World Equity Quarterly Review
Depending on daily, weekly, monthly or quarterly measures, the first quarter of 2016 exhibited extreme volatility or almost none at all. After large drawdowns in equity and commodity prices, rebounding risk appetite and an improving fundamental outlook caused prices to rally slightly above year-end levels.
The World Equity strategy underperformed its benchmark as a strong yen hurt overweight positions in Japanese equites. In addition the weak dollar more broadly hindered performance due to the hedged FX positon in World Equity relative to the unhedged benchmark. While our primary thesis of monetary policy divergence was borne out over Q1, the response of asset prices to negative interest rates was unexpected, especially in FX.
Going forward, we have updated our view of the primary global macro factors driving asset prices. A dovish Fed and more benign outlook for commodity prices suggest an overweight position in emerging markets and the United States. Without the tailwinds of depreciating FX, equity markets in Japan and Europe look less compelling.
A Volatile Quarter:
Q1 2016 started where Q4 2015 ended, namely fears about global growth and bankruptcies in the commodity complex. After PMI data out of both the United States and China showed slowing growth in the services sector, previously a bright spot in both countries, equity prices fell.
Equity markets continued to move downwards through the month with only small periods of respite after both the ECB and BoJ decisions. Both central banks stood with negative policy rates by the end of January, a policy stance meant to increase economic activity but one that instead led to renewed risk aversion because of the policy’s feared effects on banks. Banks in both Japan and Europe lagged the broader market on fears of profitability, and even solvency in the case of German giant Deutsche Bank due to the behavior of their mildly esoteric contingent convertible bonds (CoCos).
The correlation of equity prices with oil remained tight throughout much of the first quarter, with the assets rising and falling together every week until the last week of quarter. We did not see a sustained rebound in equity prices until witnessing a concomitant rebound in oil in mid-February.
The recently found tendency of equity prices to move upwards without oil is due in large part to the outcome of the Fed meeting in March. Chair Yellen struck a decidedly dovish tone. She views the recent uptick in inflation as temporary, and is regardless willing to run the risk of higher inflation in the near-term to ensure the recovery gathers steam.
World Equity Performance:
The World Equity strategy got off to a poor start in Q1. As top-down macro investors, we view the world through various fundamental factors that drive asset prices. Those factors, unchanged from 2015, included U.S. monetary policy, the divergence of that policy with Europe and Japan, economic performance in China, commodity prices, and growth in emerging markets. We felt the best risk-reward opportunities involved the first two factors.
A strong job market, falling unemployment rate, and rising inflation suggested a relatively hawkish stance of monetary policy in the United States relative to the rest of the world. This divergence led us to forecast continued dollar strength. Exchange rate moves have been extremely potent predictors of relative equity performance in developed markets as they influence the overseas earnings of multinationals.
While the relationship between equity returns and exchange rates has remained strong (see above for the Japanese example), the correlation that broke was the relationship between dovish policy shocks and foreign exchange movements.
The decision by the BoJ to take rates into negative territory, while at first accompanied by yen depreciation led not to further risk taking but instead a bout of risk-off in which all risky assets declined. As a global funding currency, in these periods of diminished risk appetite and volatility the yen appreciates as exposures are pared down. This, combined with a more dovish Fed has led to the yen proving sticky around the 110 level, even as global equity markets have rebounded. This has proven a significant drag on Japanese equities, and our overweight allocation there was the primary source of underperformance.
The Economic Landscape and Portfolio Going Forward:
Q1 saw dovish monetary policy shocks leading to an appreciating currency, and negative rates to equity market declines. With monetary policy shocks losing traction and significant developments in our other macro factors, we have reassessed our portfolio.
Thankfully, asset prices have responded predictably to the dovish stance of the Federal Reserve, even after the aforementioned confusing moves after actions by other central banks. The dollar has continued to weaken after the Fed meeting. This will be a tailwind to the overseas earnings of large U.S. corporations, giving them a badly needed earnings catalyst. Without such depreciation pushing up equity prices in Europe and Japan, we see few compelling reasons to hold equity there. Activity in Japan continues to stagnate and while green shoots have been seen in European PMIs, the presence of fragile and undercapitalized banks in the major equity indices significantly reduces their attractiveness.
While there are certainly losers in a softer dollar environment, there are winners as well. Emerging markets carry substantial external debt denominated in dollars. As the rate of appreciation of the dollar eases or ceases completely, the debt burden stops growing and financial conditions can begin to ease. The Bank for International Settlements has done extensive work on tracking the relationship between dollar appreciation and an increase in CDS spreads and credit risk premia throughout economies with large stocks of dollar liabilities (source). Anything that breaks the circuit breaker of depreciating FX leading to higher risk premia and further depreciation is helpful, and it looks as though Chair Yellen has done just that.
In addition to FX tailwinds, emerging markets are also helped by the absence of a hard landing in China. Recent evidence from trade data and surveys suggest that the feared financial crisis is, at the very least, postponed for a while. Below we can see that both official and unofficial PMIs have surged upwards in recent months. In addition, the Chinese have reversed their policy of liberalizing capital outflows. This has reduced pressure on the yuan, led to renewed reserve accumulation, and further reduced the probability of a financial crisis due to capital flight.
As a large trading partner for many emerging markets, a stable China is important for emerging market growth prospects and it looks more and more like there will be no hard landing, at least in 2016.
Finally, a rebound in commodity prices is a necessary and almost sufficient condition for a continued rally in emerging market asset prices. We see oil prices remaining firmly above $30 over 2016 and likely a sustained rise above $40. At this level, energy bankruptcies are unlikely to freeze credit and cause a recession in the United States and will, at the same time, offer much needed support to the terms of trade of emerging markets.
Oil price support will come predominantly from a reduction in U.S. supply. We can see below that Bakken and Eagle Ford, two of the primary beneficiaries of the tight oil/shale revolution, are seeing production decline. In addition, rigs continue to come offline as current prices mean more drilling is not profitable. As the saying goes, the cure for low oil prices is low oil prices. We also view the likelihood of a renewed Saudi assault on oil producers (through increases in output) as unlikely. They have proven that their threats are credible, and that credibility means large scale investment in U.S. production is extremely risky near-term.
A dovish Fed combined with stability in the dollar, oil prices, and Chinese growth suggest strategic overweights to the United States and emerging markets and that is where we will be. However, should inflation rise faster than expected and the Fed change turn hawkish, we will reevaluate our strategy and revisit our themes that have served us well over 2014 and 2015.