As some signals flash amber, proceed with caution
Global Markets Outlook - March 2014
- The unexpected slowdown in the US economy appears to be due to the unusually harsh winter and a few other temporary factors.
- If we see better data as the weather improves and inventories adjust, then we believe the macro story of stronger growth in 2014 will be validated.
- In that robust growth scenario, interest rates would likely rise, the US dollar would strengthen and equity markets would fare well.
- If we fail to get a bounce back in the data, then growth expectations for 2014 could be downgraded.
- In the case of more anemic growth, interest rates would go lower, the US dollar would weaken and equities would probably decline especially as prospects for revenue gains are jeopardized when cost compression is nearly tapped out.
- Barring a substantial resurgence of volatility, we think that the credit markets may be able to generate excess returns over Treasuries this year.
WEATHER OR NOT, CAN RECENT DATA BE BELIEVED?
A few months ago, the US macro story for 2014 seemed straightforward. Monetary policy remained extremely easy, despite Federal Reserve tapering, and the reduced drag from fiscal policy was seen as a boost to growth. Meanwhile, firmer housing and labor markets were expected to underpin consumer spending. With capital spending's contribution to growth long overdue, corporate sector surveys suggested that a new cycle of business investment was imminent. Thanks to the rekindled expansion in Europe and a secular energy boom, exports were viewed as another positive factor.
Of course, things are never so straightforward, are they? Over the past couple of months, US economic data have come in well below consensus expectations. After weak employment reports for both December and January, poor housing and retail sales data as well as a hiccup in business and consumer confidence, near-term growth projections have been revised downward. Late last year, for example, the consensus expectation was around 2.6% for real GDP growth in the first quarter of 2014. Now, we would not be surprised if growth comes in one-half of a percentage point below that. To add insult to injury, growth for the fourth quarter of 2013, which was initially reported at 3.2%, has been revised down to 2.4%. All of a sudden, rather than gaining momentum as expected, the US economy's growth spurt in mid-2013 could turn out to be yet another head fake pure fodder for those with a bearish view on the recovery.
Enter the polar vortex
US economic data is typically reported as seasonally adjusted, a statistical technique that uses historical seasonal patterns to smooth fluctuations, allowing month-to-month comparisons. December and January data have always been difficult to adjust, and this winter's extreme weather has, in our view, distorted the data to the downside but by how much is hard to tell. Unfortunately, "clean" economic data may not be available until the spring. When the snow melts, the data are likely to normalize, and there could very well be some upside surprises.
In the meantime, Russia's incursion into the Ukrainian region of Crimea has provided a reminder that geopolitical tension has the potential to provoke a risk-off reaction across the financial markets, even if Ukraine's importance to the global economy is limited. Regardless of the politics, Ukraine still faces a funding crisis that will require foreign support.
Give the US expansion the benefit of the doubt
There is little doubt that some of the recent economic moderation is genuine, mainly related to bloated inventories that added to US growth in the second half of last year especially in the auto sector, where the latest data show inventories on dealer lots at roughly 10% above normal levels. Now comes the payback, as discounting and reduced production may be needed to relieve this overstocking. The upshot is that any inventory correction, however temporary, would still be a headwind for the economy over the next several quarters.
On balance, growth is hardly spectacular, but the US economy is making progress, and we expect the recovery to continue for at least the next year or so. Though payroll gains stalled over the past two months, other employment indicators have been more positive. Job openings have increased and consumer assessments of labor market conditions have remained robust. There appears to be pent-up demand for both housing and capital spending. Excluding government cutbacks and the inventory buildup, private demand has been growing steadily at 2.5% 3% over the past year, a reasonable benchmark for the coming four quarters. We expect the second quarter to validate or repudiate the notion that 2014 is going to be a markedly more robust year for growth.
IS IT OK TO PROCEED WITH CAUTION?
Outside the United States, economic data have continued to improve, with UK GDP growth upgraded to 3.4%, global unemployment rates declining, China exports up more than 10% from January 2013 and European purchasing managers' index (PMI) data getting stronger. Yet equity markets have generally remained lifeless on concerns about continued weakness in emerging markets (EM) and an escalation of geopolitical risk given the situation in Ukraine. Nevertheless, we do not expect these concerns or the slowdown in short-term US data to derail the general economic recovery.
US market correction melted faster than the snow
We have been writing that the earnings picture will be the main driver of developed markets (DM) this year. Thus far, US earnings have been on track, though sales growth is still lackluster as gains from further cost-cutting are becoming limited. In the United States, 75% of companies beat estimates, led by financials, materials and technology. Overall, for the year ended in the fourth quarter of 2013, the blended US earnings growth rate was 10.4%.1 For the first quarter of 2014, consensus earnings per share (EPS) estimates have been revised down by 1.3%.2 While we have hoped for some improvement in the capital expenditure cycle to drive earnings further, thus far the preferred use of cash continues to be dividends and buybacks.
From a technical perspective, many near-term signals are flashing amber. During the recent brief correction in the US market, equity investors rotated back into defensives. Volatility has been inching up but remains low. Though we believe that a more sustained US correction is possible, we continue to have a positive longer-term view on the US market for many structural reasons. Our belief, however, is that stockpicking will become increasingly important. Ultimately, our view will turn if we believe there is a probability of an earnings deceleration caused by a recession.
Europe gains on growth
In the eurozone periphery of Italy, Spain, Portugal and Ireland, performance has been robust, prompting us to ask whether this leadership can continue. The macro data flow has been supportive: PMIs have indicated expansion across the board, consumer sentiment has been improving and growth is expected to be in positive territory. The biggest gains in growth are likely to be in Italy (from -1.9% to 0.8%) and in Spain (from -1.2% to 1%).3 Another supportive characteristic has been the ongoing reduction in bond yields, which is helping to ease financial and lending conditions.
On the monetary policy front, the European Central Bank (ECB) could do more, though we do not think there is any urgency. From the ECB Governing Council's perspective, liquid funding markets and functioning bond markets signal that financial stress is lower as bank funding concerns have ended, while both periphery and core economic growth is recovering.
Admittedly, the latest European earnings season was disappointing, mostly due to EM-exposed company weakness and the resulting negative impact of currency translation. Though only 50% of companies beat estimates, the overall trend remains consistent with a recovery cycle. Earnings are still about one-third below the prior peak, and forecasts are quite strong, with consensus EPS growth at 14% likely supported by economic expansion in Europe.4
Under such a scenario, we prefer domestic cyclicals such as autos, media, leisure and financials, which have significant leverage to European activity. Financials have already delivered better than expected earnings from a low base and should continue to benefit as growth rates rise. On the other hand, we remain cautious in the near term about staples, capital goods and chemicals, whose earnings and margins are under pressure and whose multiples are still not cheap relative to history. Above all, we expect to remain cautious on EM exposure as long as volatility stays high in these revenue markets.
Japan needs a weaker yen
Rounding out the developed markets, equity performance in Japan may improve after the recent correction. Fed Chair Yellen's reaffirmation of tapering could allow the US dollar to strengthen and the yen to weaken. With fiscal policy tightening relative to last year, the value-added tax (VAT) on consumption increasing from 5% to 8% and a weaker-than-expected GDP number, the Bank of Japan has again stepped on the monetary easing accelerator, doubling the amount that banks can borrow at low interest to boost growth lending.
Companies that are correlated to the weakening yen should do well, such as autos, auto parts, consumer electronics and financials. Japan's valuations are attractive relative to history and other developed markets, with a one-year forward price-to-earnings ratio (P/E) at 12.5x.5 Furthermore, earnings growth has been strong, with nearly 69% of companies beating expectations.
Emerging markets require selectivity
By contrast, there seems to be no reprieve for emerging markets. In her first congressional testimony, Yellen did not provide any support as she argued that Fed policy is focused on domestic US conditions and that EM countries can adjust their currencies to buffer the impact. Those in Asia have felt the double impact of QE tapering and yen weakening, which is putting pressure on their competitiveness.
EM stress continues to be relatively elevated. For example, China's debt is still growing, reaching 215% of GDP at the end of 2012 according to official government reports.7 January was another month of record loans, suggesting that the Chinese government has yet to move away from a credit-driven growth model and amplifying concerns about a longer-term problem with bank balance sheets. Against this backdrop, EM continues to be a place for stockpickers, and we selectively look at consumer discretionary such as autos, retail, leisure and media, which are trading at large discounts to their DM peers.
In summary, our views on global equities are not likely to change from month to month despite the stops and starts of short-term data. We still favor DM over EM, and we think that stock selection will be the key to relative performance in most markets.
Fixed income overview
DOES THE SCRIPT FOR BONDS NEED A REWRITE?
At the beginning of 2014, we expected that global bond markets would be influenced by moderately above-trend US economic growth, the Fed's policy response, and rising Treasury yields. For most fixed income sectors, we viewed the prospect of higher Treasury yields as a direct or indirect threat to performance. Our response to the challenge of further progress toward US rate normalization and the prospect of an eventual global liquidity contraction was twofold: 1) stay strategically underweight duration versus benchmark indices and 2) seek spread cushion to obtain a measure of protection for total return.
Then, around the middle of January, US macroeconomic data deviated from the consensus view by taking a turn for the worse, and labor, production and consumption data fell well short of expectations. These disappointments were ascribed to a range of factors, with bad weather figuring most prominently. While it is tempting to lay all the blame on such a fleeting cause, there may be more behind the weaker numbers than just a nasty arctic chill.
Some market participants are now questioning whether the benign macro story they embraced early this year needs to be rewritten. The bond markets have sent mixed signals about whether and to what extent they believe the narrative is being revised.
Near-term Treasury rally
In the Treasury market, the combination of weak US data and emerging market turmoil created enough discomfort to propel a safe-haven rally. Short positioning in anticipation of higher rates likely amplified the rally, with some investors scrambling to cover duration underweights. While the rally now appears to have petered out, uncertainty has remained high, allowing Treasury yields to cling to a lower range than was widely expected at this juncture. After two months of disappointment, forecasts for higher Treasury yields have generally been scaled back, although not radically so, and the majority view is that yields will be higher by year-end.
The message from the Treasury market seems to be cautiously optimistic: "The growth story has been temporarily impaired, but not enough to require a major rewrite. While bond yields are still heading higher, they may take a little longer to get there after the recent detour."
Relatively upbeat credit markets
The credit markets paused only briefly in reaction to the bad news, with US high-grade and high-yield spreads widening modestly before shrugging off concerns and returning to pre-Lehman lows. The resilience of spreads is partly technical; primary market activity suggests that investor appetite for credit has remained quite high, with good-quality new deals often heavily oversubscribed. We believe the weight of the evidence has been insufficient to suggest that the macro story will deteriorate enough to warrant lowering expectations for company fundamentals.
The credit markets appear confident that any rate volatility accompanying a reversion to the robust growth story will be manageable. After last year's big jump in Treasury yields, the risk of another sharp spike does seem diminished. And as the "correction" in US equities faded before fully earning the title, the threat to spreads from equity market volatility was quickly defused.
Relative to Treasuries, fixed income risk assets have adopted an even more upbeat interpretation in our view, and the credit markets seem to be saying, "All is well, stay the course. The economic expansion will be healthy enough to provide ample sustenance to credit."
"Risk on" in spread product and equities, along with lower Treasury yields, could also be signaling that the market sees a chance of the Fed tapering the taper. If macro weakness continues even after temporary issues are resolved, then the Fed may be easier for longer.
Speed bump, not broken bull
It is likely that we will be unable to judge the accuracy of these interpretations until we move past weather-related data anomalies. At that point, the markets will decide whether we got over a speed bump which should push Treasury yields higher or whether we need to revise the broken bullish growth story which would pull Treasury yields even lower.
We are inclined at present to favor the speed bump theory: The economy will likely recover from its mid-cycle slowdown and could approach 2.5% 3% real annualized GDP growth later this year. With that in mind, we continue to believe that interest rate risk poses a greater threat to bond investors than credit risk. We have accordingly stayed overweight the credit sectors in our bond portfolios for the carry they offer over the highest-quality debt. This has required an intensive search for the best relative value across markets that look fully valued by historical measures.
Whether a strategy of biasing portfolios toward credit markets can be successful depends, in part, on getting spreads to behave according to expectations. In our view, the risk of a breakdown in the hoped-for negative correlation between spreads and Treasury yields increases as markets become more volatile, while the odds of spreads remaining relatively stable or even compressing slightly are highest in an environment characterized by persistently low volatility. We think we can realistically expect such an environment, as it is difficult to identify clear and present catalysts for higher volatility with the obvious exception of the Ukrainian crisis, which remains extremely fluid and uncertain.
We also believe in the importance of resisting complacency and remaining ready to sacrifice yield for safety, should any change in the prevailing conditions warrant. The kind of extended mid-cycle somnolence we are experiencing does have recent historical precedents. Yet with credit spreads so tight and secondary market liquidity so thin, any threat of higher volatility deserves proper respect. Absent a major resurgence of volatility, however, we see good prospects for credit markets to generate excess returns over Treasuries this year, which could mean modestly positive absolute returns in certain sectors.
These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
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