It paid to be contrarian in the first half of this year. While equities advanced more than bonds, investor confidence in the “reflation trade” waned amid growing skepticism about the Trump administration’s ability to push through fiscal stimulus. As a result, US yields fell, the dollar weakened, and market leadership rotated from value back to growth and bond-like equities (Figure 1).
Improving European economic data and Emmanuel Macron’s victory in the French election triggered a rotation from US to European equities. Commodities had a rough first half, driven by a 15% drop in oil prices, though gold rallied amid lower real yields. Demand for growth and return was most visible in emerging markets, which rallied despite slowing growth in China and the corruption scandal in Brazil.
Reflationary trade in doubt?
2017 year-to-date total return (%)1
*Based on commodity price, not represented by an index.
1Through June 23, 2017, all returns in local currency, unless otherwise noted. | Past performance is not indicative of future results. Indexes are unmanaged and not available for direct investment. | Sources: Bloomberg, Wellington Management
With new information flooding markets since the beginning of the year—from the twists and turns in the Trump agenda to the Macron win to the soft landing in China—a reassessment of fundamentals, politics, and valuations is required.
Before I dive into the specifics, a summary of my conclusions: I continue to favor equities over bonds. Within equities, I favor Japan and Europe, in that order, and am neutral on the US, where I prefer value-oriented sectors. I am also dipping a toe into emerging markets, given stability in US yields and the US dollar, reduced trade risks (FIGURE 2), and China’s controlled slowdown. I think developed-market government bond yields are too low, and that the Federal Reserve (Fed) will continue on its tightening path despite low core inflation. Meanwhile, other developed-market central banks appear to be in no rush to reduce liquidity. Spreads could tighten further in this environment, and I favor credit spreads in financials, bank loans, structured credit focused on residential housing, and municipal bonds (taxable and non-taxable).
NANETTE'S MULTI-ASSET VIEWS
Change is from previous quarter. Views expressed are those of the author. Views are as of June 2017, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities.
Global trade less of a concern
World trade volume, Year/Year % change, January 1996 - March 2017
Sources: NBEPA, Haver Analytics, Barclays Research
INTERPRETING BOND YIELDS AND INFLATION EXPECTATIONS
While US government bond yields and a flatter yield curve are signaling a weaker global cycle, I think expectations have become too depressed. Yes, fiscal stimulus in the US is likely to be more modest and arrive later than originally thought, tempering expectations of booming growth, and recent inflation readings have declined. But I still believe the Fed will hike rates by more than the market has priced, including one more hike this year (FIGURE 3), given the tightening labor market, the Fed’s confidence in the economic outlook, and the diminished downside risk in Europe and China.
Market still below Fed's rate expectations
Market and Federal Reserve expectations for fed funds rate at end of each year (%)
As of June 14, 2017 | Actual results may vary, perhaps significantly, from the forecasts presented | Sources: Federal Reserve, Bloomberg, Wellington Management
Meanwhile, market chatter about the European Central Bank (ECB) and the Bank of Japan (BOJ) exiting or tapering quantitative easing (QE) is overdone in my view. At the most recent ECB meeting, the staff lowered its inflation forecast and ECB President Mario Draghi cited “underemployment” as evidence that the economy could run further without spurring inflation. The euro strengthened in the first half, which will also play a role in keeping monetary policy loose. In Japan, there are few signs of rising inflation and the BOJ is likely to maintain a 10-year yield of around 0% until inflation is above its 2% target.
Interest-rate divergence among developed markets should influence currencies as well. I expect the US dollar to strengthen more versus the yen than versus the euro, since the ECB is closer to policy normalization than the BOJ.
From an asset allocation standpoint, I think credit is more appealing than other fixed income options. Strong inflows to US credit from Asia and Europe are likely to persist given higher interest rates and better liquidity in the US. In addition, hedging costs for non-US investors have declined. High yield’s strong start to the year has been supported by low default rates, the demand for income, and the demand for less volatile equity-like exposure.
Spreads could grind tighter for these reasons, but since they are on the rich side, I prefer neutral high-yield exposure and instead favor bank loan and emerging market debt exposure. I also favor increasing European credit exposure relative to US credit, particularly in financials, and focusing on US structured credit in the area of residential housing. Within emerging markets, I think local debt offers attractive opportunities in countries where inflation is falling and central banks are either cutting interest rates or delaying rate hikes, including Russia, Mexico, and Indonesia.
COUNTRY AND REGIONAL FUNDAMENTALS
Among equity markets, I am most bullish on Japan given the improving economic cycle, supportive government policies, and relatively cheap valuations (Figure 4). Japan registered its fifth consecutive quarter of sequential growth in the first quarter of this year, and the growth was well balanced across consumption and manufacturing. The consumer is benefiting from a robust job market, which has driven unemployment to a 22-year low and should improve wages and consumer spending. Corporate earnings increased 26% in the first quarter (year over year), profits are at an all-time high, and industrial production is increasing steadily. I expect margins to remain elevated as Abenomics reforms continue to work through the system and companies focus on improving shareholder returns.
Japan is cheapest among developed markets
Ten-year percentile rankings, May 2017
All metrics use forward estimates except Shiller, which is the ratio of price to trailing 10-year real earnings. | Sources: Datastream, IBES, Wellington Management
While a weaker yen is highly correlated with positive equity returns, I believe the fundamentals and technicals are powerful enough to propel Japanese equities higher even if the yen is rangebound, as we saw in the second quarter. Japanese equities remain unloved, as evidenced by sentiment surveys and foreign investor flows, but I expect the combination of cheap valuations, an improving cycle, and supportive policies to draw foreign investors back to the market and provide a fillip for equities (FIGURE 5).
Japan's unloved equity market
Cumulative foreign purchases of Japanese equities and Nikkei 225 Index,N
January 2014 - May 2017
Sources: SG Cross Asset Research, Bloomberg | Past performance is no guarantee of future results. The performance shown above for the Nikkei is index performance. Indices are unmanaged and not available for direct investment. For illustrative purposes only.
Despite valuations that are no longer attractive, I favor a moderately overweight position in European equities. Europe’s purchasing managers’ index (PMI)7 is at a six-year high and is consistent with 3% growth. While the region’s recovery has been led by improvements in employment, business confidence has also rebounded sharply. From a political standpoint, we foresee opportunity for Europe, driven by its German-Franco core, to inch toward further integration and for President Macron to push through needed labor market reforms. While political risks remain in Italy, I am encouraged that the momentum of the Five Star Movement seems to have stalled. Even if the anti-euro party wins a potential early election, the government would be weak and not pose systemic risks to the rest of Europe, in my view.
China and other emerging markets
I am upgrading my emerging market equity and debt recommendations from neutral to moderately bullish in light of China’s gentle deceleration and my more sanguine view of the US dollar and global rates. While I don’t expect China to be a source of global angst, I do foresee a mild slowdown precipitated by higher interest rates and a sharper focus on deleveraging aimed at tamping down excesses in the housing market. But with the country heading for a leadership transition in the fall, I think the government will ultimately protect growth, ensuring relatively steady data in the region. Further, China’s excess household savings and sizable foreign exchange reserves give the central bank flexibility to preserve the stability of the currency and avoid capital flight. Looking across emerging markets, I find opportunities plentiful in China, India, and Russia.
I am lowering my recommendation on US equities to neutral as valuations are expensive, PMIs have peaked, and Washington, DC, has made no progress on tax reform. While business and consumer confidence remain elevated and the underlying US economy is strong, I think policy paralysis could start to tamp down animal spirits that had risen in the wake of the 2016 election. The Trump administration has yet to form a tax plan and there remain stark ideological differences among Congressional Republicans, not to mention between Republicans and Democrats. That said, I don’t think the US economy is likely to slow materially as employment gains continue to buoy the consumer, and I still expect deregulation and fiscal stimulus to be marginal contributors to US growth in the coming year.
Risks in a benign environment
What I’m describing is a fairly benign environment that is conducive to pro-cyclical positioning. However, as the saying goes, “Volatility is low until it’s not.” I would highlight several risks that temper my bullishness:
A spike in global rates — Given the degree to which financial assets have benefited from low rates and high liquidity in recent years, a rate spike triggered by a policy mistake or unforeseen inflation is the biggest risk to the markets in my view. Despite talk of tapering, central banks have added nearly $1 trillion to balance sheets year to date.
Crowded trades — Because lower volatility limits return opportunities, investors can be lured into adding risk beyond their tolerance, either by moving down the capital structure or by adding leverage. Increased flows into private equity, direct lending, and short-volatility strategies could lead to crowded trades, which could backfire if defaults rise, momentum shifts, or liquidity declines.
China — China’s high leverage and tightening financial conditions are the market-consensus fears, but the evidence suggests that China will engineer a managed slowdown.
Rich valuations — Valuations in equity and credit markets are stretched, leaving little room for error.
Geopolitics — With power spheres in motion in the Middle East, Russia, and Asia, and the US taking a more confrontational stance, the risk of a geopolitical flare-up somewhere in the world is higher than usual.
The first half of 2017 was a reminder of the danger of being wed to a single theme. I suggest investors consider diversifying from the “reflation trade” and recognize the cross-currents in markets that offer opportunities across a spectrum of themes:
In equities, consider favoring Japan over Europe, and Europe over the US — Changes in growth momentum and valuations are key to my equity views, and I see Japan as the next market to capitalize on the combination of improving nominal growth, rising corporate profitability, and attractive valuations. Within Japan, high-quality companies can be found in various market caps and sectors, particularly in health care, technology, financials, and consumer discretionary.
Consider favoring European equities ex UK — Even though European equities are rich relative to their own history, the usual discount to US equities is even larger than normal. But I expect that to narrow as nominal growth and corporate earnings improve. I would avoid UK equities. I expect Brexit negotiations to be messy, putting capital spending, the currency, and the UK cycle at risk.
Consider favoring financials across regions — US mega-cap banks remain attractively valued, and rising interest rates, a strong housing market, and deregulation would support higher prices. In Europe, French banks are particularly levered to the recovery and still trade at discounted levels. Japanese banks suffer from poor profitability and low rates will continue to be a headwind, but greater focus on business and shareholder returns could likely translate into longer-term outperformance.
Consider leaning into emerging markets — I think the government will do what it takes to prevent a market collapse in China. In addition, absent a spike in US yields or the US dollar, I think emerging markets can continue to benefit from the healthy fundamental backdrop among developed countries. Given the heterogeneity of emerging markets, I suggest focusing on countries with improving current accounts and lower inflation.
Consider favoring US bank loans, investment-grade bank debt, structured credit in housing-related assets, and municipal bonds — I favor moving up in quality from high yield to bank loans. Bank debt remains an attractive sector in Europe in particular. US housing is in good shape, supported by favorable supply/demand fundamentals as millennials form households amid a lack of housing inventory. In a tight credit spread environment, municipal bonds offer “value for risk” and diversification given lower default risk and insulation from shareholder-friendly activity relative to the corporate credit market.
Consider hedging downside risk with high-quality government bonds, inexpensive option strategies, and gold-related assets — Given rich valuations across major asset classes, I think investors should consider exposure to assets that could perform well in a risk-off environment.
2Price-to-Earnings is the ratio of a stock’s price to its earnings per share.
3Price-to-Book is the ratio of a stock’s price to its book value per share.
4Price-to-Sales is the ratio that compares a company’s stock price to its revenues.
5Price-to-Cash Flow is the ratio that compares a company’s stock price to its revenues.
6Shiller Price-to-Earnings is the ratio of price to real trailing 10-year earnings..
7Purchasing managers’ index is an indicator of the health of the economy. Readings over 50 suggest economic growth should rise from its current pace, while readings under 50 suggest economic growth should fall from its current pace.
AMSCI USA Energy Index is designed to capture the large and mid cap segments of the US equity universe. All securities in the index are classified in the Energy sector in the Global Industry Classification Standard (GICS®)
BCredit Suisse (CS) Leveraged Loan Index is designed to mirror the investible universe of the United States dollar-denominated leveraged loan market.
CMSCI USA Financials Index is designed to measure the performance of the large and mid cap segments of the US equity universe. All securities in the index are classified in the Financials sector as per the Global Industry Classification Standard.
DUSA high yield is represented by Bloomberg Barclays US High Yield Corporate Bond Index 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.
ES&P/GSCI Industrial Metals Index provides investors with a reliable and publicly available benchmark for investment performance in the industrial metals market.
FMSCI Japan Index is a free-float adjusted market-capitalization index designed to measure large- and mid-cap Japanese equity market performance.
GEM sovereign bonds (USD) represented by JP Morgan Emerging Markets Bond Index is a broad-based, unmanaged index which tracks total return for external currency denominated debt (Brady bonds, loans, Eurobonds and U.S. dollar-denominated local market instruments) in emerging markets.
HUSA long Treasury is represented by the Bloomberg Barclays US Treasury Index, which measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury.
IMSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market. With 627 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US.
JMSCI Europe Index 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.
KMSCI USA Utilities Index is designed to capture the large and mid cap segments of the US equity universe. All securities in the index are classified in the Utilities sector as per the Global Industry Classification Standard (GICS®).
LMSCI Emerging Markets (NYSE:EM) Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of 21 emerging market country indices.
M The MSCI USA Information Technology (Info Tech) Index is designed to capture the large and mid cap segments of the US equity universe.
NNikkei 225 Index, commonly known as the Nikkei Index, is a price-weighted index for Tokyo Stock Exchange.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. Investments in high-yield (“junk”) bondsinvolve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Bank Loans can be difficult to value and highly illiquid; they are subject to credit risk and risks of bankruptcy and insolvency. 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. These risks are generally greater for investments in emerging markets. Commodities may be more volatile than investments in traditional securities. Diversification does not ensure a profit or protect against a loss in a declining market. Risks of focusing investments on the healthcare-related sector include regulatory and legal developments, patent considerations, intense competitive pressures, rapid technological changes, potential product obsolescence, and liquidity risk. Municipal securities may be adversely impacted by state/local, political, economic, or market conditions. Investors may be subject to the federal Alternative Minimum Tax as well as state and local income taxes. Capital gains, if any, are taxable. Value investing may go out of favor, which may cause the Fund to underperform the broader stock market.
The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice. 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 and different fund sub-advisers may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of 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 or Hartford Funds.
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.