As we move into the final month of the year, markets are coming to terms with the fact that quantitative easing (QE) will not last forever. And yet, even as investors prepare for the Federal Reserve to begin to wind down its $85 billion per month asset purchase program, risk assets continue to move higher. As November came to a close, 84% of stocks listed on the S&P 500 were trading above their 200-day moving average.
Investors are indeed becoming more comfortable with the idea of Fed tapering. Easing concerns is the fact that “tapering is not tightening”- a message we will surely continue to hear and one which the Fed is sending to markets. What this means is that a reduction in QE does not mean an end to the Fed’s zero interest-rate policy (ZIRP). Currently, the Federal Funds futures market prices in the first rate hike only in late-2015.
Janet Yellen, the heir apparent to Fed Chairman Ben Bernanke, is partly responsible for this coming-to-terms. Her testimony to the Senate Banking Committee was very much in line with the thinking of Chairman Bernanke. While she noted strength in the U.S. economy, she argued in support of a continuation in accommodative monetary policy in order to get the economy back on track. The labor market is of particular concern. Though unemployment has fallen from 7.9% to 7.3% in 2013, the participation rate has fallen to 62.8%, its lowest level since 1978. This means that fewer people are looking for work and there is still much unused potential in the economy.
In November, the U.S. 10-year Treasury posted its first monthly loss since August. Yields pushed higher at the beginning of the month following a strong payroll number showing an addition of 204,000 jobs. During the month, yields traded in a 28bp range and closed at 2.745%. We expect yields to continue to trade in a narrow range, barring a surprise move by the Fed to begin tapering during its December meeting.
As yields rose, credit spreads compressed further. The extra yield investors demanded to hold HY US credit narrowed 4 basis points in November, according to the Bank of America Merrill Lynch High Yield Index. Default rates were at 1.1% at the end of October and we believe that spreads remain elevated relative to default risk, keeping HY an attractive asset class
Across the Atlantic, the European Central Bank (ECB), surprised markets with a 25bp cut to its main refinancing rate as monetary authorities battle deflationary pressures. Inflation in the Eurozone rose in October to 0.9% from 0.7%, though it remains well-below the ECB target of “close to, but just below 2%.” October was the 10th consecutive month inflation was less than 2%.
Even in the face of a dovish central bank, the euro currency remains resilient. After posting its 2013-high of 1.3802 on October 25, the euro depreciated 3.88% but then recovered 2.45% to 1.3591. A strong euro weighs on exports and poses risks to growth. While confidence measures improved in Europe, business activity fell with the flash composite euro zone purchasing manager's index (PMI) falling to 51.5 in November, from 51.9. Readings were also weaker in France, while Germany’s PMI expanded to 54.3 from 53.2. We expect the euro to weaken in 2014 as we do not rule out the ECB taking additional steps to boost prices through unconventional monetary policy such as negative deposit rates and financing to banks through another LTRO.
In Japan, weaker 3Q13 GDP figures did not stop Japanese equities from continuing to outperform. The Nikkei 225 rose 10.28% in October on expectations that the Bank of Japan (BoJ) will take additional measures to ease monetary policy. In 3Q2013, Japan’s GDP rose 1.9%, following a 3.8% gain in 2Q13. This puts additional pressure on Abenomics to fuel growth and battle deflation. Inflation increased 0.9% in October—its highest level in 15 years. This was the first time since 1998 that inflation was higher in Japan than in Europe.
In China, most of the focus was on the country’s reform agenda and the recently concluded third plenary session of the 18th party congress. The implementation of an ambitious reform package, which encompasses government, land, tax, financial and social safety reform will be critical for enabling China to return to organic growth. China’s PMI hit an 18-month high of 51.4 in November, suggesting an improvement in growth momentum.
Our portfolio allocation strategy continues to favor equities, as they offer the highest risk-premium and are the asset class least vulnerable to a withdrawal of central bank liquidity. We continue to prefer cyclicals over defensives, which outperformed again in November. We increased our allocation towards Europe and are underweight Emerging Market equities given their dependence on QE.
Across credit markets, we are overweight EUR HY rated corporate bonds with an average 3 to 4-year to maturity. For US HY, we do not anticipate a material tightening in spreads as we move into 2014. We prefer short term credit and will hedge out duration risk. We prefer to avoid Emerging Market bonds (local and hard-currency) due to their high-beta status and strong historical dependence on QE.
We remain underweight commodities. A catalyst across this complex was the interim agreement between Iran and the US, together with the P5+1, a bearish development for oil markets. Though the price of Brent crude fell initially, it finished 1.07% higher on the month. Oil sanctions remain in place and Iran is still limited to exports of around 1 million barrels per day. We do not expect additional near-term weakness as a result of this agreement. Gold prices remained under heavy pressure and were down 6.81% on the month. We expect further weakness given the lack of upside catalysts, namely inflation and a weak USD.
A high degree of volatility across financial markets is likely to persist as we enter the new year and transition into a ‘new normal’ of a less expansionary Fed. That is why a proper regional and sector selection strategy, combined with rigorous risk-management should remain the decisive factor for investment performance. As usual, don’t hesitate to contact us to discuss investment performance or financial markets more generally.