Uncertainties Present Opportunities For Long-Term Investors

| About: Vanguard Total (VT)

By Dr. Chenjiazi Zhong, CFA, CAIA, FRM

Macro Update

On U.S: The solid employment growth continues to support consumer spending. Inflation pressures are rising as well. On the other hand, the weakness in commodities has led U.S. energy and mining firms to cut back investment in plant and equipment spending.

On Europe: Although Brexit has complicated the outlook on Europe, its growth is benefiting from monetary stimulus and low commodity prices. Additionally, relative to its recent history, the growth in domestic demand in Europe appears buoyant.

On China: As the recent fiscal stimulus fades and the country turns to deleveraging, and the Chinese growth in recent months is largely the result of a more expansionary fiscal stance and an unsustainable acceleration in the pace of credit expansion, the problems for China are likely to return to the forefront.

On Brazil: The ongoing corruption investigation involving Petrobras (NYSE:PBR) presents a challenge. Additionally, Brazil's fiscal deficit reached more than 10% of GDP as of the end of 2015, and gross debt stood at 74% of GDP[1]; however, the country is benefiting from stabilizing commodity prices, and the new government aims to achieve significant steps toward structural reforms, particularly the adoption of budget reforms.

global-economy-622x415

Third Quarter 2016 Will Depend on Stabilization

How the financial and economic environment will develop in the third quarter of 2016 will depend heavily on several factors:

The Brexit settlement: Markets are expecting a settlement on the relationship between the U.K. and the European Union (EU) and on the future of the EU itself. Uncertainty will weigh on investor sentiment and economic activities.

Energy price stability: Oil prices rebounded to $45 a barrel as of early July[2]. A sharp reversal of the recovery could trigger financial volatility, and further large gains would be negative for global consumers. Oil prices in the range of $40-$60 would support equities.

Global economic growth: Despite the uncertainties associated with Brexit, the U.S. economic expansion appears intact, although still subdued. U.S. monetary policy should remain supportive, and domestic consumption is in good shape. On the other hand, the presidential election may negatively impact investor sentiment. In China, growth continues to muddle down, but the reduced pressure on the U.S. Federal Reserve to raise rates should support China's renminbi.

Looking to Capitalize on Volatility

In this prolonged low-yield environment, investors should identify countries where yields are relatively high and may have potential to decline due to disinflation and subdued growth.

Sharp Turnaround in Risk Appetite across Credit Markets in Early 2016

As of June 30, 2016

Click to enlarge

Source: Barclays, J.P. Morgan

Among higher-yielding markets, decelerating inflation in Indonesia affords its central bank flexibility to further ease policy to stimulate growth. Brazilian bonds, which offers double-digit yield at the front of the curve, could generate price gains, assuming an effective structural reform that allows for less restrictive monetary policy.

Investment Implications

Investors should be prepared for additional bouts of volatility. The uncertainties, however, associated with these factors present risks, but also opportunities, for long-term investors.

With yields low across major sovereign markets, investors should look for countries with healthier yields and the potential for rate cuts while being careful with currency exposures. If cost is reasonable, investors can employ exchange rate hedges to protect against the currency depreciation, which often accompanies rate cuts.

Selectivity and caution will be critical for navigating in such environment, as investors will need to distinguish between the short-term price effects of market volatility and underlying fundamental values.

Markets are expecting the Fed to take advantage of below-target inflation and proceed with unprecedented caution, taking time to assess the impact of each step in the process of normalizing the stance of monetary policy.

[1] International Monetary Fund (IMF)

[2] Bloomberg