The last week of February witnessed a material repricing of Federal Reserve policy by financial markets which currently assign a 95% probability the U.S central bank will raise interest rates by 25 basis points when it meets on March 15. This is a sharp increase from the 32% probability the market assigned at the beginning of February and resulted in 2-year U.S. Treasury yields hitting new highs on the year. It is noteworthy that the renewed hawkishness from the Fed did not derail the momentum in U.S. (and global) equity markets which made new highs into the beginning of March. This stands in sharp contrast to previous episodes during the current cycle in which risk assets sold off as the Fed indicated it would tighten policy. We believe this accounts for the fundamental strength of the U.S. economy in which rate normalization is viewed by investors as confirmation that the current business cycle is on solid footing and that we have shifted out of the deflationary mindset which dictated markets in the first half of 2016 and entered a new regime.
The most important feature of this new regime, characterized by higher growth, inflation and interest rates, is the material improvement in the U.S. (and global) manufacturing sector which effectively emerged from a recession in the middle of 2016 as commodities bottomed and Chinese economic activity picked up. February saw continued improvements with the U.S. ISM Manufacturing PMI printing at 57.7, its sixth consecutive increase and its highest read since April 2011. This bodes well for increases in capital expenditure going forward and is consistent with a general reflationary dynamic at play.
At the same time, surveys measuring consumer and economic sentiment are close to their cyclical highs suggesting a partial unleashing of animal spirits which, if actualized, would further promote business spending and corporate profit momentum.
While the Fed’s preferred measure of inflation at 1.7% is still below its official target of 2%, other market based measures of inflation have meaningfully increased over the last few months. Five-year breakeven rates are at 2.14% while five-year swap rates are at 2.3%. Regardless of the measure, the market is pricing in a stronger inflationary backdrop. At the same time, we believe that the Federal Reserve is cognizant of the structural headwinds to inflation resulting from technology and demographics which are likely to keep traditional readings of price rises contained. Nevertheless, the Fed does not want to be too “behind the curve” in which unexpected rises in inflation force it to tighten policy faster than forecast. On these bases, we think the Fed wants to take advantage of the current window of opportunity.
This opportunity is also a function of an improved global dynamic. Over that last couple of years, financial market commentators have noted that this is the most international Federal Reserve in history meaning that international financial conditions are as important as the domestic setup to the Fed’s reaction function. In this regard, the Fed’s setting up the market for another rate hike is indicative of the global and synchronized upswing in growth that is underway.
We are especially encouraged by recent macro data in Europe which strengthens our conviction in being overweight European equities. The Eurozone composite PMI recorded its highest print since April 2011 and is consistent with real GDP growth of 2.5%, according to J.P. Morgan. While this is above our own forecast of 1.5% growth, we believe that growth has the potential to surprise on the upside given the extent to which political risk has dampened investors’ expectations. Money growth, as measured by M1 which is another leading indicator of economic activity, has also rebounded, suggesting the durability of the current cyclical upswing while loan growth to non-financial corporates has also increased and is consistent with double digit earnings growth. Indeed, corporate earnings forecasts for European equities are being steadily upgraded at a higher rate than its developed market peers; consensus is calling for low double-digit earnings growth.
Japan is also seeing additional momentum and earnings are being upgraded as a result of stronger economic activity and the impact of a weaker yen. Importantly, Japanese GDP growth is expected to get a boost from the increase in capital expenditure against a backdrop of fiscal stimulus, still accommodative monetary policy and higher capital expenditure. In February, the Ministry of Finance reported that capex increased 8.5% in the last quarter of 2016, strengthening our view that fiscal stimulus is encouraging private investment. Manufacturing PMI data also continues to trend higher, hitting 53.3 in February, its highest level since March 2014. We continue to be overweight Japanese equities, given the stronger macro backdrop, relatively attractive valuations, and continued increases in dividends and share buybacks which are likely to persist into 2017 given momentum in corporate governance reforms.
February saw a further improvement in China’s economic momentum as evidenced by the rise in producer price inflation which increased 6.9% in January as a result of higher commodity prices and stronger domestic demand. This has led to a steady improvement in corporate profits and is consistent with the further improvement in manufacturing PMI which stands at 51.6, firmly in expansionary territory.
On the back of this stronger global economic backdrop, equity markets continued to perform well in February with the MSCI All-Country World Index (ACWI) up 2.9%. Emerging markets narrowly outperformed their developed market peers, gaining 3.1% according to MSCI indices as emerging market currencies fared well against the U.S. Dollar amid ambiguities surrounding U.S. trade policy and the impact of border adjustment taxes.
Within credit, U.S. high-yield spreads compressed further and delivered 1.6% in total return. At 360 basis points, spreads are only 25 basis points away from their lows of the cycle. While we remain constructive on the asset class given projected returns of between 5.5-7%, we acknowledge that the prospect of additional capital appreciation remains limited given the extent to which spreads have already compressed.
Investment grade credit also generated positive total returns, gaining 1.2% in February as U.S. 10-year Treasury yields declined seven basis points to 2.39% but quickly reversed at the beginning of March as the market discounted additional Fed tightening.
We expect to see a further increase in U.S. 10-year Treasury yields but expect the shorter end of the yield curve to move higher on a relative basis (bear flattening) given its higher sensitivity to Federal Reserve policy. As a result, we have a more cautious view towards investment grade credit in the U.S. but still forecast positive returns given the strong technical dynamic at play amid an environment in which yield remains scarce.
Going forward, we continue to be positioned for a continuation in the reflationary dynamic and prefer equity markets which are more leveraged to the global cycle. In this regard, we believe European and Japanese equities will continue to outperform on a currency hedged basis, both as a result of stronger earnings momentum as well as more attractive valuations. While we remain constructive on U.S. equity markets, we believe that heightened policy risk and extended valuations augur for lower returns relative to other developed markets. We continue to like China and emerging market-Asia which have delivered 9.8% and 9.9% respectively this year according to MSCI indices, given stronger macro momentum, discounted valuations and earnings growth.
The reflationary theme will support risk assets in 2017 though we remain prepared for continued bouts of volatility. Europe has a jampacked political calendar including elections in Germany, the Netherlands, and France. In the U.S., policy uncertainty remains high and we await more clarity on issues related to tax reform and trade policy. Meanwhile, the process of interest rate normalization in the U.S. will generate additional volatility as the Fed responds to higher inflation.
The interplay of these market drivers should give rise to higher volatility and new opportunities. 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.