August 2016 - The Search for Yield Supports Risks
Updated: Jul 10, 2018
July was a positive month for risk assets as a series of central bank meetings, data releases and corporate earnings announcements supported credit and equity markets. Global equity markets as measured by the MSCI All-Country World Index gained 4.3% on the month, putting it just 3% below its all-time high reached in 2014 while credit spreads continued to narrow.
Concerns over global economic growth have abated somewhat, though we remain in the slow-but-positive growth paradigm. The U.S. remains a standout with its resilient labor market supporting private consumption, as confirmed by recent strong retail sales data. Moreover, cuts in capital expenditure in the commodity and manufacturing sectors are bottoming out. Annualized real GDP growth in the U.S. is expected to be 1.8% for the second quarter vs. 1.1% in the first quarter according to the Atlanta Federal Reserve Board. Markets are now forecasting no more than one 25 basispoint rate hike through the end of 2017, though we believe this view may be too complacent given the potential for additional hikes as inflation pressures grow and wages continue to pick up.
Corporate earnings remain in focus and require material improvements for U.S. equities to make new highs in our opinion. Thus far, U.S. earnings are heading for their fifth straight quarter of declines, dragged down mostly by energy companies’ struggles with low oil prices and a tepid growth. With about two-thirds of S&P 500 index members having reported, earnings have declined 3.3% from a year earlier and sales have slumped 0.5%, but this is still better-than-expected.
Excluding results from energy companies, earnings have risen 1.1% and sales have gained 3%. We could see a rebound in the coming months given what has been a series of stronger data points; the Citigroup index measuring data surprises relative to market expectations turned positive in July for the first time since the beginning of 2015. Consumer confidence, new home sales, retail sales and industrial production have all outperformed estimates.
China's economy, which is being supported by fiscal and monetary policies, has stabilized and official figures are now putting GDP growth for the second half of this year at 6.7%. Over the past 18 months, the People’s Bank of China has made a series of cuts to interest rates and the reserve requirement ratio. They have also loosened prudential controls to free up additional cash for lending. Authorities have been pumping additional credit into banks, companies and local governments, with an additional $244 billion (1.63 trillion yuan) of financing flowing into the economy in June. New yuan loans climbed to 1.38 trillion yuan in June from 940 billion yuan in May. HSBC’s China Monetary Conditions Indicator rose to a fiveyear high in June.
While the political future of the UK within Europe remains uncertain after the Brexit vote, the issue is a local and political one rather than a global one. On July 21, the European Central Bank adopted a wait-and-see approach to the UK’s Brexit decision and will wait for at least its next meeting before deciding whether it needs to take new actions to boost growth in the Eurozone, while leaving open the possibility of fresh cuts in interest rates or an expansion of its quantitative easing program.
In Japan, the yen has surged more than 17.5% against the dollar in 2016, making it the best-performing major currency and frustrating Japanese efforts to restart growth. In a surprise move, the Bank of Japan decided not to cut rates or to buy more bonds on its last meeting on July 29, limiting itself to buying more stocks through exchange-traded-funds (ETFs). It is likely that the Bank of Japan could further cooperate with Prime Minister Shinzo Abe who announced a fiscal spending package worth more than 28 trillion yen ($275 billion) in a bid to revive growth. The Bank of Japan's review of its monetary stimulus program promised for September has revived expectations it could try more drastic maneuvers and adopt some form of “helicopter money”, printing money for government spending to spur inflation. The government could issue 50-year bonds and the Bank of Japan could commit to hold them for a very long time. Other options include creating a special account at the Bank of Japan that the government can borrow from and committing to hold a certain percentage of outstanding government debt or buying corporate bonds.
In July we also witnessed oil and stocks decouple. In the beginning of the year, WTI crude oil and stock markets were strongly correlated which resulted in weaker equity markets as oil sold-off. However in July, while the S&P 500 surged to new highs and gained 3.68%, WTI dropped by 16% and pulled back to its lowest level in more than two months, ending the month at $42. We believe this recent drop in oil prices is more the result of a weaker demand especially for gasoline than a fundamental supply shift in crude. Refineries have been on a buying spree since crude-oil prices began their descent two years ago. But while demand for gasoline has been strong, particularly in the U.S., consumption hasn’t been enough to mop up all the fuel spilling out of refineries resulting in near-record levels of gasoline put into storage around the world, about 500 million barrels in total, according to Citigroup. As a result, we could see oil prices trading in the $40-$45 range for the rest of the year. The past few years’ tight relationship between WTI and energy bond prices has broken down with plenty of issuers taking advantage of the past few months’ conditions to enhance liquidity.