Markets despise uncertainty. The psychological shadow of the unknown can often be more of a hurdle for financial markets than the expected events themselves. In this regard, greater clarity boosts confidence as the range of potential outcomes narrows and investors can allocate capital with a higher degree of confidence amid greater visibility.
The following helps to explain the recovery in financial markets since the beginning of the year, and most recently, a relatively strong finish to the month of May for developed market equity indices which saw the S&P 500 gain 1.5% after having been down by as much as 1.3%. Volatility, as measured by the VIX index, has also fallen significantly with current readings close to this year’s lows while credit spreads have continued to compress. What accounts for the recent lull in risk-aversion?
The market has achieved greater clarity on two major issues which were previously sources of major tail risk. The first relates to the Federal Reserve’s pace of interest rate normalization and the timing of the next rate hike. In May, the Fed released the minutes from its April 2016 meeting which made clear that the next 25 basis point rate hike could come as early as this summer meaning June or July. This release was followed by a number of statements by various Fed officials, including Chairwoman Janet Yellen, indicating that a rate hike could be just around the corner. Fed futures markets are now assigning a 53% chance of a rate hike in July, up from 17% a couple of weeks ago.
This is especially true for emerging market equities, which are up 5.7% this year as per the MSCI Emerging Markets Index, as a weaker USD has eased pressure on their currencies and made their USD liabilities more manageable. The same linkages exist within commodity markets; this year’s rise in Brent crude oil began just days before the USD topped out.
In the past, a sudden repricing of rate hike expectations has been greeted with some concern, as investors weigh the ability for risk assets to absorb slightly tighter financial market conditions and the second-order effects of a stronger U.S. Dollar. Most recently however, it appears that the market has interpreted a more hawkish Fed as an indication that the U.S. economy is strong enough to warrant such a move. Notwithstanding still-soft manufacturing data, the U.S. household remains in good shape, home prices are rising and the labor market continues to tighten with unemployment down at 5.0%. In April, wage growth advanced by 2.5%, matching recent highs in January. As for overall growth, the Federal Reserve Bank of Atlanta is forecasting real GDP growth for the second quarter of 2.9%, suggesting a strong recovery from the inventory-led soft-patch in the first quarter in which GDP rose 0.8%.
The second area of clarity comes from China where only a few months ago the market was discounting a material decline in GDP growth and a disorderly devaluation of the renminbi. Since then, the cyclical backdrop has improved as a result of various demand-side measures including fiscal expansion and a further easing of credit. In this regard, authorities have hit the pause button on parts of China’s reform agenda in order to create greater financial market stability. In the real economy, recent data from May showed a further expansion in manufacturing with the PMI at 50.1, its third consecutive month of expansion. While recent comments by Chinese authorities suggest reforms can only be postponed for so long, the ability for China to manage a steady currency depreciation while maintaining domestic demand seems much more plausible than it did in January. This is evidenced by the steady 1.6% depreciation in the renminbi in May as opposed to concerns over a major one-off currency devaluation which markets had feared in January.
While China’s currency has weakened, the U.S. Dollar witnessed its strongest monthly gain since November 2015, up 3% in May. This helped European equities which had been weighed down, not only by a weak earnings season and political uncertainty, but also euro strength. A weaker euro, down, 2.7% over the month, lifted European equities, especially the export-oriented DAX Index which gained 1.9% and outperformed its developed market peers. We remain constructive on European equities given stronger economic momentum relative to the U.S. and a more accommodative monetary policy backdrop. Relative valuations also look more compelling; the Eurostoxx 50 currently trades at 12.6x forward earnings versus 15.8x for the S&P 500, the largest gap in three years. We believe the European Central Bank’s Corporate Sector Purchase Program (CSPP) should also support equities as credit spreads narrow further and boost incentives for M&A activity and capital investment. Indeed, in May European companies issued €48.5bn in debt, the busiest month on record.
Japanese equities significantly outperformed their peers, with the Nikkei 225 up 5.3%, its strongest monthly gain since October 2015 as the yen fell 4%. We continue to hold a constructive view on Japan and expect continued outperformance as the market begins to further discount the likelihood of additional monetary stimulus, yen weakness, as well as the June 1 announcement of a delay to a sales tax hike from April 2017 to 2019. Various Japanese officials, including Finance Minister Taro Aso have also indicated that additional fiscal stimulus might be warranted to ensure a stronger economic recovery.
The implementation of a large fiscal package could be as much as 10 trillion yen ($90 billion) according to the Nikkei newspaper. The Bank of Japan will meet on June 16 and could increase its annual purchases of government bonds and ETFS, currently at 100 trillion yen, along with a further cut to the deposit rate.
Credit markets continued to perform well in May as U.S. high-yield spreads narrowed another 16bp putting spreads at 608bp and delivered returns of 0.7% for the month, according to the Bank of America-Merrill Lynch Index. U.S. high-yield is now the best performing asset class within credit, up 8.2% on the year. The last time U.S. high-yield spreads ended the month below these levels was October 2015. European high-yield spreads widened from their yearly-lows by a mere 3bp, putting spreads at 458bp and delivering 3.9% on the year. A large portion of the U.S. outperformance came as a result of the rebound in commodity markets, namely crude oil as Brent crude pierced the $50 mark briefly, ending the month up 6.9%. We continue to like high-yield credit, both in the U.S. and Europe given the resurgent search for yield dynamic, prevalence of low and negative interest rates, benign maturity walls as well as spread levels which are adequately compensating investors for default risk. That said, we think the recent spread tightening may take a breather given the recent round-trip from their February wides though the opportunity for carry remains compelling.
This summer is setting up to be an eventful one for financial markets and will not be without its risks. The second week of June will include major monetary policy decisions by the Bank of Japan and Federal Reserve and will be followed by the Brexit vote on June 23. While recent polls indicate that Britain is likely to vote to remain in the European Union, the risk of a “leave” vote remains and poses a risk to markets. Additionally, we think the current period of low-volatility remains stretched and risks moving higher in the coming months. On this basis, we continue to assume a more tactical approach to our equity allocation while maintaining a strategic long allocation in credit. 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.