Two and a half weeks ago, global equity markets were down some 10% from their yearly highs. This had some market participants asking whether the sell-off was merely a healthy correction, or something more drastic which revealed current economic weaknesses. As noted in our Special Report (20 October 2014, “Following Recent Sell-Off”) we believe the selloff was foremost driven by the unwinding of crowded trades amid uncertainties over central bank policy that went on to create its own negative feedback loop. This was exacerbated by thin liquidity, especially in the high yield market, and accounted for a large portion of the correction we witnessed this October. Fast forward to the first day of November and both the S&P 500 and Dow Jones reached new highs.
The swift recovery in risk assets should not be interpreted as though global growth concerns are unwarranted. Whether it’s the ”New Normal” or a period of ”secular stagnation”, the real economy as well as financial markets are going to have to get used to a period in which growth is lower and asset price gains are more muted. There are a variety of reasons for this, among them the normalization of interest rates, demographic shifts and general deleveraging.
As investors, it is important to constantly ask ourselves whether, and to what extent the fundamentals have changed. On this basis, we witnessed two major shifts in global monetary policy at the end of the month which show very clearly how economic divergences are giving way to policy diversity among G4 (U.S., Eurozone, Japan and U.K.) central banks. This has broad implications for asset class performance going forward.
In October, the U.S. Federal Reserve closed a chapter on its easy money policy—quantitative easing (QE) —as it ended its monthly asset purchase program which began in 2012.
At the same time, the Fed maintained its language that interest rates will remain low for “a considerable period”, meaning that it still believes improvements in the labor market and U.S. growth outlook is not sufficient to merit a departure from its zero-interest rate policy (ZIRP). The Fed is also telegraphing to the market that once it begins to raise interest rates, the pace at which is does so will be slow and steady.
It is noteworthy that as the Fed closes the book—for now—on quantitative easing, the market is more concerned about deflation than inflation. Standard economy theory would have predicted a much different situation given years of easy money. Inflation expectations as measured by the 10-year breakeven rates are at 1.9%. At the same time, the U.S. Dollar (USD) continues to soar. One implication for this scenario is that the Fed might actually let the USD do the work of tightening financial conditions rather than raising interest rates in the beginning of 2H15. The fact that oil prices—a major component of inflation—have fallen by around 25% from their yearly highs is another factor which could delay—however slightly—the time at which the Fed hikes rates.
Our constructive view on U.S. equities is being supported by healthy earnings with consensus now expecting growth of around 7% for the year. Of the 80% of companies which have reported 3Q14 earnings in the U.S., 78% have beaten estimates. We continue to prefer large-cap, cyclical names and are beginning to see some opportunities among energy names following the recent re-rating.
Across the Pacific, the Bank of Japan took the market by surprise and announced it would raise its Quantitative and Qualitative Easing (QQE) by 30 trillion Yen to 80 trillion Yen ($724 billion). That is equivalent to 16% of Japan’s GDP.
At the same time, the Government Pension Investment Fund (GPIF) announced that it would lower its target of domestic bonds by 25%, increasing its allocation towards Japanese and foreign stocks to 25% from 12% each. This was an issue we had been watching for some time and bolstered our constructive view on Japanese equities. As a result, the Nikkei 225 rose close to 5% on the day the measures were announced.
In Europe, it remains to be seen as to whether the European Central Bank (ECB) will launch “full-blown QE” and purchase sovereign debt in the face of deflation and recessionary risk. What we do know is that European assets—especially equities—have been downgraded as a result of growth concerns spreading to Europe’s core. While we acknowledge the severity of these concerns, we also see reasons for why Europe’s equities could surprise to the upside.
European equities are attractive on a relative value basis. Based on earnings estimates for the current year, Europe trades at 14.2x, while U.S. equities trade at 16.3x. Meanwhile, U.S. corporate earnings are some 50% above their pre-crisis peak, while European corporate earnings remain around 25% below pre-crisis levels. We believe that even small increases in sales can generate nice profit growth. A weaker euro should also benefit Europe’s exporters and we believe the recent action taken by the Bank of Japan provides further incentive for the European Central Bank to depreciate its currency and deliver on its mandate to achieve price stability and increase credit growth and boost inflation. Furthermore, any action taken by the ECB has the ability to further spark a rally in European equities while the weaker macroeconomic data is making it easier for equities to positively respond to small data beats.
Europe’s banking sector is also in better health as evidenced by the ECB Comprehensive Assessment of banks. The results— which were announced at the end of October—showed that Europe’s banks had materially improved their balance sheets. This- along with the transparency the test creates—is likely to help reassure market participants about the health of the banking sector.
A key question is whether this improvement in Europe’s banks will translate into credit growth going forward. Indeed, the ECB hopes to provide additional liquidity through its purchases of asset backed securities (ABS) and covered bonds.
If this fails to spread into the real economy, and if disinflation persists in the Eurozone, the ECB could move towards the outright purchase of sovereign bonds—QE—though this would surely be met with political resistance from the German Bundesbank.
Markets are growing increasingly vulnerable to changing expectations of Central Bank behavior—namely the ECB and Fed. This environment is creating divergences but also opportunities. 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.