August 2015 – Still Resilient
Despite a host of challenging macro factors ranging from the threat of a “Grexit” to the rapid decline in Chinese equities, global financial markets were surprisingly range bound during the month of July. As we have written about before, we believe this is largely due to the fact that markets are stuck somewhere in the middle of a regime change for global monetary policy as the Federal Reserve readies to raise interest rates amid a global growth environment which is neither too hot nor too cold. As a result, global equity markets as measured by the MSCI World Index are up a modest 3.3% for the year. Meanwhile, the S&P 500 is trading in its tightest range in over twenty years and has not closed more than 3.5% above or below its starting point for the year, an unprecedented feat for the U.S. index.
Nevertheless, this less than stellar market for returns has also proven to be quite resilient in the face of uncertainty. The headline grabbing brinksmanship between Greece and her creditors has quietly moved into an arguably more important period of domestic politicking and technical discussions over reforms. Greek-induced volatility will almost surely return to the market, but for now, the threat of contagion has been contained. At the same time, the European Central Bank (ECB) is continuing along its path of purchasing EUR 60 billion in bonds per month which has helped prop up equity markets. The Eurostoxx 50 is up more than 9% from its lows and is off 6% from its highs on the year. Highly accommodative monetary policy and a more solid macroeconomic backdrop in the eurozone as evidenced by improving manufacturing trends and credit conditions should come back into investor focus. On this basis, we continue to hold a constructive view on European equities and believe their outperformance versus U.S. equities will persist.
Notwithstanding Japan’s recent underperformance versus its developed market peers—the Nikkei 225 was flat over the last month — we continue to believe that Japan will provide the best equity market returns this year versus its peers. With inflation stuck around 0%, monetary policy in Japan is unlikely to change any time soon given the Bank of Japan’s target of 2% inflation. We also believe that the structural rotation out of government bonds into domestic equities by Japan’s institutional investor class and the Government Pension Investment Fund (GPIF) still has room to go. This should continue to contribute to Japanese equity outperformance, along with a weaker yen amid Fed tightening and the continuation of corporate governance reform.
In the U.S., risky assets are caught between micro strength and macro uncertainty. Nearly 70% of S&P 500 companies have reported earnings for the second quarter of 2015 surprisingly positively by 5% versus bottom-up estimates. On a sectoral basis, we continue to like the large-cap technology sector and are increasingly constructive on U.S. financials given stronger net interest margins which should continue as short term interest rates move higher.
More important for U.S. equities in the near-term are expectations on the timing, pace and destination of rate hikes by the U.S. Federal Reserve. Despite being one of the most widely telegraphed rate hikes in history, the move from zero-interest rates after nine years of extremely easy monetary policy is likely to cause some short-term market dislocations and spikes in volatility. How the dust settles will depend on whether the market believes the Fed is hiking given the sustainability of economic growth or to tame inflation. Whether the Fed conducts its first rate hike in September or December will be heavily influenced by the two non-farm payroll reports between now and the next Fed meeting. The fact that the Employment Cost Index—a widely watched measure for labor costs—rose only 0.2% in the second quarter of 2015 will raise the bar for the next jobs reports.
It is important to consider that just as the Fed is moving closer to increasing interest rates, we are also witnessing another leg down across the commodity complex. The S&P Goldman Sachs Commodity Index is trading below its 2008 lows and is down 14.3% this year. Its largest component, crude oil, is down around 10% this year as the market continues to adjust to U.S. production which is just slightly below its highs at 9.4 million barrels per day.
The disinflationary impacts of falling commodities are important given that the Federal Reserve operates under a dual mandate. While it must maintain full employment, it must also ensure price stability with an inflation target of 2% over the long run. Though the labor market has tightened materially over the last year with unemployment standing at 5.4%, inflation expectations as measured by the five year forward breakeven rates are actually lower than they were when the Fed launched its second round of quantitative easing in November 2010. On this basis, further declines across commodities—especially energy—could lead the Fed to reconsider whether it raises rates before the end of this year. That being said, we continue to have a bullish view on the USD and expect it to strengthen against a trade weighted index given the structural divergence in monetary policy.
Within the emerging markets complex, the story of the month was China, whose equity market is down 30% from its 2015 peak as measured by the Shanghai Composite. Despite the attempts by the People’s Bank of China (PBoC) to stem the fall by prohibiting the selling of shares by certain shareholders and lowering the one-year deposit rate, the market is still searching for a bottom. This has negatively impacted other parts of the emerging market space with major currencies falling to decade lows, which has been exacerbated by the fall in commodities and USD strength. The Brazilian Real leads the pack, down 22% against the USD. Other victims include the Turkish Lira (-15.7%), Malaysian Ringgit (-9.1%) and Mexican Peso (-8.5%).
While we continue to underweight commodities and emerging markets, the recent selloff is having second order effects in the high yield market, reminiscent of the weakness which occurred in the fourth quarter of 2014. This is due to the fact that energy, metals and mining companies make up around 17% of the high yield market. This year, energy and metals/mining bonds are down 4.52% and 7.23% respectively. This has contributed to a 20bp widening in spreads, leaving the Bank of America-Merrill Lynch U.S. High Yield Index up 2.4% for the year. The fact that yields are now above 7% should bring more interest to the market, while wider spreads will allow high yield to better absorb any back up in U.S. Treasury rates. We continue to prefer corporates over government bonds, both in the U.S. and Europe.
The dog days of summer are shaping up to be critical ones for a number of market developments. With Greece in the rear-view mirror for now, markets will continue to pivot off incoming macro data from the U.S. and the Fed. All of this is set against a backdrop of divergent monetary policies, heightened currency volatility and loftier valuations on financial assets which has 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, 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.