Following one of the toughest Januarys on record and a volatile month of February, financial markets were kinder during the month of March as the MSCI World gained 6%. The shift in markets was driven by a variety of factors, which improved risk sentiment and reduced some of the market’s concerns over a global economic slowdown, that were so prevalent just two months ago. We continue to believe that the risk of a global recession remains low and that risk assets should continue along their path of recovery as global economic growth, led by developed markets, expands at a moderate place amid still highly expansionary monetary policy. That said, the prospect for higher volatility remains elevated given a host of uncertainties and merits a more tactical approach to asset allocation.
Among the drivers of the recovery in risk assets in March was the turnaround in the price of crude oil, which is up 38% from its lows of the year. Correlations between Brent crude oil and the S&P 500 rose to multi-year highs of around 0.7 at the height of oil’s sell-off, which dragged equity markets down with it. The most recent recovery in the price of oil allowed equity markets to march higher. Given the fact that the fundamental supply and demand picture remains roughly unchanged, our belief is that oil prices could still move lower again before the market rebalances in earnest.
This is due to the fact that Saudi Arabia and Russia continue to produce at near record-levels while a production freeze does nothing to reduce current output. That said, we are nearing the period of the year where U.S. energy companies must renegotiate their borrowing bases from banks, which are likely to be cut significantly given the reduction in the value of their assets. We continue to believe that the oil market will balance this year but will be led by cuts to U.S. production (namely high-yield independent producers), as opposed to freezes from OPEC members which do not have a material impact on global output.
The second contributor to the improvement in risk appetite was a wave of central bank actions that continued along the path of highly expansionary monetary policy. On March 10, the European Central Bank (ECB) announced a series of measures to further loosen financial conditions in the euro area. These included a 10bp cut to its deposit rate to -0.4%, an expansion of its asset purchase program by EUR20bn to EUR80bn to include corporate bonds, and the introduction of four long-term refinancing operations (LTROs). While markets were unimpressed initially given ECB President Mario Draghi’s comments that interest rates would not be lowered further, credit markets have since strengthened despite euro strength. This is mainly due to the fact that the ECB has made it clear it prefers to ease policy through the credit channel, as opposed to merely lowering rates, which have not been interpreted positively by market participants given their impacts on bank profitability. Since the ECB announcement, investment grade credit spreads have narrowed by 17bp and the yield on the 10-year German government Bund has fallen from 0.31% to 0.13%.
On the other side of Atlantic, the Federal Reserve decided to keep interest rates unchanged on March 15 and provided a dovish guidance for the future path of interest rates. This was driven less by concern over the state of the U.S. economy, than it was international global financial developments, which the Fed will continue to monitor as it assesses the pace of interest rate normalization. Regarding the future path of interest rates, the Fed guided towards two interest rate hikes this year, which is closer in line with the market’s expectations. At least in the short-term, the Fed appears comfortable with letting inflation overshoot its 2% target by keeping interest rates at historically low levels even as inflation picks up. The most recent core PCE read, the Fed’s preferred measure of inflation, came in at 1.68%, its highest level since February 2013.
As a result of the Fed’s dovish stance, the U.S. dollar (USD) trended lower during the month of March, down 3.60% on a trade-weighted basis. This helped the emerging markets complex rally, prompting a 13% rally in the MSCI emerging markets index. This was also aided by constructive news out of China regarding an increase in fiscal spending and a further stabilization in the RMB. However, the sharp move higher has not been accompanied by a material turnaround in emerging market fundamentals. Despite a still large underweight position among investors, we are not chasing the emerging market rally and continue to wait for a turnaround in economic fundamentals. This is consistent with our view expressed at the beginning of the year that global growth, albeit moderate, would be led by developed markets.
Recent data supports this thesis. In the U.S. the weakest part of the economy, the manufacturing sector, is beginning to show some green shoots. The most recent PMI data for the manufacturing sector printed at 51.8, its highest level since July 2015 and is back in expansion territory. Regional indices measuring manufacturing activity have also meaningfully improved over the last month suggesting that the worst of the manufacturing recession in the U.S. may be over. The key driver of the economy, the labor market, continues to demonstrate significant strength with the most recent jobs report showing the addition of 215,000 jobs for the month of March, well above the 100,000 jobs needed to keep the unemployment rate constant.
Data in Europe has also improved. Recent PMI readings showed an improvement in the services and manufacturing components of the economy. At the same time, credit growth remains firm. The annual growth rate of loans to the private sector edged up to 0.9% year-overyear in February from 0.6% in January and loans to households rose from 1.4% to 1.6%.
What does this all mean for our asset allocation? We continue to express a pro-cyclical bias and remain overweight risk assets. That said, we have reduced a portion of our U.S. equity exposure given the outperformance of the S&P 500 versus its developed market counterparts and will look to add risk at more attractive levels. We remain overweight European and Japanese equities on the basis of still highly expansionary monetary policy and relatively attractive valuations. European indices have been weighed down by the strength of the euro, which we do not expect to persist given interest rate differentials with the U.S. amid still divergent monetary policy. We also expect to see the Japanese yen weaken given the potential for additional quantitative easing from the Bank of Japan. Indeed, the underperformance of Japanese equities has largely been driven by Japanese yen strength, which has appreciated 7.60% in 2016 amid global flight to quality.
We remain overweight U.S. high-yield credit, which has delivered 3.25% this year amid a firmer oil price backdrop. We continue to believe that spreads at 753bp discount too high a rate of default, which we expect will come in around 5% for the year. We also find U.S. investment grade credit attractive with spreads at 193bp. With nearly two-thirds of German government debt and 70% of Japanese government debt providing negative yields, we think there is likely to be an increase in overseas demand for high-quality U.S. corporate debt and expect to see a further compression in spreads.
March saw a major turnaround in risk assets amid higher oil prices, central bank action and a general improvement in economic data. This all took place against a backdrop of lower volatility which we think risks moving higher in the coming months. Indeed, a range of uncertainties remain, stemming from Chinese growth dynamics, the possibility of a “Brexit”, heightened geopolitical risk and the direction and potency of global monetary policy. On this basis, we continue to assume a more tactical approach to asset allocation to take advantage of financial markets that have gotten ahead of economic fundamentals. 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.