, 01.10.19<br/
10 https://www.federalreserve.gov/newsevents/speech/powell20190823a.htm
11 https://www.ft.com/content/7416987a-da38-11e9-8f9b-77216ebe1f17
12 https://www.imf.org/en/Publications/WEO/Issues/2019/07/18/WEOupdateJuly2019
13 https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2019/september-2019
14 https://www.ft.com/content/9b2c29c0-d53d-11e9-a0bd-ab8ec6435630
15 https://www.boj.or.jp/en/announcements/release_2019/k190919a.pdf
16 https://www.ft.com/content/aef9b1e2-c90e-11e9-a1f4-3669401ba76f

All data is sourced from FactSet unless otherwise stated. All references to dollars are US dollars unless otherwise stated.

The opinions expressed in this document are those of Newton and should not be construed as investment advice. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell this security, country or sector. To the extent that copyright subsists in any picture used in this document, Newton recognises the copyright therein.

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