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We started the year bullish on global growth, commodities, and emerging markets, and despite challenges in the second quarter, we maintain this view. We think events in Q2 were mainly a growth scare.
Concerns about a slowdown in China and globally, along with trade tensions, helped trigger selloffs that resulted in local currency emerging markets debt falling over 10%1—which is one of its more significant falls within a single quarter—and Chinese equities falling 20%.2 However, we think this global growth scare was overdone.
Although U.S. growth has been strong, we think the perception that it is far ahead of the rest of the world is an exaggeration. Europe saw a slowdown in the first half of the year, while China is undergoing cyclical changes and taking deliberate steps to correct excesses in its financial system. The U.S. may also face future headwinds, including higher interest rates.
The Balance of Risks
We are keeping an eye on systemic risk in Europe. Despite the quantitative easing and monetary stimulus, the economy continues to struggle on the margin. The question this raises is that when monetary stimulus starts to be withdrawn, will the economy be able to grow at all? In comparison, in the U.S., as the Federal Reserve (the Fed) has raised rates, growth has continued. Brexit is also a source of potential risk in Europe. A “hard” Brexit—whereby one country is suddenly significantly cut off from the rest of Europe through higher tariffs—may have a negative impact on growth.
China offers a different story, which we think is more of a cyclical slowdown risk. The links between China to commodities and other emerging markets may have helped drive the second quarter growth scare. However, we expect China to take counteractive measures if the slow down becomes more significant.
Stuck on Interest Rates
In our outlook for 2018, our working assumption was for the 10-year U.S. Treasury nominal yield to reach 3.5% by year-end. Currently, it remains under 3%. Nominal growth continues to be positive, with GDP growth of 4% in the second quarter. If that is sustained, interest rates may be pulled higher. U.S. fiscal deficits are expected to grow, while labor markets continue to tighten, which may also support the case for higher rates.
Ultimately, however, although the Fed appears still to be on track to increase rates, we have less conviction in additionally higher interest rates in the second half of the year.
Now or Never for Commodities?
We previously said commodities could be the best performing asset class of the year, and we believe both that the bullish “grind trade” continues, as supply limits persist, and that the sector continues to “heal” and strengthen. In particular, we continue to watch energy stocks as companies have shifted to focus more on return on capital and are starting to consider how they may provide returns to shareholders.
1From 1/30/18 – 6/30/18, the Shanghai Shenzhen CSI300 Index fell -20.36%.
2From 1/29/18 – 6/30/18, the J.P. Morgan Government Bond Index Emerging Markets Global Core Index GBIEMCOR fell -9.7%.
The CSI 300 is a capitalization-weighted stock market index designed to replicate the performance of top 300 stocks traded in the Shanghai and Shenzhen stock exchanges.
J.P. Morgan GBI-EM Global Core Index (GBIEMCOR) is comprised of bonds issued by emerging market governments and denominated in the local currency of the issuer.
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International investing involves additional risks, which include greater market volatility, the availability of less reliable financial information, higher transactional and custody costs, taxation by foreign governments, decreased market liquidity, and political instability. Changes in currency exchange rates may negatively impact an investment's return. Investments in emerging markets securities are subject to elevated risks, which include, among others, expropriation, confiscatory taxation, issues with repatriation of investment income, limitations of foreign ownership, political instability, armed conflict, and social instability.
Hard Assets investments are subject to risks associated with real estate, precious metals, natural resources and commodities and events related to these industries, foreign investments, illiquidity, credit, interest rate fluctuations, inflation, leverage, and non-diversification.
Fixed income securities are subject to credit risk and interest rate risk. High yield bonds may be subject to greater risk of loss of income and principal and are likely to be more sensitive to adverse economic changes than higher rated securities. Please note that, generally, unconstrained bond funds may have higher fees than core bond funds due to the specialized nature of their strategies. International investing involves additional risks, which include greater market volatility, the availability of less reliable financial information, higher transactional and custody costs, taxation by foreign governments, decreased market liquidity, and political instability. Changes in currency exchange rates may negatively impact an investment’s return. Investments in emerging markets securities are subject to elevated risks, which include, among others, expropriation, confiscatory taxation, issues with repatriation of investment income, limitations of foreign ownership, political instability, armed conflict, and social instability.
Diversification does not assure a profit nor protect against loss.
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