The first half of 2016 was eventful, to say the least. Markets took a roller-coaster ride down in January (risk-off) and then up in February (risk-on). A period of relative stability followed, but then the wheels came off as the Brexit vote sparked a dramatic sell-off in risk assets.
Before the referendum, my view was that the European economy was improving, albeit slowly, the US economy was fundamentally healthy, and a global recession was not on the horizon. The "Leave" vote has introduced a new level of uncertainty that is likely to impact economies and asset prices for the remainder of the year and beyond. Business investment in the UK is likely to decline sharply, and Wellington Management's macroeconomist has lowered his forecast for 2017 gross domestic product (NYSEMKT:GDP)1 growth in the UK to -1%. That said, I expect European growth to slow, but not contract (our macroeconomist reduced his 2017 forecast to 1.1%), and the US economy to remain relatively insulated. We do not think Brexit will result in a global recession.
I would, however, expect Brexit uncertainty to result in a premium for safe-haven assets and a discount for risk assets, which could tighten financial conditions. For the second half of 2016, I will be focused on five market drivers: political risk, central bank policy, currencies, China's economic health, and the continued search for yield. With many questions to be answered on each of these issues in the coming months, I see a case for quality in portfolios and specifically favor credit over equities, US assets over European and Japanese assets, and US-duration and gold-related assets as hedges in a risk-off scenario.
Politics playing a bigger role in developed markets
The UK embarked on an unprecedented path when it voted to leave the European Union on June 23. In the two days after the referendum, UK financials were down nearly 20% and the British pound was down more than 10%. The spillover effects were evident, as European financials declined more than 20% and 10-year German bund yields fell solidly into negative territory.
The sentiments behind the "Leave" vote are not unique to the UK. Large swaths of the populations in many developed countries, particularly in Europe, are feeling left behind as sluggish economic growth, rising income inequality, and globalization are shrinking the middle classes. Resulting job uncertainty and wage stagnation are turning up in the polling booths, with voters venting their frustration at establishment politicians and increasingly supporting policies that reduce immigration and protect local industries. This protectionist bent could reduce global trade and cut into global GDP (Figure 1).
Protectionist policies could damage global trade and GDP
Global trade as % of GDP, 1960 - 2014
Sources: Haver Analytics, World Bank
With many important elections looming, I expect political risk to remain at the forefront of investors' minds. In the US, Donald Trump embodies this phenomenon. While markets worry about his anti-immigration and anti-trade rhetoric, voters sympathize with his strong anti-establishment views. For markets, a positive scenario would be improved relations between Trump and House Speaker Paul Ryan and a sense that Trump would implement the "Ryan Plan," including tax reform, higher defense and infrastructure spending, and regulatory and entitlement reform.
The likely Democratic candidate, Hillary Clinton, is more market-friendly. She has historically been supportive of global trade and immigration and is seen as more predictable than the politically inexperienced and bombastic Trump. While their exact views are difficult to pin down, both candidates seem to favor fiscal expansion and neither seems inclined to tackle the unsustainable pace of entitlement spending.
Central bank policy: More convergent than divergent
Given the weak US employment report in May and the Brexit shock, I do not expect the US Federal Reserve (Fed) to hike interest rates this year, and I see limited scope for hikes next year. There are simply too many pre-conditions to be met- healthy US economic data, stable global markets, and no potentially disruptive political risks-for the Fed to normalize rates anytime soon.
The Fed passed on hiking at the June Federal Open Market Committee (FOMC) meeting and revealed a significant change in its economic projections. While the median expectation still indicated two more rate hikes this year, the Fed's forecast for the federal funds rate and gross domestic product (GDP)1 growth at the end of 2017 dropped by 0.3% and 0.1%, respectively, while its inflation forecast rose by 0.2% (Figure 2).
This most recent dovish tack removed the near-term possibility of Fed tightening, and given that I expect the European Central Bank and Bank of Japan (BOJ) to remain aggressive in their stimulus efforts, global monetary policy should remain very accommodative.
Falling Fed forecasts for 2017
Fed economic projections for 2017 released at recent FOMC meetings
Sources: US Federal Reserve, Wellington Management
Currencies need to be monitored
Brexit led to a steep drop in the British pound, but it also sparked a separation of currencies considered "safe" and "risky." Among safe currencies, the US dollar (US Dollar Index +3%) and the Japanese yen (+4% vs US dollar) appreciated. Among riskier currencies, emerging market currencies depreciated (-3% to -5% vs US dollar), including the Chinese renminbi (-1% vs US dollar).
I think the US dollar will face crosscurrents from the market's lower Fed-tightening expectations (weaker dollar) and the appeal of the US currency relative to the British pound and the euro, both in terms of the relative stability of the US economy and the higher yields offered by US government bonds (stronger dollar). For this reason, I expect the US dollar to remain rangebound. By extension, this should allow underlying supply and demand forces to drive the price of oil. Given the massive capital expenditures cuts we've seen in the oil industry, I expect supply to contract and demand to remain stable. My range-bound view on the US dollar and somewhat positive view on commodities imply stability
for emerging market currencies.
The Chinese government has depreciated the renminbi versus the US dollar, which has strengthened recently. Since the disorderly weakening of the renminbi in mid-2015 triggered massive capital outflows, all eyes will be on the government's handling of this latest bout of currency volatility.
China's stimulus is lifting domestic demand
Since the middle of 2014, China has been steadily lowering interest rates, which has induced a domestic recovery (Figure 3). I expect this stimulus to continue to support the economy over the next several months, boosting demand for steel, cement, auto imports, and property.
China property prices rising following rate cuts
China, property prices, and rates, November 2006 - May 2016
Sources: NBS, PBC, Wind, CEIC, Bloomberg, Wellington Management
However, due to the recent slowdown in several economic indicators, including the pace of fixed-asset investment, a mixed picture for China's economy is probably more realistic. The slowdown in fixed-asset investment was worst for private companies (Figure 4), which is a concern given that the private sector is a better gauge of the true health of the economy and represents two-thirds of fixed asset investment.
China investments dominated by public sector
China: Estimated contribution to fixed-asset investment, y/y % change,
January 2012 - May 2016
Sources: Haver Analytics, Bloomberg, Wellington Management
The search for yield is creating strong demand technicals
With almost $12 trillion of government bonds globally trading at negative yields, the search for yield is more intense than ever. Over the last few years, European and Japanese investors have pursued higher yields by moving capital to the US market.
Governments are also behemoth buyers of debt. In Europe, the ECB is buying €80 billion in government bonds and €5 - €10 billion in nonfinancial investment-grade corporate bonds per month. In Japan, the BOJ already indirectly buys almost all the new government-bond issuance and owns one-third of the outstanding supply.
With this excess demand, a fair question is whether the credit cycle appears too extended. I do not think the credit cycle will end soon. While debt and leverage have risen back to pre-crisis levels at the index level, free cash flow and interest-rate coverage remain at healthy levels. And if we strip out commodity-related sectors, both metrics look even better. If my benign view of oil is correct, then stress in commodity-related sectors shouldn't worsen from current levels.
I prefer credit over equities given favorable valuations (Figure 5), a benign interest-rate environment, and the desirability of income in a low-growth, low-yield world. Within credit, I think US assets are particularly attractive given relatively wide spreads and exposure to the relatively stable US economy.
I favor US high-yield bonds and investment-grade credit.
Credit valuations look attractive relative to equities
As of June 30, 2016 | Green shading represents relatively inexpensive valuations; red shading represents relatively expensive valuations. | Sources: Bloomberg, Wellington Management, Datastream, IBES
Risks to my view
Since the Brexit vote leaves us in uncharted territory, it's only one's imagination that can limit the potential political scenarios from here. Of course, my quality bias could be upended if there were a political turn of events that led to a new referendum, a highly unlikely scenario in my view but one that is still possible. Another possibility is that it takes longer than expected to trigger Article 50, in which case, the UK would still be a part of the EU but a much weaker British pound could boost UK exports and the economy. Finally, the BOJ could possibly get more aggressive with wider asset purchases, further interest-rate cuts into negative territory, and increased fiscal spending. If fiscal expansion involves more money creation, that should raise inflation expectations and depreciate the yen. In this scenario, Japanese equities, which are trading at historically low multiples, could respond quite positively.
Tilt toward quality. Uncertainty about the political landscape and the sustainability of China's growth rate should lead investors toward quality in their portfolios.
Favor credit over equities. Credit valuations are more attractive and spreads deserve a premium in a low-government bond yield environment. I prefer US high yield and investment-grade corporates for their exposure to the US economy and relatively high yields.
Favor US equities. Despite higher valuations, I favor US equities over their European and Japanese counterparts. The US economy is on a more stable footing and relatively insulated from Brexit.
Look for sectors less affected by global turmoil. These include utilities, telecommunication, health care and consumer staples. If these sectors are unduly punished in a Brexit-related sell-off, I would view that as a buying opportunity.
Avoid sectors vulnerable to UK weakness. These include cyclical sectors such as autos, housing, and consumer discretionary. I would also avoid European banks as they should suffer in a weaker growth and lower interest-rate environment.
Choose carefully among emerging markets. Brexit and the potential spillover to European and global growth constitute a negative backdrop for emerging markets, so differentiation will be a key to investment decisions. Several factors make me positively inclined toward emerging markets local debt, including the potential for interest-rate cuts (given that inflation appears to have topped out in several countries), attractively valued emerging market currencies, and high local-bond yields relative to US Treasuries.
Yields will remain pressured. I hold a neutral view on US interest rates, despite the fact that they remain historically low. Brexit risks and ever-lower government bond yields in other developed countries are likely to continue exerting downward pressure on yields.
Consider certain macro-risk hedges. I also think a small allocation to precious metals, like gold or gold miners, may be a cost-effective hedge against global macro risk. Given the economic risks associated with Brexit and other potential election results, I expect more central bank action.
Cautious optimism on oil. I continue to recommend oil-related assets, especially exploration and production companies, because I believe oil supply and demand is rebalancing. Given the uncertainties around China, I would avoid exposure to non-oil-related commodities, including industrial metals.
1. Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period.
2. The US Dollar Index (USDX) is an index (or measure) of the value of the United States dollar relative to a selection of foreign currencies.
3. Rangebound is when a market, or the value of a particular stock, bond, commodity or currency, moves within a relatively tight range for a certain period of time.
4. Option-adjusted spread (NYSE:OAS) measures fixed-income yields while taking into account any embedded options.
5. Price-to-Earnings Ratio (P/E ratio) is the ratio of a stock's price to its earnings per share based on 12-month forward projections.
6. The Barclays US Corporate High-Yield Bond Index (US HY) is an unmanaged broad-based market-value weighted index that tracks the total return performance of non-investment grade, fixed-rate publicly placed, dollar-denominated and nonconvertible debt registered with the Securities and Exchange Commission.
7. The Barclays US Corporate High-Yield Bond Index (US HY xEnergy) is an unmanaged broad-based market-value weighted index that tracks the total return performance of non-investment grade, fixed-rate publicly placed, dollar-denominated and nonconvertible debt registered with the Securities and Exchange Commission, excluding energy.
8. The Barclays US Corporate Investment Grade Bond Index (US IG Corps) covers all publicly issued, fixed rate, nonconvertible, investment grade debt.
9. The Barclays Global High Yield Index (Global HY) is an unmanaged index considered representative of fixed rate, non-investment grade debt of companies in the U.S., developed markets and emerging markets.
10. The Barclays Euro Corporate Bond Index (Euro IG Corps) is a broad-based benchmark that measures the investment grade, euro-denominated, fixed-rate corporate bond market.
11. The J.P. Morgan Emerging Bond Index (EMI+) is a benchmark index for measuring the total return performance of international government bonds issued by emerging market countries that are considered sovereign (issued in something other than local currency) and that meet specific liquidity and structural requirements.
12. The MSCI USA Index (US) is designed to measure the performance of the large and mid cap segments of the US market. With 637 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US.
13. The MSCI Europe Index (Euro) is a free-float adjusted market-capitalization-weighted index designed to measure the equity market performance of the developed markets in Europe: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.
14. The MSCI Japan Index (Japan) is a free-float adjusted market-capitalization index designed to measure large- and mid-cap Japanese equity market performance.
15. The MSCI Emerging Markets Index (NYSE:EM) is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. It consists of 21 emerging market country indices.
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All investments are subject to risk, including the possible loss of principal. Fixed income risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall; these risks are currently heightened due to the historically low interest rate environment. U.S. Treasury securities are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. Foreign investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as political and economic developments in foreign countries and regions. Investments in high-yield ("junk") bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. These risks are generally greater for investments in emerging markets. Commodities may be more volatile than investments in traditional securities. Risks of focusing investments on the health-care sector include regulatory and legal developments, patent considerations, intense competitive pressures, rapid technological changes, potential product obsolescence, and liquidity risk. Risks of focusing investments on the utilities and industrials sectors include regulatory and legal developments, competitive pressures, pricing and rate pressures (utilities), rapid technological changes, potential product obsolescence, and liquidity risk
The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice or as the views of Hartford Funds. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.