Global equity markets staged an impressive recovery in October following their weakest quarter since 2011 at the end of September. The recent monthly advance, in which the MSCI World gained 7.8%, was the strongest for global equities since October 2011. The boost to global risk sentiment was propelled—again—by global central banks. First off was the People’s Bank of China (PBOC) which cut the reserve requirement ratio by 25 basis points (bp) as it seeks to stabilize financial market conditions in China. This was followed by the European Central Bank (ECB) when its president Mario Draghi laid the groundwork for additional quantitative easing come December. With the Federal Reserve on hold, at least until December, a more dovish Bank of England, and the prospect of additional asset purchases by the Bank of Japan, global risk markets were able to rally without a material change to the fundamental growth outlook.
It is noteworthy that this all occurred just as some financial market commentators were preparing eulogies for the impact of future monetary stimulus. Indeed, the ability for central banks to support asset prices through liquidity is increasingly being called into question. While we do not subscribe to the notion that global central bankers have run out of powder, we also recognize the law of diminishing returns as it relates to monetary policy. Without an upgrade to global growth, returns in financial markets are likely to be more subdued than they have been over the last six years, even with highly accommodative monetary policy.
That being said, going into year-end we believe that both equities and credit should remain supported against a backdrop of less expensive valuations, still modest growth, an improvement in investor sentiment and continued support from monetary policy.
The ECB prepared the market for more easing in December. It was noteworthy that Mr. Draghi made a direct comparison with the Swiss National Bank—currently the bank with the largest balance sheet as a percent of GDP. A further loosening of monetary policy could consist of an extension of bond buying to March 2017, though as Mario Draghi indicated the ECB is open to “a whole menu of monetary policy instruments.” The announcement triggered a downward move in the euro, which is down 3.9% against the U.S. Dollar since the middle of September. With monetary policy between the U.S. and Eurozone set to diverge—December could be the first time since May 1994 that the market experiences a Fed hike and an ECB rate cut in the same month—we expect the euro to continue to trade in a lower range against the USD.
The outlook for interest rate normalization in the U.S. is less clear. While the market is almost unanimous in its call for the Fed to raise rates somewhere in the next six months, it is still unclear whether we will see “lift-off” in 2015. In its most recent statement, Federal Reserve chairwoman Janet Yellen indicated that a rate rise was still on the table for December 2015. Prior to the meeting the futures market assigned a 26% probability that the Fed would raise rates in December; the market is currently pricing in a 50% chance as the outlook for international financial conditions has improved and U.S. domestic conditions remain firm.
While the headline 1.5% advance in U.S. GDP for the third quarter of 2015 was well below the 3.9% pace of growth recorded in the second quarter, the details of the report revealed that private consumption held up well rising 3.2%. A slowdown in inventory accumulation could reverse in the final quarter of the year, sending growth closer to the 2.5 to 3.0% range. This, along with still strong gains in the labor market could be sufficient for the Fed to hike.
That being said, it may still be difficult for the Fed to do so just as the ECB and PBOC are further loosening monetary policy, given the deflationary pressures that result from cheaper imports for the U.S. Though it deferred during its most recent meeting, the Bank of Japan could also expand its asset purchase program. A volatile move higher in the U.S. Dollar on a trade weighted basis could weigh again on international financial conditions and prompt the Fed to wait until 2016 before it moves.
What does this mean for our equity allocation? We continue to believe that European equities will outperform U.S. markets into year-end. Support from the ECB, a lower trading range for the euro, and resiliency in leading economic indicators provide a constructive backdrop for European equities into year end. The Eurostoxx 50 is up close to 15% from its late September low, but is still 10% off its 2015-highs. A stabilization in China’s macro data has eased some of the pressure on Europe’s major exporters while a fading of Volkswagen-related headlines helped spur a near 25% rally in the automobile sector from its late-September lows.
U.S. equity markets meanwhile have undergone a change in leadership with healthcare, previously the market leader, taking a backseat as headline risk over drug pricing and crowded positioning exacerbated selling. For the S&P 500, earnings for the third quarter of 2015 have come in on the weaker side at -2.2% on a blended basis. While 76% of companies have reported earnings above estimates, only 46% have done so with sales. While we see relatively less upside in U.S. equities versus Europe, we continue see value within technology which remains the cheapest sector versus history on a relative price to earnings ratio and is showing stronger earnings momentum. Given our view of a still challenged environment for commodities we remain cautious on the energy sector and emerging market equities more broadly given deteriorating fundamentals and the prospect of capital outflows once the Fed hikes.
We continue to have a favorable view of Japanese markets. While the market has sputtered—off nearly 10% from its yearly-highs—we think recent weakness in the macro data will force the hand of the Bank of Japan to expand its asset purchase program. Corporate profit margins continue to rise and Japan is one of the few regions where profits are being revised up, not down.
Within credit, the U.S. high yield market experienced its strongest rally since January 2012. Spreads on the BofA Merrill Lynch US High Yield Index compressed 68bp and currently stand at 597bp. While yields of around 7.5% remain attractive given the current default picture of around 3%, we think October’s rally has capped some of the upside into year end. For European high yield, the fundamental backdrop is slightly more favorable as the area is in a less mature part of the credit cycle compared to the U.S with net leverage for European issuers remaining remarkably stable over the last seven years. In addition, the prospect of expanded quantitative easing by the European Central Bank will provide a tailwind to the asset class and should contribute to further spread compression.
Globally, policymakers are confronting the challenges of how to reflate economies. Continuing down the path of easy monetary policy and expanding current asset purchase programs has been the easiest choice, given the politics associated with implementing fiscal stimulus and structural reforms. In the medium-term, these will be necessary to promote real economic growth. Going forward, we believe the deflationary impulse—driven by demographics, debt and technology—will continue to keep real interest rates low amid a modest growth backdrop. This environment is complicated by higher volatility, especially in currency markets. In our view, generating positive returns requires increased flexibility and the ability to look through periods of higher volatility. In that context, riskmanagement 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.