One of the themes we highlighted at the beginning of the year was the implications of divergent central bank behavior on asset class performance. As the summer fades from view, this issue is picking up steam. On September 4, the European Central Bank (ECB) implemented a new round of monetary policy easing—including an asset purchase program—aimed at boosting inflation and promoting credit growth. Meanwhile, in the U.S., the Federal Reserve continues to taper its own asset purchase program and could begin to raise rates as early as 1Q15. These divergences, which can also be seen across emerging market economies, demand a careful analysis given the opportunities and challenges they present to investors.
Looking back, equities and fixed income performed strongly in August following July’s modest performances. Government bond yields were the big story this past month, as we observed another leg down in yields for developed market (DM) bonds. The standout was the German Bund 10-year which fell below 1% for the first time and finished the month yielding around 0.885%. This took U.S. fixed income securities with it as the U.S. 10-year Treasury fell 21 basis points (bp) to 2.34%. Elsewhere in Europe, peripheral debt continued its hot streak with the Spanish 10-year falling below its U.S. counterpart to 2.25%.
Unlike the compression in yields which occurred towards the beginning of this year, the one this summer appears to be driven more by a softer economic environment and ECB policy rather than optimism over Europe’s recovery. Indeed, data is showing Europe mired in an economic soft patch with manufacturing data for the monetary union falling to its lowest level since July 2013. Italy has returned to a state of recession and Germany—the continent’s stalwart—is showing signs of weakness. GDP in the Eurozone’s largest economy fell 0.2% in 2Q14 as a slowdown in trade and weaker capital investment contributed to the contraction.
Geopolitical unrest (pick your hot spot)--especially between Ukraine and Russia-- certainly played a role in the bond market’s rally. Europe’s equity markets tell a similar story as the Eurostoxx 50 was down 4.6% off its high at the start of September. It is noteworthy that the DAX, Germany’s benchmark, is the region’s underperformer as investors take a cautionary approach to companies most exposed to Russia. This stands in stark contrast to the U.S. where the Down Jones and S&P 500 each made new record highs in August.
Enter Mario Draghi, the president of the ECB. On September 4, the ECB cut all three of its main interest rates by 10bp, leaving the main benchmark rate at 0.5% and the deposit rate at -0.2%. In addition, the ECB implemented a new round of unconventional monetary easing through a program of buying Asset Backed Securities (ABS) with the objective of spurring credit growth from European banks to the private sector. Meanwhile, the rate cut makes the September and December Targeted Long Term Refinancing Operation (TLTRO)—which provide funding at fixed rates— more attractive for banks. In essence, the ECB is underwriting private sector credit whose measures will keep the euro— which has already fallen around 6.45% from its yearly highs against the dollar—at lower levels. This is a welcomed adjustment for Europe’s exporters. Across the Atlantic, the Fed is on a path towards a normalization of interest rates. The futures market is pricing in a more than 50% probability that the Fed will raise rates in 1Q15. The economy is progressing at a stable clip and the labor market has firmed with the unemployment rate down to 6.2% from 7.3% one year ago. A key question is how much slack exists in the labor market and at what point wages—a key driver of inflation—will increase. Barring an unexpected surprise in the macro data, we believe the risk is that the Fed hikes rates before 1H15.
This divergence in monetary policies has implications for our allocation towards fixed income. At a spread of 380 bp, we believe that the U.S. high yield market is approaching fair value. Following the recovery from July’s outflows, we are comfortable paring back some of our U.S. high yield exposure as we believe that the market will witness increased volatility and outflows as the Fed gets closer to “lift-off”. We are more comfortable with our high yield exposure in Europe given the highly accommodative monetary stance which is likely to persist. The fact that monetary policy in certain emerging market economies—including Mexico and Brazil—has a dovish bias, strengthens our conviction that there is still more juice to extract from the hard currency corporate debt in the emerging markets’ space.
While we remain constructive on equities, we are quite cautious, as we believe that certain segments of this market are starting to look stretched. Earnings season for 2Q14 showed strong performance with earnings growth of S&P 500 companies around 7.7%; 74% reported earnings above the mean estimate. Net margins are at their highs though companies are not yet dealing with wage pressure. In the U.S., we prefer large and mega cap names in cyclical sectors as we believe they continue to offer better relative value. We continue to like Japanese equities. This is based not only on attractive valuations, but also for share price appreciation as the Government Pension Investment Fund (GPIF) considers increasing its allocation towards equities. We also remain constructive on China both on a relative value basis but also as the authorities take measures to ease credit and follow through with some of the reforms targeting state owned enterprises (SOEs) and improving their return on equity.
Meanwhile an array of geopolitical hotspots threatens to cast a darker spell over financial markets. Thus far however oil prices remain contained and we are not seeing contagion. Markets may at some point become vulnerable to an increased focus on an earlier than expected first hike by the Fed. 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.