July 2014 - At Halftime, Markets Remain Well Supported
Notwithstanding a series of unforeseen events in the first half of 2014, risk markets continued to march ahead this year with the S&P 500, Dow Jones Industrial Average and DAX all hitting record highs. The most surprising outcome came from the world’s largest economy as U.S. GDP contracted 2.9% in 1Q14—its weakest nonrecessionary read in the post-World War II-era. Added to this list was geopolitical turmoil in Ukraine, default fears in China, an emerging market sell-off at the beginning of the year and most recently, concerns of an oil price spike given events in Iraq. All failed to produce a massive increase in market volatility. In fact, we have seen just the opposite. Implied volatility—as measured by the VIX Index—is near a seven-year low, leading some to believe that market participants have become too complacent. While we think a more defensive approach in certain asset classes is warranted, we continue to believe that this most-distrusted bull market still has legs to rally further.
As we move into the second half of the year, the current market environment can be characterized by low-to-moderate growth and still ample liquidity. This is despite the fact that global central banks are no longer operating in lockstep with one another, which has broad implications across asset classes.
The U.S. Federal Reserve has indicated it will keep rates low until 2015. Still, risks remain that the Fed will hike rates earlier than it has indicated should inflation come in stronger than expected. In May, the Fed’s preferred measure of inflation—the Personal Consumption Expenditure (PCE) Index—rose to 1.8%, its highest level in more than 18 months.
Across the Atlantic, the European Central Bank (ECB) delivered on its commitment to ward off deflation by pushing short-term deposit rates into negative territory—an unprecedented step for a major central bank. The ECB indicated that it will take additional steps if necessary—including new long-term refinancing operations (LTROs)—to boost lending by banks and ward off the stubborn appreciation of the euro.
Meanwhile the Bank of Japan (BoJ) continues with its Godzillasized balance sheet expansion and while expectations for further easing have been pushed back, we expect that the BoJ will continue with its highly accommodative monetary policy.
Notwithstanding a Federal Reserve which could raise rates faster than expected, and the Bank of England which may be the first major central bank this year to raise rates, the current environment remains one of low rates and low yields on government bonds. In contrast to what many believed at the start of this year—including ourselves-- interest rates in the U.S. have failed to rise materially as the yield on the 10-year Treasury ended the month at 2.53%, down from 3% at the beginning of the year. But a rally in bond markets does not mean risk assets cannot also strengthen and we continue to believe that the current low rate/low inflation/low growth environment will be supportive for equities in the near-term.
Still, valuations appear stretched in some asset classes which requires a high degree of selectivity across regions and sectors. We think an improvement in credit growth in the Eurozone merits increasing exposure to European financials. While equity markets look more stretched in the U.S. than elsewhere, we believe that relative value can still be found by overweighting large-cap cyclical stocks tied to an increase in capital expenditure. Though our view on Japan did not play out in the first five months of the year, key valuation measures look even more attractive. We believe that Japanese equities should benefit from additional structural reforms introduced by the Abe government and increased demand for equities among domestic investors, namely the government pension fund (GPIF) which is expected to increase its weighting towards domestic equities. We are more constructive on emerging market equities as well given the near 25% discount offered relative to developed markets on a 12-month forward P/E basis.
The high yield bond rally continues to advance and spreads have compressed close to pre-crisis levels. We acknowledge that overweight credit might be one of the most crowded trades out there and are therefore taking a cautious approach to credit selection. Corporate issuers—especially in the U.S.—are beginning to increase their leverage and we do not rule out the possibility of a correction in the high yield space in the medium-term. Still, we remain confident in our low duration strategy which protects against a move higher in interest rates. Our allocation is centered around B / BB-rated bonds with 3-5 years till maturity, from U.S. and European corporates with a smaller increase towards hard currency emerging market bonds which offer compelling yields for mainly investment grade companies.
Market accidents might happen, especially when implied volatility is trading at historically low levels. Markets may at some point become vulnerable to an increased focus on an earlier than expected first hike by the Fed. 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.