July 2017 - A Strong First Half
Updated: Jul 10, 2018
The first half of the year has come to a close and amid a stable growth environment, risk assets performed remarkably well. This came in the face of two interest rate hikes by the U.S. Federal Reserve, a 20% decline in oil prices, and elevated policy and geopolitical risk. Nevertheless, a continuation in the global synchronized economic expansion in which global growth is tracking at the upper end of its recent range amid easy financial conditions has proved to be the most important factor driving financial returns. While we believe returns in the second half of the year will be positive, their magnitude is likely to be smaller as the market faces the prospect of less dovish central banks and slightly tighter financial conditions.
Over the last six months, a tranquil macro environment coupled with still easy monetary policy produced outsized gains for equity markets with the MSCI All-Country World Index (ACWI) up 12%. According to a study by the Wall Street Journal, of the world’s 30 largest global stock markets, 26 registered positive returns through June 2017. That nearly half of these markets closed at, or close to, their record highs, is indicative of the synchronized expansion underway.
The improvement in corporate earnings growth this year has been a significant factor supporting equities. For the year, analysts are expecting global corporate earnings to grow by 13.4% as per companies in the MSCI World Index. In the U.S., companies in the S&P 500 posted a 14% increase in earnings in the first quarter of the year, their strongest growth since 2011.
European equities in particular have seen a major increase in investor inflows as a result of cheaper valuations, a material improvement in its macro backdrop and a reduction in political risk following the election of French President Emmanuel Macron in May. We believe European equities will continue to outperform their developed market peers through the second half.
Credit markets similarly delivered strong returns thus far as the global credit cycle pushed ahead amid accommodative financial conditions for corporates. In the U.S., high-yield credit returned 4.9% as spreads narrowed 50 basis points to 372 basis points according to the Bank of America-Merrill Lynch High Yield Index. Currently, spreads sit just 37 basis points above their intra-cycle low recorded in June 2014. While we do not expect a major widening in credit spreads over the next six months given low expected default rates we acknowledge that current valuations have become more stretched and believe that coupon will account for the majority of high-yield’s return over the next twelve months. On this basis, we have pared back slightly our overweight allocation to the asset class. Investment grade credit has also provided a respectable return, delivering 3.8% this year given the tailwind of spread compression amid lower long-end U.S. government bond yields through much of the year.
As we move into the second-half of the year we believe a number of key themes will drive financial markets. The first is the direction of global monetary policy. The pickup in developed market government bond yields in the last week of June came as a result of central bankers, both in the U.S. and Europe (as well as the U.K), appearing less dovish. This resulted in yields on the U.S. 10-year Treasury and German 10-year Bund rising 20 and 24 basis points, respectively. Our base case assumes a continuation in this trend, though we do not discount the possibility of bond yields revisiting their lows before drifting higher over the course of the year. This view is the result of the Federal Reserve still guiding for one additional rate hike this year and another 3 hikes in 2018, far ahead of the market’s expectations for one additional hike. The Fed also expects to normalize its balance sheet by the end of the year by slowly running of its stock of agency debt and mortgage-backed securities. The European Central Bank (ECB) meanwhile is likely to announce a tapering of its 60 billion euro per month asset purchase program by the end of the year which will begin in early 2018. This policy pivot by the ECB has resulted in an appreciation of the euro versus the U.S. Dollar by 8% this year. Going forward, we believe that monetary policy tightening which proceeds at a faster pace than expected could lead to a significant pick-up in volatility and demands careful attention.
The second is the pace of China’s deleveraging efforts. China’s softlanding has been cushioned by a major build-up in credit which stands at roughly 250% of GDP. This year, regulators have taken steps to reign in the pace of this growth by cracking down on shadow banking and other forms of non-bank finance. In May 2017, Bloomberg reported that sales of asset-management products by lenders and trust companies, major participants in China’s shadow banking sector, fell by more than 30%. This resulted in a tightening of China’s financial conditions which we believe is responsible for weakness across the commodity complex, including a 33% decline in the price of iron ore from its yearly highs.
More recently, we have seen a decline in overnight lending rates in China which points to the balance regulators must take between reigning in excesses and maintaining growth in line with their target of around 6.5%.
The third is the Trump administration’s ability to execute its policy agenda including corporate tax cuts, regulatory reform and infrastructure spending. The market euphoria which greeted Trump’s election has given way to a sobering of expectations, especially given the gridlock associated with reforming the Affordable Care Act. The delivery of a pro-growth policy initiative could lead to another leg higher in equities and a resumption of the reflation trade in which bond yields and risk assets move higher in tandem.
While market volatility has remained relatively depressed over the last few months, we do not expect this to persist, especially given continued policy uncertainty in the U.S., geopolitical clouds and the pace of central bank tightening policy. The interplay of these market drivers should give rise to higher volatility and new opportunities. On this basis, we continue to assume a more tactical approach to our equity allocation while maintaining a strategic long allocation. In our view, generating positive returns requires increased flexibility and the ability to look through periods of higher volatility. In that context, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.