Risk assets continued their move higher through most of April, only to consolidate at the end of the month as a series of factors led investors to reassess market conditions and the durability of the market recovery which began in mid-February. Our view is that a continuation in global growth led by developed-markets, amid improved sentiment towards emerging markets and a highly accommodative central bank landscape should continue to support risk assets going forward.
That said, there are a number of uncertainties which the market would like greater clarity on. Principal among these is the state of the Federal Reserve’s rate hiking cycle and whether the door remains open for rate hike this June. While a 25-basis point rate hike may seem of less consequence for risk assets than U.S. corporate earnings, a rationalization in commodity markets, or stimulus measures in China, the outsized role of the U.S. Dollar (USD) amplifies the importance of any future move by the Fed.
The USD stands front and center within global financial markets. According to Blackrock, 43% of global GDP is tied to the USD in the form of a soft or hard currency peg. This is what makes the Fed a global central bank whose actions have consequences far beyond the borders of the U.S. On this basis, the recent convergence of central bank policy—with the Fed pivoting towards a more dovish stance while the rest of the world’s systemically important central banks pursue highly accommodative monetary policy—has been a key factor driving the rally in risk assets.
This is especially true for emerging market equities, which are up 5.7% this year as per the MSCI Emerging Markets Index, as a weaker USD has eased pressure on their currencies and made their USD liabilities more manageable. The same linkages exist within commodity markets; this year’s rise in Brent crude oil began just days before the USD topped out.
So where does the Fed stand now? This depends on who one asks. The market, as measured by Federal Funds futures, is predicting less than one full rate hike for the rest of the year. The Fed’s own “dot plot” (official estimates of future interest rates) was revised in April to two rate hikes this year, down from four at the beginning of the year. Someone will be proved wrong. Our analysis of the Fed’s most recent monetary policy statement leads us to believe that Fed chair Janet Yellen wants to keep the door open for a rate hike in June but will need to see an improvement in the data to pull the trigger. This is especially true following the release of first quarter GDP growth for the U.S. which at 0.5% on an annualized basis was the slowest pace of growth in two years. That said, most economists expected such weakness given prior inventory builds which cut 0.3 percentage points from growth. The picture looks better going forward with the Federal Reserve Bank of Atlanta estimating growth at 1.8% for the second quarter of 2016.
Outside the U.S., the picture has improved considerably since the start of the year which explains why the Fed omitted from its April 27 statement the risks posed by “global economic and financial developments.” As discussed earlier, part of this has to do with an easing of global financial conditions as a result of this year’s 6% decline in the USD on a trade-weighted basis. The stabilization in data from China has been equally, if not more important, for global sentiment. Manufacturing data from the world’s second largest economy showed a continued expansion with the official PMI at 50.1. This comes as China reported GDP growth of 6.7% for the first quarter of 2016, in line with the government’s revised target of 6.5-7.0%. Aggressive stimulus measures including meaningful credit growth and increased fiscal spending have further eased concerns over a “hard-landing”. The weaker USD has also reduced pressure on China’s monetary authorities to weaken the renminbi whose stabilization has removed one of the most significant tail risks from the market. That said, it is important to acknowledge that these measures, especially a further buildup in credit growth, will require a more difficult rebalancing when the government (or the market) forces a deleveraging event. Our base case is that this does not occur in 2016.
While the stabilization in China should benefit Japan’s economy, equity markets there have meaningfully underperformed their developed market peers as markets are focused on the 14% appreciation in the yen which has bruised sentiment towards Japanese corporates. The decision by the Bank of Japan to maintain its current monetary policy stance in April was negatively interpreted by markets as analysts had expected a further expansion in the bank’s balance sheet. Following the decision, the yen appreciated by 3%, a four-standard deviation move.
That said, we continue to believe that Japanese equities offer compelling value, with the MSCI Japan index trading at 12.6x forward earnings versus 15.7x for the MSCI U.S. Index. At the same time, Japanese companies are still delivering mid-single digit earnings growth, well above their U.S. counterparts. A number of catalysts exist which could reinvigorate Japanese equities including a potential postponement of the VAT increase scheduled for April 2017, an expanded fiscal package which could be announced around the end of May when Japan hosts the G7 summit and additional monetary easing given yen strength and inflation which at -0.3% is running well below the Bank of Japan’s target of 2.0%.
In addition to Japan we also remain constructive on European equities which advanced 2.5% in April. The European Central Bank (ECB) is succeeding in boosting credit growth through its announced EUR80 billion in monthly purchases of government and corporate bonds and targeted longer-term refinancing operations (TLTRO II). At the same time, data continues to show positive, albeit moderate, economic growth for the euro area. According to Markit, the euro area composite PMI continued to show expansion at 53.0 in April while manufacturing new export orders and new business indices both rose.
Our credit positions continued to perform well in April as the U.S. high-yield market returned 4% following an 80 basis point compression in spreads while U.S. investment grade credit narrowed 18 basis points and delivered 1.2% for the month according to Bank of America-Merrill Lynch Indices. We continue to believe that investors are being adequately compensated in high-yield with spreads at 615 basis points given the stabilization in commodity prices, a benign maturity wall for 2016, and the increase in defaults which are well discounted by the market in our view.
April saw a continuation in the broad market rally which we think has further room to run given the stabilization in a number of issues which were plaguing the market at the start of the year. That said, we think the current period of low-volatility remains stretched and risks moving higher in the coming months. Indeed, a range of uncertainties remain, stemming from Chinese growth dynamics, the possibility of a “Brexit”, heightened geopolitical risk and the direction and potency of global monetary policy. 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.