The second quarter of 2016 continued a theme seen often since the Great Recession: slow but steady growth in the U.S. amidst downside shocks across the Atlantic.
U.S. economic data continued to oscillate. Markets priced a July Fed hike as roughly a coin flip in May, only to reverse and see a cut as more realistic by the end of June. Jobless claims continued to move downwards while nonfarm payrolls showed worryingly small numbers of jobs were added. Retail sales beat expectations handily while durable goods orders were weak. Meanwhile, worries across the Atlantic stemming from a “Leave” vote in the British referendum as well as worries over European banks led to equity market volatility. Japanese markets were again disappointed by a lack of action from the BoJ, leading to continued yen strength and equity underperformance.
Cabezon’s World Equity lagged its benchmark over the 2nd Quarter. An allocation to emerging markets underperformed as perceptions of a Fed hike swung sharply, strengthening the dollar against emerging market currencies. In addition, the portion of our U.S. overweight allocated to the Nasdaq-100 dragged on performance.
Looking to Q3, we continue to like U.S. equity over elsewhere in the developed world. The after effects of Brexit should be small, but we see a tail risk were similar political movements to gain momentum elsewhere in the Eurozone. Recent outperformance in Japan due to hopes of stimulus will be undone as any stimulus package will likely fall short of market expectations. Faster growth and higher yields should support emerging market equity and FX through continued capital inflows and we currently like a tactical position there.
Review of Q2
Differing exposures to Brexit impacts, monetary policy, and commodity prices drove the dispersion between global equity indices over the second quarter. The S&P 500 briefly set an all-time high only to fall after the Brexit vote. Early in the quarter, traders pushed the Nikkei up significantly on hopes of Bank of Japan (BoJ) action only to be disappointed yet again. European equities performed well early in the quarter as well, only to suffer a large drawdown due to the British referendum result and ensuing questions about the viability of the currency union going forward.
Contradictory data and the Brexit vote meant markets pushed out the timing of the next Fed rate hike. The chart below shows the volatility of nonfarm payrolls over the month. The April print was substantially below both the consensus forecast and 3 month moving average heading into the release. However, even this miss did little to prepare markets for the extraordinarily low May release. The May data ruled out a June rate hike, even affecting probabilities of a single hike by December. Jobs growth returned in June, but the sell-off in rates was short lived as the Brexit vote led to a significant bid for fixed income at all maturities.
After the vote, market derived probabilities of a Fed hike by December fell to 5%, having stood at 40% only weeks earlier. Equity markets rebounded in the final week of the month on hopes of lower rates for longer and recent data after quarter-end have helped rates markets return to a less extreme outlook for Fed policy.
We continue to remain overweight U.S. equity relative to the rest of the MSCI World benchmark. In addition, we have added emerging markets exposure.
Our U.S. thesis continues to rest on slow but steady economic growth in the world’s largest economy. The figure below shows that wage growth is returning to levels last seen before the Great Recession. The Job Switcher series from the Atlanta Fed, which has traditionally led overall wages, has jumped sharply in recent months.
With continued wage growth consumption will increase and retail sales should continue to pick up. We can see below that the 6 month moving average of year-over-year sales growth has begun rising from its lows in late 2015. While far from spectacular, retail sales show persistent growth even in the face of large deflationary pressures from falling prices in the energy complex.
One risk to our thesis of slow but stable U.S. growth is if firms respond to rising wages and slower than average sales with layoffs. This would slow consumption growth and overall GDP growth. However, if that were imminent, measures of forward looking business activity would reflect it. Instead the ISM Manufacturing and Non-Manufacturing surveys have turned up sharply through the second quarter.
While GDP growth is somewhat tepid, it is entrenched and a recession looks unlikely. Still, even in macroeconomic environments better than this one it is possible for equities to be overvalued and expected returns low. That does not seem to be the case currently. Investors may balk at a price to earnings ratio in line with historical averages in a growth environment that promises slower future growth, it is important to take into account the behavior of risk-free interest rates.
The chart above plots the S&P 500 earnings yield vs the 10-year Treasury rate. While the 10-year has continued its multi-decade bull market, earnings yields in the large cap index have remained relatively stable. With trillions in sovereign debt now offering negative yield, investors will continue to be forced to equities for income. This gives U.S. equity significant room to appreciate, even in a less than stellar growth environment. In addition to our overweight position in U.S. equity, we have entered an emerging market equity position. Economic growth across the EM landscape is significantly higher than in the developed markets. This will drive earnings growth there.
In addition to faster growth, some of the near term risks to emerging markets have abated. Fears of a hard landing in China, for instance, gripped market attention near the end of 2015 and first quarter of 2016. This fear linked movements in the Chinese yuan to global risk appetite, causing global equities to fall. In recent months however, that correlation has broken. As seen below, recent depreciation of the yuan has had little effect on risk appetite, with the correlation turning positive in recent months.
The primary risk to emerging markets is Fed policy. However, we do think the path of interest rate hikes will remain gradual (albeit slightly higher than the market expects at this point). This may mean near term volatility for emerging markets, but their higher rates will support capital inflows, buoying their currencies and thus dollar returns.
We remain unconstructive on European and Japanese equities. We do not see a large direct economic impact from Brexit. However, the main risks to Europe are political. The British referendum raised the inevitable what ifs? over the future of the Eurozone should a country using the single currency decide they wish to leave the monetary union. The list below, compiled by Citi, illustrates the potential political flash points coming in the years ahead. Uncertainty over the outcome of these elections will likely drag on equity returns in the region going forward.
In Japan we feel the market has gotten significantly ahead of itself over the prospects for significant stimulus. We would love to have been a fly on the wall at the meetings between former Fed Chair Ben Bernanke and various Japanese officials; however, the legislative restrictions to helicopter money make it unlikely to happen in 2016. In addition, the record of BoJ officials in doing what is necessary is less than stellar over the past several decades.
The rest of 2016 promises more of the same. We feel our portfolio is structured in investments with high expected returns and should outperform the MSCI World.