August 2014 – The Macro View Remains Intact
Sometimes, market weakness can be attributed to a fundamental change in the macroeconomic backdrop. In other cases, the selling of risk asset stems from a negative technical setup, stretched valuations, or position squaring. The broad-based selling seen in equities and high yield bonds towards the end of July and beginning of August— which pushed the Dow Jones and Eurostoxx into negative territory for the year--appeared to be driven less by a change in fundamentals and more by a series of isolated risks as we believe the current macroeconomic environment remains sound. This backdrop should continue to support risk assets, though we do not rule out higher volatility in the coming months.
While data supports our view that global growth is heading towards the 3% handle, a host of idiosyncratic events have contributed to recent weakness, both in equities and in high yield bonds. Argentina went through a selective default. Tensions in the Middle East—from our own front in Israel to Iraq—remain.
Still, energy price rises have been contained and the risk to global growth—at least for now—remains moderate. In Europe, Portugal’s second largest lender, Banco Espirito Santo, will soon be the recipient of government aid, making clear that risks to European banks have not disappeared. The greatest risk in our view remains Russia given its economic links with Europe.
New sanctions targeting the country’s banks and energy sector were levied by the U.S. and EU in July. A key question is whether Putin will disrupt the flow of gas to Europe which will have a significant effect on growth in Europe.
Stepping back, the macro picture has improved in the U.S., with 2Q14 GDP registering an improvement of 4% following a dismal 2.1% contraction in 1Q14. Job growth also continues to trend higher, as the economy added another 200,000 jobs in July. While the employment cost index rose to 0.7% from 0.3% in 1Q14, inflationary pressures in the U.S. remain subdued and we do not believe the Federal Reserve will hike rates before 2Q15. 2Q14 earnings growth also looks good, trending around 7.5%. Yields on the 10-year U.S. Treasury fell below 2.5% in July given some of the feedback from the aforementioned risks while yields on German, Swiss and Japanese government bonds all revisited record lows.
Part of this explanation stems from the fact that the macro environment in Europe has weakened slightly, as the momentum in the Purchasing Managers Index (PMI) —a proxy for economic activity-- stalled. Business surveys point to a small pick-up in economic activity in 3Q14 and we expect bank lending to pick up only after the bank stress tests and asset quality review are published in October 2014. Inflation remains very subdued at 0.4%. The European Central Bank continues with its accommodative monetary policy stance and the euro/dollar currently trades below its range for the year at around 1.34. We believe a continued depreciation of the euro will benefit countries in the Eurozone as exports become more competitive.
Emerging markets (EM) outperformed their developed market (DM) counterparts in July as the MSCI EM Index rose 1.4%. The gains were led by China where growth stabilized in 2Q14 due to a number of targeted government stimulus measures. Japan also continued to perform well, as equities continued to push higher on the market’s belief that a greater proportion of domestic investors will hold Japanese equities along with faith— albeit cautionary—in the reforms of the Shinzo Abe government. Valuations continue to be attractive.
The potential for weakness in high yield credit was something we had warned of, as spreads compressed to pre-crisis levels. Earlier in the month, Federal Reserve Chairwoman Janet Yellen cautioned that valuations in the high-yield market “appear stretched.” While the U.S. HY Index fell 1.7% over the month, we do not believe this weakness mirrors that of “taper-gate” last year and believe that the fundamental setup—a slightly dovish Fed and low default rates—should continue to benefit the high yield market. Still, we think the upside remains more limited. Our allocation is centered around B / BBrated bonds with 3-5 years till maturity, from U.S. and European corporates with a smaller increase towards hard currency emerging market bonds which offer compelling yields for mainly investment grade companies.
The array of geopolitical hotspots is casting a shadow over financial markets. Thus far, we are not seeing contagion. Markets may at some point become vulnerable to an increased focus on an earlier than expected first hike by the Fed. 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.