May was another strong month for financial markets as the global synchronized expansion continued to advance against a backdrop of accommodative financial conditions. Global equity markets gained 2.3% as per the MSCI All-Country World Index while volatility remained supressed. Emerging market equities continued to outperform their developed market peers with the MSCI Emerging Markets Index rising 3% and up 18.6% this year versus 11.4% for the MSCI Wold Index. Our view continues to be that developed markets remain firmly in expansion mode as evidenced the steady, albeit moderated, strength in macroeconomic data. In this late-phase expansion, we continue to prefer equities over fixed income and corporate credit over sovereign debt.
In the U.S., the economy remains on firm footing. The recovery in consumers’ balance sheets has supported a solid pace of consumption growth while the labour market continues to strengthen with unemployment falling to a 16-year low of 4.3% in May. Consumer sentiment is around multi-year highs while manufacturing activity is still in expansionary territory with the ISM Manufacturing PMI at 54.9, below the high of the year but well above last year’s level. The Federal Reserve Bank of Atlanta is forecasting second quarter real GDP growth of 3.4%.
Nevertheless, global bond yields have failed to meaningfully rise. In fact, the U.S. 10-year Treasury yield is currently trading around its lowest level of the year at 2.15%, well below what many analysts had expected at the start of the year.
At the same time, the U.S. yield curve continues to flatten with longer end yields falling more than those on the shorter end, suggesting more subdued expectations for future growth. This has contributed to the outperformance of defensive stocks in the S&P 500 which are up 6.4% versus the 3% gain in cyclicals. At the same time, growth stocks continue to meaningfully outperform with the FANG (Facebook, Amazon, Netflix and Google) quartet up 31.5% this year.
Undoubtedly, the inability for bond yields to rise higher is partially due to revised expectations of the Trump administration’s ability to implement its economic policies which include corporate tax reforms, fiscal expansion and regulatory reform. While the market has not given up on this entirely, a delay in the fiscal boost has led to a moderation in inflation expectations which have fallen to 1.7% at time of writing from 2.1% in January according to U.S. five-year breakeven rates.
Of even greater importance however is the strong technical backdrop of fixed income markets, which is exercising an influential force on global bond yields given the enormous demand for income generating assets in a world of still highly accommodative monetary policy. This is evidenced by the fact that global central banks now hold roughly onethird of the $54 trillion tradeable bond market according to J.P. Morgan. The scarcity of yield has further accelerated demand for U.S. bonds and resulted in structurally lower yields. This does not mean that U.S. Treasury yields will not move higher; indeed, rates can still drift higher as the Federal Reserve continues along its path of interest rate normalization and as growth continues to firm. That said, the strong technical dynamic at play, along with the deflationary influences of technology and demographics are likely to keep bonds from moving meaningfully higher in the near-term. This should continue to provide a hospitable environment for U.S. investment grade and high-yield credit which have delivered 3.7% and 4.8% in total return this year respectively.
Lower bond yields in the U.S. have led to a narrowing in interest rate differentials with Europe and have contributed to the depreciation of the U.S. Dollar versus the euro which has appreciated 7% this year. On a trade-weighted basis as well, the U.S. Dollar has weakened 5.35% this year as the market has scaled back its expectations for rate hikes by the Federal Reserve. While the Fed is likely to raise rates when it meets on June 13, the market is pricing in only three additional 25 basis point hikes by then end of 2018. This has helped support the emerging market asset class whose sensitivity to U.S. Dollar strength is well documented.
Our portfolios have benefited from overweight allocations to emerging market Asia and China (H-shares) equities which are up 23.2% and 24.4% this year, respectively. A stronger macro backdrop as evidenced by a material improvement in trade data as well as healthier external conditions have supported investor inflows which were net buyers of Asian equities for the sixth consecutive month in May. While we do not expect the pace of this outperformance to persist, we remain constructive on this asset class.
Our allocation to European equities has also generated strong performance, with the Eurostoxx50 up 10.4% on the year. Indeed, Europe continued to surprise to the upside as the resiliency of its cyclical recovery combined with diminished political risks has boosted demand for the regions’ assets.
Follow through has also been seen on the earnings front as 60.5% of companies on the Stoxx Europe 600 Index reported earnings above expectations. We expect European equities will continue to outperform their developed market peers given the earlier phase of its economic cycle against a backdrop of still highly accommodative monetary policy.
While market volatility has remained relatively depressed over the last few months, we do not expect this to persist, especially given continued policy uncertainty in the U.S., geopolitical clouds and the pace of rate hikes by the Federal Reserve. The interplay of these market drivers should give rise 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 credit. 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.