Entering the final quarter of 2018

The third quarter has drawn to a close. The outcome was broadly positive for diversified equity investors, with the MSCI All Country World Index climbing 4.7% largely due to a 7.7% return in US stocks.

And US stocks passed a historic milestone, with the bull market becoming the longest in modern US history by some measures at 115 months. But a 20-basis point rise in US 10-year yields added to headwinds for emerging markets, with the MSCI EM Index returning –1.1% in US dollar terms. This 8.8-percentage point gap between emerging market stocks and the US market was the widest since 2013.

As we enter the final months of the year, I'd like to reflect on what drove markets in the third quarter and what we expect the focus to be in the last quarter of 2018.

Third-quarter drivers

Trade negotiations

US brinkmanship on tariffs was the dominant concern for global investors, with the White House talking tough with the EU and its NAFTA partners, as well as with China. Ultimately, investors appeared reassured by a USEU agreement in July to put potential auto tariffs on hold, and by the conclusion of a trade deal with Canada and Mexico on 30 September. This progress appeared to leave the US fighting a trade war on just one front, with China.

Emerging markets

Confidence in emerging market assets came under pressure through the third quarter amid continued evidence of an economic deceleration in China along with country-specific concerns in the likes of Argentina and Turkey. That helps explain the 1.1% fall in the MSCI EM Index, and a 3% decline in the JP Morgan Emerging Market Currency Index. The sharp underperformance also reflected capital outflows as yield-seeking investors gravitated back toward safer US dollar assets amid rising rates.

US exceptionalism

After a period of synchronized global growth early in 2018, the US economy outperformed, expanding by 4.2% annualized in the second quarter, more than double the rate for the Eurozone. US earnings per share rose 26% in the second quarter compared to 6% for the Eurozone. In addition, the US non-manufacturing ISM index increased to 61.6 in September, its highest level since August 1997.

What's in store for 4Q

As we look ahead, we believe the main focus for investors in the final quarter of the year will be the following:

Tariffs will take effect

While rising tariffs look likely to be confined to the US and China, we still need to be alert for the impact on growth and profits. We expect higher tariffs – as with any tax increase – to slow US growth somewhat. The impact will depend on how easy it is to avoid the tax through production shifts. Employment may also be affected if supply chain disruption becomes significant.

Higher interest rates

Last week, the yield on 10-year US Treasuries staged the largest one-day rise since November 2016, as strong economic data consolidated market expectations for a further Fed rate hike in December. The 10-year yield is now at the highest level since July 2011. And with the European Central Bank poised to end quantitative easing in December, the overall balance sheet of global central banks will start to contract.

Regional economic convergence

Despite the recent pickup in the speed of US economic growth, we will be watching for whether the gap with the rest of the world begins narrow in the fourth quarter. This could have important implications for regional equity market performance, given the extent of US outperformance so far.

So, on balance, we believe positive factors will continue to outweigh potential risks. As a result, we favor a modest overweight position on global equities. We are also starting to see some value in emerging markets following the recent sell-off and so we recently added to our overweight on EM dollar-denominated sovereign bonds. However, we still consider it prudent to hold several positions that would benefit in the event that risk scenarios materialize – especially on trade. We remain overweight US 10-year US Treasuries and, in our FX strategy, we prefer the Japanese yen relative to the Taiwanese dollar.

Bottom line

Global equities rose in the third quarter, with a 4.7% return despite worries over trade talks and idiosyncratic problems in certain emerging markets. In the final quarter of 2018 we expect investors to focus on the economic effects of tariffs, monetary tightening, and a potential narrowing of the US growth advantage over the rest of the world. On balance, we believe positive factors will continue to outweigh potential risks and we favor a modest overweight position in global equities.

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