Overview
It’s finally arrived – a correction of sorts. Forecasted over and over in recent years, markets pulled back starting in late January. If one must point to a single event that merits more of the blame (or credit) than others, fear of higher inflation and sharper increases in interest rates in the U.S. tops the list.
We have often argued that it’s impossible to predict triggers for short-term market shifts, and this may be just such an event, as financial assets bounce off the guardrails day to day, week to week or even month to month. Valuations are stretched, which presents a headwind for gains, as do meaningfully higher interest rates. But other forces are pulling the other way, and may put off the day of reckoning.
North America
Tony M. Caxide, CFA®
Chairman - Senior Investment Council
We’ve observed that several forces were pulling harder and harder on wage costs, from low levels of unemployment, to corporate compensation intentions, and employees’ increasing comfort that jobs are plentiful and sometimes available at higher pay. Data releases a few weeks back, along with upward revisions to prior months’ suggested wage costs, have been accelerating and led both bond and equity markets to sell off.
Wage costs are one component of broad inflation, but commodity prices have also risen, leading consumer prices to suddenly look close to (for the core components of inflation, near 1.7%) or well over (for all consumer prices, including volatile components like food and energy, running at near 2.2%) our central bank’s inflation target of 2%.
We don’t think this is an economic crisis – certainly nothing near the inflationary 1970s. But we do feel it presents an important headwind for markets that for too long underestimated many risks.
Japan
Jeffrey G. Wilkins,
Deputy Chief Investment Officer
Japan’s economic fundamentals suggest that growth has become more entrenched, although the currency’s recent appreciation could present a meaningful risk, should it continue. Factors such as industrial production, various confidence surveys (including the Tankan), employment, and retail sales all suggest that the economy is picking up steam. The yen, which can affect export demand and the translation of overseas sales into profits, has appreciated over 5% since its weakest point in January. If the currency continues to strengthen meaningfully, it should benefit Japanese consumers, but it could impede further economic progress, as exports have been a key driver thus far
Europe
Srinath Sampath, CFA®, PhD
Managing Director, Portfolio Management
Low lending rates in the EU and continued stimulus by the ECB have contributed to sustained strength in many areas. Industrial production is growing at 4.2%, retail sales and new car registrations are robust, and core inflation is stable at 1%. The unemployment rate has declined steadily since mid-2013 and is at a post-crisis low of 8.7%. However, one cause for concern is the strengthening currency: the euro has appreciated 2.6% this year, in part reflecting the view that the EU is finally out of the Global Financial Crisis. This puts ECB President Mario Draghi on the horns of a dilemma: extend the stimulus to prevent the euro from strengthening further, or end the stimulus in September as planned and let the economy find its feet.
UK
Jeff (Shengde) Liu, CFA®
Managing Director, Portfolio Management
The UK economy remains in the slow lane. Fourth-quarter growth was near 1.4%, lower than prior estimates. The consumer sector continues to be the biggest detractor, as higher inflation and low wage growth make people “poorer.” The UK’s real wage growth has been negative since February 2017. Business investment was also stagnant, as corporations absorbed faster inflation due to the fog of Brexit, which gets thicker by the day. Prime Minister May still has not given a clear picture of what a post-Brexit UK will look like: Will Britain shadow EU rules and regulations or strike out on its own? Although the Bank of England (BoE) left its policy unchanged, inflation has taken over as the BoE’s primary concern. The central bank’s tune has turned somewhat hawkish since it raised key interest rates last November.
Emerging Markets
Jeff (Shengde) Liu, CFA®
Managing Director, Portfolio Management
EM economic fundamentals remain strong. Monetary policy, in general, remains loose. The consumer sector is healthy, especially in China. Some early signs show that EM aggregate growth may soon peak. One of the concerns is currency levels. In recent months, as the U.S. dollar continues to weaken, most EM currencies have gotten stronger and stronger. For example, China RMB has appreciated by about 5% since September 2017 and by 9% since December 2016. Rising currencies is not a good omen for most EM countries whose economies are still dependent on exports. Another concern is that the locomotive of EM growth, China, is likely to slow as it deals with its heavy debt levels. Commodity prices that helped most in EM corporate earnings last year may not rise as fast this year. Geo-political hot spots such as North Korea and the Middle East also add uncertainty. That being said, we don’t expect sharp weakness in the EM economy and related equity markets.