Notwithstanding a mid-month mini correction, global equity markets registered their tenth consecutive monthly gain in August. The MSCI All-Country World Index (ACWI), which stands less than half a percent below its all-time high, returned 0.3% to be up 15.9% on the year as a combination of stronger global growth, healthy corporate earnings, and still accommodative financial conditions generated strong returns across risk assets.
The gains across risk assets came despite a series of headline risks which visited markets over the month and produced the biggest spike in the CBOE Volatility Index (VIX), a measure of S&P 500 Index volatility, since May 2017 and sent gold above $1300 per ounce for the first time this year. It was geopolitics that took that center stage, as North Korea stepped up its bellicose rhetoric towards the U.S. and testfired a long-range missile over Japan on August 28. This was followed up by its sixth nuclear bomb test on September 3. While we continue to believe that neither North Korea nor the U.S. want to see this conflict turn “hot”, these developments have introduced a new layer of risk to markets which we do not expect to dissipate in the near-term. That said, barring a miscalculation, we do not see these development derailing the supportive backdrop for risk assets going into the Fall.
This is largely the result of a constructive global economic backdrop. Indeed, the second quarter of 2017 saw global GDP growth expand by 3.8% on an annualized basis, its strongest quarterly growth since 2010. Global Purchasing Manager Indices (PMI) point to continued growth; in August 2017, the J.P. Morgan global manufacturing PMI printed at 53.1, its highest level since 2011.
Despite the robustness of the current expansion, global bond yields remain relatively depressed. As September began, the global market value of bonds trading with a negative yield stood at $7.4 trillion, up 60% from its low of $4.6 trillion at the start of 2017. Benchmark government yields continued to fall in August with the U.S. 10-year Treasury yield ending the month at 2.12%, its lowest monthly close on the year; in Europe, the German 10-year Bund which closed lower on 20 of 26 trading days in August currently sits at 0.36%. There are a variety of explanations for the inability of rates to move meaningfully higher and which we have discussed in previous market commentaries including: a strong demand backdrop for fixed income assets given demographic trends, the deflationary impact of technology and the very cautious stance that global central banks are taking towards normalizing monetary policy.
U.S. markets in particular are pricing in a very gradual approach by the Federal Reserve. Indeed, futures markets in the U.S. are pricing in only around 80% of a rate hike by the end 2018 and a full hike in the first quarter of 2019. There are a number of reasons for these muted expectations, the most important of which is inflation that has failed to move meaningfully higher. In July 2017, core PCE, the preferred measure of inflation for the Federal Reserve, came in at 1.4%, well below the Fed’s target of 2%. At the same time, despite firm domestic demand and a labor market which is close to full employment, wage growth at 2.5% has also failed to reflect labor market tightness.
Pared back expectations for Federal Reserve rate hikes in conjunction with a European Central Bank (ECB) which is expected to taper its quantitative easing program early next year is at least partially responsible for the euro’s 13.2% appreciation against the U.S. Dollar this year. The next catalyst for the euro will be the ECB Governing Council meeting on September 7, where ECB President Mario Draghi will give further guidance on the timing and pace of its tapering program. The euro’s strength acts as a headwind for inflation and could weaken against the U.S. Dollar should the ECB highlight its deflationary impact. Core inflation of just 1.3% in the Eurozone is well-below the ECB target of “below, but close to 2%” and a euro which continues to appreciate will make achieving this target all the more difficult.
The moves across currency markets are exerting a powerful impact on equity markets. The 9.5% depreciation in the U.S. Dollar on a tradeweighted basis continues to drive emerging market equity outperformance. In August, the MSCI Emerging Market Index gained 2.5% to be up 28.1% on the year versus 14.3% for the MSCI World. While Europe continues to see strong economic momentum with economic confidence at its highest level since July 2011, its equity markets have underperformed as a result of the stronger euro given that around 60% of revenues generated by companies listed on the Eurostoxx 50 are earned abroad. In the U.S., the S&P 500 gained 0.3% to be up 12.2% on the year with gains primarily coming from the technology sector which accounts for 23.4% of the index.
Within credit, U.S investment grade continued to provide decent returns as lower bond yields offset a 7 basis point widening in spreads, leading to returns of 5.45% on the year, according to the Bank of America-Merrill Lynch Index. U.S. high-yield was flat on the month, as lower benchmark yields were offset by a 22 basis point widening in spreads. Year-to-date, U.S. high yield has delivered 6.2% in total return. At 382 basis points, U.S. high-yield spreads are still well below their 20- year average of 550 basis points and suggest that returns going forward will be driven by mainly by coupon as opposed to price appreciation.
As we say good-bye to the summer, investors will need to prepare for a busy September as the market gears up for series of important central bank meetings, debt-ceiling negotiations in the U.S, and a range of geopolitical uncertainties.
All of this could lead to higher volatility and new opportunities. On this basis, we continue to assume a more tactical approach to our equity allocation while maintaining a strategic long allocation. 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.