Five key issues for the capital markets

After an upbeat first half of the year, risk assets underwent a correction in the summer. A whole range of risk factors returned to investors’ consciousness. How should investors now position themselves in view of central bank policy shifts, the economic development and politics? Max Holzer, Head of Relative Return, takes a closer look at five key issues.
Max Holzer

An article by Max Holzer

Max Holzer is in charge of the relative return department within the multi-asset portfolio division at Union Investment. He is also a member of the Union Investment Committee (UIC).

At the start of August, US President Donald Trump posted what sounded like a friendly tweet: “We look forward to continuing our positive dialogue with China on a comprehensive Trade Deal, and feel that the future between our two countries will be a very bright one!” But it was actually the start of the next phase in the trade dispute. He was referring to the establishment of a “small additional tariff” of 10 per cent on the remaining US$ 300 billion of US imports from China that are not yet subject to punitive tariffs. And how did China respond? No more purchases of US agricultural products and the devaluation of the renminbi to its lowest level since spring 2008. It will clearly be some time before the two superpowers enjoy the “bright future” announced by Trump.

In the capital markets, this next phase of escalation in the trade dispute did trigger a sell-off in opportunity-oriented asset classes, such as equities and bonds from the emerging markets, but it was not the only reason. Poor economic data and hopes that were dashed by the central banks had already put paid to bullish sentiment. In other words, the correction is based on a whole range of risk factors that had previously been ignored but are now rapidly returning to investors’ consciousness. As a result, the DAX – a particularly sensitive share index – lost around 1,000 points between the start of July and the start of August.

Five key issues will influence the capital markets

Following a very upbeat first half of the year, the question in the wake of the price fall is what next for the capital markets. Are the risks really as big as the price slump suggests? Or should investors use the lower level as an entry point? There are five key issues at play:

1. Trade dispute

The dispute between the US and China is essentially a power struggle. This is about much more than just tariffs. The trade dispute will therefore remain on the capital markets’ radar.

Our prediction: We do not expect the arguments to be resolved any time soon. In the markets, investors will continue having to pay the political risk premiums that are taking their toll on share prices.

Significant adverse impact of a trade dispute escalation

Significant adverse impact of a trade dispute escalation
January 2010 = 100; sources: CPB World Trade Monitor, Union Investment, as at 2 August 2019.

2. Economy

The trade dispute is already making its mark because the growth of protectionism is acting as a brake on global trade. The growth engine that is globalisation is struggling.

Our prediction: Global economic growth will continue to weaken because the trade dispute is likely to escalate. But we do not anticipate a recession.

3. Monetary policy

In the first half of the year, the central banks spurred on the capital markets by raising the prospect of easing. Although the Fed and ECB did take action in July, they did not go as far as the markets had hoped.

Our prediction: Monetary policy will continue to influence the markets. We anticipate further stimulus from Washington and Frankfurt that will support riskier asset classes.

Monetary policy: loose for longer

Union Investment’s expectations regarding monetary policy at the major central banks
Monetary policy: loose for longer
Source: Union Investment as at: 1 August 2019; Legend: APP: Asset Purchase Programme, CSPP: Corporate Sector Purchase Programme, Covereds: Covered Bonds, PSPP: Public Sector Purchase Programme

4. Corporate profits

Slower growth and higher wages resulting from stronger trade barriers eat into companies’ margins. The differences in profitability are becoming more pronounced. However, profits are unlikely to rise much further Overall.

Our prediction: We expect profits to remain flat in 2019. This means that valuation will become the crucial factor for the equity markets.

5. Geopolitical tensions

The trade dispute is not the only issue. Other conflicts are also affecting the capital markets, such as the Iran dispute and Brexit.

Our prediction: Sudden and sharp spikes in volatility are highly probable. We believe a snap election is looming in the UK, and the Brexit deadline is likely to be extended beyond 31 October.

Investors need to take action and remain vigilant

It used to be an accepted wisdom that the impact of political developments on the stock markets was short-lived. And it is still the case that the capital markets are driven by fundamental factors such as the economy and monetary policy in the medium term. But politicians now act far more aggressively and create conditions that have a longer-lasting effect than in the past. The influence of politics on the stock markets has increased.

What does the combination of these factors now mean for the capital markets? We do not expect to see a repeat of the broad-based rise in risk assets that occurred in the first half of the year. Targeted allocation in the most promising sub-asset classes, coupled with careful security selection, is becoming increasingly important. Investors therefore need to take action and remain vigilant, because not all areas are affected to the same degree or hit by Trump’s Twitter outbursts. While investors should currently avoid cyclical sectors such as automotive and engineering because of the weak economy and the trade dispute, there are opportunities in less export-dependent industries – not only in companies’ shares but also their bonds. These include consumer goods manufacturers and pharmaceuticals.

At country level, we prefer economies with a strong domestic focus, such as the US. Among commodities, the current geopolitical tensions make precious metals a good addition to the portfolio. Although the price of gold has already risen sharply, prices for silver and platinum are still expected to climb.

Given the unsettled conditions, safe government bonds remain an important shock absorber for the portfolio overall. However, they are not a good source of returns in the long term, as interest rates are being pinned down by monetary policy. In terms of fixed-income investments, spread products such as corporate bonds and paper from the emerging markets have much better prospects. Loose monetary policy is particularly beneficial for these segments, so they offer plenty of potential. Equities are essential, but their prospects are limited. With profits likely to rise only moderately, the valuation – and thus geopolitical developments and monetary policy decisions – will determine the potential for price gains.

Prospects for selected sub-asset classes

Prospects for selected sub-asset classes
Source: Union Investment, as at 15 August.

Unless otherwise noted, all Information and illustrations are as at 16 August 2019.