June 2018 - Summer Heats Up
Updated: Jul 10, 2018
At the beginning of the year, we identified the withdrawal of central bank liquidity as one of the main contributors to a period of higher volatility and tighter financial conditions. This past month revealed to investors just a few of the markets which are most vulnerable to these shifting conditions, especially when politics enter the equation. The stress seen across Argentine, Brazilian, Turkish and Italian assets in the month of May came as a result of bad politics and concerns regarding debt sustainability in a world where the path of least resistance is for bond yields to move higher. Yet despite these market tremors, which produced a -0.2% return for the MSCI All-Country World Index in May, we believe the overall economic backdrop remains strong and maintain our overweight allocation to equities versus fixed income and corporate credit to sovereign bonds.
One of the features of this year's shifting investment landscape has been the outperformance of developed markets equities versus their emerging market counterparts. Year-to-date, the MSCI World Index is up 2.6% versus a -0.28% return for the MSCI Emerging Markets Index. The bulk of this underperformance came in May 2018 as emerging market currencies experienced heavy selling pressure given rising U.S. yields and concerns over debt costs amid a stronger U.S Dollar which rose 2.3% on a trade weighted basis, its strongest monthly return since November 2016. Countries with large current account deficits experienced the biggest selling with the Argentine peso down 17.7% while the Turkish lira fell 10.3% (both to record lows) over the month. Interest rate hikes helped steady the sell-offs though fundamentals in each country remain weak and we continue to prefer obtaining emerging market exposure across Asia whose equities have outperformed the broader emerging market complex by 2% year-to-date according to MSCI Indices and which benefit from better current account dynamics.
Within developed markets, growth momentum has moved across the Atlantic from Europe to the U.S., which is likely to experience nominal growth of around 5% this year on the back of fiscal stimulus and an expansion in private capital expenditure. The strength of the U.S. labor market has been remarkable with the economy adding another 223,000 jobs in May 2018, bringing the unemployment rate down to 3.8%, its lowest level since 2000. A continued firming in wage growth, which rose 2.7% in May, will contribute to stronger inflation which is running at 1.8% as per core PCE. This is only slightly below the Fed's target of 2% which suggests the U.S. central bank will continue along its path of normalization and will raise rates another two or three times this year. Given more than 20% earnings growth expected for companies in the S&P 500 this year, we believe U.S. equities should continue to represent a core holding across portfolios though we continue to prefer Japanese and European equities given more favorable valuations.
While concerns regarding Italy's sovereign debt have returned to the fore, we believe the threat of contagion remains limited and that growth fundamentals across the eurozone will reassert themselves in the coming months. The threat of an Italian exit from the common currency zone remains remote with most Italians still favoring membership. While volatility will remain elevated as the country prepares for new elections we believe the market will begin to price in more positives including the 2.6% decline in the euro versus the U.S. Dollar which should boost corporate earnings and lead to stronger results for the second quarter of 2018.
Corporate credit continued to underperform equities in May, with the Barclays U.S. Aggregate Index up 0.44% versus a 2.9% gain for the S&P 500. This is largely a function of the relationships between U.S. bond yields and credit spreads which have been moving in the same direction. Indeed, year-to-date, the U.S. 10-year yield has increased by 52 basis points to 2.92% while credit spreads for U.S. investment grade have widened 23 basis points to 127 basis points according to the ICE Bank of America-Merrill Lynch Index. We believe this is the result of larger bond supply given the reduction in buying by the Federal Reserve and an increase in hedging costs which reduces demand for U.S. credit from foreign buyers. While high-yield has remained more resilient, the asset class is flat year to date; we continue to expect low, but positive single digit returns over the course of the year as the underlying fundamentals remain strong and as defaults remain low.
Undoubtedly, the market is dealing with a number of moving pieces ranging from politics to trade against a backdrop of less liquidity, higher rates and a slowdown in the momentum of growth. Risk assets have responded in kind. Still, the fundamentals remain encouraging and recessionary risk remains low this year. On this basis, we continue to advocate a strategic long position in equities given our belief in the underlying economic picture. In our view, generating positive returns requires increased flexibility and the ability to look through periods of higher volatility. In that context, riskmanagement 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.