Risky assets glided higher during the month of August as yearly lows in volatility and narrow trading ranges made for a relatively quiet month for markets. The S&P 500 continued to trade around its all-time highs, but was flat on the month and has registered 37 consecutive days without a 1% move up or down, making it the least volatile month in more than 20 years. While some of this quiet can be attributed to the summer doldrums and lower than average trading volumes, we think the fundamental picture is in the driver’s seat: an ultra-low interest rate backdrop across much of the world combined with a slightly improved global macro picture which has strengthened confidence, albeit from low levels, that markets can continue to advance.
This partially explains the muted market reaction following Federal Reserve Chairwoman Janet Yellen’s comments at the Jackson Hole Economic Policy Symposium. The much anticipated event proved to be somewhat of a non-event , as Ms. Yellen signaled that a rate hike for 2016 was still very much on the table given stronger economic conditions in the U.S. Specifically, she noted continued strength in the labor market, which has added 190,000 jobs on average per month over the last three months, as well as expectations for moderate growth in GDP. The Federal Reserve Bank of Atlanta forecasts annualized GDP growth of 3.5% for the third quarter on the back of stronger private consumption. Since Ms. Yellen gave her speech, the odds of a 25 basis point rate hike have increased to 36% from 28% for September and to 60% from 53% for December. We continue to believe that economic conditions in the U.S. warrant a rate increase and that such a move is unlikely to derail the recent strength in risk assets, though shorter-term volatility is likely to move higher as a result.
The view that a Fed rate hike will not lead to an unraveling of financial markets is supported by the fact that global economic conditions continue to improve. The Citibank Global Economic Surprise Index (CESI) is at 2.7, and hit a two-year high in August. At the same time, monetary policy conditions remain incredibly easy as net global central bank asset purchases are at their highest levels since 2013 according to Citibank. This is likely to keep bond yields artificially low and strengthens the case for holding riskier assets.
Our asset allocation continues to favor equities and corporate credit, both high-yield and investment grade. Within equities, we have maintained our cautious view on the U.S. market, despite its outperformance this year among developed markets. Valuations are demanding with price-toearnings ratios in the 70th percentile of their historic range according to Blackrock and earnings growth expectations for 2017 which appear to be ahead of themselves at 13.2%.
We continue to believe there is more compelling value to be found outside the U.S. given more attractive relative valuations and a more accommodative monetary policy backdrop. We continue to like Japanese equities, which gained 2% in August and outperformed their U.S. and European counterparts. Undoubtedly, the imposition of negative interested rates by the Bank of Japan (BoJ) on January 29 had a detrimental impact on equities, especially within the banking sector, as concerns regarding their profitability dented shares. At the same time, the market interpreted negative rates as a sign that the Bank of Japan had simply run out of options.
Most recently however, we have seen the market begin to price out further rate cuts into negative territory with the focus turning to some combination of fiscal and monetary expansion which we believe is supportive for equity markets. Japan already announced a fiscal package worth 28.1 trillion yen ($276 billion) in July, a portion of which will go towards infrastructure finance and other growth-oriented investment. This prompted a slight steepening in the Japanese yield curve which contributed to the recent outperformance of Japanese banks. The Bank of Japan will hold its next meeting on September 20, where it is expected to announce an additional form of stimulus.
European equities also remain attractive on a relative basis. The macro picture has continued to firm in the euro zone, in spite of the political risks and aftermath of Brexit. Most recently, the PMI Index rose for the second consecutive month coming in at 53.3. Credit growth also remains resilient, as lending to non-financial corporations continued to accelerate in July. This is consistent with a stronger domestic backdrop. European banks gained 6.7% in August, their best monthly performance since February 2015, supported by earnings that beat analysts’ estimates for the first time in a year. Still, inflation continues to remain stuck in neutral, with the most recent gauge of inflation coming in at 0.2%, slightly below expectations. This has strengthened the case for the European Central Bank to extend its Corporate Securities Purchase Program (CSPP) which we expect to be announced before the end of the year.
Our equity allocation to emerging markets continues to be skewed towards emerging market Asia and China which gained 1.8% and 6.2% respectively over the month, outperforming all other geographies and consistent with a general improvement in emerging market fundamentals which has driven $26 billion into emerging market equity funds over the last six months. For Asia ex- Japan, valuations look set to improve further given that earnings expectations for 2016 are at 2%, while earnings are likely to have troughed in the second quarter according to Pinebridge.
The macro backdrop has also improved especially given the depreciation of the region’s currencies which has since stabilized and improved competitiveness. Our China exposure is to the less expensive H-shares market which stands to benefit from the recently approved Shenzhen-Hong Kong Stock Connect which will facilitate investment from mainland China into Hong Kong-listed shares.
On the fixed-income side, corporate credit continued to shine in August. This comes amid an intensification in the the search for yield with the value of negative-yielding bonds rising to more than $13 trillion in August. U.S. high-yield gained 2.2% on the month as spreads narrowed 59 basis points; U.S. high-yield is up 14.5% on the year according to the Bank of America-Merrill Lynch (BoAML) High-Yield Index. European high-yield spreads similarly narrowed 26 basis points, gaining 1.3% on the month, to be up 7.5% on the year. Over the last twelve months, the default rate for the U.S. high-yield market is around 3.5%, slightly above the long-term average of 3.3%. That said, this is largely in the commodity sector; ex-commodities, the default rate is closer to 0.5%. On this basis, we think investors continue to be adequately compensated given yields around 6.3%, according to the Bank of America-Merrill Lynch High Yield Bond Index.
In July, we increased our allocation to hard-currency emerging market corporate credit as both technical and fundamental factors augured well for the asset class, which has gained 2.4% since then. On the technical side, global investors continue to seek out yield and have warmed up to building positions in emerging market debt following three years of major outflows. Indeed, J.P. Morgan expects inflows into emerging market debt to reach $40 billion in 2016, a major shift following the $74 billion that left emerging markets over the last three years. On the fundamental side, the combination of monetary stimulus in China along with a stabilization in commodity prices and slower appreciation of U.S. Dollar has contributed to an improvement in growth expectations for emerging markets. According to the International Monetary Fund (IMF) emerging market GDP growth is expected to increase to 4.7% in 2017 from 4.2% in 2016 and 4.1% in 2015. On these bases, we believe that emerging market credit should do well in the current environment.
Notwithstanding the summer doldrums, we think the current period of low-volatility remains stretched and risks moving higher in the coming months given a variety of policy catalysts including upcoming meetings for the European Central Bank, Federal Reserve and Bank of Japan. And then there is the U.S. election. 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.