November 2013 - Bullish Tone into Year-End
Financial markets met political risk head-on in the beginning of October as a 16-day U.S. government shutdown culminated in an agreement to resolve critical fiscal issues down the road. Despite the absence of a resolution, stocks made new highs with the S&P 500 up 23.5% year-to-date as the Federal Reserve maintained its monetary policy stance in its penultimate meeting of the year. Yields on the U.S. 10- year closed around 2.61%, 40 bp lower than where they were in early September.
The shutdown and subsequent fiscal agreement in the US achieved three things. First, it imposed three new deadlines on the U.S. government: budget negotiations must conclude by December 13; government operations will be funded through January 15; and the debt ceiling is lifted until February 7 after which the U.S. Treasury will likely have an additional month before breaching its borrowing limit. Second, it created a fiscal drag whose impact could shave 50bp off of GDP in 4Q13. Third, the shutdown grounded tapering expectations to mid- 2014, buoying risk assets.
There is still a high degree of uncertainty as to when the Federal Reserve will begin to scale back its $85 billion a month asset purchase program. In May 2013, nearly 90% of the Street expected QE infinity; in September, the market was caught off-guard again. Expectations are firmly grounded in March 2014 though there is a tail risk we could get tapering in December. With lower visibility on forward guidance, risk assets are set to grind higher but not without creating volatility on the way. Meanwhile, the U.S. macro outlook continues to improve though we expect that the Fed will put less emphasis on the unemployment rate--which fell one percentage point to 7.2% in October--given the decline in the labor participation rate.
Across the Atlantic, political risks have subsided in the Eurozone (EZ). In Germany, a grand coalition is expected to emerge which will incorporate German Chancellor Angela Merkel's CDU/CSU on the right, and the Social Democratic party on the left. This will help pave the way for introducing a mandate for a European banking union in November. Debt levels are still high among Europe's periphery and programs for Greece and Portugal will likely need to be revised, but not until next year. The lack of fresh negative catalysts in the EZ and political uncertainty in the US pushed the euro to a twoyear high of $1.382 in October while the Euro Stoxx 50 was up 16% year-to-date. The euro however could not hold onto its gains and fell to a two-week low of $1.349 at the start of November on expectations of additional monetary easing from the European Central Bank (ECB).
Indeed, the Eurozone (EZ) recovery remains fragile. While PMI numbers continue to show growth--albeit at a decelerating pace in October, high unemployment and low inflation continue to persist. In October, the annual rate of inflation in the EZ fell to its lowest level in four years at 0.7%. This was the ninth consecutive month the rate has undershot the ECB target of “close to, but below 2 per cent." This has strengthened the case for further expansion in ECB monetary policy and we expect the ECB to maintain is accommodative stance. The spectre of a rate cut when the ECB meets on November 7 is also not off the table as the Central Bank considers lowering borrowing costs to stave off deflationary pressures.
On the emerging market (EM) front, we believe that an environment of high liquidity should support risk assets and that equities will be the main beneficiaries of an improved global macro outlook and loose monetary policy. We are therefore increasing our exposure to EM stocks. Our view is supported by recent PMI data out of China which showed that its manufacturing sector accelerated to its strongest reading in 18 months in October.
We believe that US equity markets will remain supported into the end of the year and continue to favor cyclical over defensive stocks.
In U.S. fixed income markets, we expect bond yields to trade in a comfortable range as we do not expect any surprise from the Fed before the end of the year. Within credit, we favor the US, as default rates remain benign at 1.11%. In this environment, we prefer credit risk to duration risk.
A high degree of volatility across financial markets is likely to persist throughout the end of the year 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.