More careful selection in a less certain world
Global Markets Outlook - April 2014
MAKING WAY FOR A NEW REGIME
We maintain our baseline economic view that global growth will accelerate this year, supported by the reduced fiscal drag and the lagged effect of stimulative financial conditions. Developed economies could be the chief beneficiaries of these trends. We believe the United States in particular will likely see a further boost to growth without weather-related distortions and with fewer headwinds from private sector deleveraging. In fact, the first US data releases for March point to a bump in consumer confidence and an ongoing improvement in the labor market.
Emerging economies, on the other hand, continue to be challenged by cyclical, structural and idiosyncratic forces, which have prevented the global cycle from moving in a truly synchronized fashion. This has restrained commodity prices, thus holding back inflationary pressures. The absence of inflation augurs for the extension of easy money policies.
While moderate but improving global growth, low inflation and monetary accommodation should remain supportive of risk assets, evidence is building that the markets may be on track to downshift from last years strong gains to a more modest return path. In March, we detected three such signs:
RUSSIA AND UKRAINE TENSIONS PERSIST
The situation is clearly fluid following Russias incursion into Crimea in early March. As we write this, tens of thousands of Russian troops are massed on Ukraines eastern border, and the stakes have risen in the wake of US and European sanctions against Russia and the International Monetary Funds aid package for Ukraine. There are clear incentives for both sides to aim for a de-escalation of tensions. From Russias perspective, the ruble and the stock market have sold off sharply, interest rates have spiked and the economy could face higher inflation and a severe hit to growth.
At the same time, if energy supplies from Russia are disrupted, we suspect that Europes fragile recovery could also take a hit though probably not head back to recession, since direct export and financial linkages are manageable. More generally, countries like the United States and the United Kingdom are less exposed. Still, both sides stand to lose economically in this stalemate, so we hope that cooler heads will prevail.
US FEDERAL RESERVE MODIFIES FORWARD GUIDANCE
The Federal Open Market Committees latest statement and Chair Janet Yellens first press conference offered a new twist on the Feds thinking: Rather than hinging interest-rate forward guidance to the unemployment rate, the policymakers will take into account a wide range of information, including labor market conditions, inflationary pressures and expectations, and financial developments. In other words, the Fed is seeking maximum flexibility. By stating that the target federal funds rate will remain below normal widely viewed at around 4% even after the economy reaches full employment, the FOMC may be attempting to placate the markets. This is a noble mission, to be sure, but risks fueling inflation in either financial assets or general wages and prices.
Accompanying the statement was a revised assessment of the appropriate pace of tightening that showed a higher rate path than the prior projection. In the post-statement press conference, Yellen mentioned that the timeframe for the first rate hike would be about six months after the end of quantitative easing somewhat earlier than had been discounted by the financial markets. Hiking rates sooner would flatten the yield curve, negatively impacting the equity valuations that have been supported by the abundant liquidity associated with a steeper curve. And with multiple expansion going from a tailwind to a headwind, equities would require earnings growth to drive returns.
CHINA EASES FOREIGN-EXCHANGE CONTROLS
The Peoples Bank of China doubled the yuans daily trading band to 2% as a way to proceed with financial liberalization and structural reform. The currencys weakness after this policy change has the added benefit of stimulating the economy, which had slowed sharply in recent quarters amid signs of credit stress. More support could give commodity prices a short-term boost, but a large stimulus package that eases monetary policy and boosts construction and infrastructure spending would add to the credit and capital expenditure excesses once again delaying the necessary economic rebalancing. In our view, China is managing a path toward slower growth that will be difficult to reverse.
While there is no direct link between these three events, a common conclusion can be drawn: Last years strong stock gains, based on multiple expansion, have given way to a new regime of heightened geopolitical tension and a backdrop of shifting liquidity and uncertainty about China all of which have changed the metrics on the risk premium. Market gains will require the economic and earnings environment to show progress, at a minimum, or more likely, upside surprises.
WEIGHING THE TAIL RISKS
The very beginning of 2014 was somewhat surprising, as we saw some of the worst performers in 2013 Indonesian and Indian stocks, materials stocks and gold, for example start off well. In our view, investors would be prudent not to extrapolate this trend going forward, however. What is becoming clear is that the markets initial foray into seemingly inexpensive emerging markets has been tempered by rising tail risks such as Russias annexation of Crimea, the continued slowdown in earnings and the potential for accelerated rate increases in the United States to negatively impact funding costs. By contrast, we are still structurally more positive on equities in developed markets, which have continued to exhibit better earnings growth and higher and improving returns (see Exhibit 1).
The market is trying to weigh whether EM valuations are fully discounting all the risks, but given the nature of these risks, it is hard to say that we have seen the bottom. Without some stabilization of growth and loan defaults in China, the reversal of fiscal deficits in Brazil or the reduction of political risk in Ukraine, Russia, Turkey and Thailand, EM equity risk premia may continue to rise. Consistent with our views in previous monthly outlooks, we are not saying that EM should be avoided, but that stockpicking is going to be the primary means of trying to generate alpha as return dispersion increases. We particularly see opportunities in financials and consumer discretionary.
The trend in US earnings and margins has shown steady improvement over the past few quarters, though top-line growth disappointed again in the fourth quarter of 2013. Nonetheless, we think that earnings can continue to expand and the capital expenditure cycle can improve with drivers such as gains in consumer confidence and sales, high existing capacity utilization and low funding costs. A boost in capital spending will be supportive of sectors such as technology, although we urge caution around the stratospherically priced social networking stocks. We also see opportunities in financials as the yield curve starts to normalize.
We continue to be constructive on Europe but less so than we were last year, as valuations relative to US valuations have returned to historical averages. The markets equity risk premium has normalized, and we do expect that profits will improve as European economies move from contraction to expansion, which could lead returns on equity to also return to normal. In particular, any sign that loan growth and monetary supply are improving could be favorable, enabling companies to consider expanding their balance sheets. One dampening factor that may limit the earnings recovery is the lack of meaningful wage adjustments or structural change. In this environment, we still like domestic cyclicals and selected multinational corporations in sectors such as consumer staples and retailing that have lagged because of EM exposure.
We believe that Japan still provides a tactical investment opportunity because of its significant and increasingly loose monetary policy regime, relatively attractive valuation the market is currently trading at a discount to other developed markets and the contrarian indicator of poor market sentiment. Given the recent appreciation of the yen and the 1 April hike in the consumption tax, along with inflation that is persistently below Bank of Japan targets, we expect another round of easing. Longer term, we think that trend growth could be challenged as the labor force continues to shrink, and we remain skeptical about the lack of progress on structural reforms.1
Overall, investors are starting to get slightly nervous about valuation and the sustainability of the market rally after five years. The economic growth picture is continuing to improve, but the tail risks that had settled down last year are starting to increase again. We think equities could still provide a solid investment alternative to bonds, but we expect that individual stock picking will be required, rather than trying to buy the entire market. In other words, equity investors may proceed, but they should do so selectively.
Fixed income overview
VOTING YEA OR NAY ON BOND SECTORS
In recent months, we have addressed the challenges of searching for relative value in the fixed income markets. Rates have been extraordinarily low for an extended period of time, but we believe they are poised to move higher in response to better macro conditions and gradually less accommodative monetary policy. As a result, coupon income in the most rate-sensitive markets does not offer much of an offset to potential price declines. In addition, spreads in many credit markets have compressed to pre-crisis levels, suggesting that even higher-yielding bonds could offer a relatively modest spread cushion to help absorb the impact of higher rates.
In short, being a bond investor has not been easy. At the sector level, nothing in the bond world looks particularly cheap to us. And at the individual issue level, careful selection is critical because the markets seem increasingly likely to discriminate between the good and the bad.
It may be helpful if we summarize the main currents of thought that have informed our portfolio positioning across the major bond sectors we research, looking specifically at our best arguments for and against overweighting sectors relative to what we deem to be neutral exposure. Since there are some areas where we are finding better value than others, we will also review our picks and pans within sectors.
There are a couple of caveats: We operate from the premise that diversification matters, and that prudence demands a well-diversified approach to risk-taking. Furthermore, everyones idea of neutral differs. We often use market indices as our definition of neutral, but of course risk tolerance varies from one investor to another.
DEVELOPED MARKET SOVEREIGN DEBT
We still favor credit markets, but sovereigns could benefit from a safe-haven trade if geopolitical tensions escalate. Our base case, however, is that US growth and QE tapering are slowly leading the way toward higher yields globally. Our bias has been to favor lower-for-longer rate regimes such as the eurozone, where the central bank may be forced to take easing measures. Moves in other developed market sovereigns may be low beta to moves in US Treasury yields.
Our core expectation is that growth picks up to an above-trend level, QE tapering continues, and US Treasury yields rise. But what if the slower growth experienced lately is not just about the weather? On a valuation basis, the sector remains rich. Short-term rates are still anchored by the Fed, and the long end of the curve is less exposed to tapering, while two- to ten-year yields in the belly look more vulnerable.
US AGENCY AND COMMERCIAL MORTGAGE-BACKED SECURITIES (MBS AND CMBS)
In our view, agency MBS may offer safer spread with better liquidity than credit markets, though the sector is still captive to the technicals of Fed asset purchases and fundamentally overvalued as a result. CMBS may provide better value than agency MBS and an attractive relationship between spread and duration that is, good excess yield for the rate risk accepted but at the cost of more volatility and less liquidity. Within MBS, we tend to favor higher-coupon, shorter-duration pass-throughs and delegated underwriting and servicing (DUS) bonds, while we would avoid lower-coupon, longer-duration pass-throughs.
US HIGH-GRADE CORPORATE BONDS
Investment-grade corporates have tended to offer comparatively low volatility carry. We feel that fundamentals have peaked but remain solid, and demand for new issuance has been strong. But high-grade corporates have modest breakevens, which means that they provide only enough spread cushion to offset a moderate rise in rates. And with spreads relatively tight, the balance of risk is skewed toward widening. We prefer selected BBB-rated industrials, A-rated financials and crossover names credits rated below investment-grade that we believe possess investment-grade fundamentals. We would steer clear of the stretched valuations in the highest quality tiers of the investment-grade corporate bond universe.
US HIGH-YIELD CORPORATE BONDS
If volatility stays low, collecting coupons could mean high-yield corporate bonds outperform again in 2014, especially as defaults also remain low by historical standards. Yet high-yield valuations are rich: Average dollar prices are high and all-in yields are low by historical standards. We favor BB-rated names with the potential for ratings upgrades, while we find that the lowest quality tiers of the high-yield corporate bond market are the most vulnerable.
EMERGING MARKET DEBT (EMD)
In our view, EMD offers reasonably good value relative to other credit markets, with enough spread to absorb higher Treasury yields. On the other hand, interest rates are moving higher and asset flows are still going the wrong way. EM growth has disappointed, and the necessary adjustments could plunge some EM economies into recession. Again, we have found that selectivity based on fundamentals is critically important. In particular, US dollar-denominated sovereigns and corporates have tended to provide better value than local currency issues. Indonesia and India are looking less fragile, but we would proceed with caution on the Terrible Three of Ukraine, Argentina and Venezuela, as well as Russia.
We believe tax-equivalent yields are superior to yields on taxable corporates of comparable quality and maturity, and restrained new issuance is a supportive technical factor. On the other hand, municipal bonds represent a comparatively long-duration asset in a rising rate environment. In addition, legislative, legal and regulatory risks remain, along with unfunded pension liabilities. Within the sector, we have favored essential service revenue bonds for their visible cash flows, and we have been biased toward the lower end of the investment-grade debt spectrum, while we would avoid general obligation bonds, which may not be as safe as once assumed.
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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