Financial markets continue to grapple with a variety of issues ranging from the trajectory of central bank policy and the potential for global fiscal stimulus to sluggish, albeit improved, corporate earnings growth and the outcome of the U.S. election. All of this continues to take place against a backdrop of still highly accommodative monetary policy including the purchases of both risk-free and risky assets by global central banks which is driving valuations on financial assets higher and further igniting the intense search for yield dynamic. As we move into the final months of the year, we continue to see this backdrop, combined with a stronger global growth dynamic, as benefiting risky assets into year-end.
Global equity markets finished October close to the bottom of their recent ranges with the MSCI All-Country World Index down 1.8% for the month. Year-to-date, the index is up 2.9%. A variety of factors accounted for the softer tone to markets, though we believe the turnaround in bond yields was the most likely culprit. Global bond yields across developed markets hit multi-month highs resulting in the largest losses in sovereign bonds since May 2013 when the Federal Reserve announced its decision to taper its asset purchases. The U.S. 10-year Treasury rose 25 basis points during the month, closing at 1.83%, its highest level since June.
The proximate cause for the rise in government bond yields is the recognition that the Federal Reserve is on course to raise its benchmark interest rate by 25 basis points when it meets in December, its first hike in one year. Futures markets are pricing in a 70% probability of a rate hike, up from 59% at the beginning of September. Confidence in the ability for the Fed to move was strengthened following the release of third quarter GDP growth which printed at 2.9%, the most in two years. The Federal Reserve Bank of Atlanta is forecasting GDP growth for the fourth quarter of 2.7%. Additionally, an inflection point in the labor participation rate in the U.S., which ticked up to 62.9% in September from 62.4% a year ago, could suggest a tightening in the labor market and with it, growing inflationary pressures.
The normalization of interest rates in the U.S. has not been the sole driver of higher bond yields. Inflation expectations have also steadily risen across developed markets with 10-year breakeven rates, a measure of investors’ inflation expectations, climbing markedly in the U.S., Europe and the United Kingdom. This is also being reflected in the headline data. In the U.S. for instance, core PCE printed at 1.7%, up from 1.3% a year ago, but still below the Fed’s target of 2%.
Inflation expectations were also driven by the moderate pickup in global growth as evidenced by stronger macro data over the month; Citibank’s Economic Surprise Index (CESI) for major economies rose to its highest level since August following a sharp decline over the summer. At the same time, oil markets have stabilized around $48, but have been subject to bouts of volatility on account of the questionable durability of the OPEC decision to limit future output. A more vociferous discussion over the need for global fiscal stimulus has also played a role in boosting inflation expectations with the market expecting some form of increased government spending from whichever presidential candidate ultimately resides in the White House.
As bond yields rose in the U.S., so did the value of the U.S. Dollar which gained 2.9% on the month, on a trade-weighted basis and rose to its highest level since January. Counterintuitively, higher yields in the eurozone were also accompanied by the largest depreciation in the euro against the U.S. Dollar since May, falling 2%. The reason is that higher bond yields in the eurozone increase the number of eligible securities the European Central Bank (ECB) can purchase as part of its 1.7 trillion euro quantitative easing program; the ECB is prohibited from buying bonds which yield less than its deposit rate of -0.4%. This reduces the likelihood the ECB will begin to taper its current easing program in the near-term and clears the way for a continuation in its expansionary monetary policy.
Our strategic equity allocation remains unchanged and we continue to favor markets which trade at more attractive relative valuations but still stand to benefit from easier credit conditions. Our European equity allocation outperformed its developed markets peers over the month as the Eurostoxx50 gained 2% versus a 1.9% decline for the S&P 500. The move higher was partially driven by the uptick inflation expectations— inflation rose to 0.5% from 0.4% in October—as well as further improvement in the macro backdrop. Indeed, the purchasing managers’ index (PMI) for the eurozone rose to 53.7 in October from 52.6 while the sub-index measuring prices charged by businesses to customers rose to a five-year high.
Business surveys in Germany, the trading bloc’s largest economy, also indicate additional economic momentum and are consistent with GDP growth of around 0.4-0.5% for the fourth quarter according to Pictet.
European equities continue to stand out on the basis of valuations and we expect to see their valuations continue to narrow versus developed market peers. On a price-to-book metric, eurozone equities trade close to a record discount at a ratio of 0.7 versus U.S. equities. At the same time, what was a consensus long at the beginning of the year has shifted, creating more room for fund flows, especially as confidence over the eurozone recovery, as evidenced by recent data, takes hold.
Our Japanese equity allocation also outperformed its developed market peers with the Nikkei 225 gaining 6% in October. The gain was led by Japanese cyclicals as the Topix Banks Index rose 8%. The 3.2% decline in the Japanese yen versus the U.S. Dollar provided additional momentum to Japanese shares. The anchoring of the Japanese 10-year bond at close to 0%—a part of the Bank of Japan’s “yield curve control” policy—also helped support the financial sector on account of a steeper yield curve. Going forward, we continue to believe that Japanese equities represent compelling value given their near record discount versus the U.S. and remain encouraged by the fact that year-to-date, companies have spent a record 4.35 trillion yen in buybacks, consistent with the renewed focus on shareholder-friendly corporate behavior.
We also continue to have a constructive view on emerging market Asian equities. For Asia ex- Japan, valuations look set to improve further given that earnings expectations for 2016 earnings are likely to have bottomed. In China, the government continues to strike balance between its medium-term reform agenda and the shorterterm need to stabilize growth through credit creation. The latter has allowed China to meet its current growth targets of between 6.5- 7.0%. For the third quarter of 2016, the National Bureau of Statistics reported GDP growth of 6.7% its third consecutive quarter of such growth. At the same time, there is little indication that credit growth is faltering. In September, China’s broadest measure of credit, total social financing, rose 11.3% year-on-year, its highest September figure on record and well above expectations.
On the fixed-income side, returns from U.S. and European highyield credit moderated over the month while investment grade credit generated negative total returns of 0.8% in the U.S and -1% in Europe as a result of the backup in government bond yields, according to the Bank of America-Merrill Lynch (BoAML) Corporate Bond Index. U.S. high-yield credit spreads continued to narrow, though only by 6 basis points, finishing the month at 491 basis points and delivering 0.3% of total return, according to BoAML High-Yield Index. Meanwhile, European high-yield outperformed its U.S. counterpart delivering 0.9% in total return as spreads narrowed 40 basis points. Indeed, European high-yield has seen five consecutive weeks of inflows as the ECP Corporate Securities Purchase Program (CSPP) continues to depress yields in investment grade, sending investors into riskier areas of the market. Overall, we continue to have a constructive view on both U.S. and European high-yield as we move into the final months of the year on account of the still powerful search for yield dynamic, an inflection point in default rates in the U.S. and a firmer commodity backdrop.
Business surveys in Germany, the trading bloc’s largest economy, also indicate additional economic momentum and are consistent with GDP growth of around 0.4-0.5% for the fourth quarter according to Pictet.
November will not be without headline risk, beginning with U.S. elections on the 8th. While we do not believe the outcome of the election will determine the direction of markets over the mediumterm, we are anticipating higher volatility over the coming weeks. This is likely to continue after the election, as the markets turn their attention to the Federal Reserve and the upcoming referendum in Italy. On this basis, we continue to assume a more tactical approach to our equity allocation while maintaining a strategic long allocation in credit. 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.