June 2015 – Comfortable in the Middle
We are standing in the middle of a regime change in global monetary policy. Neither at the peak of liquidity conditions, nor anywhere near a global synchronized move towards monetary tightening, markets continue to pivot off of expectations for central bank behavior. Notwithstanding divergences in performance, the broad-based gains across equity markets this year—the MSCI World Index is up 4% on the year—are receiving strong support from still ample liquidity and a global growth outlook which is neither hot enough to induce unwanted inflation, nor cool enough to trigger a recession. This ''goldilocks scenario'', which continued to play out in May as developed market equities outperformed government bonds, should continue to support risky assets going forward. Still, we continue to anticipate divergent performances across regions, largely driven by differences in monetary policies.
Japan stands out in this regard, with the Nikkei up 17.7% this year, making it the top performer among developed markets. In U.S. Dollar terms, the Nikkei has outperformed the S&P 500 by more than 11% in 2015. This outperformance continued into May as the Topix rose for eleven consecutive sessions, its longest winning streak since 2009 on top of strong volumes while the yen touched a 12-year high of 124.
We continue to hold a highly constructive view on Japan’s equity markets which is based not only on the largesse of the Bank of Japan, but a number of the government’s reforms incentivizing greater shareholder friendly activity which are feeding through to equity markets.
According to Nomura, dividends and buybacks among Japanese companies are estimated to have risen by $104 billion in the 12 months ending in March. This is expected to continue, as Japanese companies court a smaller pool of funds held by insurance and pensions. The fundamental picture for Japanese companies has also improved, as earnings are expected to rise by double digits this year. Japanese companies are also seeing the strongest earnings revisions among their developed market counterparts as both firms and consumers benefit from lower energy prices and an expansion in business investment.
In Europe, the macro economic backdrop has improved considerably. In the first quarter of 2015, the euro area grew 1.6% on an annualized basis, its strongest growth in nearly two years. The credit cycle also appears to be turning as the growth of money— known as M1—continues to accelerate suggesting further improvements in economic activity. Fears of deflation have also fallen considerably as the most recent reading on eurozone inflation showed an increase of 0.3%. What’s more, we are only two months into the European Central Bank’s 60 billion euro per month asset purchase program which should contribute to a further expansion in the economy and earnings catch-up among European firms.
This backdrop keeps us highly constructive on European equity markets. The first quarter earnings season is nearly complete and 68% of European companies published earnings per share (EPS) above or in line with estimates, above the 10-year historical average of 63%. For the year, EPS growth is expected to come in at 6.5%.
Greek debt fears have been a drag on the market over the last few weeks as volatility trended higher. While the next key date in the saga is June 5 when Greece faces a 300 million euro payment due to the International Monetary Fund, failure to pay is unlikely to result in the ECB cutting off liquidity to the government. The more important date is July 20 when Greece must pay back 3.5 billion euros in marketable debt to the European Central Bank. We continue to watch the situation closely and expect Greece and its creditors to reach some type of agreement before the end of July.
In the U.S., expectations for stronger growth in the first quarter disappointed with a 0.7% contraction. While temporary factors related to port strikes and weather surely played a role, a strong dollar and weaker spending from the U.S. consumer despite lower oil prices presented headwinds to growth. We think some of these pressures will reverse course in the second half of the year as we are already beginning to see some improvements in the data including housing starts which rose to a nine-year high in May as well as wage inflation and core CPI which moved higher this past month.
Given a more subdued macro backdrop in the U.S. and coming rate hikes by the U.S. Federal Reserve which we think will come this year, we have pared down some of our U.S. equity market exposure. While we do not believe we are at the end of the U.S. bull market, another leg higher in equities is going to require consistently firmer data such that the first rate hike is seen as confirmation that emergency monetary policy is no longer warranted.
Chinese markets soared in May, as continued accommodative policy from the People’s Bank of China and strong domestic retail flows have lifted the Shanghai Composite by 52% this year. These gains were also associated with higher volatility as equities posted a 6.5% decline on May 28, only to recover the following day. We continue to maintain exposure to China’s H-shares market which trades at a discount to equities listed onshore and which continue to trade at a discount to their historical valuations. While we do not believe the China equity rally has entered bubble territory, stronger growth is going to have to show up in the data as bad news can exist as good news for only so long.
As for the high yield markets in both the U.S. and Europe, the asset class has continued to provide respectable returns. In the U.S., the high yield market has returned 3.87% while Europe has provided 3.19%. The recovery in oil prices, with Brent crude up 14% this year, has helped stabilize the high yield market amid the recent spike in bond market volatility in both the U.S. and Europe.
We are in unprecedented times for financial markets as central bank behavior has pushed up valuations on financial assets and incentived greater risk-taking among market participants. In our view, generating positive returns requires increased flexibility and the ability to look through periods of higher volatility.
Notwithstanding the challenges associated with divergent central bank behavior, we believe that opportunities also exist. 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.