The synchronized improvement in global growth provided a healthy backdrop for global risk assets in the first quarter of 2017 as activity momentum picked up across regions. Annualized global nominal GDP is on track to grow by 6% for the first quarter, a meaningful pickup from the 4.5% annualized growth rate recorded over the last two years. This dynamic helped fuel global equity markets, which had their best quarter since 2013 and returned 6.4% as per the MSCI All-Country World Index (ACWI). Notwithstanding the potential for a period of consolidation in risk markets in the near-term following a strong quarter, we remain constructive on risk assets given the global economy’s emergence from a manufacturing recession which ended last year, a more efficient transmission of monetary policy as central banks move away from automatic balance sheet expansion and the introduction of expansionary fiscal policy across developed markets. All of this is helping to support the reflationary dynamic at play which we expect to persist, albeit not in a straight line.
Improvements across the goods producing sector, along with a softer U.S. Dollar and easing concerns over protective trade policy from the U.S. drove the outperformance of emerging market equities which returned 11.1% during the quarter as per the MSCI Emerging Markets Index. This was the best quarterly performance for the index since the first quarter of 2012. Better conditions for emerging market currencies provided additional support to equities as an accommodative financing environment led to stronger earnings momentum; consensus is forecasting high double digit earnings growth for companies in the MSCI Emerging Markets Index.
Our portfolios benefited from allocations to Chinese (Hong Kong) and emerging market Asia equities which were standouts in the emerging market complex, gaining 13.2% and 14.6% respectively during the quarter. Stocks in China benefited from a stabilization in the renminbi, easing concerns over global trade, and massive inflows from mainland China as a result of the Hong Kong stock connect which allows local investors to access international markets. Positive momentum in the macro backdrop further benefited the asset class. Producer-price inflation remains firmly in positive territory while China’s Manufacturing PMI printed at a 5-year high at 51.8. While we acknowledge China’s debt overhang as a structural issue, we do not see the current credit dynamic derailing growth this year given still expansionary fiscal policy and the second order effects stemming from the 2016 stimulus and rationalization of sectors operating at overcapacity.
Developed markets similarly put in a strong performance, with the MSCI World Index up 6.5% over the quarter. Eurozone equities outperformed their peers, delivering 7% over the quarter. We continue to be overweight Eurozone equities as a result of more attractive valuations and the resiliency of its cyclical recovery which is leading to consistent earnings upgrades. The first quarter of 2017 saw a further improvement in the region’s macro picture; the Eurozone composite PMI printed at 56.7, a 71- month high while employment growth expanded by its most in a decade as both the services and manufacturing sectors responded to rising book orders. Money growth, as measured by M1 which is another leading indicator of economic activity, also rebounded, suggesting the durability of the current cyclical upswing while loan growth to non-financial corporates has also increased and is consistent with double digit earnings growth. While we acknowledge the risks associated with upcoming elections, principally in France, a large degree of uncertainty is already priced by the market. Furthermore, we believe that a victory by Emmanuel Macron could drive another leg higher in Eurozone equities given the amount of pessimism currently discounted by markets.
Elsewhere, Japanese equities as measured by the Nikkei 225 underperformed their developed market peers and fell 1.1% on the quarter as the yen appreciated 5% against the U.S. Dollar. The past three months however have not altered our constructive stance towards Japanese equities. Indeed, global economic forecasters have revised upwards their estimates for Japanese GDP growth given a range of positive data surprises spanning industrial production, net exports, and consumption. At the same time, valuations remain at relatively attractive levels amid estimates for double-digit earnings growth.
U.S. equities returned 6.1% for the quarter but have been fairly muted since the S&P 500 touched a record-high on March 1, having shed 1.25% since then. The prevailing narrative attributes this loss in momentum to the collapse of the Trump healthcare bill which sought to reform the American Healthcare Act (ACA) and is indicative of future political gridlock that the Trump administration will face in passing a number of its tax and fiscal reforms. From the beginning of the year, we believed that U.S equity markets were pricing in too smooth an implementation of Trump’s legislative agenda. While we continue to have a constructive view of U.S. equities given high single-digit earnings growth and a robust economic backdrop, we do not discount the possibility of higher volatility which will provide a more attractive entry point for exposure. Furthermore, our neutral view on U.S. equities is also premised on a relatively modest outlook for forward returns compared to other developed markets given elevated valuations; the S&P 500 cyclically adjusted price-to-earnings (CAPE) ratio is currently at 29x, roughly 74% above the long-term average.
In fixed income, the U.S. 10-year Treasury yield ended the quarter at 2.38%, six basis points lower than where it began the year, challenging the reflationary theme which posited that bond yields would only be lifted higher. The quarterly open and close obscures the wider range yields traded in as yields touched 2.62% on March 13 but fell after the Federal Reserve raised rates 25 basis points on March 15, its third rate hike this cycle. Bond markets interpreted the Fed’s guidance as a “dovish hike” given that it did not change its forecast for two additional hikes this year and another three hikes next year, despite inflation which is running close to the Fed’s target of 2%. Overall, the U.S.
Treasury curve flattened as shorter-end rates moved higher thqn yields further along the curve. While we believe that U.S. Treasury yields will move higher over the course of the year, we do not see the 10-year Treasury yield moving well above 3% given the structural demand for yield in a world of still very low interest rates. In this regard, we think the U.S. Treasury curve will bear flatten going forward as the Fed further normalizes interest rates.
As a result of slightly lower U.S. Treasury yields, U.S. investment grade credit delivered positive returns of 1.5% on the quarter as spreads narrowed six basis points to 137 basis points. High-yield credit had to contend with the influence of rising, then falling rates, softer oil prices, and investor outflows which by mid-March had unwound the $8bn in inflows high-yield took in since the U.S. presidential election. That said, high-yield still managed to return 2.7% over the quarter as spreads narrowed 30 basis points to 392 basis points. Spreads are currently only 57 basis points from the low of the current credit cycle recorded in mid-2014.
Going forward we continue to have a constructive view on high-yield credit. While default rates are likely to trend lower of the next quarter following the inflection point last year, the technical picture remains very strong as a result of demand for short-duration spread product. Going forward, we continue to be positioned for a continuation in the reflationary dynamic and prefer equity markets which are more leveraged to the global cycle. In this regard, we believe European and Japanese equities will outperform on a currency hedged basis, both as a result of stronger earnings momentum as well as more attractive valuations. While we remain constructive on U.S. equity markets, we believe that heightened policy risk and extended valuations augur for lower returns relative to other developed market peers. We continue to like China and emerging market-Asia given stronger macro momentum and earnings growth.
While volatility remained relatively depressed over the quarter, we do not expect this to persist, especially given the first round of French elections which will be held on April 23 along with the policy uncertainty that surrounds U.S. tax and trade policy. Meanwhile, the process of interest rate normalization in the U.S. will generate additional volatility as the Fed responds to higher inflation.
The interplay of these market drivers 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 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.