July 18, 2012
The summer slowdown in the financial markets is taking hold, with volatility falling and asset class returns relatively muted despite significant developments in the economy and the European sovereign debt crisis. We believe investor interest is increasingly turning to the state of the economic recovery, as indicated by the positive relationship between the performance of the S&P 500 and the trend in initial unemployment claims. In this near-zero interest rate environment in the developed world, recent central bank actions are generating collective yawns as the efficacy of the policies is being questioned. The baton for action has been passed to politicians — and while we believe Europe will continue to plod along with limited but steady progress, saber-rattling in the United States ahead of the "fiscal cliff" could increase stock market volatility in the fall.
Positive economic surprises peaked earlier this year, and have steadily decreased thereafter. The U.S. recovery has been supported by manufacturing, but job growth has been disappointing — raising questions about real income growth and final demand. Continued growth in bank lending supports the U.S. economic outlook, differentiating it from Europe where credit is contracting. Emerging-market growth continues to slow, while policy continues to ease. If inflationary pressures remain under control, emerging-market growth momentum should stabilize in the second half of 2012.
In late June, European leaders concluded their 20th summit since the start of the crisis. While leaders tried to positively surprise markets by underpromising and overdelivering, a lack of specificity once again scuttled their plans. With more than two years of the crisis behind us, investors are somewhat inured to the process, and portfolios are already positioned for trouble in the euro areas. While this reduces financial market risk that could develop, Europe is increasingly facing structural recession as its banking system deleverages and its politicians debate and implement austerity plans. Europe seems unlikely to deliver a major surprise on debt crisis policy during the next year.
Domestically focused companies have performed best in recent years.
Companies with a U.S. focus are still attractive as Europe's problems continue..
When analyzing the performance of Dow Jones Industrial stocks based on the geographic sources of revenue, we see that the market has recently been penalizing companies with a significant reliance on non-U.S. revenue sources. This is because of the deteriorating economic picture overseas, as well as reduced investor risk appetite. We expect this relationship to persist as European policymakers struggle to advance their policy prescriptions to increase bank oversight and fiscal responsibility — necessary precursors to more significant programs like bank deposit insurance and common-bond issuance. While U.S. stocks trade at a valuation premium to European shares based on price-to-earnings ratios and dividend yields, we believe this premium is warranted and will persist until Europe makes greater strides toward fiscal union.
Europe & Asia-Pacific Equity
European monetary policy easing is failing to spur credit creation.
Japanese economic data is showing continued recovery, but the outlook is mixed.
Equities outside the United States continue to struggle on the back of lackluster economic data and euro depreciation. The European Central Bank's (ECB's) interest rate cut and the Bank of England's (BoE's) additional £50 billion in quantitative easing are further evidence of continued accommodation in monetary policy. However, that accommodation isn't making it into the broader economy, with eurozone consumer credit failing to expand this year. The Japanese economic recovery in the second quarter was on track, supported by reconstruction-related demand, yet deflation concerns continue with the year-over-year consumer price index remaining around 0%. Conditions, as measured by the Tankan survey, were indicative of improved business sentiment, while Japan's Purchasing Managers' Index (PMI ) dipped slightly to 49.9 in June, marking the first reading below the important 50 level reading since November.
Emerging Markets Equity
Inflationary trends are slowing this summer, in contrast to last year.
Lower inflation should allow room for further central bank easing, if needed.
Higher consumer prices during the last several years, from energy to agriculture, led emerging-market central banks to raise rates steadily through last summer. Monetary policy has been easier of late, in reaction to slowing growth and accommodated by moderating inflation. Signs of economic slowdown from China to Brazil have been apparent, and politicians are focusing on restoring growth without rekindling inflation. In a country like China, this means stimulus will likely be more measured than during the financial crisis. While further increases in agricultural prices could short-circuit this easing trend in emerging markets, our base case expectation is for continued monetary policy accommodation and economic growth that will beat the current negative market expectation.
U.S. Fixed Income
Credit yields are near all-time lows, but spreads remain attractive.
Strong fundamentals and low interest rates support corporate debt.
Slowing global growth, European sovereign risks and the pending U.S. fiscal cliff haven't slowed investor demand for investment-grade credit. During the first half of 2012, a record $469 billion of investment-grade credit was issued across 450 issuers. With all-time low yields across investment-grade asset classes, credit is one of the few asset classes that generates positive real returns. And it remains an attractive asset class on a historical basis. Credit investors should take comfort in strong corporate balance sheets and an uncertain global environment that will limit management's impetus to take risk. With risk-free rates at historic lows, we believe corporate debt is attractive in what we expect to be an extended low-rate and slow-growth environment.
U.S. High Yield
High yield spread widening hasn't led to actual selling of bonds.
Investors' aversion to risk enhances high yield's attractiveness.
The graph at right shows daily high yield trading volumes relative to the high yield option-adjusted spread (OAS). During periods of market weakness, indicated by an increase in the OAS, trading volume has declined. We believe this demonstrates that investors haven't reacted to weak periods by selling positions and moving to cash or other assets. Investors have just stopped trading while waiting for an attractive buying opportunity. In positive markets, indicated by a declining OAS, trading volumes increase. The lack of sellers results in some lag, but positive markets attract new issuance, which increases liquidity. This activity is indicative of investors' support for the asset class and high yield's continued attractiveness, which sports a current yield-to-worst of around 7%.
Higher yielding global real estate investment trusts (REITs) are far outpacing global equities year-to-date.
Low rates endorse an equity-oriented approach to natural resource exposure.
Real assets are labeled as such because of their sensitivity to the outlook for inflation. However, so far this year, they have been more driven by their income-generating characteristics. As seen in the accompanying chart, global REITs (with their 3.8% dividend yield) have far outpaced global equities in the year-to-date period through June 30 — despite the volatile markets. With natural resources, equity oriented exposure has proven to be a better source of returns than its futures-based counterpart — in part because of equity dividend yields that far outpace the collateral yield associated with futures.
Despite slowing global growth and continued worries about the European debt crisis, investment returns for the first half of 2012 were very favorable. Slowing growth supported investment-grade bonds, while a benign view of the risk of recession supported credit markets and corporate debt. We expect the current low-interest-rate environment to continue, supported by slow growth and central bank intervention, and believe credit spreads could tighten during the remainder of the year. This generally sanguine outlook for moderate growth with low interest rates creates a reasonable backdrop for equities, underpinned by major stock markets, which continue to yield more than domestic sovereign bonds.
With global economic growth slowing, and inflation following suit, we expect strong central bank support to continue. We think a further interest rate cut from the ECB is in hand, and the Federal Reserve will likely expand its unusual accommodation programs after its recent increase in "Operation Twist." Even though we can't forecast the economic effects of this accommodation with much certainty, we think the financial market impact will be clear. Investors will increasingly take the Fed at face value and allocate their portfolios with an understanding that interest rates are going to stay low for a long time. We believe that this will lead investors during the next several years to reallocate from cash and low yielding fixed income investments to higher yielding stocks and bonds.
In fixed-income portfolios, we continue to favor high yield bonds over cash and sovereigns because a nonrecessionary environment leads to steady credit quality and high total return potential. U.S. equities have handily outperformed their major global competitors this year, and even though the level of outperformance may not be repeated, we still see them as attractive. Finally, while the price of gold has languished this year in U.S. dollar terms, it has done better in euros, and we think its strong action during periods of rumored central bank balance sheet expansion illustrates its hedge potential as an alternative currency.
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.
Yield-to-worst lowest potential bond yield received without the issuer defaulting, it assumes the worst-case scenario, or earliest redemption possible under terms of the bond.