Movements in global equity markets were relatively subdued during most of the period, but as the September meetings of the U.S. Federal Reserve (Fed) and Bank of Japan (BoJ) drew near, moderate levels of volatility returned to financial markets. This was largely due to shifting investor perceptions regarding potential changes to Fed policy. Ultimately, the Fed decided to leave its policy interest rate unchanged, stating that while "the case for an increase in the federal funds rate has strengthened" since its July meeting, the Committee will await "further evidence of continued progress toward its objectives" of maximum employment and price stability.
Global equities turned in a strong performance for the quarter, with the MSCI All Country World Index returning over 5% on both a local currency and U.S. dollar basis. This was largely due to very strong performance during July amid easing investor concerns about the United Kingdom's (NASDAQ:UK) possible departure from the European Union (EU), including the quicker-than-expected transition to a new prime minister (PM). Information Technology led with double-digit returns, buoyed by a rotation into cyclical stocks as well as tech company sales and earnings that generally beat consensus expectations. We continue to favor the sector, specifically targeting companies levered to secular growth trends.
Utilities and Telecom, meanwhile, were the worst performing sectors in the third quarter, as a midyear rotation away from crowded defensive stocks weighed on both sectors. These two sectors and Consumer Staples were the only ones that experienced negative absolute returns. This is notable insofar as the Utilities and Telecom sectors have been highfliers for most of the year, since these sectors consist of securities that tend to benefit from low-rate environments and where yield is a big component of total return. Utilities and Telecom are two sectors where we have maintained an underweight across our core portfolios for a number of years, most recently due to our view of low growth prospects and unattractive valuations for the highest dividend-payers.
In the fixed income space, although third-quarter returns were not as robust as they were during the April through June period, global fixed income markets (as measured by the Bank of America Merrill Lynch Global Broad Market Index) generated positive absolute returns on both a local currency and U.S. dollar basis.
Manning & Napier Market Insights
In response to post-Brexit surveys showing steep declines in consumer and business confidence, the Bank of England (BoE) cut its key interest rate by 25 basis points to a record low of 0.25%. The BoE also revived its government bond buying program that had been on hold since 2012, announced that it would begin purchasing corporate debt, and said it would provide banks with ultracheap four-year loans to finance lending to households and businesses.
It is apparent by now that the Brexit process is taking longer than initially expected. The resiliency in UK economic data is perhaps showing the impact of Brexit is limited, with consumers and businesses moving on with their lives. Counter to the results of the soft data surveys that the BoE based its stimulus decisions on, recent hard data have come in stronger than consensus expectations.
Housing and retail sales in particular have proven to be resilient, and consumer confidence logged a better-than-expected rebound in both August and September. This was also the case with the UK manufacturing and construction PMIs. The string of stronger economic data also has led to a relatively more stable pound of late.
Despite the improvement in the various indicators, we remain cautious on the UK. The Brexit process has not yet started and the country still faces the hard choice of EU market access versus migration control. PM Theresa May has indicated that Article 50 will be invoked at some point in early 2017, with Parliament having a say but not a vote on the Article being triggered. Hence, we would not be surprised if market uncertainty returns as Brexit-related commentary resurfaces in the headlines. Additionally, while the pound remains well below pre-Brexit levels, the relative stabilization of the currency during the third quarter diluted our export-oriented investment call to some extent and favored investments in domestic-oriented companies that were more beaten up following the vote to leave the EU. We maintain our view, however, that the path of least resistance is continued weakness in the pound over the medium term.
Emerging market (EM) equities notably outperformed developed markets (DM) during the third quarter as investors searched for yield and their appetite for riskier assets increased. Abating unease related to China, a relatively stable U.S. dollar, the year-to-date upturn in commodity prices, and increased liquidity amid generally easy policy across the globe also provided tailwinds for EM assets during the period.
There are various other recent positive developments in the EM space that are worth highlighting. Leading economic indicators have turned up in a number of EMs, and while one of the component series this can be attributed to in many cases is share prices, there has been progress in a number of other areas suggesting that we may be nearing an inflection point:
- The commodity price upturn is positive for net exporters of commodities such as Brazil and Indonesia, where currencies have also stabilized and inflation has been slowing.
- Political situations are stabilizing/improving in some EMs, with reformist minded leaders/governments in countries including Brazil, Argentina, India, Indonesia, and Peru.
- After years of tightening monetary policy to attract inflows, some EMs now have room to ease. With Europe and Japan also easing aggressively, this will act to offset any potential tightening in U.S. policy.
- Relatively easier DM monetary policies and lower resulting yields should continue driving capital into higher-yielding EMs.
- If capital flows continue into EMs, rates should drop and the earnings picture, especially in domestic businesses, should improve.
Valuations in EMs also remain generally attractive relative to DMs, but heterogeneity in the space due to diverging macro cycles at the country level increases the importance of selectivity. For instance, countries such as Brazil and South Africa have embarked on a hiking path, whereas Russia, India, and China have cut their benchmark interest rates.
From a macroeconomic perspective, we continue to suggest avoiding EMs which are heavily influenced by capital flows, characterized by trade/current account deficits and high foreign debt levels. Conversely, we are most constructive on markets including Argentina, India, and Indonesia (where risks are falling), as well as Singapore, South Korea, Mexico, and Spain (where risks are stable).
The BoJ held its two-day monetary policy meeting September 21-22, after which it announced an overhaul to the bank's policy focus. BoJ Governor Haruhiko Kuroda stated that controlling the yield curve was now the central part of his plans. The announced overhaul includes introduction of a new policy framework, "Quantitative and Qualitative Monetary Easing with Yield Curve Control." Through yield curve control, the BoJ - in addition to short-term rates - will now control rates on the long end of the curve. The bank will target a near-zero yield for 10-year Japanese government bonds (JGB), which yielded just below zero as of quarter end.
The steepening of the yield curve that the BoJ stated will result from this new policy should act to lessen the headwind that negative interest rates have had on the Japanese banking system, specifically in regard to pressure on net interest margins. Indeed, the Japanese banking sector was hard hit following implementation of the BoJ's negative interest rate policy and has not yet recovered to prior levels.
The BoJ has also agreed on inflation-overshooting, committing itself to expanding the monetary base until observed headline inflation less fresh food exceeds 2% and remains above target in a stable fashion.
We view the announcement of a new policy framework as the BoJ running out of policy options. The bank has opened the door to unlimited expansion of the central bank's balance sheet, and the near-zero yield target on 10-year JGBs makes it essentially costless for the government to carry out an expansive fiscal policy.
Moving forward, it will be important to continue to monitor Japanese inflation, whether it is domestically generated via success of Abenomics feeding through into economic data and stronger wages, externally generated from higher commodity prices or an improved growth/trade outlook, or the result of an expansion of government fiscal spending.
For now, we remain cautious on Japan. We continue to pursue selective opportunities levered to secular growth trends as opposed to Japanese macroeconomic growth, but to become more bullish on Japanese equities, we need to see positive rates of change relative to deflation and public debt/deficit reduction, as well as structural reforms aimed at reducing demographic headwinds.