The first quarter of 2019 finished with largely impressive numbers: the S&P 500 boasted its best quarter in ten years, up by 13.1% almost erasing the disastrous losses of the last quarter of 2018. Globally,stocks generally posted solid returns for the quarter as the MSCI EAFE Index produced a return of 9.04%. International stocks were led by the BRIC countries which generated a 13.01% return. Even lackluster regions like Africa posted a positive return of 3.98%. Indeed, when considering the full range of threats the global economy faced at the beginning of the year, investors should be happy that markets were able to shrug off those concerns and generate solid returns for the first quarter.
While we are delighted by 2019’s market performance thus far, we sense the palpable risk that the markets’ positive form is on borrowed time and that the 2019 of muted growth that we envisaged at the end of 2018 may return. We still feel very far away from the market friendly Brexit and United States (US)-China trade deal we were anticipating only a month ago. Both items continue to cause a considerable lack of clarity, which will likely perpetuate market instability. This, and other factors, remain problematic even in the face of last month’s optimism and have compelled us to face the reality that 2019 may yet become an uphill battle for international equities.
It was largely a foregone conclusion that Britain would leave the European Union (EU) on March 29, 2019 ever since Primer Minister Theresa May and Parliament invoked Article 50 to begin the count down two years ago. Indeed, this was due to happen either with a mutually beneficial deal or an acrimonious divorce; i.e. a ‘no deal’ Brexit. And yet, to the joy of some and ire of others, the supposedly immoveable Brexit deadline was pushed back, first to May 22nd – were May able to get Parliament to pass her deeply unpopular Brexit deal – and most recently to October 31st due to Parliament rejecting her deal three decisive times and failing to agree on any viable alternative arrangement. May once said that ‘no deal is better than a bad deal’, which suggested that she would have been prepared to see Britain ‘crash’ out of the EU on April 12th, were the new six month Brexit extension not granted. Alas, she ate her words and extended Britain’s withdrawal and in the process risked Brexit never happening at all, a reality that markets may find rather appealing. Part of the latest Brexit extension is that, were Britain able to agree on a Brexit deal by May 22nd, it would be able to formally Brexit on June 1st. Of course, the UK Parliament’s failure to do so, would mean that Britain would have to participate in the European Parliamentary elections, something that May has always been reluctant to do as it would be – in her view – an abrogation of democracy and send the wrong signal about having respected the result of the 2016 Brexit referendum. In terms of next steps, it is genuine guesswork, yet plausible items on the horizon include a battle within the Conservative Party, with May defending herself from being ousted as Prime Minister from her own Members of Parliament, as well as a so-called People’s Vote referendum that would give final say to British voters about how it will want to proceed on Brexit, or if it even still does want to Brexit at all.
At February’s close we had good cause to believe that the incipient blaze of a possible US-China trade war was about to be extinguished. Just as the March 2, 2019 deadline that was to see the tariff on over $200bn of Chinese goods more than double from 10% to 25%, President Donald Trump confidently proclaimed that all planned increases would be indefinitely suspended as a result of a new bilateral trade deal nearing completion. Yet more than a month later not only has a deal not been confirmed, the US and China appear to be much further apart than what Trump’s bluster and the general bonhomie between the superpowers would have suggested. While it must be said that it appears that an all-out trade war between the world’s two largest economies has been averted for now – a reality that investors would have been all too eager to embrace only a matter of months ago – it seems that it was premature to have expected a mutually beneficial trade deal that would abolish all tariffs and give international equities the boost they have craved.
China is reported to be pushing back against US trade demands that it perceives as one-sided; moreover, they want all tariffs lifted immediately, which the US is reluctant to do. Consequently, Chinese negotiators are evidently less gung-ho about fulfilling their key promises on intellectual property rights, which for Trump and both sides of Congress is the foundation to any meaningful trade deal. The superpowers are caught in a tedious Catch-22: the US will not roll back tariffs until China fulfills its key commitments, but China refuses to honor its side without movement on tariffs. Robert Lighthizer, Trump’s chief negotiator, deflated expectations by saying, ‘If there’s a great deal to be gotten, we’ll get it. If not, we’ll find another plan.’ Furthermore, news that Trump and Chinese President Xi Jinping’s meeting has been postponed by at least a month until the end of April also suggests that a quick, easy and market friendly solution is not at all imminent. According to reports, it is unlikely that any future trade deal will begin by repealing all existing tariffs and will instead be more like a trade cease-fire that will see no new tariffs introduced. Of course, it is plausible that the deal may set stages at which tariffs are lifted when particular targets or agreements are met, but one has to wonder if there ever will be a medium term scenario of free, frictionless trade between these two super powers given that they are, and will remain, commercial, economic and military rivals? Yet, Trump continues to hype up his delivery of a positive trade deal with China, which, if he were able to achieve, would give him at least one foot into a second term at the White House and offer markets a positive jolt. This should give him plenty of incentive and what is more Democrats may even cheer him on (privately, of course). However, politicians, markets and investors will likely have to face the facts that the road to economic peace with China will be long, harrowing and may even be impossible in the short to medium term.
In Brazil President Jair Bolsonaro’s honeymoon period is over. The Brazilian market hit its all time high in mid-March but dismal reports over Bolsonaro’s questionable economic ideas and concerns over rapidly increasing inflation cost the market almost 6% in the final 2 weeks of March. The sweeping market optimism that his corruption fighting, business-liberalizing premiership was thought might bring has turned sour as Bolsonaro is under widespread criticism from across the Brazilian political spectrum. What is more, his apparent inexperience and desire to get into Twitter battles has not only mitigated his ability to navigate himself out of his current political quandary, it has also distracted him from selling his ambitious and necessary plans to lawmakers. Bolsonaro aims to make wide-ranging changes to Brazil, yet none is more important than his proposed reform of the state pension system, which is crippling the state’s coffers. Pushing his reform through would cut 1TR Reals from the fiscal deficit in the next decade and would shore up Brazil’s public finances. Of greater importance to investors, it is believed that it would also spark the economy into high gear. Yet, the so called ‘apprentice President’ is facing an arduous battle as opposition parties either oppose the reforms in their entirety or want to chop and change them until they are so watered down they lose their fiscal and economic potency. Bolsonaro has so far failed to engage with the opposition political parties whose support he requires to make meaningful change to Brazil’s state pension; what is more, instead of courting the support of Brazil’s most powerful lawmaker House Speaker Rodrigo Maia, for whom pension reform is also very important, Bolsonaro has chosen to trade petty insults with him. As things currently stand, Bolsonaro has scant support in Congress for pension reform and if he fails to build bridges through the so-called ‘pork barrel politics’ of which he has been so critical, he will fail and South America’s largest economy will likely remain in the catastrophic political and economic situation in which it has found itself for the past few years.
In more positive news, the US Federal Reserve confirmed what was widely speculated: there are no plans to raise interest rates in 2019 due to slower than anticipated economic growth. Chairman Jerome Powell indicated that the current rate of 2.5% is rate neutral and that it would take some time before the employment and inflation outlook called for a change in fiscal policy. The Fed did indicate, however, that regardless of its recent announcement its policy remained nimble and was subject to change depending on future economic indicators.
Despite 2019’s first quarter having outperformed expectations, we fear we are creeping back to the muted optimism and incipient pessimism with which we began the year. It seems highly unlikely that the US and China will agree the mutually beneficial trade deal markets have expected for more than 8 months. Moreover, a decisive and market friendly Brexit is at least 6 month’s away and it is widely believed that further ‘kicking the can down the road’ delays are extremely possible. As a result, we are left with a petering-out US economy, China in the midst of an economic slowdown, a Britain frozen by Brexit uncertainty and an EU economy that is flat-lining. Adding to the negativity are first quarter corporate earnings that are anticipated to be lackluster. And yet, investors will be thankful that we have at least avoided an all-out trade war between the US and China and a devastating ‘no-deal’ Brexit, which could have made matters much worse than what they may be poised to become.
A spot for genuine, unmitigated optimism may be EM equities, which have rallied in 2019 and may outperform for the next 6 to 12 months. Moreover, we believe it is reasonable to expect EM equities to claw back their 2018 losses. We have already seen the MSCI EM Index up 9.56% in the first quarter of the year. China will help Asia lead the way for EM equities through their own policy of monetary and fiscal easing. Other countries like Mexico and Brazil may not be so lucky as the former may see capital outflow as a result of domestic political uncertainty as well as trade tension north of the border and the latter will be stuck in a well without a ladder unless Bolsonaro can abandon his idiosyncratic style and effectively push his state pension reform through the Brazilian Congress.
In conclusion, it seems unlikely that markets will benefit from the much-desired steroid injection of a US-China trade deal in the short term. President Trump is still talking up the possibility of a mutually beneficial, market catalyzing solution, but taking him at his word might be unwise. A more likely victory for markets may be Britain leaving the EU through a ‘soft Brexit’ – or even doing an about-face and persisting as an EU member. However, any market-friendly resolution is not only difficult to imagine in the short term, there also remains the perpetuated uncertainty fostered by the October 31st extension as well as the risk of Brexit culminating into something pernicious for investors. For 2019 we believe that US equities will continue in positive territory despite a likely earnings recession, that Europe will be mired in uncertainty until Brexit is resolved and that EM equities may offer investors excellent opportunity, particularly in Asia where share prices are comparatively cheap.
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