April 2015 – From ZIRP to NIRP
Generally stronger growth across developed markets and aggressive monetary stimulus has combined to produce a respectable quarter for returns on financial assets. The battle against deflation is in full force and the search for yield has intensified as twenty-three central banks eased monetary policy in the first three months of 2015. In Europe, we moved from zero interest rate policy (ZIRP) to negative interest rate policy (NIRP) as almost one-third of the euro-area’s $6.26 trillion of government bonds trade below zero percent.
Increased foreign currency volatility has been a salient feature of this new financial market landscape. According to Bank of America-Merrill Lynch, this last quarter witnessed the highest level of currency volatility for the asset class outside a crisis-period. It is no coincidence that developed market equity indices with currencies that depreciated (Germany, Japan) outperformed those whose currencies appreciated (Switzerland, U.S.).
Higher volatility in currency markets is consistent with the persistence of divergent monetary policy, a principle theme we identified at our Annual Investment Conference. The most notable moves have come from the surging trade weighted U.S. Dollar Index which rose 8.7% and the depreciation of the euro, which fell 11% against the U.S. Dollar. This is emblematic of the broader macro backdrop which continues to be driven by growth and monetary policy divergences as the U.S. Federal Reserve and Bank of England ready themselves to begin tightening monetary policy while the European Central Bank and Bank of Japan aggressively expand their balance sheets.
In the U.S., the economic expansion underway has moderated but is still growing at a decent clip. Economic data has surprised on the downside though strength in the labor market persists. Still, lower oil prices have not fully fed through to the consumer with retail sales faltering so far this year. Lower oil prices have also weighed on energy companies, which make up around 8% of the S&P 500, and have cut capital expenditures materially. Meanwhile, the U.S. Dollar has also weighed on corporate profits. While exports account for only 13.5% of U.S. GDP, 40% of profits are earned abroad for S&P 500 companies. Downward revisions for U.S. earnings have pushed up valuations to 17.5x forward earnings compared to its 10- year average of 14.1x and partially account for the underperformance of U.S. equities relative to their developed market counterparts.
Moderating economic growth in the U.S. contributed to the decision by the U.S. Federal Reserve to change the wording of its forward guidance, adding that it would be appropriate to raise rates when a “further improvement” is seen in the labor market. Though the Federal Reserve maintains the optionality of raising rates in June 2015, we think it is unlikely to do so and believe that the first rate hike will come in September, barring a material deterioration in economic data. Yields on the U.S. 10-year Treasury dipped lower following this change in tone by the Federal Reserve and ended the quarter at 1.92%.
In Europe, macro data has surprised on the upside. The European Central Bank’s 1.1 trillion euro bond buying program, a weaker euro, lower oil prices and a reduction in Russian-related geopolitical pressure have all positively contributed to Europe’s acceleration.
What does all of this mean for risk assets going forward? We are still overweight equities as we believe this bull run, though extended, still has legs and has not yet entered the stage of euphoria. Very low bond yields will continue to support demand for equities as investors need to look elsewhere to generate returns, especially in Europe. On this basis, we increased our allocation to European equities at the expense of our overweight position in U.S. equities. In the U.S. we continue to prefer cyclical stocks and the technology sector and maintain our bias towards cyclicals in Europe.
We continue to hold an overweight position in Japanese equities following a 9% rise in the Nikkei during this last quarter. This rally was buoyed by domestic demand among pension funds and other institutional market participants. Japanese companies are delivering a higher return on equity and we think that higher share buybacks and dividend increases will continue to support Japan’s equity markets.
Our outlook on emerging markets continues to be driven by trends in the commodity complex, debt dynamics and political reform. We prefer emerging market Asia given political reforms and are underweight Latin American given weaker commodity prices and higher debt levels whose burden is exacerbated by a stronger U.S. Dollar.
According to the Bank for International Settlements, emerging market U.S. Dollar denominated debt has increased from $2 trillion to $4.5 trillion since 2009, increasing the risk associated with the beginning of rate hikes by the Federal Reserve.
Amid record low yields for sovereign debt, the high yield credit market has performed well this year. U.S. high yield credit has returned 2.6% while European high yield credit is up 2.7%. The absence of inflationary pressures and the fact that rate rises in the U.S. are likely to be gradual, combined with low default rates strengthens our constructive view on the U.S. high yield market. The currency tailwind that non-U.S. investors can capture is another supportive factor for the asset class. Still, we are highly cognizant of the energy risk embedded in the high yield market and prefer companies which have larger exposure to the domestic consumer. In Europe, we prefer companies rated BB and above and are more comfortable with slightly higher duration risk to credit risk in order to protect ourselves from highly levered companies.
We are in unprecedented times for financial markets as central bank behavior has pushed up valuations on financial assets and incentived greater risk-taking among market participants. In our view, generating positive returns requires increased flexibility and the ability to look through periods of higher volatility. Notwithstanding the challenges associated with divergent central bank behavior, we believe that opportunities also exist. In that context, riskmanagement 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.