October 17, 2012
With the U.S. election a short three weeks away, the impact of politics on fiscal policy (and financial markets) is in stark relief. The presidential race has tightened during the last month, with President Obama's lead in key swing states either shrinking or disappearing. In Europe, the Spanish government's path to bailout aid may be slowed by regional elections. In a small nod to the negative effects of austerity on growth, Portugal is being granted a loosening of its bailout program terms as reward for its efforts to date. The importance of these fiscal decisions is highlighted by a recent International Monetary Fund study that contends that the effect of fiscal policy on growth is higher than economists had previously believed.
These fiscal debates are taking place in a global economy whose outlook is mostly cloudy. For the forecast to be upgraded, the nascent signs of acceleration in U.S. growth must persist and emerging-market growth must broaden. U.S. consumer spending is being bolstered by improving sentiment, while manufacturing may be seeing some signs of stabilization. Brazil has shown emerging-market leadership; a series of reductions in its benchmark interest rate during the last year from 12% to 7.25% is leading to forecasts of increased growth. Even though China's growth data has yet to signal a turn, signs of improved trade activity in Asia may be a building block for stability.
In response to continuing high unemployment in the United States, the Federal Reserve unveiled "QE3" in mid-September. The unique aspect of this version of quantitative easing is its open-ended structure — the Fed has promised to keep purchasing $40 billion of mortgage-backed securities until the labor market improves substantially. The European Central Bank laid the groundwork for the further purchase of sovereign debt, contingent on the subject country applying for aid. The commitment of the world's major central banks to easy monetary policy improves the outlook for global equities beyond what economic fundamentals alone would historically support.
Dividend-paying stocks will likely see increased volatility until 2013 tax rates are set.
Our research suggests dividend strategies should focus on company quality.
Dividend investing has been a popular strategy in recent years, with dividends contributing a significant portion of total equity return. Uncertainty over tax policy in 2013 has created some wariness about buying dividend-paying stocks today, but we don't believe taxable investors should sell current positions because of this policy uncertainty. We expect dividend investing to remain in demand longer term for investors seeking total return and income. Many dividend strategies focus on historic dividend growth, and performance of the dividend growth factor has been particularly strong of late. However, our proprietary research suggests that certain measures of companies' financial strengths and qualities are more reliable indicators of future dividend growth and returns over the long term.
Europe & Asia-Pacific Equity
Disappointing data clouds the growth outlook for the European Union.
Growth in Asia was slowed by weaker export markets.
European markets continue to be driven mostly by policy developments, which has been a positive. Economic confidence has slipped for seven consecutive months, and the Purchasing Managers' Index for September fell to a three-year low. Driven by weakened economic data, growth estimates for the United Kingdom have been reduced for 2012 but still point to expansion in 2013. Growth in the relatively resilient Australian economy has slowed, as some drag from the mining sector has taken hold and the manufacturing sector continues to slow. The Bank of Japan continues to pursue monetary easing, while exports fell for the fourth consecutive month because of export market weakness and yen strength. Because of structural concerns in Europe, we expect U.S. and emerging-market growth to outpace European growth during the next year.
Emerging Markets Equity
Slowing emerging-market growth is well discounted in markets.
An eventual turn in growth should bolster share performance.
Emerging-market stocks haven't performed their usual role as bull market leaders, as the U.S. market has significantly outperformed during the last year. The slowing emerging-market economic picture can be well illustrated by relative earnings growth, which is expected to lag the United States by 4% in 2012 but outpace it by 2% in 2013. Emerging-market central banks have been loosening monetary policy, and that action should begin to be reflected in an improved growth outlook. China's growth remains a key wildcard, with September trade data giving a glimmer of hope among otherwise sober reports. After the strong recent outperformance of U.S. stocks, we believe investors will start to focus on the gradually improving emerging-market picture, and move to a tactical overweight in emerging-market stocks this month.
U.S. Fixed Income
QE3 involves the open-ended purchases of U.S. agency mortgage-backed securities.
The Fed will likely maintain its dovish stance for the next several years.
The Federal Open Market Committee has repeatedly noted a depressed housing sector and high unemployment as impediments to the U.S. economy resuming faster growth. Its announced QE3 program is an open-ended plan to purchase U.S. agency mortgage-backed securities and is designed to put downward pressure on interest rates, support mortgage markets and make financial conditions more accommodative. This announcement has led to a massive repricing of mortgage-backed securities relative to U.S. Treasuries, as investors rush to own an asset class that will be backstopped by the Fed for the foreseeable future. We think this is just the latest example of the Fed's efforts to make it very expensive to own high-quality fixed income, motivating investors to buy risk assets and hopefully fuel the animal spirits that can spur economic growth.
U.S. High Yield
The yield differential between leveraged loans and high yield bonds has narrowed materially.
Interest in the loan market has relieved some new issue pressure on the high yield market.
Reflecting strong flows into high yield bonds this year, the yield differential between leveraged loans and high yield recently narrowed to just 0.64%. The declining differential has increased investor interest in leveraged loans, which are senior to high yield debt. Demand from the loan market provides technical support for the high yield market, as well as fundamental support that helps reduce the default outlook. A healthy leveraged loan market also helps issuers avoid liquidity triggers by extending maturities. While we remain comfortable with the credit and interest rate outlook for high yield, we believe the significant compression in spreads this year reduces the future return potential.
Recent interest rate increases are being driven by higher inflation expectations.
Negative real rates highlight the cost of inflation insurance in the current environment.
Although many investors consider Treasury Inflation-Protected Securities (TIPS) within their fixed income allocation, the asset class deserves mention in a discussion of real assets. Based on changes in the consumer price index, the holder of the bond is compensated for changes in the cost of living through an adjustment to the principal value. Because of the current low nominal interest rate environment, those yields have been negative all year. While this may seem unattractive, it simply reflects the real return investors should expect on traditional bonds. The market is currently pricing in 10-year inflation expectations of approximately 2.5%, in line with our long-term views. Therefore, we believe TIPS offer no advantage over owning traditional government bonds.
Global stock markets have taken a breather during the last month, as investors assess the slowing global economy. In addition to analyzing the prospects for growth, investors need to gauge the resulting policy response and prevailing investor sentiment (which we believe remains cautious). We expect monetary policy to support financial markets during the next year as U.S. growth is steady, Europe struggles with recession and emerging markets grow below potential. Global short rates have fallen 0.80% during the last year, which should support growth into 2014. This should start to support improving momentum in emerging markets, where policy flexibility has been greater than in developed markets.
Uncertainty surrounding the U.S. fiscal cliff remains high, with potential tax hikes and spending cuts at the start of 2013 totaling 4.4% of U.S. gross domestic product. Economic performance around the globe remains highly differentiated, with the United States growing more steadily than its peers. This has led to highly varied asset class performance, with U.S. equities outperforming their developed market counterparts. In fixed income, the scarcity of yield has led to significant tightening of corporate credit spreads, reducing the future upside potential in credit. While we don't expect a significant reversal of these trends, it raises our interest in identifying asset classes that haven't yet caught investor favor.
MSCI Emerging Markets IndexSM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. It is not possible to invest directly in an index.
Purchasing Managers' Index (PMI) is a measure of the overall performance of the manufacturing sector, based on a survey conducted with purchasing managers to determine changes in economic conditions. A reading of 50 indicates no change, a reading of greater than 50 indicates an expanding economy and a reading below 50 indicates a contracting economy.
Russell 3000 Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market. It is not possible to invest directly in an index.
Yield-to-worst is the lowest potential bond yield received without the issuer defaulting, it assumes the worst-case scenario, or earliest redemption possible under terms of the bond.