May 2018 - Back to Normal
Updated: Jul 10, 2018
For investors, 2018 feels a lot different than 2017. Volatility is higher, returns are lower, risks seem greater and the direction of markets appears less certain. This setup stands in marked contrast to the vintage backdrop of 2017 that was characterized by extremely low volatility and strong returns in which the S&P 500 delivered 6.7% over the first four months of the year compared to -0.4% in 2018. What explains this shift in markets and what can we expect going forward?
It is important to recognize that while the current environment may feel different, it actually represents a return to more normal conditions where financial markets are driven more by economic fundamentals than central bank policy. In this regard, the previous few years have been more of a historical aberration than the current state of affairs.
At the beginning of 2018, we argued that a decline in central bank stimulus and policy normalization by the Federal Reserve would introduce additional volatility into the market. This is due to the fact that global liquidity would increasingly be driven by real economic activity, foreign exchange accumulation, and demand for credit rather more aggressive expansionary monetary policy. The latter is inherently less volatile than liquidity which depends on real economic growth. In this setup, global growth can remain strong while risky assets, namely equities, demonstrate greater volatility while still outperforming other assets.
It is noteworthy that while volatility, as measured by the CBOE VIX Index, is higher in 2018, readings remain below their historical average. The average weekly level of the VIX is 17 for 2018 versus 19.4 since 2001; the last few years of historically low volatility have led many investors to forget what normal conditions actually are.
Volatility across bond and foreign exchange markets meanwhile remains fairly subdued relative to their equity counterparts. This is largely due to the fact that equities are a leveraged play on growth which, as the cycle matures, will demonstrate greater dispersion. But it is also due to the fact that markets are in a sweet spot in which expectations of central bank policy across the U.S., Europe and Japan, are in line with the official estimates and communication of the central bankers themselves.
This is especially true with regards to the Federal Reserve. Both the Federal Reserve and fed futures markets expect the fed funds rate to end the year at 2.125%, suggesting another two 25 basis point rate hikes. It is now widely believed that inflation will approach, if not slightly exceed, the Fed's target of 2% as wage pressure increases on the back of an unemployment rate which at 4.1% is likely to fall further and as fiscal stimulus uses up additional spare capacity and the output gap turns more positive.
The inflation backdrop across the Eurozone and Japan meanwhile looks much different and supports our view that neither the European Central Bank nor the Bank of Japan will pursue any material monetary policy tightening in the near-term. Indeed, Eurozone CPI has fallen to 1.3%, below the ECB's forecast of 1.5% while core CPI in Japan stands at 0.5%, leading the Bank of Japan to drop its forecast for when it would achieve 2% inflation. We continue to expect core government bond yields to move higher in the U.S. relative to its developed market peers and are thus underweight duration across U.S. fixed income.
While the financial press focuses on the 3% level of the U.S. 10-year Treasury, we believe that increases on the shorter end of the yield curve have been far more meaningful with greater implications for asset allocation. Yields on the U.S. 2-year Treasury have increased 60 basis points this year and stand at 2.48%, a nine year high. U.S. 10-year Treasury bonds were yielding the same amount as recently as January 2018. The rise in short-end yields means that investors can now obtain a relatively attractive yield without taking undue duration or credit risk, a reversal from the extreme search for yield dynamic that has prevailed over the last several years and when the 2-year part of the U.S. Treasury curve yielded less than 1% which it did from 2009 to 2017.
We believe the appeal of short end, risk free rates is partially responsible for some of the weakness across U.S. investment grade corporate credit which is down 3.4% over the year, according to ICE-Bank of America ML bond indices. While some of the weakness is duration-related, credit spreads have also widened by 17 basis points given an increase in supply and less buying by foreigners due to higher currency hedging costs. On these bases, we prefer shorter duration investment grade credit. While we are not adding to U.S. high-yield given tight spreads at 345 basis points, we have been impressed by its resiliency and 308 basis point outperformance versus investment grade credit given investor demand for low duration spread product and low default rates.
Moving down the capital structure, we continue to believe that equities will outperform other asset classes this year. While economic surprise indices have turned lower and momentum has slowed, albeit from high levels, global growth will remain firmly above trend this year. According to Bloomberg, 85% of countries its monitors have manufacturing PMIs that are in expansionary mode with only Turkey, Malaysia, South Korea and Thailand showing sub-50 readings. We continue to expect double-digit earnings growth over the year and have added exposure on market weakness.
Earnings results from the first quarter of 2018 confirm our constructive view. As of April 26, 325 of S&P 500 companies reported results with 77% beating earnings estimates and earnings growth up 23%. In Europe, 23% of Stoxx600 companies have reported with 60% beating estimates. Going forward, we continue to be overweight European equities which are trading at a 22% discount to their U.S. counterparts according to MSCI indices. What's more, the hurdle rate for U.S. companies stands at 20% earnings growth for the year versus 7% for Europe, according to J.P. Morgan. A weaker euro, which peaked at 1.25 in February, could also benefit sales over the next quarter. While we do not expect a material weakening in the euro versus the U.S. Dollar, we believe that the momentum has subsided for now given widening interest rate differentials and a market where long euro positions are stretched. We continue to like Japanese equites as well given a favorable liquidity backdrop and a weaker yen which should support earnings and sales.
Undoubtedly, the market is undergoing a shift as it transitions into a period of less liquidity, higher rates and a slowdown in the momentum of growth. Risk assets have responded in kind. Still, the fundamentals remain encouraging and recessionary risk remains low this year. On this basis, we continue to advocate a strategic long position in equities given our belief in the underlying economic picture. 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. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.