April 17, 2012
This year’s rally in risk assets lost some steam during the last month, as concerns rose over European debt and global growth. Investors were discerning, punishing European banks the most harshly (down 10%), while U.S. equities were relative outperformers (falling 2%). Corporate credit remained well bid, while 10-year U.S. Treasury yields took a round trip from 2% to 2.4% and back again. Oil prices, both Brent sweet crude and West Texas Intermediate, are off their recent highs. We expect market focus to be dominated by economic growth and the European fiscal situation, with the upcoming potential U.S. fiscal cliff and oil prices secondary risks.
The weak March U.S. jobs report caught investors by surprise, but we think it’s reflective of the muted growth environment faced by developed nations. U.S. economic activity likely was boosted in the first quarter by exceptionally mild weather, and we should expect some payback during coming months. European growth continues to be suppressed by austerity programs, while overall emerging-market growth remains solid. Chinese growth in the first quarter may have been modestly disappointing, but its economy appeared to gain momentum as the quarter progressed. Global financial markets continue to depend on G-2 (United States and China) economic growth to underpin global growth and investor risk appetite as Europe deals with its ongoing fiscal challenges.
Even though market concerns around the European debt crisis have started picking up after a quiet interlude, we don’t expect a riotous breakout. To some extent, policy makers understand that market pressures are needed to force difficult change. It’s no coincidence that Silvio Berlusconi resigned as Italian prime minister last November as Italian bond yields were striking their peak levels of 7.25%. We expect continued market volatility around the Greek and French elections this spring. As long as U.S. and Chinese growth meets expectations (our base case), we expect the European debt crisis to be a manageable irritant.
Potential year end dividend tax increases shouldn't lead to abandonment of dividend-paying stocks.
Higher yielding stocks remain attractive given company fundamentals and demographics.
Although dividend tax rates are expected to increase from the current level of 15%, they may only increase to be in line with long-term capital gains rates. While the tax impact is important, it isn't the major driver of returns — even for stocks with high dividend yields. We feel high-dividend-paying stocks remain attractive because companies are expected to increase payouts from current low levels. In addition, the stocks should benefit from the continued demand for income created by an aging population. Also, if market volatility increases, investors tend to flee toward the relative safety of dividends, which further enhances the relative attractiveness of equities with the potential for above average, sustainable dividend yields.
Europe & Asia-Pacific Equity
The recent market selloff results from further uncertainty in Europe and mixed U.S. results.
Valuations appear cheap, but not cheap enough for the feared structural stagnation.
Overall, Europe posted weak economic data during the last month, and concerns about the depth of recession in Europe continued. The period ended with a selloff in global markets, particularly in Spain, whose markets were down to 2009 levels. The outlook for Europe remains mixed. The European Commission projects that the economy will shrink 0.3% during the year and suggests potential contractions by half of the region's countries. Valuations would appear enticing if one were to assume a normal cyclical rebound, but we fear a more structural shift will be required. Japan has shown some recent resolve to take monetary policy matters into its own hands; it will need to be dedicated to further easing policies to ensure success.
Emerging Markets Equity
Emerging-market equities have retreated during recent market weakness.
Easier monetary policy may be an upcoming catalyst for better returns.
Emerging-market stocks strongly outperformed earlier this year, returning 17% in the first two months, as investors embraced greater risk taking. More recently, emerging-market shares have underperformed, as markets have worried about the pace of global growth and the European debt crisis. Europe's woes not only affect export markets, but potentially restrict credit availability in these markets. The European Central Bank's long-term refinancing operations (LT RO) have helped ease credit availability, as surveys of emerging-market lenders indicate easier funding conditions. Emerging-market growth rates may bottom midyear, as the bounce-back from the Thailand floods works its way through the system. We expect additional support from monetary policy as the year progresses, with Chinese easing mitigating the odds of a hard landing in the world's second largest economy.
U.S. Fixed Income
Investment-grade option-adjusted spreads have continued to narrow this year.
Excellent fundamentals support current spreads, which we expect to remain tight.
We believe corporate debt continues to offer significant value in the low interest-rate environment we expect to persist in the United States for the next few years. Corporations are in excellent financial condition, having used the low-interest-rate environment since 2008 to refinance their balance sheets. Issuance of investment-grade debt rose to its highest ever during the first quarter, as companies continued to take advantage of the favorable environment. Constructively, much of this debt is refinancing — leaving overall leverage unchanged. Corporations also continue to hold a record amount of cash on their balance sheets, providing fixed-income investors comfort that their investments are more likely to be repaid in the future.
U.S. High Yield
Institutional trading volume has declined since February.
Lower trading volume suggests that cash is still available to support markets.
After the initial new-year positioning, institutional trading volume has declined since mid-February — despite high levels of cash inflows. We believe this is an indication that institutional investors still hold healthy cash balances, because investors are reluctant to sell positions when they already have excess cash. Record first-quarter new issuance hasn't appeared to keep pace with cash inflows. Much of the new issuance has been to refinance existing bonds, which often results in a net increase in a holder's cash position. The trading volume decline has been exacerbated by regulatory changes that have reduced the amount of liquidity brokers can provide. Uninvested cash balances should continue to support high yield valuations until there's a material change in overall asset allocation.
Global inflation is expected to remain contained, influencing demand for real assets.
Low yields are affecting the attractiveness of real assets in different ways.
We continue to expect the Federal Funds rate to remain at "exceptionally low levels" until late-2014. These low rates, and the continued low inflation expectations that allow for such policy, have notable implications for real assets. Continued low inflation makes broad commodities, which provide the best offset to inflation given the high correlation to rising prices, less attractive. Meanwhile, low interest rates make both global REITs and gold more attractive — but for slightly different reasons. Global REITs benefit from higher yield levels near 4% while U.S. 10-year Treasuries yield just 2%. Gold continues to provide "store of value" benefit as investors worry about paper currencies while the opportunity cost of owning gold (short duration fixed income yields) continues to sit near zero.
Global stock markets have been differentiating during the recent weakness, with relatively stronger U.S. fundamentals supporting those equities while European stocks have been hit harder. After a brief jump in both U.S. Treasury and German bund yields last month, they promptly fell back on increased risk aversion. Credit markets have been well behaved of late, reflecting strong corporate fundamentals and a thirst for income, and not signaling worries about a double-dip recession. We expect U.S. economic growth to meet or exceed the relatively modest consensus expectations of 2.3% for 2012, while we expect Europe to undershoot the benign 0.40% expected contraction. Emerging-market growth should begin reaccelerating midyear, with the potential for a boost to Chinese growth from easier monetary policy.
In this economic environment, we see major central bank policy remaining highly accommodative. As such, the return on risk-free bonds will be negligible (and real rates negative in most instances). The prospect of this continuing for the next two-plus years has us favor higher income vehicles, such as U.S. high yield and global real estate, over investment-grade bonds. While European shares represent attractive value relative to the United States, we don't expect that to support better performance until the growth picture improves, and we therefore continue to favor U.S. equity over Europe, Australasia and Far East (EAFE) equity.
Our principal risk cases include the dependence on G-2 growth and the risks of increased uncertainty in the European debt crisis. Secondarily, we're monitoring the upcoming "fiscal cliff" in the United States and the continuing risk of a spike in oil prices to the global economy. Of course, it's important to remember these risks can evolve both positively and negatively. While we aren't close to predicting this outcome, progress in Washington in dealing with the budget crisis as part of the fiscal cliff discussions would likely be a significant positive for the financial markets.
Brent crude is a grade of crude oil used as a benchmark to price European, African and Middle Eastern oil that is exported to the West.
Option-adjusted spread measures the yield spread between similar securities (typically bonds) with different options, such as prepayment or call options which are very interest rate sensitive.
West Texas Intermediate (WTI) is a grade of crude oil used as a benchmark in oil pricing. It is the underlying commodity for the futures contracts on the Chicago Mercantile Exchange and the New York Mercantile Exchange.
This material is provided for informational purposes only and does not constitute an offer or solicitation to purchase or sell any security or commodity. Any opinions expressed herein are subject to change at any time without notice. Information has been obtained from sources believed to be reliable, but its accuracy and interpretation are not guaranteed.