December 2015 – The Real Divergence Begins
Early in 2015, markets were anticipating the beginning of monetary policy divergence between Europe and the United States. It has taken nearly twelve months, but it appears that December 2015 will finally see this divergence turn kinetic as the European Central Bank (ECB) is likely to expand its monetary stimulus while the U.S. Federal Reserve looks primed to increases interest rates for the first time in nine years. December could well be the first time since May 1994 that central banks in the U.S. and Europe move in opposite directions.
Thus far, the currency markets have been the principle channels through which these expected differences in monetary policy have expressed themselves. This year, the euro has depreciated 12.3% against the U.S. Dollar (USD). Meanwhile, the USD has appreciated 10.6% against a trade-weighted basket of currencies. Interest rate differentials have also widened to decade highs. The difference between the yield on the two-year U.S. Treasury and two-year German government bond has widened to its highest level since 2006. The fact that this has occurred even before the first U.S. rate hike demonstrates the extent to which markets trade off of expected, rather than actual, events.
Notably, it was not long ago when the conditions which are allowing for this divergence were being called into question: namely the strength of the U.S. economy and its ability to weather marginally tighter monetary conditions. The sell-off in global equity markets which occurred this August had many market commentators asking if the next U.S. recession was just around the corner. Three months later, the market is pricing in a 76% chance that the Fed will raise rates this month, suggesting something is more right, than wrong, with the U.S. economy.
While we tend to agree with this prognosis—that growth in the U.S. is on a solid trajectory—not insignificant weaknesses exist. For one, the manufacturing and services sectors are experiencing very different recoveries. The latest U.S. manufacturing PMI figure, which measures the strength of the sector, fell to 52.6, its lowest level in twenty-five months. Indeed, the industrial sector of the economy is sagging as overcapacity, a stronger U.S. Dollar, and collapsing commodity prices have hit company profits. In the third quarter of 2015, earnings from companies in the industrials and basic materials sectors fell 7.2% and 21.9%, respectively, compared to a year ago.
At the same time, domestic demand in the U.S. remains robust. The services sector, which accounts for around 80% of U.S. economic output, continues to expand at a rapid clip. Most recently, the service sector PMI rose to 56.5, a seven month high. The labor market also continues to tighten, with unemployment falling to 5%. Though structural issues remain, including an increase in workers leaving the workforce, the Federal Reserve does not want to wait for inflation to suddenly rise, before it raises interest rates.
The path of monetary policy in the U.S. stands in contrast to Europe, where the European Central Bank is likely to expand the size and/or duration of its asset purchase program, which currently stands at 60 billion euro a month until at least September 2016. Inflation continues to run well-below the ECB target of “below, but close to 2%” and real growth, however resilient over the last year, is still below the first quarter of 2008. While credit conditions have improved, the ECB is determined to ensure that this is translated into higher inflation and accelerating economic activity. The most recent economic data showed that momentum is still on the eurozone’s side as the composite PMI expanded to 54.4 in November, a five year high.
Other central banks are adding complexity to financial markets. The Bank of Japan may still expand its monetary stimulus, as the country is again mired in recession, notwithstanding strong growth in corporate profits and the outperformance of its stock markets. The People’s Bank of China also looks primed to further ease monetary policy as the country balances its transition to more consumption-based economic growth.
What does all of this mean for equity markets? We continue to believe that global equity markets should trend higher into year-end. Our preferred geographic allocations remain Europe and Japan on the basis of monetary support, relatively more attractive valuations, and earnings momentum. We have pared back some of our U.S. equity exposure, as profit margins remain close to all-time highs and as results from the third quarter of 2015 were less than inspiring: compared to last year, sales growth from companies in the S&P 500 fell 4.05% while earnings fell 4.6%. We are more constructive on Asia within emerging markets given better current account dynamics and tailwinds associated with lower commodity prices compared to their Latin American counterparts.
Our view on credit markets is cautiously optimistic, as they have been far less buoyant than their equity counterparts, largely due to continued weakness in commodity markets. Indeed, this year commodity sectors have accounted for three-quarter’s of 2015 total default volumes in the U.S.
Following its October rally of 3.1%, U.S. high yield credit fell 2.2% in November as spreads widened by 47 basis points (bp) to 644bp, retesting a four year high, according to the BofA Merrill Lynch US High Yield Index. U.S. investment grade credit has also languished, with spreads largely unchanged in November against a backdrop of record issuance. European high yield has fared better, rising 0.8% in November as spreads narrowed given a more accommodative monetary policy backdrop and a smaller energy component weighting. While we expect credit markets to trade stronger into year-end, we think returns going forward will be constrained due to ongoing commodity weakness.
It feels as though financial markets are growing more complex each day as investors must contend with divergent monetary policies against a backdrop of historically weaker growth and a higher geopolitical risk premium. At the same time, the deflationary impulse—driven by demographics, debt and technology—will continue to keep real interest rates low. This environment is complicated by higher volatility. 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.