The first six months of 2016 have been a tale of two halves punctuated by a political shock from the UK which all but ensures an even more accommodative monetary policy backdrop across the globe. This, along with a stabilization in global growth led by the U.S. , further supports the case for risk assets which should show a stronger performance as we move into the second part of the year.
While the decision of British voters to exit the European Union has produced higher volatility across financial markets, this is foremost a political issue and the risk of financial market contagion remains low in our opinion. (Our views on the Brexit were outlined in our note “Post Brexit Market Assessment” from July 27). The U.K. accounts for only 2% of global GDP and the Bank of England has further room to ease monetary policy (a 25-50 basis point cut is expected in the third quarter) and implement non-conventional measures. The political outlook however remains highly uncertain given the leadership vacuum within the Tory and Labor parties and the long road ahead for negotiating a final exit from the EU. While we expect volatility to persist, we think investors will return to market fundamentals as we enter the second half of the year.
This year of two halves began with a massive exodus from risk assets as concerns over the “three Cs”—China, commodities and central banks (i.e. Fed rate hikes)—morphed into global recessionary fears. As global growth expectations stabilized and China implemented fiscal and monetary stimulus, risk assets staged a sharp recovery and the S&P 500 traded within a few percentage points off its all-time highs. The MSCI All-Country World Index recovered 13.5% from its first quarter lows while commodity prices gained 23% as measured by the Bloomberg Commodity Index.
Some of the most notable moves however have taken place in bond markets, which are indicative of the low-but-positive growth paradigm the global economy continues to muddle through as a result of changing demographic trends, meagre gains in productivity and technology’s deflationary impacts. These dynamics continued to exert themselves on fixed income markets in the second quarter of the year which sent yields on developed market bonds to all-time lows.
From the start of 2016, the yield on the J.P. Morgan GBI Global index of developed market government bonds has been cut in half from 1.6% to around 0.85%. The German 10-year government bond now yields -0.12% and the Japanese 30-year government bond, one of the best performing assets in 2016, yields a mere 8 basis points. All told, there is more than $11.5 trillion in negative-yielding sovereign debt outstanding. This dynamic has intensified the search for yield and helps account for why yields on the U.S. 10-year Treasury touched an all-time low of 1.378% on June 30. We believe that continued demand from yield-seeking investors, especially institutional needs from Europe and Japan, will keep longer-end U.S. Treasury yields anchored around the 1.5% area.
Certain asset classes have fared better than others as a result of these historic moves in bond markets. The flattening of the U.S. yield curve over the last quarter, which saw the difference between yields on the U.S. 10-year and 2-year bond fall to 85 basis points helped U.S. investment grade credit put in another solid quarter. In the second quarter, U.S. investment grade spreads narrowed 8 basis points and delivered 3.5%, according to the Bank of America-Merrill Lynch US Corporate Bond Index. We expect to see a continuation in this trend, as demand for U.S. corporate bonds increase amid incredibly low rates in Europe in Japan and less concern over Fed rate hikes. While we are also constructive on European investment grade credit, especially given the European Central Bank’s ongoing purchases of corporate bonds (~$20bn per month), low yields as a result of central bank intervention make the value proposition less compelling.
The environment of slow-but-steady growth and low inflation has also benefited U.S. high-yield credit which returned 5.8% in the second quarter, according to the Bank of America-Merrill Lynch High-Yield Corporate Bond Index. Spreads have staged a remarkable recovery from their February wides of 887 basis points to 612 basis points at the end of the June. The stabilization in oil prices, which gained 37.6% in the second quarter, has also played a major factor, given the 15% weighting towards energy companies in the high-yield index. While we think the bulk of returns in high-yield have already been captured, there is still room for additional spread tightening as an improvement in corporate fundamentals and commodity markets amid highly-expansionary monetary policy support the asset class.
Equity markets continued to underperform global fixed income over the second quarter of the year. While the MSCI All-Country World Index gained 1.2% during the second quarter, it is still 9.4% off its 2015-highs. This is largely due to downward revisions in global earnings growth, stable but below-trend GDP growth, mediocre productivity and an additional risk premia as a result of heightened political risk. That said, we think we are setting up for a more constructive second half of the year for equity markets for three main reasons.
First, second quarter global growth is expected to come in firmer. In the U.S. for instance, the Federal Reserve Bank of Atlanta is forecasting annualized real GDP growth of 2.6% for the second quarter, up from 1.1% in the first quarter.
Second, global monetary policy will become even more accommodative, intensifying the search for yield and widening the risk premium between equity and bonds. Already, the spread between the dividend yield of the Eusostoxx 50 and 10-year German bund is at a record high. The U.S. Federal Reserve is unlikely to raise rates before its meets again in September and the Bank of Japan, European Central Bank and Bank of England are all expected to further cut rates or expand their non-conventional monetary easing.
Third, we are seeing a further stabilization in China’s economy as a combination of fiscal and monetary stimulus is helping guide the country towards its official growth target of 6.5%. This included a 9.4% yearly increase in the amount of loans issued by Chinese banks in May, which was above forecasts. While the expansion in credit, including to state owned enterprises (SOEs) has been criticized for undermining China’s reform agenda, the country’s leadership has indicated these efforts are meant to stabilize growth in the near-term and that a return to domestic consumption-led growth is critical towards a sustainable path ahead.
Within equities, we continue to like Europe despite its recent underperformance. The valuation case remains compelling: European equities (ex-UK) trade at a 15% sector adjusted forward P/E discount to the U.S., according to Credit Suisse. This is consistent with crisis-periods which we think prices in too pessimistic a scenario given the current credit cycle and growth outlook.
Indeed, the macro picture in Europe is encouraging. The most recent Purchasing Manufacturers’ Index (PMI) rose to 52.8 in June, its strongest reading in six months. PMI new orders showed particular strength, and are consistent with GDP growth of 1.8% according to Credit Suisse. Unemployment in the eurozone also continues to trend lower, hitting 10.1% in May, its lowest in nearly five years. At the same time, credit conditions continue to ease and demand for credit among corporates is near its 2007 highs.
We also believe the recent period of Japanese equity market underperformance, largely the result of yen strength, will reverse as the Bank of Japan further eases monetary policy when it meets on July 28. The yen appreciated 8.4% in the second quarter as a flight to safety boosted its value. Further gains could be interrupted by unilateral intervention in the currency market by the Bank of Japan which could reverse a trend in downward revisions to earnings growth. On the macro front, Prime Minister Abe announced the postponement of a 2% increase in the consumption tax which should boost domestic demand while the possibility of a larger fiscal package remains.
The results of the Brexit vote are a classic example of how the wisdom of the crowd can sometimes be vastly off the mark. While predicting the outcome of political events is incredibly difficult, we believe it is of greater importance to have a plan in place should the unexpected come to fruition. This explains our assuming a more tactical approach to our equity allocation to take advantage of sharp rises in volatility and market sell-offs 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.