Last month we wrote about the potential repercussions from stronger growth. The January U.S. payroll report, issued February 2, raised concerns on this front as wages jumped 2.9% for the month. The prior two months also were revised upward. This was an apparent catalyst for the ensuing selloff in global equities – but is this a complete diagnosis? While we agree that the hotter wage increases are something to watch, we don’t think this is the sign of an upward march in inflation. Neither, apparently, do the fixed income markets: the breakeven rate of inflation embedded in the 10-year Treasury Inflation Protected Securities (TIPS) has actually fallen from 2.14% on February 2 to 2.07% today. What may be playing a bigger role in the selloff are the quantitative investment funds whose trading is significantly driven by market activity. Analyst reports indicate a significant pickup in selling among commodity trading advisor (CTA) strategies, volatility targeting and risk parity strategies as a major contributor to the downturn. CTA performance has sharply reversed this year and the trend-following nature of many of these funds has driven significant selling.
Are we seeing other signs in the market, beyond equity index prices, that raise concerns about the fundamental outlook? Broadly speaking, the carnage has been limited to stocks. U.S. investment grade credit spreads are virtually unchanged, and the 0.5% increase in high yield spreads can be explained by the 10% drop in Brent crude oil prices. Currency markets haven’t been too volatile; the U.S. dollar has rallied just 1% and emerging market currencies are down 1.5%. European sovereign bond markets have remained steady, with the Italian, Spanish and Portuguese bond spreads having increased just 0.04% to 0.07% this month. Finally, gold prices have actually fallen 2.5% this month, tied to dollar strength and an absence of safe-haven buyers.
So when will the selling pressure abate? While we don’t know how much more selling may come out of the quantitative funds, we continue to receive positive fundamental data and expect this to lead the markets higher over the next 12 months. Corporate performance remains strong, with current quarter earnings reports showing revenue up 7% to 9% and earnings growth of 12% to 15% across the major developed markets. We expect U.S. growth will be bolstered by the new tax plan and increased government spending, with some offset from the recent tightening of financial conditions. As shown below, markets have handled the repercussion of rising wages in the past – because they have generally occurred alongside rising profit margins.
The selloff in Treasuries this year has been significant, with 10-year U.S. Treasuries moving 0.5% higher in only 40 days. Yields have now reached their highest levels since January 2014. Half of the increase in yields over the last six months is due to increasing real rates, supporting our view that higher rates have been driven by positive fundamentals amid synchronized global growth. Additionally, we believe that the 10-year U.S. Treasury may approach 3% in the near term, providing some much needed steepness to the curve and reducing fears about a yield curve inversion.
Given our view that the Fed is going to raise rates twice over the next 12 months, and inflation is likely to remain contained, we have positioned portfolios to be underweight the short end of the curve and overweight the long end. Recent European Central Bank and Bank of Japan meetings brought no real news; both maintained the status quo. They are continuing with their quantitative easing plans, which will keep yields on their bonds suppressed. This plays into our view that current U.S. rates are high on a relative basis, and even if they move higher to 3%, technical pressure from foreign investors should limit the upside risk.
Within our risk assets portion of the portfolio, high yield has been a relative safe haven. With global equities down approximately 10% over the past two weeks, high yield has fallen only 1.5%. For context, high yield has historically had a 0.5 beta to global equity markets (when the equity market has historically fallen 10%, high yield has generally fallen by 5%). The sanguine drop in high yield can be attributed to well behaved credit spreads; high yield spreads have only increased by 0.5% while investment grade credit spreads have increased by less than 0.1%. Well behaved credit markets supports our belief that broader market fundamentals remain strong and that recent weakness is merely a correction of overextended markets and not something more troubling.
The increase in U.S. Treasury rates to start 2018 has caused concern over high yield market impact. The accompanying chart shows the correlation between 10-year yield changes and returns across the various high yield rating categories. While rising Treasury yields caused a material negative return in the BB rating category, the B and CCC rated securities show gains. For these categories, the negative effect of interest rates is overwhelmed by the positive credit effect (credit spreads generally move in an opposite direction to interest rates). This effect was seen in January’s returns. While BB-rated securities were flat, B-rated securities returned 0.7% and CCC-rated securities returned 2.0%.
After a remarkable 80 weeks without a 5% correction, equity markets finally experienced an overdue drawdown. From their peak in late January, equity markets fell 10% over nine trading sessions. The apparent catalyst was the January jobs report, which indicated accelerating wage gains, prompting inflation concerns. Notably, the market drop was very broad-based, showing very little sector or factor dispersion – no material flight to defensive sectors, dividends or quality. In other words, investors were just selling equities, not remixing their equity positions more defensively. On a year-to-date basis, while the market is down, defensive “bond-proxy” sectors (e.g., utilities, telecom) have underperformed materially.
With fundamentals remaining strong, including a more favorable growth backdrop and positive earnings revisions, we do not view the recent market correction as indicative of sustained equity market challenges. The market decline has restored some value to equities through lower valuations. Just since the end of January, U.S. equities have gone from a multiple of 19 times 2018 earnings to 17.3, while multiples for developed markets ex-U.S. have fallen to 14 times earnings, and emerging markets are at an attractive multiple of 12.
We use real assets in portfolio construction as ways to get slightly different flavors of equity risk in the portfolio. All real assets carry notable equity exposure, but natural resources can also provide commodity price exposure, while global real estate and listed infrastructure gain some of their return from exposure to term and credit risk (interest rate and credit market movements). Market downturns – such as the recent correction in global equity markets – provide a chance to analyze how real assets respond to such environments.
The recent 8.9% fall in global equity prices led to declines of 10.3%, 8.5% and 8.0% in natural resources, global real estate and listed infrastructure, respectively (see chart). This is largely in line with what we would expect. All real assets have notable exposure to the equity markets leading to the notable drop in real asset values. Natural resources have seen a slightly larger drop than global equities; the recent market weakness also weakened commodity prices – including a 10% drop in oil prices. Meanwhile, the interest rate and credit market exposure of global real estate and listed infrastructure has helped soften their drawdowns. Interest rates have moved slightly higher – but the aggregate U.S. Treasury return drawdown has been less than 1% – and investment grade and high yield credit spreads have not materially moved. All said, real assets are performing as expected – and we continue to hold strategic positions in the global policy model.
This month’s investment strategy discussions took place in the middle of the market downturn, allowing us to assess these developments real-time as we reviewed our strategy. Our conclusion is that a lot more has changed in the financial markets than in the real economy. The sell-off has improved valuations across the equity markets, but we are mindful that episodes such as this can take some time to stabilize as investors recalibrate their expectations and markets find new equilibrium levels. This is more challenging to assess in an environment where increasing amounts of money are being managed on a quantitative basis driven by market prices. Our focus on “repercussions” last month remains front and center, and the outlook for interest rates is central to the outlook for stocks over the next year. Many investors will focus simply on the reported wage gains in the payroll report, but we think it is important to understand the environment within which the wage gains are being realized.
Historically, wage inflation has had to reach 4% before it shows any statistical linkage to overall inflation. As long as rising wages are paired with productivity gains, corporate margins can expand and the markets can behave well. This cycle has the added twist – a new leader of the Federal Reserve, alongside numerous new governors. The markets will likely “test” the new leadership to try to learn how they will react. Our expectation is that the Fed will raise rates in March and then once more this year. More important than the number of hikes will be the climate in which they occur – it will be much better for the Fed to be “able” to raise rates when the market is expecting it, versus the Fed “having” to raise rates because inflation is taking hold. The latter scenario characterizes our first risk case of central banks making a mistake, in which the Fed tightens beyond what is warranted by inflationary trends. Our second risk case remains focused on Chinese economic growth, which has been slowing since last fall based on measures of private activity, such as electricity usage and bank loans.
The causes of rapid sell-offs like we have experienced this month can be tough to diagnose, and we will learn more about its roots in coming weeks. One of the repercussions of the selloff is a tightening of financial conditions (mostly due to falling stock prices) – which does some of the Fed’s work for it. Fed members may be satisfied to see some easing in financial asset valuations, while the yield curve has retained its new found steepness. This facilitates future rate hikes, and also demonstrates the market’s constructive view about economic growth. We’ve gone from concerns about an inverted yield curve two months ago to concerns about rising rates. I’ll take the renewed steepness in today’s yield curve over the flatness of yesteryear. We made no changes in asset allocation policy – and continue to expect global equities to outperform over the next 12 months.
-Jim McDonald, Chief Investment Strategist
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