M E D I A  C E N T E R

  • Sweetwood Asset Managment

August 2017 - Focused on Fundamentals

Updated: Jul 10, 2018


There was no shortage of market narratives for investors to feast on in the month of July to justify moves across financial markets. Each month, there seems to be a new story de-jour to explain the behavior of the market and July was no different with market participants focused on political dysfunction in Washington, quantitative tightening by central banks, and record-low volatility to make sense of the day-to-day (and sometimes hour-to-hour) moves across asset classes. Our outlook meanwhile continues to focus on the medium-term cyclical and structural economic forces at play which we believe are the ultimate determinants of financial market returns. On the basis of these inputs, we continue to remain constructive on risk assets as the global synchronized economic expansion advances and as underlying corporate fundamentals improve against a backdrop of only slowly rising interest rates.



Entering into the year, we believed the global economy was in a much different place than it was 12-months prior as deflationary fears abated and sentiment across both Wall Street and Main Street improved. While the reflationary story has been challenged by structurally lower inflation as a result of technological and demographic forces, underlying growth has meaningfully improved. In its most recent World Economic Outlook released in July, the International Monetary Fund (IMF) upgraded its forecasts for growth in the euro area, Japan and China and affirmed its forecast of 2.8% real global GDP growth, up from 2.6% in 2016.


We are especially encouraged by the macro momentum currently underway in the Eurozone where GDP grew at an annualized rate of 2.3% in the second quarter with unemployment at its lowest level since 2009.


Constructive economic fundamentals along with easy financial conditions produced another strong month for risk assets in July. The MSCI All-Country World Index (ACWI) recorded its strongest monthly gain all year, advancing 2.8% to be up 15.5% on the year. Emerging markets outperformed their developed market peers for the seventh month in a row, delivering 6% in total return, up 26.1% on the year.



Developed market equities returned 2.4% in July and are up 13.7% on the year. Our overweight positions within the emerging market complex continued to outperform. Emerging market Asia equities are up 30.3% on the year while the MSCI China is up 37.3%, its strongest performance since its 2009 recovery from the lows of the global financial crisis. A stronger fundamental backdrop combined with more attractive relative valuations have driven those regions’ outperformance. Developed market equities meanwhile were supported by generally strong results from second quarter earnings season. Around 60% of companies have reported earnings in the U.S. and Europe and 40% in Japan; all three regions have delivered positive surprises according to J.P. Morgan. In the U.S., earnings for companies in the S&P 500 are up 9% with all sectors delivering positive earnings growth. For the year, earnings are expected to rise by double-digits. In Europe, second quarter earnings growth for companies in the Stoxx600 are up 13% while earnings for Japan’s TOPIX companies are up 20%. We continue to expect global corporate earnings to grow by around 12% this year.


July saw a continuation in a number of trends across foreign exchange markets as the U.S. Dollar (USD) continued to weaken on a tradeweighted basis. The 9% fall in the USD Index this year has been attributed to a number of factors including political gridlock in Washington, a series of growth disappointments in the U.S. and the gradual pace of tightening by the Federal Reserve which has led investors to price out another rate hike this year. While it is difficult to isolate any one of these drivers, we believe that a failure by the Trump administration to pass some type of corporate tax reform this year would justify the current USD weakness though we do not expect another major leg down for the greenback and anticipate more range bound trading. On the other end of the spectrum, the euro continued to appreciate versus the USD and is up 12.5% on the year. The most recent leg higher came as European Central Bank President Mario Draghi indicated that it would announce a reduction in the current pace of quantitative easing beginning in 2018 as soon as September 2017. This contributed to a narrowing in the yield differential between U.S. and European 10-year borrowing costs and increased demand for euros. At the same time, the market is now only assigning a 5% probability that the Federal Reserve hikes rates in September, down from 48% in May 2017 which also boosted the euro against the USD. A repricing of the Fed’s interest rate path on the back of stronger than expected inflation in the U.S. would challenge the euro’s recent strength. While markets generally recognize the importance of global central banks moving away from still highly accommodative monetary policy, there is also an understanding that the process will be very gradual barring a jump-step higher in inflation. Central banks themselves are treading with caution given the massive build-up in non-financial debt that has taken place over the last several years which stands at 220% of global GDP according to the Bank for International Settlements, up from 200% in 2011.


July saw a continuation in a number of trends across foreign exchange markets as the U.S. Dollar (USD) continued to weaken on a tradeweighted basis. The 9% fall in the USD Index this year has been attributed to a number of factors including political gridlock in Washington, a series of growth disappointments in the U.S. and the gradual pace of tightening by the Federal Reserve which has led investors to price out another rate hike this year. While it is difficult to isolate any one of these drivers, we believe that a failure by the Trump administration to pass some type of corporate tax reform this year would justify the current USD weakness though we do not expect another major leg down for the greenback and anticipate more range bound trading.


On the other end of the spectrum, the euro continued to appreciate versus the USD and is up 12.5% on the year. The most recent leg higher came as European Central Bank President Mario Draghi indicated that it would announce a reduction in the current pace of quantitative easing beginning in 2018 as soon as September 2017. This contributed to a narrowing in the yield differential between U.S. and European 10-year borrowing costs and increased demand for euros. At the same time, the market is now only assigning a 5% probability that the Federal Reserve hikes rates in September, down from 48% in May 2017 which also boosted the euro against the USD. A repricing of the Fed’s interest rate path on the back of stronger than expected inflation in the U.S. would challenge the euro’s recent strength.


While markets generally recognize the importance of global central banks moving away from still highly accommodative monetary policy, there is also an understanding that the process will be very gradual barring a jump-step higher in inflation. Central banks themselves are treading with caution given the massive build-up in non-financial debt that has taken place over the last several years which stands at 220% of global GDP according to the Bank for International Settlements, up from 200% in 2011.


While this is likely to keep benchmark borrowing costs low, longer end yields are also anchored by a strong technical backdrop given the search for yield dynamic which persists across savers, especially given current demographic trends and the demand for income.


Given our belief that interest rates will rise only moderately with the U.S. 10-year rising closer to 2.75% over the balance of the year, we remain constructive on credit assets. In the U.S., investment grade credit has already returned 4.8% as spreads have narrowed 23 basis points. We remain fully invested with a slight underweight in duration, but recognize that the magnitude of returns will moderate going forward and will come mainly from coupon. High-yield credit should also continue to do well though returns will also moderate given valuations which are richer. High-yield spreads currently stand at 360 basis points, 25 basis points above the cycle low recorded in June 2014.


While market volatility has remained depressed throughout this year, we do not expect this to persist into perpetuity. At the same time, continued policy uncertainty in the U.S., geopolitical clouds and the pace of central bank tightening policy should give rise to higher volatility and new opportunities. On this basis, we continue to assume a more tactical approach to our equity allocation while maintaining a strategic long allocation. 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.

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