March 2014 - Back Where We Started
Following a bout of volatility and an emerging market-led sell off at the beginning of the year, major equity indices have returned to levels around which they opened this year. Still, volatility remains skewed to the upside, as the market digests a slowdown in positive economic data from both the U.S. and Europe, and tries to decipher the next move of global monetary authorities. Adding to financial market volatility is the recent geopolitical unrest in Ukraine, a key transit hub for Russian energy to Europe. Notwithstanding this potential for higher volatility, our view for a higher growth trajectory remains unchanged.
In the U.S., the S&P 500 recovered its losses and finished the month up 0.6%. Gains were supported by healthy 4Q 2013 earnings growth which is running at around 8.5%, in line with our 2014 Outlook. On the macro front, much is being made of the “weather affect” and the extent to which extremely cold temperatures in the U.S. have contributed to a series of weak data prints. Job growth remains the key metric for assessing the health of the U.S. economy. While the unemployment rate fell to 6.6% in January, the labor participation rate remains at historically low levels. Our baseline scenario is for a gradual tapering of the Federal Reserve’s asset purchases this year, though we believe the Fed will increasingly look at inflation rather than the unemployment rate for assessing the pace at which it tapers. We continue to see growth in the U.S. running at around 3.0% for 2014.
Across the Atlantic, the European Central Bank (ECB) left its main policy rate unchanged at 0.25%. As stated in our 2014 Outlook, we do not discount the potential for the ECB to implement additional non-conventional monetary easing to counter deflationary pressures. Most recently, inflation in the euro area printed at 0.8% for the second consecutive month, well below the ECB target of “below, but close to 2.0%.” The next meeting of the ECB will take place on March 6.
On the macro front, manufacturing data in the euro area stalled, as the PMI fell to 53.0 from 54.0 following four consecutive monthly rises. We continue to believe that growth from Germany and more recently, Spain will support the euro area’s recovery while more accommodative financial conditions should continue to support equities. Yields on peripheral debt moved lower in February, as yields on Greek 10-year bonds fell to their lowest levels since April 2010.
In China, markets focused their attention on the depreciation of the country’s currency, the renminbi, which unexpectedly fell to levels last seen in June 2013. The key question is whether this decline is a policy designed by the People’s Bank of China (PBoC) to stem capital inflows into the country, or signs of greater financial vulnerability. Chinese equities continued to underperform in February and we think current valuations in Chinese stocks are undeservedly low.
In Japan, the Nikkei recovered some of its losses in February, following a month in which the yen sharply appreciated and put pressure on Japanese equities. Flows into the Japanese currency were likely driven by outflows from emerging markets. Inflation continues to strengthen and printed at 1.3% in January while the Bank of Japan implemented additional credit easing measures as part of its plan to achieve 2% inflation. We are continuing to watch growth in Japanese wages as we believe this will be an important factor for monetary authorities and whether they consider additional monetary stimulus.
High-yield credit markets remained firm, helped in part by yields on the U.S. 10-year Treasury which traded in their narrowest band since April 2007, finishing the month at 2.65%. We continue to believe that U.S. Treasury yields will trade at higher levels going forward, which reinforces our conviction to be long credit and short duration. U.S. high yield bonds tightened by 37bp. In Europe, highyield bonds tightened by 35bp.
In our view, equities continue to offer the highest risk premium and we continue to favor late cyclical stocks in the U.S. and European equities on our conviction for further momentum in the euro area’s recovery.
We believe that high yield credit remains an attractive asset class despite the significant compression of spreads last year as a result of highly accommodative monetary policy. We are overweight European high yield through lower rated corporate bonds with average maturities of between three and four years.
A high degree of volatility across financial markets is likely to persist throughout 2014 as we transition into a "new normal" of a less expansionary Fed. That is why a proper regional and sector selection strategy, combined with rigorous risk-management should remain the decisive factor for investment performance. As usual, don’t hesitate to contact us to discuss investment performance or financial markets more generally.