April 2014 - Keep Calm and Carry On
Going into 1Q 2014, there was a great deal of consensus among market participants on positioning and the direction of markets. For us, this constituted one of the more significant risks entering the year given the number of “unknown, unknowns.” As we enter 2Q, we are noticing greater divergences among opinions on how this rest of this year will unfold. We are sticking by our call that developed market equities will lead the way forward and believe value can still be found in high yield credit, though proper name selection is critical given the extent to which spreads have already compressed in this asset class.
The following is just a sample of some of the questions market participants are asking themselves: Is recent weakness in the U.S. economy a function of weather, or are there greater structural issues at work? Are China’s credit markets dangerously close to seizing up or does the government have more power to avoid a traumatic deleveraging event? Are emerging markets still susceptible to another sell-off or have we arrived at valuations which make these markets look like bargains?
Two events in March further complicated this landscape. The first was the Russian incursion and subsequent annexation of Crimea. Western sanctions against Russia have been relatively mild as the country’s financial and energy sectors have emerged largely unscathed. Still, it is difficult to predict events and the potential for another Russian assault in eastern Ukraine remains a possibility. Sanctions targeting Russian financial or energy companies would have immediate repercussions for European equity markets given the linkages between banks and Europe’s dependence on Russia for around 30% of its natural gas.
The second was a series of weak data points out of China, led by an unexpected 18.1% decline in exports in February. Later in the month, reports surfaced of the first-ever default by an onshore bond issuer which exacerbated concerns over the country’s $7.5 trillion shadow-banking system. This led to fears around commodity financing deals which weighed on copper while iron ore experienced its second largest single day sell-off. While Chinese equities have massively under-performed this year, we are beginning to hear murmurings of “discount-buying” and could well see China being touted as the next target for emerging market investors seeking attractive valuations.
In the U.S., 1Q 2014 was characterized by a series of disappointing data points, though a portion of this appears attributable to colder than-normal temperatures. The Federal Reserve continues to point to slack in the labor market yet remains comfortable with an improving growth scenario. In its most recent FOMC meeting, the Fed announced another round of tapering, bringing its monthly asset purchases to $55 billion per month. It also switched to a more qualitative forward guidance, dropping the 6.5% unemployment threshold. Overall, the market interpreted Janet Yellen’s first FOMC meeting as slightly more hawkish than expected and brought forward its expectations for the next rate hike by a couple of months to April 2015. U.S. 10-year yields continue to trade in a range between 2.58% and 2.81% and the market will likely require a new catalyst-such as an impressive non-farm payroll print—to move outside this range. We expect yields to end the year closer to 3.25%.
In Japan, equity markets under-performed despite a surge in corporate earnings. Geopolitical tensions have boosted demand for the yen which has weighed on stocks while the looming consumption tax increase from 5 to 8% beginning April 1 has dented consumer sentiment. Still, we retain our belief in the attractiveness of valuations in Japan and believe that divergent monetary policies of the Bank of Japan and the Fed will ease some of the upside pressure on the Japanese currency and provide support to stocks.
The Eurozone’s recovery, though fragile, remains in place. The euro area economy expanded for the third consecutive quarter in 4Q 2013, growing by 0.3% as domestic demand showed a modest improvement. Manufacturing activity has picked up, as demonstrated by an improvement in PMIs, though some of the earlier momentum has tired.
The monetary union remains dangerously close to deflation. Inflation for March 2014 came in at 0.5%-- a five year low. This strengthens the rationale for the European Central Bank to take additional, non-conventional measures to ease monetary policy which should take some pressure off of the euro which has strengthened by 0.3% this year. We expect the euro to weaken against the USD going into 2Q 2014 as the growth differentials and different stages in rate cycles do not warrant such a strong outperformance in the euro in our opinion.
Meanwhile, Europe’s periphery continues to outperform as consumer sentiment recovers and credit conditions improve for corporates' and small and medium-sized enterprises. Yields on Italian and Spanish sovereign debt have moved below 3.5%, levels which were difficult to imagine less than two years ago. This has been accompanied by a surge in corporate issuance, especially among European financials which are seeking to take advantage of low yields.
Overall, high yield credit has performed quite well this year, up 2.28% in Europe and 2.98% in the U.S. We still believe there is some juice left in this rally, but are cognizant that in this environment proper name selection remains critical. In Europe, we are closely watching the large issuance of hybrid and contingentcapital (coco) debt securities which are cheap ways for banks to raise capital and can be written off should a bank’s capital fall below a certain threshold. We see opportunities in this asset class but remain selective and prefer the most-well capitalized European financials.
We continue to have a favorable view of equity markets and believe that the global economy is still some distance away from the business cycle which typically ends equity rallies and expect stocks to end the year higher. Valuations are in line with historic norms, though some parts of the market appear somewhat stretched. This is not unexpected, as the U.S. equity bull market has entered its fifth year. This stage is characterized by more muted gains. We believe there is still value to be found in U.S. stocks. We are seeing improvements in the outlook for capital expenditure and believe that industrials' and technology should outperform.
We believe that European equities offer more attractive valuations as stocks are trading at a 32% discount to their U.S. counterparts on a price-to-book basis. European margins are still below their precrisis highs and we see potential for catch-up.
A high degree of volatility across financial markets is likely to persist throughout 2014 as we transition into a "new normal" of a less expansionary Fed and emerging market risk. That is why a proper regional and sector selection strategy, combined with rigorous risk-management should remain the decisive factor for investment performance. As usual, don’t hesitate to contact us to discuss investment performance or financial markets more generally.