September proved to be yet another difficult month for equities and other risk assets as financial markets discounted a higher degree of uncertainty over global growth. This led global equity markets to post their weakest quarter since 2011 with the MSCI World Equity Index down 9.10%. We appear to entering a new volatility regime as the efficacy of looser monetary policy is being questioned as the sole antidote for low growth. While we do not believe we are on the cusp of a global recession, it is becoming less clear that liquidity can replace real growth as the main catalyst for gains in financial assets. That being said, we believe the current patch of weakness represents more of a mid-cycle slowdown than the beginning of a larger global economic contraction.
This new volatility regime was exemplified by a new range for the CBOE Volatility Index (VIX). Over the last month, the VIX persistently traded above 20 points which stands in sharp contrast to its 4-year average of 15.5 points. The increase in volatility appeared to be driven more by stress in emerging markets than domestic U.S. financial conditions. Indeed, credit default swaps on select emerging Asian government bonds (ie. Indonesia, Malaysia) rose to their highest levels since 2009 while capital continued to leak from emerging market equities leading to a 17.7% decline in the MSCI Emerging Markets Equity Index in the third quarter of 2015.
A key question, for both investors and the U.S. Federal Reserve is to what extent weakness across emerging markets and China can unhinge developed market economies.
The decision by the U.S. Federal Reserve to defer raising interest rates in September was not met with the usual enthusiasm that generally accompanies a dovish policy stance. This was largely due to disproportionate attention that was given to weaker “global financial and economic developments” which the Fed highlighted as a reason to keep rates near zero. A weaker than expected jobs report in September further eroded investor confidence, despite the surge in hiring the U.S. has experienced over the last 12 months. Equities have staged a sharp rebound since then as markets are increasingly pricing out the potential for a rate hike in December with the odds currently at around 30%, down from 42% at the beginning of September.
While a weaker growth outlook is well-priced into emerging market financial assets, financial pundits are increasingly asking whether the U.S. and other developed markets are set the follow a similar, recession-bound trajectory. We think this negativity is overdone and have a more constructive outlook. Notwithstanding a weaker jobs report, unemployment in the U.S. continues to fall and stands at 5.1%. Wages are moving higher, albeit at a slower-than-expected pace, and retail sales are increasing, posting their second consecutive rise in September. The housing market is another bright spot; the National Association of Homebuilders sentiment index is at its highest point in the cycle. Meanwhile, the yield curve remains upward sloping; in anticipation of recessions, the yield curve typically inverts. We expect U.S. GDP growth to come in around around 2.5% in 2015.
The recovery in Europe also continues to track well. Euro PMIs remain firmly in expansionary territory, the German IFO recorded its third consecutive higher reading in September and money supply metrics point to a further pickup in GDP. We expect the Eurozone to grow by around 1.5% in 2015, up from 0.8% in 2014. One area of concern has been the decline in inflation, which fell back into negative territory in September, down 0.1%. This has increased the odds that the European Central Bank will expand its asset purchase program, which currently involves the purchase of €60bn in assets per month until 2016. Such an expansion could include both an extension of the program until 2018 as well as an increase in purchases by around €10 billion per month.
While accommodative monetary policy—whether in Europe, Japan or China— will act as a tailwind to risk assets, we think an improvement in underlying growth will act as the more important driver for markets. To date, most of the weakness has been confined to the manufacturing sector, which makes up only 12% of U.S. GDP and 19% of German GDP. Specifically, an improvement in data from the U.S. as well as incrementally stronger export and manufacturing numbers from China should help rebuild faith that the global expansion is not tipping in the other direction. A material deterioration in the non-manufacturing data would force us to revisit our views on the global growth outlook.
What does this mean for our asset allocation? We continue to remain constructive on Japanese equities. While the Nikkei has fallen close to 19% from its peak in June on global growth fears and disappointing domestic economic activity, we have reason to believe Japan’s equities will finish the year higher. Corporate profit margins continue to rise and Japan is one of the few regions where profits are being revised up, not down. Relative valuations are also attractive as Japan trades at an 8% discount to the MSCI World Index given current price -to-earnings ratios.
Meanwhile, falling inflation expectations have increased the chances that the Bank of Japan will ease monetary policy further. This could include an increase in the current asset purchase program from 80 trillion yen to 100 trillion yen ($830 billion), an extension of the average maturities of Japanese government bonds purchased, a cut to the interest rate on excess reserves, or an increase in the purchases of exchange-traded funds.
We continue to prefer European equities over U.S. equities on the basis of valuations and earnings growth. On measures such as price-toearnings and price-to-book ratios, European equities trade at a 15 percent discount to their U.S. counterparts. It is also noteworthy that foreign flows into European equities have been negative in Q2 and Q3, which provides a more constructive technical picture compared to the U.S. which has not seen comparable outflows. Drilling down, with think the derating of Germany’s DAX may also be overdone. Significant EM exposure and the Volkswagen scandal have pushed the forward P/E ratio of the DAX to an all-time low relative to the MSCI Eurozone. Though uncertainty is still high, we think German equities have room to outperform in the medium-term.
Credit markets have also not been spared recent risk-off behavior. High yield credit has come under increasing pressure over the last quarter with the Bank of America-Merrill Lynch U.S. High Yield BB Index down 0.7% on the year. Indeed, this was the worst quarter for the asset class since the third quarter of 2011 as lower commodity prices, elevated equity market volatility, and higher supply led to spread widening. Currently, high yield bonds are yielding around 8.4%, according to the J.P Morgan High Yield Index, which we believe is adequate compensation given the continued economic expansion in the U.S. which should keep defaults (ex-energy) low. Spreads excluding commodities currently imply a default rate one year from now of 4.8% (6.4% including commodities) which we think overstates the vulnerability of high-yield issuers given the broader fundamental outlook.
This new volatility regime is not fatal and central banks have not exhausted their strength. At the same time, we must be prepared for this higher volatility regime to persist. We continue to identify opportunities amid a landscape which has become more uncertain. This environment is complicated by divergent monetary policies, heightened currency volatility and loftier valuations on financial assets which has 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. 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.