Changes in central bank rhetoric and trade war threats push investors to safety, ETF flows suggest

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  Morgane Delledonne 
  ETF Investment Strategist

 

 

The upward revisions in both US GDP growth projections for 2018 and the number of rate hikes this year - from three to four - suggest the US Federal Reserve (Fed) forecasts a faster convergence of the economy towards full capacity.

Despite the lack of academic evidence, all eyes are now on the US yield curve to predict the timing of the next recession in the US. With the Fed’s policy stance shifting from accommodative to neutral, we believe three more rate hikes may suffice to invert the yield curve, potentially in the first half of 2019. Based on past US monetary tightening cycles, the Fed has generally hiked two times after the yield curve inverted. Overall, the Fed could probably hike five more times in this cycle with an ending Fed funds rate of 3.25% by the end of 2019. Historically, recessions have happened between 12 to 24 months after the yield curve has inverted, suggesting the US economy could fall into recession as early as the first quarter of 2020.

Striking the right balance

The Fed’s challenge is to find the right balance between keeping the economy running at its full potential and pre-empting the build-up of financial vulnerabilities. The major uncertainty relates to the magnitude of impact of the large US fiscal stimulus on the US economy and consequently on the pace of Fed monetary policy tightening. The procyclical nature of fiscal stimulus generally serves to boost economic growth, potentially accelerating the convergence towards the economy’s full potential, as well as increasing the risk of overheating. We believe the Federal Open Market Committee (FOMC) will refrain from committing to a pre-set course of actions as monetary policy becomes neutral, instead acting on a case-by-case basis.

Central banks elsewhere begin to ‘normalise’

In the rest of the developed world, central banks have just started their normalisation process. In the eurozone, President Mario Draghi announced on mid-June the termination of the Asset Purchase Programme in December this year, while promising that the European Central Bank (ECB) will keep its policy rate unchanged at least until the summer of 2019. Investors have perceived the ECB’s message as dovish, sending both the euro and eurozone bond yields lower. The slowdown in the first quarter across the region has weighed on the ECB’s economic growth projection for 2018 (2.1%, down from 2.4% in March) partly reflecting weaker surveys and growth impetus from global trade; Draghi noted a pullback from the solid growth in 2017.

Is it time to play safe?

For investors, the timing around de-risking portfolios is a trade-off between forfeiting upside potential and playing it safe. Value stocks ETFs have recorded net outflows since the beginning of the month, amid risk-off market sentiment. The unexpected drops in both US industrial production in May and German factory orders for four straight months to April, coupled with a fall in eurozone exports, raise concerns about global economic prospects, leading investors to shift away from Value stocks. Value stocks generally outperformed during expansionary phases, with corporates recording strong profits. Later in the cycle, investors tend to rotate towards growth and quality stocks to protect from economic slowdowns.

Past performance should not be seen as an indication of future performance.

Emerging markets sell-off, opportunities emerge in Asia

Investors withdrew money from emerging markets (EM) equity and bond ETFs for the fourth consecutive week, as EM currencies came under pressure despite central banks’ intervention in FX markets. In addition to the faster pace of monetary tightening in the US, the escalation in trade tensions buoyed risk-off sentiment towards EM assets. Despite significant discrepancies among EM countries regarding growth prospects and debt financing, none was immune to the sell-off, suggesting the recent pullback was mostly driven by fears of a global trade war rather than economic concerns.

Past performance should not be seen as an indication of future performance.

The medium-term outlook differs among EM regions. We expect that the effect of a stronger US dollar and the increase in US interest rates will be uneven across EM, albeit that the risk of a trade war leaves no one unscathed. We expect EM countries that rely on short-term external debt financing to be the most vulnerable to the rise of US interest rate, namely Mexico, Turkey and South Africa. However, we believe the sell-off offers good entry points into fundamentally sound EM countries, such as those with current account surpluses, namely South Korea and Thailand.

Past performance should not be seen as an indication of future performance.

In general, screening for companies according to quality and dividend yield provides higher long-term prospects. BMO MSCI EM Income Leaders ETF (ZIEM) tracks the MSCI EM Select Quality Yield (SQY) Index which focuses on three criteria to capture quality, namely: profitability, leverage and earnings’ quality, before selecting the top 50% of companies exhibiting the highest dividend yield.

Past performance should not be seen as an indication of future performance.

The funds or securities referred to herein are not sponsored, endorsed, issued, sold or promoted by MSCI, and MSCI bears no liability with respect to any funds or securities or any index on which such funds or securities are based. The prospectus contains a more detailed description of the limited relationship MSCI has with F&C Management Limited and any related funds.