October 2017 - The Reflation Trade Returns
Updated: Jul 10, 2018
Global equity markets moved higher in September following a period of consolidation during the summer and produced another impressive quarter of returns, with the MSCI World Index up 5%. The gains recorded in September came as global bond yields moved sharply higher from their yearly lows, suggesting that risky assets are comfortable with a gradual move higher in rates as they reflect a firmer economy and expectations for higher inflation. This relationship is important, especially as the Federal Reserve prepares the market for its third interest rate hike this year and as the European Central Bank begins to draw down its quantitative easing program in early 2018. Against this backdrop, and a synchronized global expansion which continues to move ahead, we continue to remain constructive on global equity markets versus fixed income and credit versus government bonds.
As we move into the final quarter of the year, a range of positive economic fundamentals which ended the deflationary spiral of 2015 and first half of 2016, remain in place. Indeed the second quarter of 2017 saw global GDP growth expand by 3.8% on an annualized basis, its strongest quarterly growth since 2010. A portion of this can be attributed to growth in global trade, which the World Trade Organization estimates at 3.6% for the year, up from 1.3% in 2016. In the U.S., second quarter GDP growth gained 3.1% on an annualized basis and leading economic indicators suggest recessionary risk remains low. While soft spots such as subprime auto lending and the retail sector demand careful monitoring, gradually rising wages against a backdrop of near full-time employment suggest the U.S. can weather further interest rate normalization.
Europe in particular is showing impressive economic momentum, with the manufacturing PMI registering a cycle high in September while the German IFO is close to its highest on record. While data has softened in China recently, both manufacturing and service PMIs show the country remains firmly in expansionary territory while industrial production continues to show improvements across Asia.
The fundamental backdrop described has resulted in a fairly impressive year for global risk assets with the MSCI World up 16.5% year-to-date while U.S and European high-yield are up 7% and 6% respectively, according to Bank of America-Merrill Lynch Indices (BoAML). The emerging market complex continues to outperform as a result of a stronger trade, firm commodity prices, a weaker U.S. Dollar and contained inflation. The MSCI Emerging Markets Index gained 8% during the quarter and is up 28% on the year while emerging market credit gained 2% to be up 6.4% on the year according to BoAML. Our portfolios have benefited from overweight positions in MSCI China and Emerging Market Asia-ex Japan which are up 45% and 32% respectively on the year. While we expect emerging markets to outperform their developed market counterparts in the near-term, we acknowledge that a near-term bottom in the U.S. Dollar could see some consolidation until year-end.
We continue to remain very positive on European equities which outperformed their U.S. counterparts in September as the Eurostoxx50 gained 4.5% versus a 1.9% gain for the S&P 500. A slight weakening in the euro versus the U.S. Dollar at the end of the month played a role in this dynamic, as the market begins to price in further Fed rate hikes. Indeed, the market is now assigning a 70% probability of a 25 basis point hike in December, up from 25% at the beginning of September. The resiliency of European PMIs is likely to lead to additional corporate earnings growth this year which is likely to outperform the U.S., according to J.P. Morgan. At the same time, valuations remain attractive with European equity price-to-earnings ratios trading close to one standard deviation below their U.S. counterparts on a cycleadjusted basis as per MSCI Index data.
Japanese equities showed renewed momentum as the Nikkei 225 gained 3.95% in September, its strongest monthly gain this year. Following its first-half underperformance, we believe the fundamental case for Japanese equities remains strong. Corporate earnings revisions remain more positive than any other developed market while earnings growth for the second quarter was the strongest among its developed market peers. At the same time, Japanese equities are trading more than one standard deviation below the MSCI World on a price-to-book basis. The key item in the near-term will be the snap elections that will take place on October 22 which Prime Minister Shinzo Abe called to firm up his mandate. Our base case assumes that Abe will hold onto his mandate and that Japanese equities will benefit from the gradual move higher in interest rates globally.
While we continue to run a strategic long U.S. equity position across portfolios, it is our least favoured developed market. This is largely the result of valuations which remain the most expensive across a range of valuation metrics compared to other developed market regions as well as the late cycle nature of the expansion as it progresses through its ninth year. That said, the market continues to reward U.S. high tech growth companies, with FANG stocks (Facebook, Amazon, Netflix, Google) up 37% year-to-date. Going forward, we believe that U.S. smallcap stocks, which are up 11% on the year, have room to catch up given they are major beneficiaries of corporate tax reform and a stronger U.S. Dollar which we believe has put in a near term bottom given the likelihood of additional Fed rate hikes in 2018.
Corporate credit spreads continued to grind lower during the third quarter. U.S. investment grade credit returned 1.4% to be up 5.5% on the year, according to BoAML. During September, the 29 basis point move higher in U.S. 10-year yields from their September lows was offset by spread tightening as demand for U.S. investment grade credit continues to remain strong. Spreads on U.S. high-yield credit put in new lows at the end of the quarter, narrowing to 356 basis points from a recent high of 400 basis points in mid-August with the BoAML High Yield Index up 7% on the year. A portion of this came as Brent crude oil moved 20% higher during the quarter as surplus stocks of oil fell. While we continue to believe in the fundamental case for 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.
September, and the quarter more broadly, was characterized by extremely low equity market volatility. The CBOE Volatility Index (VIX), a measure of S&P 500 Index volatility, settled at 9.87 at the end of September, the lowest monthly settlement ever according to Bank of America. We believe a range of headline risks could upset this dynamic, at least momentarily, given the evolution of central bank policy normalization, tax-reform negotiations in the U.S, and a range of geopolitical uncertainties. All of this could lead to 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.