May 2015- A Month of Market Rotations
The month of April closed with the reversal of a number of crowded trades. The most consensual of these was the reversal in the U.S. Dollar, which fell by 3.9% against a trade-weighted index, its largest monthly decline since 2011. Similarly, the yield on the German Bund posted its largest monthly gain since 2013. As for those less loved trades, Brent crude registered a gain of 17.75% on the month while emerging market equities outperformed their U.S. counterparts by 5.45%.
Do the beginnings of these reversals signal a more fundamental shift in the market setup and returns on risk assets? We tend to believe that not much has changed to the low growth/asset reflation theme we have discussed over the course of the year. Monetary policy remains highly accommodative in Europe, Japan and China which has pushed investors out the risk frontier. This has been compounded by the fear of loss amid negative yielding fixed income securities across the European continent which has added to the attraction of equity markets.
One fundamental setup which has shifted are expectations for deflation, especially in the Eurozone, which are less pronounced following the introduction of the European Central Bank’s 1.1 trillion euro bond buying program. In April 2015, inflation in the Eurozone was flat following four consecutive months of deflation.
A cheaper euro, which raised the price of imported goods and higher energy costs contributed to the flat reading. Bank lending to businesses also picked up in March and gained 0.1%, the first positive reading since March 2012. 10-year U.S. break-evens, which measure inflation expectations, rose to 1.94% from their lows of 1.54% in January.
Turning to risk markets, it is not a coincidence that the markets which are experiencing the most aggressive quantitative easing are also the ones whose equity markets have registered the biggest gains. This partially explains the fact that the Dow Jones is up 1.39% this year, as the market readies itself for the beginning of rate hikes.
Our belief is that growth in the U.S. will pick up in the second quarter of 2015 and will set the stage for the first rate hike, either in September of December of this year. Growth in the first quarter of 2015 printed at 0.2%, well below expectations of 1.0% growth. This is consistent with a pattern of first quarter weakness. Since 2010, the average annualized first quarter GDP growth has printed at 0.6%, while each quarter for the rest of the year has been above 2.5%, according to Blackrock. The decision to raise rates remains data dependent and the Fed will closely monitor increases in wage growth, which increased by 0.3% in March and could mark the beginning of more robust gains.
Our constructive view on equities has been assisted by decent earnings growth for the first quarter of 2015. While earnings in the U.S. are down 0.4%, this is well above expectations for a 4.7% decline for the quarter. In Europe, where around 50% of companies have reported, earnings are up around 6% for the first quarter while in Japan, Topix companies have delivered growth of around 8%.
Notwithstanding the recent outperformance in emerging market equities, our less constructive view continues to be driven by trends in the commodity complex, debt dynamics and political reform. That being said, we increased our exposure to China and emerging market Asia at the beginning of the month at the expense of U.S. stocks given valuations and our expectations for more accommodative monetary policy. China’s H-shares market rose 15.1% in April which was assisted by the 100 basis point cut in banks’ reserve requirement ratio.
High yield credit, both in the U.S. and Europe continued to perform well in April, up 3.58% and 3.11% respectively for the year. The move higher in oil prices has helped U.S. high yield while the back-up in government yields in Europe tightened spreads in Europe. We continue to believe that these markets provide decent carry.
While equity market volatility has remained relatively contained this year, there are a variety of near-term risks which loom on the horizon. These include ongoing negotiations between Greece and its creditors and the prospect of a “Grexit”.
While we believe the risk of serious contagion is far more limited that what it was five years ago, such a scenario would call into question the durability of the single monetary union. Elections in the U.K. this week could also introduce some uncertainty, especially if coalition talks stall on for weeks.
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.