The Israeli conflict isn’t a global factor ... yet
Disruptions minor so far amid a global outlook that's a bit meh.
As harrowing as the terrorist attack on Israel by Hamas has been, market reaction has been muted. Oil prices initially jumped but held below YTD highs. Developed-market sovereign bonds rallied, particularly Treasuries, but this may have had more to do with Fed-speak suggesting policymakers are done hiking rates in a market that arguably was oversold than it was a flight-to-safety trade. The big worry is if the conflict expands beyond Israel and the Gaza strip, particularly to include Iran—an outcome that could rattle all global markets. For now, that’s just worrisome speculation.
In the meantime, an update of the Federated Hermes International Outlook Committee’s take on global economies and equity markets after meeting this week arguably can be summed up with one word: “meh.” The committee viewed most major economies as generally stuck in neutral, with Japan offering potential upside and the U.K. potential downside. It did see some green shoots in manufacturing, with global manufacturing PMIs troughing after declining over the last 12 months. It seems the inventory correction of the last 14 months may be giving way to a rebuild. Even in Germany, September’s manufacturing PMI improved slightly but at 39.6, remained deep in contraction.
Global exports also seem to be bottoming, with export-driven economies such as China and South Korea at an inflection point. Inflation is falling in most major and developing economies—at 4.3% and 6.7%, respectively, annual inflation in Europe and the U.K. remains well off its highs though above that in the U.S. The market expects inflation to continue to fall steadily as both the ECB and Bank of England renewed their commitment to a 2% target rate. Weaker consumer demand is a concern; the global service PMI for September fell to 51.1 from 55.5 in June, and was below breakeven 50 in the eurozone and the U.K.
Japan, Brazil potential bright spots
Looking at international equity markets, a stronger dollar—it hit new highs in Q3 on rising U.S rates and growth—is a headwind. In Europe, where Italy, Greece and Spain have outperformed the Nordic markets and Germany, a lot depends upon what happens in China (more below), its biggest trading partner. European equity markets are attractively priced, with much of the bearish news more than priced in as benchmark valuations remain below historic levels. The committee’s view is more muted on the U.K., where Brexit remains a drag on growth, housing has weakened and with elections next year, the ruling Tory party trails the Labor party in polls. Still, as in the eurozone, valuations reflect the economic headwinds.
A bright note in developed markets is Japan, where equities look attractive for a range of reasons: their positioning as a hedge against global inflation; a weaker yen; low valuations; Japan’s exit from deflation and rising investment; corporate governance reforms; and inflows from retail investors. The committee cannot underestimate changes by Japanese companies in corporate governance, with the reforms broadening the universe of investors and driving up equity valuations. After a 30-year fight against deflation, inflation has arrived (though at 3.2%, below the rest of the world), and the Bank of Japan has relaxed its yield-curve controls. Expectations are its negative interest-rate policy will be next.
In emerging markets, the big question is, whither China? Its economy is still expected to grow faster than the U.S. and eurozone, but nothing close to past historic levels. Business and consumer sentiment is low but potentially turning—the recent Golden Week holiday saw travel and spending rise over last year’s levels, though not much more than in 2019. The central government has launched incremental fiscal and monetary stimulus programs, not the “bazooka” stimulus the market wants. And its property market remains in deep distress, no longer able to serve as a source of growth. Still, China’s equity market is pricing in all this uncertainty.
Latin American arguably offers the best EM opportunities. Its markets should benefit from rising global trade as companies start restocking depleted inventories look to de-risk supply chains out of China. Higher oil prices, which could turn even higher depending how the Israeli conflict plays out, benefit Brazil, a major crude producer. Yet inflation generally is coming down and central banks are cutting rates. Finally, in a region known for a volatile political environment, we see stability with leftist leaders such Brazil’s Lula proving to be somewhat pragmatic and business friendly.