The month of February ended with a stabilization in a number of market issues that had been plaguing risk assets since the start of the year. Fears over an imminent devaluation of China’s renminbi subsided while oil prices ended the month up more than 20% from their lows of the year. These developments, combined with a weaker U.S. Dollar, took equities higher, with the MSCI All Country World Index up 5.8% from its mid-February lows, but still down 6.9% year-to-date. At the same time, global government bond yields continued to trade lower as negative-interest rate policy in Japan and parts of Europe pushed yields to new lows on the year as the spectre of deflation returns to the fold.
The question going forward relates to the durability of the current market stabilization and whether the bounce in risk assets will be supported by an improvement in economic data. Our central scenario remains one of continued, albeit modest growth led by developed markets without a U.S. recession. This should prompt a further recovery in risk assets though markets will seek confirmation in the data before their next leg higher.
The month of March is setting up to be a critical one for financial markets given a series of monetary policy events which are scheduled to take place. The first will be a meeting by the European Central Bank (ECB) on March 10, in which President Mario Draghi is expected to announce a further expansion in its highly accommodative monetary policy. Recent inflation data for the month of February printed at -0.2%, its lowest in a year, which puts additional pressure on the ECB to act.
Whether this comes in the form of an expansion in the ECB’s 60bn euro per month asset purchase program, a further cut in the deposit rate from -0.3%, or both remains uncertain, though we think a further loosening in monetary policy conditions will benefit European risk assets going forward.
While risks to Europe’s recovery have grown over the last month, we continue to expect GDP growth of around 1.6% in the Eurozone which is consistent with high-single digit earnings growth. Credit growth also continues to expand with January’s data showing a further increase in lending to the private sector. This strengthens our conviction that the credit cycle in the Eurozone has further room to grow, an important factor underpinning our constructive view on European equities.
The ECB decision will be followed by a meeting by the Bank of Japan (BoJ) on March 15. We believe the BoJ may increase its monetary stimulus to combat yen strength which acts as a headwind to the corporate sector. Indeed, Japanese equities have come under considerable pressure given this year’s more than 5% appreciation in the yen versus the USD, with the Nikkei 225 down 11.9% year to date. Sentiment was especially dented following the January 29 announcement by the BoJ of negative deposit rates, which led to a major underperformance of Japanese financials as investors showcased concern over bank profitability and net interest margins.
Despite these recent developments, we remain overweight Japanese equities. The monetary backdrop remains supportive with more to come. At the same time, corporate profitability has held up well and we are likely to see an acceleration in share buybacks by Japanese corporates who are sitting on record levels of cash amid share prices that are more attractive.
Capping off the month will be a meeting by the Federal Reserve Open Market Committee (FOMC) on March 15 in which the Fed is highly likely to keep interest rates unchanged given a tightening in global financial conditions and somewhat weaker data in the U.S. including the well documented slowdown in the manufacturing sector. We expect Fed Chair Janet Yellen to strike a dovish tone, while making clear that despite recent financial market volatility, the Fed will continue along its path of rate normalization. This view is supported by the most recent inflation data in the U.S., in which personal core expenditures (PCE) for the month of January printed at 1.67%, its highest reading since February 2013.
We continue to anticipate an acceleration in economic activity in the U.S. that is underpinned by the strength of the consumer. Data from January showed a 0.4% increase in real consumption, a recovery from a weaker-than-expected fourth quarter. This is taking place against a tighter labor market backdrop and an increase in wage growth, which grew 2.5% compared to a year ago in January. The Atlanta Fed’s GDP forecast model is calling for first quarter growth of 2.1%, far from recessionary territory.
And yet, despite data which continues to show the U.S. is not on the brink of a recession, there is still a high degree of risk aversion in financial markets. Cash levels among fund managers are at multi-year highs and investor sentiment remains fragile. Going forward, we believe a further stabilization in some of the epicentres of risk will be required before fresh buying emerges.
Chief among these will be signs that we have seen the lows in the price of oil. While defensive rhetoric from the world’s largest producers—namely Saudi Arabia and Russia—which commits to production freezes is helpful in this regard, the market will need to see real declines in production before oil prices can stabilize in earnest. In this regard, it is not sufficient for Russia to freeze production at 10.8 million barrels per day, a post-Soviet high. Further declines in U.S. shale production will be required which are more likely to be seen in the second quarter of the year when banks renegotiate how much energy companies can borrow and could force some highly-leveraged producers out of business.
A stabilization in sentiment towards China is also required, which we believe is currently underway. First, markets appear less obsessed with the day-to-day movements of the Shanghai Composite and are focused more on China’s domestic growth story and the tools available to policymakers to avoid a hard-landing. Recent statements by the governor of the People’s Bank of China (PBoC), Zhou Xiaochuan, have been encouraging in this regard, providing greater visibility on the government’s intentions towards currency depreciation and monetary stimulus. We expect the PBoC will continue to lower the required reserve ratio (RRR) as it did on February 29 to ease financial conditions and could introduce additional tools to manage downside risks.
Financial markets have not enjoyed an easy start to the year. While global economic data has come in softer than expected, we think the erosion in investor confidence has pushed markets to levels which are unjustified given current recession risk and that fundamentals should improve over the course of the year with the assistance of further monetary stimulus. That said, a range of uncertainties remain, stemming from the possibility of a “Brexit” to the outcome of the U.S. Presidential elections, heightened geopolitical risk and the direction and potency of global monetary policy. On this basis, we continue to assume a more tactical approach to asset allocation to take advantage of financial markets which have gotten ahead of economic fundamentals. 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.