Mid-year reflections and projections

Andrew Milligan

Halfway through the year and there’s still no resolution to the US-China trade war. Andrew Milligan, Head of Global Strategy at Aberdeen Standard Investments, considers what this means for investors and what the implications are for the global economy. He also considers how emerging markets are performing, whether UK interest rates will ever change, and the impact of the European Parliamentary elections on the Eurozone.


The trade war rumbles on

The trade war between the US and the China is definitely giving investors a roller coaster ride. Not only are there complex trade negotiations and technology transfer rules to understand, but there’s also the unusual backdrop where Presidential tweets and occasional Chinese government responses can quickly cause large amounts of investor capital to swing around sharply.

There’s a possibility that a lot of what we’ve witnessed is political posturing for a domestic audience, in both countries. And it could be that at, or soon after, the G20 summit in Tokyo in late June an agreement is finally reached and the world can breathe a sigh of relief.

However, there’s more likely to be a long drawn-out series of talks which may not reach agreement for months, if ever. Both sides are getting entrenched and the stakes are rising, especially for technology. But this doesn’t mean a full-blown trade war or global recession is imminent as that wouldn’t be sensible for either President at this moment in time.

At Aberdeen Standard Investments, we expect recovery in global business activity to be even more muted than originally forecast. Trend rates of growth will be slower, with businesses altering their supply chains, building up spare inventory, and duplicating research and development facilities. Meanwhile, consumers will respond too by changing their purchases as new and higher tariffs have an impact on prices.

Equities may give better returns than other assets but the margin of outperformance can be lower. In this environment, active stock picking in attempt to predict the winners and losers is even more important.

Emerging markets – where there are losers, there will be winners

As global trade is affected, it’s no surprise that emerging markets have come under pressure. There have been outflows from many equity and some bond markets so far this year. At the time of writing, Asian indices are only up about 0-5% year-to-date, while the US stock market is up closer to 10-15%.

In these circumstances, it’s important to look at emerging markets by region and sometimes by country as there’s considerable diversity. Trade pressures mean much more for companies based in Asia than for those in Latin America and Europe, for example.

On a regular basis, we measure how strong or fragile emerging markets are in a number of important areas, such as their current account and debt levels. These can help our fund managers look for opportunities, or where to steer clear.

But where there are losers, there will always be winners. Already it’s clear that more firms are considering or planning on moving business operations, from China to Vietnam or Korea for example.

A key measurement we’re currently looking at is the level of the Chinese currency, the renminbi, versus the US dollar. This is a very managed currency pair. If China allowed the exchange rate to break through 7 to the dollar (it’s currently sitting at 6.9) then this would be seen as a sign to sell emerging market assets. If the renminbi suffers a major devaluation, this would put extra pressure on many emerging market economies.

An ancient Japanese proverb says that even monkeys fall from trees

Japan’s economy unexpectedly grew in the three months to March, suggesting forecasts for a contraction in the world’s third largest economy were incorrect. The fact is that Japan isn’t an easy economy to forecast – the data can be quite volatile, partly due to trade but also because of the variable quality of the statistics – and sometimes the experts do get it wrong.

The Japanese economy did grow faster than expected in the spring, reflecting a milder-than-anticipated retreat in private capital investment, a surprisingly strong boost from external demand and an unexpectedly positive contribution from companies building inventories. However, these were provisional figures and significant revisions to growth estimates wouldn’t be a surprise.

At Aberdeen Standard Investments, we’re quite positive about Japanese equities. Despite volatile economic data, we think Japan could grow moderately this year and next, and believe it’s a market worth keeping on the radar. In particular, we like the fact that corporate governance is improving in Japan, and the government slowly but steadily pushes through with economic reforms, all potentially leading to better returns to shareholders.

Can bond markets foretell the future?

The stock market made a comeback in the spring before profit-taking during the latest bouts of trade conflicts. But when it comes to bond investors, they often take a longer-term view than their equity counterparts. After all, you can buy 50, even 100-year bonds.

2019 has seen capital flow into bond markets, despite low yields and expensive valuations. US benchmark bond yields are currently their lowest since 2017. This is partly due to safe haven effects as investors worry about where to put cash as the US-China trade war continues.

Another issue is the continued decline in underlying inflation, even with oil prices picking up above $70 a barrel. The Federal Reserve looks like it’s going to keep interest rates on hold this year, while the Bank of Japan and European Central Bank are boxed into a world of negative interest rates.

We believe bonds are pricing in a world of slow growth, but not recession. This is a reasonable backdrop for corporate bonds, equities and property, as long as company cash flows remain positive and costs are kept under control.

Bank of England keeps interest rates on hold

The Bank of England has kept interest rates on hold amid continued uncertainty over Brexit – a situation made even more uncertain by the Prime Minister’s recent resignation and the results of the EU elections. Investors want to know if the Bank will raise interest rates in the second half of the year, if a no-deal Brexit is avoided.

The fact is the Bank has an unenviably difficult task in front of it. On top of the normal economic cycle, there are changes to global monetary conditions, activity in key overseas markets, plus a growing degree of political sensitivity to contend with. This relates not only to Brexit but also to a possible UK general election in the coming year.

For now, we believe the Bank is likely to keep any changes to interest rates on hold. As with many central banks, it is ‘date dependent’; if there is a very strong theme in terms of economic growth or inflation pressures, it will act. Until then it will keep its powder dry.

The unloved Eurozone

Issues affecting Germany and Italy recently prompted the European Commission to reduce its forecast for growth across the EU to 1.4% this year – just above what it expects for the UK.

It’s worth noting that the growth forecast for the whole of the EU masks some areas of strength, such as Spain, but it also masks areas of weakness. For example, Italy is forecasting that its economy might only grow by 0.3% this year and weak activity in Germany’s manufacturing sector is certainly continuing into the second quarter.

The results of the EU Parliamentary elections will be important for activity in 2020. We’ve seen substantial losses for the two main groups, the centre-right European People’s Party and the centre-left Socialists and Democrats. Meanwhile, the Greens and Liberal groups have made gains, as have the right-wing nationalist and populist groups. What does all this mean for the Eurozone?

We think that the results of the EU elections are more important for individual countries than for the region as a whole. For example, strong populist support means we expect Italy to press for more public spending and tax cuts to boost its economy. Such discussions are likely to be long and complicated, especially as key personnel at the EU Commission and European Central Bank (ECB) will be replaced in coming months. The price of such political risks can be seen in the size of the spread between Italian and German bond yields. If politicians cannot press ahead with economic reforms, so the pressure continues on the ECB to keep interest rates at these historically low levels.

On balance, we remain neutral on European equities. Profits growth does not look as strong as in other parts of the world. However, as they are generally unloved by global investors so there are opportunities for active stock pickers in some companies and sectors.


The information in this article should not be regarded as financial advice. Please remember that the value of your investment can go down as well as up and may be worth less than you paid in. Information is based on Aberdeen Standard Investment’s understanding in June 2019.