April 2019 - Too Fast and Furious
Risk assets continued their upward trend in March, marking the third straight month of gains. The MSCI All-Country World Index rose 1.0% on the month in $US terms, bringing Q1 gains to 11.6% (the second strongest quarter on record). Along with optimism on a trade deal between the U.S. and China, dovish messages from the ECB and Federal Reserve drove global bond yields lower and made equity markets look relatively more attractive. We think that some equity indices could break new highs in the near-term, but it is also prudent to tactically reduce the equity exposure given the strength of the rally.
U.S. equities outperformed developed market counterparts by rising 1.7% compared with 0.8% for the MSCI World ex-USA index. On a sector basis, Information Technology (trade optimism) and Real Estate (lower yields) outperformed (+4.8% and +4.5% respectively) while Financials (lower yields) and Industrials (Boeing) lagged (-2.7% and -1.2%). The US economy is showing signs of rebounding from its Winter and Govt Shutdown driven slump, with the ISM manufacturing index rising to 55.3 (from 54.2) and the jobs market adding 196,000 jobs. We view the U.S. equity market as slightly rich on an absolute basis (forward P/E of 17.6x) but attractive relative to bonds. We remain overweight US equities given the potential for stronger than expected corporate profits during the year and still robust domestic economy.
In Europe, the Euro Stoxx 600 index rose 1.7% in March, bringing Q1 gains to 12.2%. Top performers within Europe were Italy (3%), UK (2.3%) and France (2.1%) while laggards were Germany (0.1%) and Spain (-0.5%). European economic activity continues to be pressured by trade tensions with the region’s PMI index dropping further into contractionary territory. The ECB has voiced its concerns over the region’s downside risks and launched a new program aimed at helping banks extend credit to support growth. The market is not expecting any rates increases from the ECB until at least mid-2020. We keep our stance on European stocks at marketweight given that the P/E ratios remain relatively cheap (forward P/E of 14x) and signs of stability in China which should support net exports. Regarding Brexit, after repeatedly failing to secure a deal, the deadline was pushed back by 6 months, granting UK politicians more time to come up with a plan that will be approved by both sides. UK equities are cheap (FTSE 100 trading at a P/E of 13.1x with a high dividend yield of 4.7%) and wesee value in maintaining a slightly overweight exposureusing a mix of domestic and multinational companies.
Elsewhere, Japanese stocks dropped -1% in March while emerging market equities gained 1.2% in local currency terms (0.7% in USD terms). EM Asia outperformed other EM regions, led by China and India. The onshore CSI 300 index rose 5.5% on the month (29% in Q1) while Chinese offshore stocks as represented by MSCI China rose 2.4% (18% in Q1). Indian stocks also outperformed (6.3% in March) given rising prospects of a Modi victory in the upcoming elections. Countries that significantly underperformed were Turkey (-10% in TRY terms) given the contentious local elections and underwhelming economic reforms announced recently as well as Argentina given persistently high inflation (-3% in ARS terms). Overall, we hold an overweight stance on EM equities with a preference towards Asia, and an underweight stance on Japan.
In USD fixed income, U.S. Treasury yields dropped 25 (2-year) and 31 bps (10-year) on the month, the largest monthly decline in yields since the Brexit vote in June 2016. The 3M/10-year Treasury curve inverted during the month following weak global PMI data, but it has since moved back to positive territory (+14 bps). We think the inverted yield curve is overstating the risks of a recession in the near term. The Federal Reserve also announced the process and timing of ending its balance sheet normalization (quantitative tightening) which was anticipated by the markets. The market is now pricing in a roughly 50% probability of one rate cut this year. Our bigger concern about the Fed stems from growing political interference by the White House, which includes nominating two new members to the FOMC which lack traditional economic experience and may exert pressure on cutting rates.
US HY credit returned another 1.0% (7.4% YTD) even though spreads widened 13 bps. In contrast to historical trends, the majority of total returns this year (5.7%/77%) have come from price appreciation while income returns (1.7%) have accounted for 23%. Higher quality bonds outperformed on the month, with BBs returning 1.2%, Bs 0.9% and CCCs only 0.2%. Overall this year, performance between BBs, Bs, and CCCs has been even (7.2%), which suggests some signs of caution as CCCs typically outperform in a rising market. US HY funds received another $2 bn of inflows and supply volumes were strong at $23 bn. We are neutral on US HY from here given that spreads (368 bps) are only 50 bp off the post-crisis tights. EUR HY slightly outperformed US HY by delivering total returns of 1.1% (5.3% YTD) on the back of spreads tightening 5 bps to 357 bps. European HY credit should continue to perform well given the meagre yields available in government bonds and new Brexit timeline.
US IG had a very strong month with spreads tightening 4 bps to 125 bps and total returns of 2.5% (5% YTD). Higher yielding sectors such as the Tobacco and Telecom sectors outperformed while Aerospace/Defense (Boeing) and Industrial Products lagged. Technicals remain favorable with IG mutual funds seeing inflows of 1.1% of AUM in March while supply volumes of $127 bn were absorbed by the market. We think US IG spreads are fairly valued at the moment but they may continued their tightening bias given the dovish Fed and improving macro headwinds.
In Emerging Market debt, hard currency corporates and sovereigns returned 1.4% and 1% while local currency sovereigns dropped -1.4% in $US terms. The latter’s returns were negatively impacted by the stronger $US (1.7% on average), particularly vs. the Argentine Peso (-9.7%), Turkish Lira (-4.2%) and Brazilian Real (-4.2%). Argentina and Turkey continue to be the weak links within the EM complex, given their very weak macro situation and political uncertainties. EM debt funds have received inflows throughout the year, and demand in the primary market remains strong (as witnessed by the $100+ bn in orders for Saudi Aramco’s debut offering). We continue to favour EM debt (hard currency over local) given attractive yields but emphasize the importance of country selection and active management.
Overall, we think the dovish stance by the Fed and ECB, new Brexit timeline and likely trade deal between the U.S. and China could push equity markets to all time-highs and support risk taking. However, we think it is prudent to tactically reduce equity exposure given the strength of the rally which has brought valuations to richer levels. The main catalysts for a pullback could be weaker global growth, stronger political influence on the Fed, increased trade tension between the U.S. and the EU, and a crisis in select EM countries. As always, 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.