October 2016 - Waiting on the Fed
Updated: Jul 10, 2018
As we move into the final quarter of 2016, we believe there is some upside risk to global economic growth as many of the factors which weighed on the global landscape earlier in the year have mostly subsided. These consisted of a collapse in China’s growth rate, a further decline in commodity prices, the prospect of an aggressive Federal Reserve, and most recently, a Brexit-induced contagion. Structurally, while it will be very difficult for global growth to break-out, the support provided by highly accommodative monetary policy across developed markets combined with the prospect of coming fiscal stimulus is likely to propel risk assets along an upward trajectory. Still, we acknowledge that the slope of that ascent has likely moderated given the maturity of the present economic expansion along with multiples which are trading close to, or above, their long-term averages.
The month of September saw a number of important central bank meetings. In the U.S., concerns over a hawkish Federal Reserve have moderated and the mantra of “lower-for-longer” appears more and more justified. Even in the event that the Federal Reserve raises its benchmark interest rate 25 basis points this December, which remains our base case, the path of interest rate normalization is likely to remain relatively shallow. Indeed, in its most recent meetings in September, the Federal Reserve lowered its forecast for future rate hikes in 2017 from three to two, which partially explains why interest rates at the front end of the U.S. Treasury curve have moved higher than those on the longer end (bear flattening). The Fed futures market is now assigning a 60% probability of a rate hike in December, up from 50% in the middle of September.
Global quantitative easing (QE) continues to dominate markets and ignite the search for yield despite concerns over tapering—the slow reduction in asset purchases by a central bank.
Concerns of this sort, which are reminiscent of the Federal Reserve’s announcement in May 2013 that it would scale back its quantitative easing program and which sent bond yields sharply higher, weighed on bond markets in mid-September and caused the German 10-year Bund to move into positive territory before settling back to -2 basis points. Nevertheless, the policy backdrop remains as easy as ever.
In final quarter of this year, the European Central Bank, Bank of Japan and Bank of England are expected to purchase a combined $506 billion in assets, mostly government bonds. This would be the largest quarterly sum since the Federal Reserve first began its quantitative easing program in 2009. Citibank estimates that the collective balance sheet of central banks is now 40% of global GDP. This effectively reduces the amount of securities available to investors and accounts for the very strong technical backdrop for global credit, especially U.S. high-yield and emerging market debt given the more than $12 trillion in negative yielding debt outstanding.
The investment implications of this landscape are complex. Some investors subscribe to the idea of TINA (There Is No Alternative) and see the backdrop of easy monetary policy as an effective put on all risk assets. While we acknowledge that current liquidity conditions combined with stable growth are likely to support equities and riskier credit into the end of the year, we also acknowledge the diminishing returns on monetary largesse which makes those markets which trade at higher multiples particularly vulnerable.
On this basis, our equity allocation continues to favor markets which trade at more attractive relative valuations but still stand to benefit from easier credit conditions. In this regard, we continue to believe that European equities offer compelling value. The Eurostoxx 50 trades at a major valuation discount to its U.S. counterpart at 13x forward price-toearnings versus 16.1x for the S&P 500. The European benchmark also sports a dividend yield of 3.7% versus 2.2% for the S&P 500. Meanwhile, the macro backdrop in the Eurozone has also improved; most recently, the International Monetary Fund raised its estimate of GDP growth for the Eurozone to 1.7% which historically is consistent with mid-single digit earnings growth.
We also believe there is value to be found in Japanese equities whose benchmark Topix trades at 12.9x forward price-to-earnings, a major discount relative to developed market indices. Japanese equities this year have been challenged by the 16% appreciation in the yen against the U.S. dollar along with the corrosive impact of negative interest rates in the country’s banking sector. The latter explains why the Bank of Japan announced a policy on September 21 of “yield targeting” for the 10-year government bond rather than cutting rates further into negative territory. By doing this, the Bank of Japan hopes to steepen the yield curve and provide some support to its banks. At the same time, the Bank of Japan pledged to overshoot its target of 2% inflation—currently at -0.4%— further cementing its commitment to highly expansionary monetary policy. We believe that as the market progressively discounts a rate hike by the Federal Reserve in December, the yen is likely to weaken and support Japanese equities in the near-term while ongoing fiscal stimulus under the recent electoral success of Prime Minister Shinzo Abe should assist in boosting inflation expectations.
Our equity allocation to emerging markets continues to be skewed towards emerging market Asia and China which gained 10.7% and 14.4% respectively during the third quarter, outperforming other geographies and consistent with a general improvement in emerging market fundamentals. For Asia ex- Japan, valuations look set to improve further given that earnings expectations for 2016 are at 2%, while earnings are likely to have bottomed.
On the fixed-income side, returns from corporate credit moderated in September following a very strong August performance. U.S. high-yield credit, added 0.6% in September, delivering 5.5% during the quarter according to the Bank of America-Merrill Lynch (BoAML) High-Yield Index. European high-yield registered its first monthly loss since June’s Brexit, falling 0.5% given mounting concerns over some banks’ Tier 1 debt and the general health of the sector. Still, the asset class was up 3.5% for the quarter, its strongest all year. Over the last twelve months, the default rate for the U.S. high-yield market is around 3.54%, slightly above the longterm average of 3.3%. That said, this is largely in the commodity sector; ex-commodities, the default rate is closer to 0.5%. On this basis, we think investors continue to be adequately compensated given yields around 6.2%, according to the Bank of America-Merrill Lynch High-Yield Bond Index.
Notwithstanding a brief spike in volatility in mid-September, we think the current period of low-volatility remains stretched and risks moving higher in the coming months given a variety of risk events including a referendum in Italy and most importantly, the U.S. election. 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.