Q2 2018 RECAP
July 10, 2018
TRADE DISPUTES ESCALATE; EMERGING MARKETS TURN SOUTH, SEE OUTFLOWS FOR 1ST TIME IN 2 YEARS; OIL PRICES JUMP, DESPITE OPEC
Emerging Markets – much was gained over a two-year stretch of time going back to early 2016, but Q2 took away a chunk of those gains. The main differences: turning sentiment; specific countries hit a wall with investors due to poor fiscal and economic management; a general paring down given heightened geopolitical concerns after an exceptional two-year period, and a stronger U.S. dollar that provided a pinpoint catalyst to reduce exposure to the asset classes (equities and debt…both the external and local). A stronger greenback almost always limits upside potential, but beyond the general decline, the silver lining to date is no evidence of contagion. It is important for the sector that EM’s poor historical showing in strong dollar environments does not repeat itself. There is some reason for optimism, beginning with the- fundamentals. This appears to be the case beginning with the fundamentals. In general terms, superior fiscal and balance of payment positions, more dependency with local financing of debt, and in turn less dependence on foreign finance. Yet, there are exceptions as noted last quarter.
In today’s world, EM begins with China. It is the second largest economy, but that is deceiving in a way. A closed market, the currency’s movement is both controlled and has political overtones. But, the Yuan is now part of a select basket of international currencies, and importantly, the bond market has been opened to foreign investors this year with encouraging results. All this to say that outflows which started in mid-April as the dollar strengthened, continued into May, and saw a further acceleration of momentum in June, may soon level-off given steady interest rate policies, and a decline that has erased far less than one-half of 2-year gains in EM equities. On the debt side, In EM’s favor, is a continued global search for yield.
Oil prices rose most of the quarter, climbing to near 4-year highs after a range-bound 1st quarter of 2018. WTI opened the year and quarter near $60, a brief dip below the mark was quickly erased thus setting the stage for a steady and persistent rebound in price. The biggest catalyst was not OPEC’s semi-annual meeting in June, but President Trump’s decision to remove the U.S. from the Iranian nuclear deal signed three years ago. A series of events, including arm-twisting partners on reducing if not fully cutting-off future Iranian oil purchases led markets to factor-in the potential of an oil shortage. Historically, any fear of supply disruption has taken precedence over an immediate increase in such supply. Q2 was a case in point. Iran’s total supply would not be easily replaced in global markets (not even w/ additions from the Saudis), and so prices climbed the 2nd-half of the quarter, to-and- through OPEC’s June roundtable. Brent, the benchmark, touched $80, and WTI’s differential narrowed despite U.S. production at all-time highs. The question over summer is have we seen peak prices, and likely not given the small margin for error in the current pricing dynamic. Specifically, if Brent’s baseline is above $75, then a new high is very likely. Summer driving season exacerbates the situation, but that will turn by September, yet Iranian sanctions (limited or full) will remain a pressing issue for speculators and investors to ponder through the latter stages of 2018.
The word trade went from having positive to negative overtones in the spring. Almost on a weekly basis, something new on the trade front was being threatened or walked back, though more the former than the latter. Disputes started in late winter primarily over the NAFTA Treaty that’s in the process of renegotiation in North America. Later, it escalated on a global basis, China first, followed by Europe. At the heart of current trade tariffs is a single-minded desire for a sharp reduction in U.S. trade deficits. Though trade can be divided into manufactured merchandise and investment services (as allies have pointed out), the administration has been fixated on the manufactured goods side of the ledger. Ironically, 2nd-qtr. trade figures will add, not subtract, from 2nd qtr. GDP. The deficit narrowed the past 90 days thus the import/export balance contributed to growth.
As the quarter ended, tensions with both China and the EU had escalated. That in turn turned investor sentiment more cautious, though not outright bearish, since the prevailing and widespread consensus sees a resolution on many thorny issues before the current trading environment deteriorates to a point that falls over the edge. That, is based on both hope and participants national interests. That said, it would be difficult to dispute that it has limited market momentum. Global equities were mostly range-bound, as were sovereign debt markets, where peak yields were marked before the calendar page turned to June.
A silver lining in the current wrangling for the upper-hand in trade leverage and diplomacy is that on a few occasions where markets hit the skids short-term, non-confrontational remarks from government officials would calm the markets concerns that a worst-case scenario was possible. Globalization the past 30 years which has only accelerated the past 15, and is likely to be difficult to reverse except at the margins. Trade is highly interwoven in the fabric of the economy, and higher-value products to a high degree.
Finally, there is too much vested interest from all participants, and too many hints, both here and overseas, that taken together makes a reasonable case that the strong public disagreements being aired will not prevent major trading partners from reaching acceptable compromises.