Even so, equity markets are implying that a trade war will damage Chinese firms more than U.S. firms. Relative equity performance demonstrates this. Since the beginning of the year, Chinese companies with high U.S. sales have significantly underperformed U.S. companies with high China sales.
On global trade, we continue to have a more benign view than consensus, reflected in the modest risk-on stance in our portfolios. While concerning, the direct impact of the tariffs implemented and proposed thus far remains small. We believe that the U.S. and China will come to a deal in the medium term. In addition, we’ve yet to see “second-order” effects from tariffs, such as lower consumer/business confidence and reduced spending, which would cause greater concern.
Emerging markets: How dangerous is the selloff?
Emerging markets (EM) continued their sharp selloff during the quarter. Fears of contagion increased as economic weakness in Turkey intensified and a few EM central banks raised rates significantly to support their currencies. China was not immune from the EM weakness, in part due to the trade dispute with the U.S. Chinese equities have sold off nearly 20% since the end of January.
We are closely monitoring emerging markets for signs of stability. Our base case is that the pockets of weakness are idiosyncratic and country-specific and we do not think they will initiate a crisis in EM. Certain countries — most notably Turkey and Argentina — have suffered from a dangerous combination of negative current account balances, high externally denominated debt and high inflation. However, broadly speaking, emerging-market economies appear relatively healthy with better fundamentals as compared to historical crisis periods.
Japan: Resisting the tightening tide
In defiance of a global trend towards monetary policy tightening, the Bank of Japan (BOJ) continued to aggressively purchase assets and maintain a yield target of “around zero” on 10-year Japanese government bonds (JGBs). To help bond markets function better, the BOJ did tweak policy during the quarter, allowing 10-year JGBs to fluctuate by as much as 20 basis points in either direction. The change allowed JGB yields to increase marginally, causing a temporary steepening of yield curves in the U.S. and Europe. With inflation still well below the BOJ’s 2% target, we expect policy will remain largely stimulative in the coming quarters.
Prime Minister Shinzo Abe was overwhelmingly re-elected for a three-year term as head of the Liberal Democratic Party. His re-election was not without controversy due to recent scandals, but we believe stability and continuity in the political arena is a positive for the Japanese market.
Europe: Lower growth and persistent political risk
The economic growth outlook continued to be somewhat challenging in Europe in the third quarter as PMIs trended weaker and the European Central Bank (ECB) revised down its forecast for GDP growth in 2018 and 2019. However, ECB President Mario Draghi noted late in the quarter that he expects a “relatively vigorous” pickup in inflation as a tightening labor market pushes up wage growth. The ECB will halve its bond-buying program starting in October and is due to end the program altogether in December. Despite Draghi’s more hawkish comments, an interest rate hike is not expected until mid-to-late 2019.
The long-awaited Italian budget arrived on September 28, with the government announcing a plan that set the deficit at 2.4% of GDP, which is below the 3% EU limit but still represents a significant increase. This followed a tense battle with Italy’s technocratic economy minister. We continue to believe that the Italian coalition may be short-lived as it will have difficulty delivering on election promises.
It was a tough quarter for U.K. Prime Minister Theresa May and her Conservative Party. The resignations of Foreign Secretary Boris Johnson and Brexit Secretary David Davis showed a government in turmoil, and at a September summit in Salzburg, May was caught off guard by the EU’s denunciation of her “Chequers” plan. The prime minister must also contend with the main opposition Labour Party’s dismissal of Chequers, which may leave the door open to a second Brexit referendum. While we still expect a deal, time is running out and the probabilities of “no deal” and “hard Brexit” likely increased during the quarter.