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Stock market volatility appears to have peaked in August, and has been moderating since, in the wake of the Chinese currency devaluation. However, this doesn't mean that investors have had to search for things to worry about. For example, the frequently discussed script — that while we didn't know exactly when the Federal Reserve was going to raise rates, it was ready to do so — was tossed out after the Fed's September meeting. Citing market volatility and economic uncertainty, the Fed managed to disappoint both bond and stock investors with its dovish message. Investors are left wondering about the Fed's reaction function, and what factors will be required for it to initiate liftoff. We're of the view that the initial move is increasingly unimportant to the bond market, as it's convinced that the path forward for rate increases will be slow. In contrast, equity markets may finally breathe a sigh of relief if the initial increase is properly signaled.
The fundamental backdrop hasn't changed much of late. Domestic consumption remains the key for most important economies, whether the United States, Europe or China. Global trade continues to disappoint, reflecting the muted overall growth environment. China's 20% drop in September imports likely overstates the weakness (due to falling commodity prices), but this weakness has directly affected the outlook of important exporters like Germany. While the recent Trans-Pacific Partnership trade agreement could bolster trade between the 12 signatory nations, it's a long way from legislative approval in those countries. Meanwhile, the drop in commodity prices continues to pressure headline inflation figures, while core inflationary trends are more stable. Among the worries of today's central bankers, inflation likely remains firmly in the background.
The final months of 2015 promise to be eventful from a policy standpoint. In the United States, the recent resignation of House Speaker John Boehner is likely to complicate the upcoming negotiations over the debt ceiling (sometime in November) and the budget (December 11). Uncertainty over these issues would be another reason for the Fed to stand pat. We also expect continued debate over the potential for further quantitative easing measures out of the European Central Bank (ECB) and the Bank of Japan (BOJ). With the Fed on hold longer than anticipated, the beneficial currency weakness these two central banks have engineered has abated. All of these developments reinforce our view from this summer's five-year outlook, that we face a continued "low and slow" monetary policy outlook.
As U.S. equities have recently recovered, leadership has changed meaningfully, as laggards such as energy, utilities, materials and industrials have been the best performers during the past month. In the case of energy and materials, some relief in the form of higher commodity prices has contributed, while utilities have been supported by declining long-term rates. Health care, which had been a significant outperformer, showed the steepest decline on fears of potential drug price regulation. We continue to overweight health care, moderately overweight energy, and moderately underweight the defensive sectors of consumer staples, telecommunications and utilities. We expect volatility to continue as the market absorbs uneven macro trends and debates the pace of action by the Fed, but we remain constructive on U.S. equities as valuations have improved and interest rates remain low.
European equities stabilized during the last four weeks, declining about 2% after a double-digit correction in August. The STOXX Europe 600 has managed a slight gain this year, although it has been more than offset by a 7% decline in the euro relative to the dollar. However, there are signs that ECB stimulus is strengthening the eurozone economy, especially on the domestic front. Continued stimulus, along with relatively low economic and equity market expectations compared to the United States, could bode well for relative performance in the future. These relatively low expectations are supported by a historically low 10-year cyclically adjusted price-to-earnings ratio in Europe relative to the United States. In summary, while economic momentum looks steady across Europe, the potential for further euro depreciation could limit the returns for U.S. dollar-based investors.
The Nikkei 225 Index was off 2% since our last report, with the yen trading in line with the dollar. Japan has eked out an equity market gain this year while the yen has been treading water. The Japanese economy continues to generate erratic growth, and the 2% inflation target remains elusive. Unemployment has reached 3.4%, which is a level that the BOJ considers approximately "full employment." Despite this labor market tightening, wage inflation has been lower than expected. While both the service and manufacturing economies have been improving, the gap between services and manufacturing employment conditions has been wide relative to previous cycles. Perhaps labor shortages in the stronger services sector will finally lead to sustained wage gains for Japanese workers.
While developed-market central bankers fight with negative interest rates and calls for more quantitative easing, certain emerging-market economies still have flexibility for more traditional accommodative policy. Prominent emerging-market economies, like Brazil, Russia and South Africa, face unwelcome levels of inflation. However, commodity importing economies, such as China and India, are realizing policy flexibility due to favorable inflation conditions. This has allowed them to successively reduce rates during the last year. Hopefully, this will lead to improving economic momentum, most importantly in China. Emerging-market central banks are increasingly leading the call for the Fed to raise interest rates, as they view the current policy uncertainty as damaging. A clearer policy outlook and an improving economic picture are the remedies for emerging-market assets.
Since late August, oil prices have rebounded from levels not seen since the global financial crisis. This upward move has been driven by 1) expectations for reduced supply — only 40% of the rigs active one year ago in the United States are active today, 2) incremental expected demand increases — global demand is now expected to increase by 1.3 million barrels per day in 2015, and 3) investors covering short positions. However, investors also have reduced longer-term expectations more than they did the last time oil prices were at these levels. Comparing the current oil futures curve to late July shows the "lower for longer" mentality taking hold in the oil markets. Near-term challenges persist as inventories remain elevated, but the reduction of future expectations provides a more stable foundation for market fundamentals and longer-term returns.
U.S. HIGH YIELD
Fed policy uncertainty in a weaker global economic environment has resulted in more-attractive valuations in the high yield market. The Fed disappointed the markets with its dovish message in September. Knowing that equity volatility around the Fed meeting was likely, the high yield market basically sat on the sidelines. Therefore, any selling (often small amounts by exchange-traded funds) wasn't met by a buyer until it was offered at much lower price levels. The Fed's confusing messaging was followed by a weak September jobs report, reducing the probability of Fed tightening in the near term. Underlying fundamentals in high yield are the same as they were at tighter spreads in June, while the market yield is 200 basis points higher. We think these cheaper valuations provide an excellent risk/return opportunity during the next year.
U.S. FIXED INCOME
Option-adjusted spreads on investment-grade corporate debt are now at their widest levels in the past three years. The low-interest-rate environment has encouraged corporations to issue debt to finance share buybacks, dividend increases, and mergers and acquisitions (M&A). The increase in new supply has overwhelmed investors, who have demanded additional compensation from issuers before purchasing their debt and caused spreads to widen 75 basis points during the past 15 months. Looking forward, we expect new corporate issuance to become more manageable as M&A slows on a relative basis, providing a positive technical signal. Additionally, as the economy shows resilience and some large institutional buyers reenter the market, we believe that spreads will begin to tighten.
EUROPEAN FIXED INCOME
While the recovery in the eurozone appears intact, a pocket of disappointing data, including lower business Purchasing Managers' Indexes and weak German export numbers, has boosted talk of additional monetary policy easing from the ECB. Slowing global growth and negative eurozone inflation could justify an extension of the ECB's current asset purchase program, and the minutes of its last meeting indicated a willingness to front-load stimulus to support market functionality. The U.K. Labour Party announced Jeremy Corbyn as its new leader. Signs of political momentum for the Labour Party threaten to disrupt the current political stability in the United Kingdom, especially with ongoing speculation surrounding the "in or out" European Union referendum. Given that inflation remains below target, courtesy of low oil prices, the Bank of England is in no hurry to raise rates.
ASIA-PACIFIC FIXED INCOME
Expectations for the BOJ to boost monetary stimulus increased ahead of its October meeting, given global growth concerns. However, its decision to keep policy on hold was unsurprising in light of evidence of domestic improvements, including the rise in the nonmanufacturing business survey. Although inflation has declined recently, continued currency weakness and an emerging domestic recovery might increase confidence in eventually reaching the BOJ's inflation targets. Growth in Australia has been underwhelming of late, with gross domestic product growth slowing to 2% year-over-year in the second quarter. While the Reserve Bank of Australia kept rates on hold this month amid concerns of an overheating property market, the slowdown in Asia and the commodity markets should provide room to justify another interest rate cut as inflationary pressures continue to trend lower.
So far, it appears that developed markets are experiencing a correction and not the start of a bear market. The S&P 500 reached its one-year low on October 15, 2014, and successfully stayed above that low during both this August's and September's sell-offs. Because investors have been roundly disappointed in the Fed's policy inaction, the rebound from the lows more likely reflects confidence that the economy will continue to advance than applause over easier monetary policy. Similar to last month, our recent investment policy debates focused on whether the markets were sending a warning shot that growth was at risk, or were we experiencing a long-overdue correction and appropriate adjustment in risk appetite. As we see little excess in the real economy, and don't expect a monetary policy disruption to the growth outlook, we think the global economic expansion will continue. Therefore, we think there's been some value created in the recent sell-off and have selectively been increasing our recommended tactical asset allocations.
We think the recent sell-off in U.S. high yield bonds has created a buying opportunity. While global equities have stabilized during last month, spreads on high yield bonds continued to widen — from 7.3% on September 1 to 8.2% by October 2. Some are concerned that outflows overwhelmed the high yield funds, but we think outflows have approximated 0.5% of the asset class since the end of June. We also believe portfolio managers generally met their redemptions through cash on hand, rather than selling existing bonds. We think some of the spread widening is justified, relating to energy, material and retail bonds, but we believe this risk can be mitigated through good portfolio management. With better value now available in high yield after this sell-off, we increased the recommended exposure in our global tactical asset allocation model by 3% this month, funded by a reduction in U.S. investment-grade debt.
Our primary risk cases remain the potential for a hard landing in China, U.S. dollar strength and the potential for heightened volatility leading to valuation compression. The Chinese economy, while still slowing, should show some benefit during the next year from the policy changes the government has been implementing. Concerns remain over a U.S. dollar crisis emanating from the emerging markets, yet we've continued to hear calls from emerging-market central bankers for the Fed to raise rates to reduce uncertainty. A continuation of increased volatility could push investors to demand a higher equity risk premium, capping the small valuation expansion potential we expect during the next year. We'll also continue monitoring the developments in Syria, where Russia's increased involvement has raised the stakes. Finally, the next couple of months will be particularly eventful in Washington D.C., as the Republicans search for a Speaker of the House and a path to managing the upcoming budget and debt ceiling deadlines.