Investment Traffic Lights

Market Overview

For most, August marks the last month of summer holidays. This year, however, it has been a busy month, and not just for traders in emerging market currencies. U.S. president Donald Trump, too, has hardly been idle. His 375 tweets keep the rest of the world on edge, creating plenty of movement in financial markets. For example, Trump announced via Twitter that the U.S. would double tariffs on steel and aluminum imports from Turkey. That contributed to the rapid fall in value of the Turkish lira in global exchange markets. Compared to the dollar, the lira is down 25% for the month of August. Only the Argentinian lira was even weaker, losing almost 26%. The Brazilian real and the South African Rand both lost almost 10%.

Given these currency turbulences, it is hardly surprising that emerging markets have been the key topic of market conversation in recent weeks. Will there be contagion, with the countries already impacted dragging down other emerging markets with them? Or has there just been a collection of country specific crises that all happened to unfold at more or less the same time?

Well, in the case of Turkey, most of the problems are home grown in our opinion. Could it nevertheless prove contagious? That's a key question we consider in our outlook below. It is worth noting, though, that the Turkish crisis began to boil over when markets had good reasons to doubt the independence of Turkey's central bank, as well as its ability to counteract accelerating inflation and capital flight.

Questioning central bank independence, is no longer a topic limited to selected emerging markets. Donald Trump's unusual comments on the Fed chairman Jerome Powell raised plenty of market eye brows. President Trump appears disappointed that the Fed appears to be maintaining its tight monetary stance. This contributed to dollar weakness – a welcome development from the perspective of President Trump and many companies in the S&P 500. The U.S. blue-chip index broke two records on August 21. It reached a new height, making the current bull market the longest in the indices history – 3452 days and counting. This continues the trend of U.S. equity outperformance we have seen since the start of May. Global equities markets (MSCI AC World) are up almost 10% overall, but excluding U.S. companies from the calculation they would have lost 3% during that period. This dichotomy continued in August. The S&P 500 rose 3.3%, while the Euro Stoxx 50 and Dax declined 3.7% and 3.4% respectively. After their July weakness, technology stocks again became a source of S&P strength. The gains for two of the biggest, Apple and Amazon alone amounted to almost 300 billion dollars for the month.

In bond markets too, the picture was pretty mixed. Emerging market local currency bonds, as well as those with low credit worthiness (below investment grade) had it tough, as nervous investors preferred to put their money in issues of U.S. and European borrowers, perceived to be less risky. Except, that is, for Italian sovereign bonds. Markets remain concerned that the new Italian government will lack fiscal discipline, pushing 10-year Italian government bond yields above 3% for most of the month. By contrast, yields of German bunds and U.S. Treasuries barely moved, and even declined slightly compared to the start of the month. This probably has more to do with investors searching out safe havens, rather than any underlying macro-economic concerns. Most economic indicators remain solid, especially in developed markets, or at least did not disappoint during the month of August.

Outlook and changes

As in previous months, we remain cautiously optimistic. The U.S. has experienced another strong earnings season. Macroeconomic data in much of the rest of the world remains encouraging, suggesting solid fundamentals for most asset classes. Politics looks set to remain a drag, to be sure. Two key events to watch are the budget preparation in Italy and ongoing global trade tensions. On trade, Trump has made it pretty clear that he intends to widen the range of U.S. tariffs on imports from China. The next extension would probably involve goods worth 200 billion dollars in total. This looks set to include far more consumer goods, resulting in more immediate upward pressure on U.S. consumer prices. Europeans too could soon find themselves in the U.S. administration's crosshairs. According to Trump, the European Union is "almost as bad" as China when it comes to trade, "just smaller."^[1]

Partly as a result of global trade tensions, emerging market countries look set to remain an area of focus for many global investors. As a group, these countries appear to be in much more solid shape than 10 or 20 years ago, even as a few individual ones suffer from mostly self-inflicted problems. That said, rising U.S. interest rates and shrinking central bank balance sheets in developed markets are also having an impact. Whatever the reason, moreover, the mere fact that several emerging market trouble spots have popped up at more or less the same time risks causing ripple effects. If this were to involve an undifferentiated sell-off, it could result in interesting investment opportunities among the more solid emerging markets.

Aside from the risk of such temporary setbacks, the global economic environment continues to justify our cautiously constructive market outlook. For equities, we have not changed our target investment allocations, meaning that emerging markets remain our favorite. Given their recent strength, we remain tactically cautious on U.S. equities. Excluding technology stocks, the median price earnings ratio is close to historic highs. During the last 3 decades, U.S. equities were only more expensive once on that measure – during the dotcom bubble of the 1990s. This is why we would not be surprised by a pull-back, especially as it is becoming increasingly hard for the U.S. to deliver positive surprises. Already, the tailwind thanks to fiscal stimulus, mostly via tax cuts earlier on this year, appears to be fading.

Among key bond segments, we have mostly taken neutral positions. The world's leading central banks continue to move monetary policies towards more normal terrain, albeit at a varying pace. The Fed remains the key one to watch. Comments by the Fed chairman have invited a wide range of interpretations, but in our view, two things are reasonably clear. First, Powell looks set to stick to – and defend – his mandate. And second, the Fed continues to view the U.S. economy as sufficiently strong to justify further rate hikes. However, and that might have been a surprise to some, the Fed's commentary at the Jackson Hole conference of central banks suggests that it may be less certain than previously thought as to how high rates will need to go. Of course, that uncertainty could cut both ways, which is why we do not necessarily see the changing stance as a dovish sign. Be that as it may, though, there is no denying the potential tensions between solid economic growth figures on the one hand and escalating trade conflicts on the other. No wonder that the Fed looks set to be cautious. Against this backdrop, we expect U.S. sovereigns to continue to move side-ways. We remain neutral for all maturities of U.S. treasuries. For German sovereigns too, we have moved back to neutral for all maturities, after briefly taking a negative stance on 10-year bunds.

Among emerging market bonds, we focus on countries which have already been punished too much by markets. For hard currency emerging market bonds, we have returned to a positive stance, but remain tactically agile. We remain vigilant, not least as traditional rescue mechanisms, such as rescues by the International Monetary Fund, are either off the table (as in the case of Turkey) or being doubted - and tested - by financial markets (see Argentina).

Among corporate bonds, we have moved to neutral for euro bonds in both the investment grade and the high-yield segments. The current flood of new issuance and the looming end of net purchases by the European Central Bank leads as to wait for now. For U.S. investment grade bonds, we remain tactically negative.

As for currencies, we have reacted to the sudden movements we saw in August but are now back to neutral for the euro/dollar. For the last three months, the currency pair has traded within a narrow range, reflecting the balance of arguments in favor of each. This also means that one traditional driver of oil and gold markets is currently on hold. We are positioned neutral for both commodities.

Past performance of major financial assets

Total return of major financial assets year-to-date and past month

Equities*

		1 to 3 months (relative to the MSCI AC World)	until June 2019
	Regions
	United States
	Europe
	Eurozone
	Germany
	Switzerland
	United Kingdom (UK)
	Emerging markets
	Asia ex Japan
	Japan
	Latin America
	Sectors
	Consumer staples
	Healthcare
	Telecommunications
	Utilities
	Consumer discretionary
	Energy
	Financials
	Industrials
	Information technology
	Materials
	Real estate
	Style
	United States small caps **
	Europe small caps ***

** Relative to the Russell 2000 Index

*** Relative to the Stoxx Europe 600

Fixed Income*

		1 to 3 months	until June 2019
	Rates
	U.S. Treasuries (2-year)
	U.S. Treasuries (10-year)
	U.S. Treasuries (30-year)
	UK Gilts (10-year)
	Italy (10-year)1
	Spain (10-year)1
	German Bunds (2-year)
	German Bunds (10-year)
	German Bunds (30-year)
	Japanese government bonds (2-year)
	Japanese government bonds (10-year)
	Corporates
	U.S. investment grade
	U.S. high yield
	Euro investment grade1
	Euro high yield1
	Asia credit
	Emerging-market credit
	Securitized / specialties
	Covered bonds1
	U.S. municipal bonds
	U.S. mortgage-backed securities
	Currencies
	EUR vs. USD
	USD vs. JPY
	EUR vs. GBP
	GBP vs. USD
	USD vs. CNY
	Emerging markets
	Emerging-market sovereigns

Alternatives*

		1 to 3 months	until March 2019
	Infrastructure
	Commodities
	Real estate (listed)
	Real estate (non-listed) APAC
	Real estate (non-listed) Europe
	Real estate (non-listed) United States
	Hedge funds

Comments regarding our tactical and strategic view

Tactical view:

• The focus of our tactical view for fixed income is on trends in bond prices, not yields.

Strategic view:

• The focus of our strategic view for sovereign bonds is on yields, not trends in bond prices.

• For corporates and securitized/specialties bonds, the arrows depict the respective option-adjusted spread.

• For bonds not denominated in euros, the illustration depicts the spread in comparison with U.S. Treasuries. For bonds denominated in euros, the illustration depicts the spread in comparison with German Bunds.

• For emerging-market sovereign bonds, the illustration depicts the spread in comparison with U.S. Treasuries.

• Both spread and yield trends influence the bond value. Investors who aim to profit only from spread trends should hedge against changing interest rates.

Key

The tactical view (one to three months):

• Positive view

• Neutral view

• Negative view

• A circled traffic light indicates that there is a commentary on the topic.

• The traffic lights’ history is shown in the small graphs.

The strategic view up to June 2019

Equity indices, exchange rates and alternative investments:

The arrows signal whether we expect to see an upward trend , a sideways trend or a downward trend .

The arrows’ colors illustrate the return opportunities for long-only investors.

• Positive return potential for long-only investors

• Limited return opportunity as well as downside risk

• Negative return potential for long-only investors

Fixed Income:

For sovereign bonds, denotes rising yields, unchanged yields and falling yields.For corporates, securitized/specialties and emerging-market bonds, the arrows depict the option-adjusted spread over U.S. Treasuries: depicts a rising spread, a sideways trend and a falling spread.

The arrows’ colors illustrate the return opportunities for long-only investors.

• Positive return potential for long-only investors

• Limited return opportunity as well as downside risk

• Negative return potential for long-only investors

Footnotes:

* as of 8/31/18

¹ Spread over German Bunds in basis points

² These traffic-light indicators are only meaningful for existing private-equity portfolios

Appendix: performance

		08/13 - 08/14	08/14 - 08/15	08/15 - 08/16	08/16 - 08/17	08/17 - 08/18
	U.S. Treasuries (30-year)	14.4%	4.6%	16.7%	-5.4%	-2.8%
	German Bunds (30-year)	17.8%	5.4%	18.6%	-7.7%	3.2%
	U.S. Treasuries (10-year)	6.4%	3.4%	7.0%	-1.4%	-3.1%
	German Bunds (10-year)	10.2%	2.3%	8.0%	-2.0%	1.2%
	UK Gilts (10-year)	5.4%	5.4%	12.3%	-1.0%	-1.1%
	U.S. Treasuries (2-year)	0.8%	0.8%	1.1%	0.5%	-0.1%
	German Bunds (2-year)	0.6%	0.1%	0.3%	-0.5%	-0.7%
	U.S. high yield	10.6%	-2.9%	9.1%	8.6%	3.4%
	U.S. investment grade	9.1%	-0.4%	9.1%	1.9%	-1.0%
	Asia credit	11.7%	2.1%	10.2%	2.4%	-0.9%
	Euro investment grade	8.2%	0.4%	6.7%	0.6%	0.0%
	Euro high yield	10.7%	2.0%	6.8%	6.4%	1.2%
	Spain (10-year)	24.1%	2.4%	10.9%	-0.2%	2.4%
	Emerging-market credit	11.9%	-1.4%	11.3%	5.6%	-1.6%
	Emerging-market sovereigns	14.6%	-1.1%	14.2%	5.0%	-3.4%
	Italy (10-year)	19.8%	4.7%	9.0%	-3.3%	-6.6%
	EUR vs. GBP	-7.2%	-7.7%	16.2%	8.5%	-2.8%
	USD vs. CNY	0.4%	3.8%	4.8%	-1.3%	3.7%
	USD vs. JPY	6.0%	16.5%	-14.7%	6.3%	1.0%
	EUR vs. USD	-0.7%	-14.6%	-0.5%	6.7%	-2.6%
	GBP vs. USD	7.1%	-7.5%	-14.4%	-1.6%	0.2%
	EUR vs. JPY	5.3%	-0.6%	-15.1%	13.5%	-1.6%
	S&P 500	22.7%	-1.6%	10.1%	13.9%	17.4%
	MSCI Japan Index	14.2%	19.6%	-13.8%	18.7%	7.8%
	MSCI AC Asia ex Japan Index	18.4%	-18.0%	10.1%	22.0%	0.5%
	Stoxx Europe 600	15.0%	6.1%	-5.3%	8.8%	2.2%
	Swiss Market Index	11.8%	1.9%	-7.1%	8.8%	0.5%
	MSCI Emerging Markets Index	17.0%	-24.7%	9.2%	21.7%	-2.9%
	FTSE 100	6.3%	-8.4%	8.5%	9.6%	0.0%
	DAX	16.9%	8.3%	3.2%	13.8%	2.6%
	Euro Stoxx 50	16.6%	3.1%	-7.5%	13.2%	-0.8%
	MSCI Emerging Markets Latin America	20.2%	-43.8%	16.7%	19.6%	-14.2%
	Oil	7.2%	-29.8%	-15.8%	-2.9%	37.9%
	Gold	-7.7%	-11.8%	15.3%	1.0%	-9.1%

Past performance is not indicative of future returns.

Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 9/3/18