February 2014 - Volatility Returns
It did not take long for volatility to return to the market as equity indices in the US, UK, Eurozone and Japan had their worst January since 2010. The S&P 500 lost 3.5% while the US Dollar and gold, traditional safe havens during periods of heightened volatility, gained 1.6% and 3.1%, respectively. Still, it was emerging markets which were the focus of the Street, as the MSCI Emerging Markets Index fell 6.6%.
It is difficult to ascertain the exact source of the anxiety which has greeted markets thus far, though it is instructive that emerging markets have borne the brunt. Fears regarding the shadow banking system in China and the potential default of a very large high-yield trust certainly played a role. So did the decline in China’s PMI which showed a contraction in manufacturing activity. Market jitters were not confined to Asia and spread to other emerging markets, as Argentina devalued its currency to preserve international reserves which have fallen to a seven-year low. Stress also spread to South Africa and Turkey—countries with large current account deficits-whose currencies fell 4.8% and 5.65%, respectively. The central bank of each country raised interest rates to stem the slide in their currencies.
Notwithstanding these weaknesses and fears of contagion, data in January showed that the macroeconomic backdrop in the U.S continues to remains firm. In 4Q 2013, U.S. GDP expanded by 3.2% as consumption and export growth picked up. This followed a 4.1% rise in 3Q 2013. U.S. manufacturing output also improved, gaining 0.3% in December and 6.2% over the quarter.
These improvements helped set the stage for the Federal Reserve to reduce its large-scale asset purchases (ie. Taper) by another $10 bn for the second consecutive month to $65 bn a month. In its statement, the Fed noted that “economic growth has picked up in recent months,” but cited concerns over the strength of the labor market. This was Chairman Ben Bernanke’s final meeting as chairman of the Federal Reserve. Janet Yellen takes over this month.
Across the Atlantic, indicators measuring economic output in the Eurozone continued to expand as the PMI rose to 53.2, its highest levels since 2011. Financial conditions also continued to ease as yields on peripheral debt compressed. Yields on 10-year Spanish bonds fell to 3.62% from 3.96% in the beginning of January. Ireland, which exited a Eurozone bailout program last year, returned to the bond market and issued a 10-year bond in January which is yielding around 3.3%.
Still, disinflation continues to remain a concern in the euro area as inflation printed at 0.7% in December, well below the European Central Bank target of “below, but close to 2%.” This strengthens the case for the ECB to take additional, non-conventional measures such as another LTRO or negative deposit rates, to ease monetary policy which it could do at its next meeting on February 6.
In Japan, the Nikkei fell 8.45% over the month, despite improvements in its macroeconomic outlook, while the Yen strengthened 3.2% on risk aversion. Inflation accelerated in December to 1.3%, a five year high. Prime Minister Shinzo Abe in conjunction with the Bank of Japan hope to achieve inflation of 2% in the next two years. Right now, the market is concerned with the extent to which wages can keep up with inflation, especially as Japan implements a 3 percentage point increase in the country’s consumption tax this April.
Overall, high yield credit markets remained firm despite the sell-off in equity markets. This was largely due to the decline in yields on the 10-year Treasury which fell 39bp to 2.64%.
Despite the recent weakness in equity markets, we remain confident that an improved macroeconomic outlook will set the stage for markets to recover these losses.
In our view, equities continue to offer the highest risk premium and we continue to favor late cyclical stocks in the US and European equities on our conviction for further momentum in the euro area’s recovery.
We believe that high yield credit remains an attractive asset class despite the significant compression of spreads last year as a result of highly accommodative monetary policy. We believe that high yield spreads are still high relative to default rates. We are overweight European high yield through lower rated corporate bonds with an average 3 to 4-year to maturity.
A high degree of volatility across financial markets is likely to persist throughout 2014 and as we 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.