However, we’re hedging against the potential resurfacing of short-term deflation and economic slowdown fears by setting up carry trades in fixed income. For example, we’re long higher-yielding US bonds and short euro bonds. We also hold market-hedged exposure to high-dividend-yielding equities in Europe and high-dividend-growth equities in Japan. In our Factor Fund portfolios, we’re emphasizing relative growth in the US, while we’re more leveraged to value and income in Europe and Japan. At this point, we remain defensively positioned in Asia ex Japan as we monitor earnings revisions and profitability trends for signs of improvement.
During March, our portfolios were generally hurt by a slight underperformance in equities (where we’re overweight) and outperformance by bonds (we’re underweight). Within our equity allocation, the portfolios benefited from an overweight of non-US equities (Performance); Japan and Europe outperformed the US by 3%–4%.
Energy and related equities significantly underperformed because of concerns about incremental supply from Iran and evidence of further inventory buildup in the US. We remain overweight oil-price-sensitive exposures across many of our portfolios.
The US dollar continued to strengthen against most currencies except the yuan. The dollar’s three-year surge now ranks among the largest in history. We remain modestly overweight: we continue to see upside over the next six to nine months, although there’s near-term downside risk from weaker employment data and negative economic surprises in the US as well as relative improvements in Europe and Japan. The rationale for our position is our expectation of superior relative growth in the US, a September lift-off in rate hikes by the US Federal Reserve, and continued US-dollar demand from the refinancing of corporate debt.
High-yield and investment-grade spreads rose in developed markets but declined in emerging markets. In our view, emerging-market yields, credit spreads, equities and currencies are among the few areas of distressed valuations in the world today. The performance of emerging-market assets seems to be benefiting from the perception that the Fed could remain accommodative for longer, while credit creation in Europe and Japan should continue to provide ample liquidity. The anticipated effectiveness of new quantitative easing measures likely caused long-term bond yields and credit spreads in the euro area to decline.
This month, we look at three key issues. First, what do recent employment data and the Fed’s interest-rate guidance imply? Second, is the hand-off from the Fed to the European Central Bank (ECB) and Bank of Japan (BOJ) as liquidity providers happening smoothly? And third, what opportunities do we see in emerging markets, particularly in equities? We’ll look at currency and fixed-income opportunities in later reports.
Don’t Get Complacent with Fed Accommodation
March payroll data disappointed, and data for prior months were revised down, raising questions about the speed and magnitude of the US economic recovery. This also strengthens the case for later tightening by the Fed. We continue to expect the initial rate hike in September, but the pace of rate increases may be much slower than what we saw in 1994 and 2004.
The timing of the initial increase will likely be driven more by evidence of improving wages and unemployment rates than by specific job-creation targets. There are many leading indicators of labor-market health: Fed Chair Janet Yellen referenced at least nine on her own “dashboard.” But we’re monitoring two that we believe are particularly important, as we discussed in our November 2014 Global Market Perspective: small-business sentiment/hiring intentions and labor participation.
Small-business sentiment and hiring intentions are important because small businesses account for more than 60% of new job creation. This gauge continues to indicate strong job-growth prospects (Display 1). The labor participation rate matters because it provides a sense of labor supply, and it remains fairly tight (Display 2).
These indicators, combined with a pickup in wage growth during March, suggest that there’s limited slack in the US job market. Wage growth should get a further boost in April from recently announced compensation increases in the retail sector. Moreover, the one-off negative impacts of West Coast port delays on trucking jobs and a weather-related slowdown in construction are likely to reverse in coming months.
The pace of increase and the eventual equilibrium rate may be more relevant to determining market outcomes than the timing of the initial rate hike. The March Federal Open Market Committee (FOMC) meeting suggests a more dovish stance than before with references to a lower NAIRU (non-accelerating inflation rate of unemployment), the impact of a stronger dollar on growth and lower equilibrium interest rates.
Perhaps the most bullish indicator for the equity market—and for risk assets—from the most recent FOMC meeting was the lowering of median guidance for official short-term rates (Display 3). The FOMC’s 2015 year-end guidance came down to levels that have been implied by the futures markets for some time. But 2016 year-end guidance remains about 60 basis points higher than market-implied rates (Display 4). Will the market be surprised if the Fed maintains the current guidance and follows through on roughly 175 basis points of rate increases by the end of 2016?
History suggests that futures provide a fair bit of information about near-term rate levels, but they tend to be far less accurate beyond 12 months out. Further, market expectations of fed funds rates have tended to steepen sharply after the first rate hike. This makes sense, because the Fed rarely raises rates just one time. For example, in 2004, the futures market began to correctly anticipate year-end rate levels almost three months before the first Fed hike in June of that year (Display 5). Meanwhile, 2005 year-end futures rose sharply with the first Fed hike, but didn’t anticipate the full magnitude of the eventual rate increase until much later (Display 6).
So we don’t view the current environment as particularly unusual, and we don’t expect the market to be overly surprised by the Fed’s actions. If history is a reasonable guide, we would expect the futures market to begin anticipating September rate hikes by July or August. During that time, we’d also expect 2016 futures to imply higher interest rates.
Signs of Credit Creation—and Additional Global Liquidity
We’re seeing some comforting signs that ECB and BOJ policy actions are stimulating credit creation, which could provide additional liquidity to offset the impact of the Fed’s initiation of tighter policies.
It would be a stretch to describe bank lending in the euro area and Japan as robust. But loan growth has improved from the dismal levels of six months ago (Display 7), and growth in monetary aggregates has accelerated significantly. The sustainability of this growth is an important element in offsetting tighter Fed policy. Loose Fed policy had created a substantial amount of dollar-denominated loans, especially among emerging-market corporate borrowers (Display 8).
Emerging-market borrowing from Japanese banks appears to have picked up significantly (Display 9), reversing the post-2008 falloff in borrowing. While US bank lending to emerging markets is 8% below its March 2013 peak, growth in Japanese bank lending has more than offset the difference. If it lasts, this could bode well for emerging-market corporate credit and, more generally, high-yield debt. There’s still a hurdle to refinancing dollar-denominated debt following the recent appreciation in the dollar, but at least we’re not seeing any problems with borrowers accessing financing facilities.
Growing differences in credit spreads are also impacting the patterns of credit growth. Five-year cross-currency swaps for euro/US dollar and yen/US dollar are trading at an increasingly negative basis (Display 10), indicating that banks requiring US-dollar currency in exchange for the euro or yen for five years must accept a negative spread to their local interbank rates.
The negative basis could indicate outsize demand for dollar liquidity, which happened in 2008 and 2011. But in those two earlier periods, a crisis was the culprit; short-term cross-currency swaps this time remain relatively quiet. What we’re seeing is most likely tied to a difference in US credit spreads versus Europe and Japan (Display 11). This gap allows investment-grade corporations to borrow in euros or yen at a lower credit spread than US-dollar loans. Corporates often then have to convert the proceeds to US dollars to fund local operations or refinance existing loans. We’ve already witnessed a sharp increase in euro-area bond issuance (Display 12), which was primarily driven by US corporations.
The negative basis on the interest-rate swap effectively offsets the benefit of lower credit spreads outside the US. The end result: firms can borrow in euros and reduce their financial costs, but that advantage is neutralized once they try to convert the proceeds into dollars over the course of the loan.
Emerging Markets: Last Remaining Value Opportunity or Typical Value Trap?
Emerging-market equity returns are essentially flat since mid-2011, even as the MSCI World Index of developed-market equities returned roughly 50%. Likewise, many emerging currencies have collapsed versus the US dollar (Display 13), and emerging-market high-yield credit spreads are high compared with history (Valuations: Equities/Bonds, Display 5). This landscape suggests value opportunities in the area.
But average returns or valuations can be misleading—and so can the time frame you evaluate.
In the case of emerging-market equities, average valuations are down significantly since 2011, but they’re still only modestly below their longer-term averages (Display 14). Within emerging markets, there’s substantial divergence: the most “expensive” countries are still trading at fairly high price/earnings multiples relative to history, while the most distressed countries are trading at historically depressed valuations.
So from an investing perspective, the question is: Do you stick with perceived winners that have good fundamentals and are undergoing structural reform? Or do you invest in distressed countries on the assumption that mean reversion will lead to a rebound (Display 15)?
So far, most of our portfolios have been tilted toward Asian emerging-market stocks, which have stronger fundamental trends. However, we also see opportunity for active management. Wide valuation spreads point to a greater potential upside from stock selection, but aggregate valuations aren’t compelling enough to raise the overall market exposure.
Dynamics in bond markets are different, but the basic conclusion also holds true in that asset class: active management presents opportunities to add value by exploiting massive differences in interest rates and yield spreads (Display 16).
Our portfolios continue to overweight risk and reflation-sensitive assets. We expect improving nominal economic growth, sustained liquidity provision and continued accommodative monetary policy. Among risk assets, our largest overweights are in equities and energy, with more modest exposure to high-yield credit and an underweight in real estate investment trusts (REITs). Within equities, we favor cyclical sectors, non-US equities, and value approaches in Europe and Japan.
However, we believe exposure to income-generating investments is fairly important to manage our portfolio risk—particularly the potential for a reemergence of deflation fears like those that caused a second-half sell-off in 2014. That’s why we’re maintaining exposure to a variety of carry trades across assets. For example, we’re long US fixed income while shorting German Bunds and Japanese government bonds. We’ve also recently raised our portfolio exposure to European high-dividend-yield equities and dividend growers in Japan.