CC-BY-SA-2.0, FlickrPhoto: Jotam Trejo. Stocks Are Not the New Bonds
2016 has been notable for droughts in some places and floods in others. There has been a disconnect, if you will, in normal weather patterns. Lately, we have witnessed a growing disconnect in the financial markets too. Asset class after asset class continues to rise in value despite stagnant global economic growth and flagging corporate profits. Why are investors chasing the market higher? Extraordinarily accommodative central bank policies are the most likely explanation.
With a large fraction of the world’s pool of government bond yields in negative territory, flows that normally would have gone into high- quality fixed income securities are instead finding a home in dividend-paying stocks. This “chase for yield” has pushed up traditional high-dividend payers like real estate investment trusts (REITs), utilities and telecom stocks to historically rich price/earnings multiples. This is the most concrete evidence we have seen in years that investors are substituting stocks for bonds in investment portfolios.
Bonds: Accept no substitute
There are two powerful reasons why stocks are not a substitute for bonds. The first is the relative volatility of the two asset classes. Stocks are historically about three times as volatile as bonds. Investors therefore demand higher returns in exchange for holding these riskier assets. Second, dividend payments to stockholders are not a contractual obligation; there is no legal compunction for corporations to continue to pay dividends. Dividend payments can be — and often are — cut at the first hint of trouble.
Stock investors need to be particularly mindful of potential economic inflection points. History has shown that markets often become the most euphoric at the most perilous point in the economic cycle. The current US economic expansion is now in its eighth year, while the average business cycle typically lasts five years. The stock market has historically peaked 6–8 months before a recession begins, though forecasting recessions is always challenging. When recessions do hit, corporate profits have fallen by an average of 26% and stock markets have typically fallen by roughly the same amount. Failing to avoid late-cycle euphoria can have severe costs for investors, especially for investors who have been driven into equities for the wrong reasons.
Don’t be late
Instead of being an equity market latecomer, yield-starved investors might want to consider adding “credit,” or corporate bonds, to their investment portfolios. Pools of investment-grade corporate bonds are currently not cheap by historic standards, but they are not at extremely rich price levels either. Investors seeking yield can find attractive opportunities in corporate credit, which offers yields similar to or higher than equity dividends, but generally with far less volatility.
Global central banks have been providing novel forms of support for world bond markets with the aim of stimulating economic growth and inflation rates. But in my opinion, sound investment strategy does not include guessing where central bank policy is heading next. The guiding principles of preserving capital while generating growth are vigilance on the fundamentals, caution regarding gains, and the avoidance of fads. Don’t follow raw market emotion, especially when easy money causes the temperature of the markets to rise just as fundamentals fall.
CC-BY-SA-2.0, FlickrPhoto: Linus Bohman. How QE Distorts Prices
One of the main differences between free market and communist economies is the role of prices. In free market economies, prices play a central role as they aggregate valuable information over demand and supply in a single figure that guides economic agents – producers and consumers – to make their choices. In communist economies, on the other hand, prices do not incorporate any information, since what is produced and consumed is defined in a plan decided by a central authority.
A prime example of free market economies are financial markets, a virtual place where millions of sellers and buyers continuously exchange standardised products. In these markets, and more than in any other markets, prices play a key role. This is the very reason why trade takes place.
A Quantitative Easing (QE) programme, as decided by a central bank, is a plan that consists of buying large quantities of assets whatever the price is. As a conse- quence, prices lose their precious information content that normally enables investors to switch meaningfully between different asset classes. One example for this is the current development of government bond yields. It makes no sense that long-dated German government bonds have a negative yield, nor does the fact that Italian yields are lower than their US counterparts. Even more shocking is that the Bank of England wasn’t able to buy enough gilts during the first days of its new QE, even though the price offered to pay was high and above market prices. Furthermore, it is common knowledge that gilts are overvalued.
QE programmes are designed differently across central banks, including to various degrees sovereign bonds, corporate bonds, asset-backed securities and equities. They all have in common to purchase mainly sovereign bonds. The yields of these government bonds play a central role in asset allocation as they are seen as risk free rates and thus set the basis for the pricing of all assets. Consequently, the distortion in this specific market segment, reinforced by negative interest rate policies of central banks, has a cascading effect on other assets, thus leading to mispricing of all financial assets.
According to the Financial Times, the market value of negative-yielding bonds amounts to USD 13.4tn, a mind-boggling figure that shows the extent of the price distortion in this key market segment. In addition to central bank purchases of other above-mentioned assets which directly distort prices of risky assets, liquidity and risk premiums are further altered by investors’ thirst for yields, forcing them to take more risk for a given return.
No matter how strongly distorted each individual market price is, asset prices remain consistently priced vis-à-vis each other. For example, the yields of US treasuries and German bunds – two assets that share very similar risk characteristics in the investors’ eyes – become similar once the currency hedging costs are taken into account; and this despite different economic conditions and different central bank behaviours. Equity markets have all gone up significantly, even to new highs in the US, as the thirst for yields has obliged investors to buy equities despite an overall general pessimism and meagre growth prospects. The same is true for corporate bonds. Finally, the VIX Index, nicknamed the fear index, is close to its lowest level, as if the world economy would be looking forward to a blue sky outlook.
While mispricing can be observed in all asset prices, financial markets behave consistently, in sync, according to their own logic. We are asking ourselves how long this situation will last and how far it can go. The situation will last as long as central banks’ credibility remains intact, or in other words, as long as they are willing and able to act convincingly in the eyes of market participants. And it can go as far as the most powerful and thus most credible central bank will be able to set prices at ridiculous levels. If this proves to be true, risk-free yields are set to converge to the lowest level and risky asset prices to increase virtually in- dependently from economic fundamentals. Like in communist economies, the outcome is ultimately equality, not fairness.
Three potential symptoms could indicate that this situation is in its terminal phase. First, the credibility of central banks and governments is directly challenged, resulting in rising and diverging government bond yields as risk is repriced. Second, the currency market absorbs a part of the mispricing by rebalancing economies and markets via sizeable exchange rate adjustments. Third, the loss of credibility is directly reflected in the domestic loss of purchasing power, in other words inflation. This type of inflation, however, is not due to the usual too much money chasing too few goods, but to a lack of confidence in the government. This can potentially lead to hyperinflation, as extreme events such as Germany in the 1920s, Hungary in 1946, Zimbabwe in the late 2000s and Venezuela today remind us.
While we do not see any of these symptoms flourishing, a way to protect against this eventuality would be to invest in gold, an asset which is not under the direct control of institutions and an alternative to cash whose costs have increased dramatically with the introduction of negative rates.
In this context, the case of Japan is interesting in many respects and is a source of hope in the view of our analysis. For more than two decades, Japan has experienced a zero economy. This is an economy where growth, inflation and yields have been low. According to the IMF, government debt to GDP has been multiplied by 5 since 1980 to about 250% nowadays and is unsus- tainable. In addition, Japan has experienced various government and central bank policies with essentially no effect: yields have not repriced and growth and inflation have not come back. The Japanese yen has moved in the opposite direction to the Bank of Japan’s intention, indicating that investors are challenging the credibility of the Nippon central bank, but without triggering a full-fledged credibility crisis. Japanisation of financial markets and Western economies could thus be a benign outlook.
The wide use of unusual monetary policies in the Western world, in particular QE, has distorted massively all asset prices. While assets are mispriced, it remains true that they are consistently priced vis-à-vis each other. As long as central banks remain credible, this situation could last longer. Currently, no terminal phase symp- toms are observed, which means that the convergence in prices should continue. Gold is a good hedge against an abrupt end of this system, unless we all become Japanese.
Sayonara (さようなら) .
Yves Longchamp, is Head of Research at ETHENEA Independent Investors (Schweiz) AG.
Capital Strategies is Ethenea distributor in Spain and Portugal.
The “dog days” of summer have shown their teeth. Last week we saw some action on the S&P 500 at last. But this doesn’t feel like a real correction.
It’s worth remembering that not even a surprise like Brexit could knock equity markets off course. What set off last week’s wobble? Dovish Boston Fed Chair Eric Rosengren telling us there was a “reasonable case” for a rate hike and that ducking it could delay the economic recovery. Theories circulated that Fed board member Lael Brainard, another dove scheduled to speak three days later, was there to soften us up for a hike this Wednesday.
The Fed False Alarm
In her remarks, Brainard stayed with her dovish instincts. Fed Funds futures went from pricing in a 24% probability of a September hike to 15%—lower than before Rosengren spoke. The S&P 500 bounced 1.5%, led by the high-yielding stocks that had sold off in response to Rosengren.I’m no professional Fed watcher, but I’ll stick my neck out and predict that Janet Yellen will hold again on Wednesday.
And so then we’ll turn to the Q3 earnings season. Current expectations are for a flat quarter. To meet expectations for 2016 earnings, that implies a pop up to high single-digit growth in Q4, and given recent weakness in economic data, that seems very optimistic. But if markets stay true to recent form they will likely worry about that in December.
Before December, we have the small matter of a U.S. presidential election. With Labor Day behind us, the campaign is beginning to impinge on the market’s consciousness just as it is on the minds of voters at large.
Election Polls Are Tightening
We can see that in recent opinion polls. A month ago, the New York Times analysis of state and national polls put the probability of Hillary Clinton winning the White House at 85%. Since then, a surge for Donald Trump has pulled that back to 76%.
The latest national poll average has 44% of voters opting for Clinton and 42% for Trump, but the Electoral College math, which makes it more important to win in certain states rather than others, still favors the Democrat.
One key state to watch is Ohio, where the winner has nearly always claimed the presidency. George W. Bush in 2004 and Barack Obama in 2012 were both taken over the 270 College-vote threshold by Ohio. Trump is now slightly ahead in the Ohio polls. It’s also worth noting that his recent boost has put Trump ahead in five of the 12 most crucial states, and that in two others Clinton has only a marginal lead.
The U.S. is waking up to the possibility that this race could go to the wire.
Markets Have Been Pricing Gridlock
Financial assets have been discounting a Clinton White House, a Democratic Senate and a Republican House of Representatives. Markets would seem to prefer this outcome because a balance of power limits the potential for extreme policies. Less cynically, there is some evidence of bipartisan support for infrastructure spending. Debate about how much to spend and where to spend it could still leave the idea bogged down in Washington, but a well thought-out fiscal stimulus program could be a driver of stronger growth.
But a strong consensus for a certain electoral outcome like this creates the potential for volatility should polls start to signal a Trump presidency, or Democratic control of the House.
With more uncertainty now coming through in the polls, investors have to ask themselves what these candidates’ policies will really look like. The first debate in a week’s time may make things clearer, but at the moment that’s a challenge: Trump has no track record and his pronouncements have often been vague, and while Clinton clearly has form it’s still difficult to know how seriously to take her statements on issues like drug-pricing policy.
In other words, a few shocks in the polls could leave us facing considerable political uncertainty. That’s likely a recipe for more volatility.
The Weighing Machine Needs the Voting Machine
The great value investor Benjamin Graham once said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” His words resonate during times like these.
Those of us who, like Graham himself, think of markets as weighing machines, guiding prices gradually towards economic fundamentals, acknowledge the role the voting machine plays in giving us compelling entry points for long-term investments.
We appear due for a re-pricing of risk. Brexit couldn’t provide it. The Fed appears unwilling to. Step forward the American voter.
Neuberger Berman’s CIO insight written by Joe Amato
CC-BY-SA-2.0, FlickrPhoto: geralt / Pixabay. Afores Reduce by Almost 4% Their Exposure to International Equities in 2016
Although assets under management between December 2015 and August 2016 show a growth of 10%, half explained by the bi-monthly contributions made by workers affiliated; in the same period, is observed, a reduction in international equity investments and an increase in government debt (with lower duration) at the aggregate level.
The environment of volatility that has characterized this year, has led the Afores to show prudence and diversification in investments both in equity and also fixed income, and this situation has been reflected in a reduction in international equity positions and lower duration in debt instruments.
According to Consar, Assets Under Management ended August at 2,784,587 million pesos (mp) amounting to 148 billion dollars. Between December 2015 and August 2016 assets grew 243,624 mp, equivalent to 10%.
The resources invested in government debt in December 2015 was 50.2% and by August 2016 this percentage increased by 4.6% reaching 54.7%. This growth is largely explained by the reduction of investments in international equities from 16.2 to 12.6% reflecting a contraction of 3.6%. Domestic equities remained virtually unchanged, going from 6.4 to 6.6%
Investments in government bonds have also shown prudence and so far this year, a reduction of three months in the weighted average maturity to be added to the reduction of 12 months in 2015. Currently the Afores at the aggregate level are investing at 11.6 years. It is noteworthy that this indicator can be distorted by the derivative positions that the Afores that are allowed to use them keep.
In the case of investments in international equities, lower amount and greater diversification is observed among the 19 countries and global indexes that invest Afores.
Between December 2015 and August 2016 a contraction of 61,661 mp (-15%) was observed in international equity investment to finish August at 350,858 mp, equivalent to 18.6 billion dollars.
Regarding the weighting in international equity between the second quarter of 2015 and the second quarter of 2016, the weight of investments in the United States declined from 45% to 37% which means a reduction of 8%; while the weight of global indices rose from 22% to 31% which means an increase of 9%. In reviewing the list of countries in which the Afores invest, four Afores diversified between 1 and 4 countries and global indices; 5 Afores have 8; one Afore 13 and another 19. Pensionissste only invests in one country; Inbursa in two; Coppel three including global indices; Principal four; Azteca, Banamex, Invercap, Metlife and XXI-Banorte 8; while Profuturo 13 and Sura 19.
Nowadays it prevails a complicated environment for which it can be expected that this prudence and diversification by the Afores will continue, where the question is whether this defensive environment will also be reflected in the participation of Afores in new issues as for example CKDs, for which the pipeline includes about 20.
CC-BY-SA-2.0, FlickrPhoto: Viri G. Is the Fed Bluffing?
In the days prior to the Federal Reserve’s annual Jackson Hole Economic Policy Symposium at the end of August, senior Fed officials started to make the case that markets had become too sanguine about further rate hikes this year. Janet Yellen’s conference opener restated the Federal Open Market Committee’s tightening bias, saying “the FOMC continues to anticipate that gradual increases in the federal funds rate will be appropriate over time.” There was no softening or policy pivot here. In fact, she added that “the case for an increase in the federal funds rate has strengthened in recent months.” That was the most forceful endorsement of another rate hike from Yellen yet.
The rest of the conference, titled ‘Designing Resilient Monetary Policy Frameworks for the Future’, produced few new insights. The agenda focused on policy efficiency, especially what can be done to improve the pass-through of monetary policy to broader financial markets, and emphasized greater coordination between fiscal and monetary policy. Other speakers argued for maintaining the large Fed balance sheet for the foreseeable future and affirmed Chair Yellen’s view that the current set of policy tools – including the ability to pay interest on excess reserves, large scale asset purchases, and explicit forward guidance – are sufficient to deal with future downturns.
Yellen even provided model-based estimates showing quantitative easing and forward guidance would be as effective as allowing policy rates to fall deeply into negative territory in a future recession. That’s as clear a repudiation as you will get from her of the negative interest rate policy followed by the European Central Bank (ECB) and the Bank of Japan (BOJ). One presenter at the symposium, Marvin Goodfriend, did promote the merits of unencumbering interest rate policy at the zero bound. He argued that the current low levels of nominal bond yields leave little room to push short rates much below longterm interest rates. Yet, for such a policy to function effectively, we would have to seriously reduce Americans’ preference to use cash for transactions, which would resist negative rates. It’s hard to see negative interest rates as anything but an interesting thought experiment for the Fed.
Markets moved sideways
Reflecting the uncertainty about US monetary policy, both equity and the broader fixed income markets trended sideways last month. Both the S&P 500 and the Barclays Aggregate index were essentially unchanged in August; incidentally, both are up about 6% for the year so far.
What still worked in August was the reach for yield. The Barclays High Yield index gained 2%, pushing its year-to-date performance to over 14%. Also not surprising in an environment of possible Fed rate hikes was that financials were the best performing sector in the S&P 500 and the US dollar gained a few tenths of a percent against other major currencies.
Fundamental contradictions
Janet Yellen’s manifestly improved confidence has some backing from US fundamentals. While economic growth in the second quarter was revised down to just 1.1%, much of the weakness was due to a decline in inventories, typically a transitory headwind to growth. In fact, private domestic demand – consumption, housing, and business investment – increased at a more impressive 3% rate, up from just 1.1% in the first three months. Job growth has rebounded, too. After averaging just 84,000 new jobs in April and May, the following two months saw that trend increase to 274,000. Most forecasters are looking for a solid 2.7% growth rate in the current quarter; our forecast, at 3.2%, is even more optimistic. So, the Fed’s central case of a moderately growing economy that will continue to push the unemployment rate lower remains strong.
Still, not all the evidence is pointing in the same direction. The two main US consumer confidence surveys have been on diverging trajectories in recent months. One showed consumers feel their current circumstances haven’t been that good since the summer of 2007, which suggests the pace of consumer spending should accelerate. The other survey has deteriorated below last year’s average, pointing more to weaker spending. It’s a similar story on the manufacturing side: One of the two major purchasing managers’ indexes supports a tentative reacceleration, while the other just indicated a renewed contraction in manufacturing activity.
The Fed may not pull the trigger this year
Those contradictions are not enough to change the Fed’s central, moderate growth case. But they likely sow enough doubt about how sustainable a summer growth rebound is. Doubts like these are what persuaded the FOMC in each of this year’s five meetings not to raise rates. We think that is essentially what the committee faces when it meets later this month. With inflation still well below the Fed’s 2% target, the FOMC is under no pressure to raise rates other than the pressure it has created itself.
After the December 2015 rate hike, the FOMC still provided forward guidance of four additional increases this year. In March the committee cut that guidance to just two. The second half of the year should look similar to 2015, when the FOMC cut guidance in September from two to just one rate hike for the year and delivered that hike at the December meeting. The added complication this year is, of course, November’s presidential election, which may lead to an increase in economic policy uncertainty. That’s the main reason our forecast schedule has the next rate hike penciled in for the first quarter of 2017 and not December 2016.
Another rate hike will do very little to change the outlook for Treasuries. The Fed may be contemplating further policy tightening, but the ECB, the Bank of England, and the Bank of Japan are still looking for policy easing. That should keep yields low in much of the rest of the developed world, which serves as a valuation anchor for longer dated US Treasuries. However, US inflation trends are gradually improving behind the scenes. After averaging close to 0% for most of 2015, it took just three months for headline inflation to jump to a new 1% trend earlier this year. The same base effects are likely to push next year’s average above 2%. That should modestly pull up longer term Treasury yields. We still expect 10-year Treasuries to trade around 1.5% at the end of this year and around 2% at the end of 2017.
Markus Schomer is managing director y Chief Economistde PineBridge Investments.
This information is for educational purposes only and is not intended to serve as investment advice. This is not an offer to sell or solicitation of an offer to purchase any investment product or security. Any opinions provided should not be relied upon for investment decisions. Any opinions, projections, forecasts and forward-looking statements are speculative in nature; valid only as of the date hereof and are subject to change. PineBridge Investments is not soliciting or recommending any action based on this information.
CC-BY-SA-2.0, FlickrPhoto: DonkeyHotey. With Election Looming, Fundamentals and Fed Matter More for Investors
The United States presidential election in November will be historic in many ways, but the long-term implications of either Hillary Clinton or Donald Trump winning will likely have less of an impact than many market participants are anticipating. If history is any guide, election results have had a relatively minimal impact on longer-term U.S. or global equity returns, according to Bloomberg data and the BlackRock Investment Institute. It also hasn’t seemed to matter much whether the president belongs to the Republican or Democratic Party.
Instead, factors such as inflation, interest rates and global growth are much more important to markets. And while these areas are a focal point for Federal Reserve (Fed) policy, they remain largely outside of presidential control, except to the extent that the president nominates (and the Senate approves) the Fed chairman and governors.
Nevertheless, we do expect some short-term market volatility leading up to the election and will keep an eye on certain sectors — health care, financials and infrastructure, for example — which thus far have been hot topics for the candidates. Since real policy changes wouldn’t likely occur until 2017 (and beyond), this short-term volatility may create more attractive entry points in select areas that appear attractive.
The potential for higher volatility comes against a backdrop of an unusually quiet month for U.S. stocks. We expect volatility to pick up from these extremely low levels and the election rhetoric may just be the trigger.
Careful with health care and financials
Although volatility is likely to persist across the broad market, specific sectors may be particularly vulnerable, or conversely, offer some opportunity. Among those to be cautious on is health care. The sector has historically underperformed in election years (source: Bloomberg), due in large part to concerns over pricing pressure on the biotech and pharmaceuticals subsectors. The latest headlines over EpiPen pricing have renewed this focus and brought with it increased volatility.
Over the short term, we don’t believe that the election and a new president will have a big impact on health care stocks’ fundamentals. Given the two candidates’ opposing views on health care, however, there could well be longer-term implications on policy changes. But remember that implementing any real, significant changes to the health care system will need to pass through Congress and will likely take years, not months. That said, volatility and fundamentals aren’t always aligned and a selloff triggered by regulation rhetoric may create selective buying opportunities in the near term.
Financials could also be impacted in a similar fashion. Again, meaningful regulations could take time, but campaign rhetoric may increase volatility. The path of the Fed’s rate hike policy will likely have a bigger effect on the sector’s fundamentals. While we can expect one more interest rate hike this year given Fed Chairwoman Janet Yellen’s most recent comments at Jackson Hole, financials may benefit from widening net interest margins (the spread between what banks make on loans and what they pay for deposits.)
More attention on infrastructure
So where can investors find potential opportunities? Perhaps infrastructure spending, a rare area of agreement between the two candidates (although they disagree on how to fund such spending). As the campaign debate continues to discuss job creation and economic growth, there has been a renewed investor focus on infrastructure spending and transportation. Additionally, Fed Governor John C. Williams of San Francisco recently published a paper suggesting a shifting focus from monetary policy to fiscal policy and an emphasis on economic growth and a higher inflation target. This likely bodes well for the sector. But keep in mind: There could be significant delay from a proposal of greater infrastructure spending to passage of a bill and actual disbursement of money.
Some strategies to consider
While this election season is likely to be filled with surprises, investors may also want to consider strategies that aim to minimize equity market volatility and potentially provide downside protection. Or take a look at quality companies, characterized by high profitability, steady earnings and low leverage, which have typically outperformed when market volatility rises, according to a paper by Richard Sloan.
Investors interested in health care and financials may want to consider the iShares U.S. Healthcare ETF (IYH) and the iShares U.S. Financials ETF (IYF). To gain access to infrastructure, consider the iShares Global Infrastructure ETF (IGF), the iShares Transportation Average ETF (IYT) or the iShares U.S. Industrials ETF (IYJ). For minimum volatility and quality, take a look at the iShares EDGE MSCI Min Vol USA ETF (USMV) or the iShares Edge MSCI USA Quality Factor ETF (QUAL).
Build on Insight, by BlackRock written by Heidi Richardson
Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.
Investing involves risk, including possible loss of principal.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.
International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets and in concentrations of single countries.
Funds that concentrate investments in specific industries, sectors, markets or asset classes may underperform or be more volatile than other industries, sectors, markets or asset classes than the general securities market. There can be no assurance that performance will be enhanced or risk will be reduced for funds that seek to provide exposure to certain quantitative investment characteristics (“factors”).Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses. The iShares Minimum Volatility ETFs may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful. The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).
CC-BY-SA-2.0, FlickrPhoto: Kevin Dooley. Risk-On Sentiment Trumps Brexit Fallout Fears
The feedback loop between financial markets and the real economy has been positive this summer, relegating the status of the June 23 Brexit vote from a global scare to a domestic UK political matter. The current environment remains supportive for risky assets.
The positive feedback loop that has developed between markets and economies may be the best evidence yet that the fallout from the Brexit vote is far less dire than many feared in June. With market and sentiment channels transmitting little or no Brexit-shock into the real economy in the rest of the world, the UK political drama has swiftly morphed into a local problem rather than a global scare. Recent economic data also suggest that mainland Europe, the region most at risk of contagion, has been remarkably resilient post-Brexit.
Economic and earnings data have been a support factor globally. Positive macro data surprises in developed markets reached a 2.5-year high this month. Second-quarter corporate earnings in the US and Europe came in better than expected. The global policy mix is shifting to an easier stance again, with the Bank of England and the Bank of Japan both easing further and remaining biased to do more. The fiscal gears are also starting to turn. Japan’s government announced a large stimulus package and the US and UK governments are hinting at fiscal stimulus measures in the 2017-18 period.
With investor sentiment turning positive for the first time this year and cash levels reaching 15-year highs, the right conditions for some of that money coming into the market are emerging. The flow momentum seems likely to remain a support factor for risky asset classes like equities, real estate and fixed income spread products, at least until technically overbought levels are reached, or until new macro or political shocks occur. With neither of those on the radar at this stage, we keep our risk-on stance tilted to these asset classes.
Jacco de Winter is Senior Financial Editor at NN Investments Partners.
CC-BY-SA-2.0, FlickrFoto: Melges Rocks / Vimeo. Operando entre la multitud
Risk-on sentiment has dominated markets in a post-Brexit world characterized by expectations for lower-for-longer interest rates. The result? Certain investments have become very popular, and investors will want to tread carefully and be selective.
The chart below shows where the crowds are, based on an analysis of fund flows, fund positioning and price momentum. Postions with scores between 1 and 2 (and -1 and -2) are considered as popular, and those with scores above 2 (and below -2) as very popular. The higher the score, the more popular the overweight is. The lower the score, the more popular the underweight is. The most popular investments today: overweight U.K. government bonds (gilts), emerging market (EM) sovereign debt, developed market credit and gold, as well as underweight eurozone equities.
Managing risk is key
Investment popularity does not tell us much about the direction of returns over the long run (i.e. the next 12 months). In fact, many of today’s consensus trades could be long-term winners as low economic growth and low interest rates persist.
Yet some popular positions are approaching extreme levels (scores above 2 or below -2), which can be seen as an important signal of short-term risk. These positions may be vulnerable to a market shock or rising volatility, especially when combined with high valuations. It’s crucial to manage this risk by being selective.
Reducing popular positions where prices have moved beyond fundamentals (examples are gilts and bond-proxies such as utility stocks) may be beneficial. Resisting taking contrarian positions in sectors facing big structural challenges (e.g. European banks) may also be productive. But popular overweights with supportive fundamentals and valuations (such as EM debt and U.S. credit) are still worth considering, and gold can offer portfolio diversification benefits. More than $8 billion has flowed into dividend equities since the Brexit vote, according to EPFR, and we prefer dividend growth over dividend yield. An overweight EM equity position doesn’t appear popular despite recent inflows into the asset class.
Bottom line: Be mindful of the short-term risks embedded in consensus trades, and look for potential opportunities the crowds haven’t yet reached.
Build on Insight, by BlackRock written by Richard Turnill
CC-BY-SA-2.0, FlickrPhoto: zoonyzoozoodazoo
. The Wait Is Over: The Shenzhen-Hong Kong Stock Connect
The Shenzhen-Hong Kong Stock Connect was approved in principle on Monday by the China Securities Regulatory Commission and Hong Kong’s Securities and Futures Commission. Global markets have been widely anticipating the Connect because it will allow global investors to trade stocks listed on the two exchanges. In an unexpected move, aggregate quotas for both Shanghai and Shenzhen Connect schemes also were abolished, although daily quotas remain.
Eligible shares will include Shenzhen Stock Exchange (SZSE) Component Index, SZSE Small/Mid Cap Innovation Index (which has a market cap of more than RMB6 billion/ US$900 million), Hang Seng Composite Large-Cap/Mid-Cap and Small-Cap index (over HK$5 billion/US$600 million market cap), and Shenzhen/Hong Kong dual-listed stocks. About 880 Shenzhen stocks and 417 Hong Kong stocks are qualified under Shenzhen- Hong Kong Stock Connect. Implementation should begin by late in fourth-quarter 2016.
Why the anticipation?
The Shenzhen-Hong Kong Connect represents another critical step in China’s capital market reforms. We believe it will further boost the case for the inclusion of A shares in MSCI indices, which could attract large amounts of fund flows to the Chinese stock market. (Although concerns over capital mobility, share suspensions, and restricted availability of A-share products are still being addressed.)
Through the Shenzhen-Hong Kong Connect, the Shenzhen exchange also will provide global investors with more opportunities to gain access to China’s new economy, particularly in sectors such as IT, high-end manufacturing, and new materials. The Shanghai exchange, in contrast, is dominated by state-owned banks and oil companies.
Finally, mainland China investors will also be able to diversify their exposure into the Hong Kong market. Our recent conversations with brokers, however, suggest that many of the mainland investors with a keen interest in Hong Kong are already invested, either through Shanghai-Hong Kong Stock Connect or through a local brokerage account in Hong Kong. It will be interesting to monitor the size of Southbound flows into Hong Kong Small/Mid-Cap names, to see whether or not the A-H share gap will finally narrow.
What next?
At first glance, banks and brokers should benefit initially from the potentially increased trading flows following the implementation of Shenzhen-Hong Kong Connect. However, we expect the incremental trading volume and, thus, revenue impact from Shenzhen-Hong Kong Connect to be minimal in the near term. Apart from the short-lived rally in April 2015, flows from Shanghai-Hong Kong Stock Connect have largely been disappointing, though they have picked up recently.
Although high valuations of many Shenzhen-traded companies – with an average of 40x price/earnings ratio compared with around 16x in the Shanghai Composite Index and 12x in MSCI China Index – may deter initial interest, the strong earnings growth for many Shenzhen-traded companies certainly warrants a closer look from investors.
What about H-shares?
Following Brexit, the MSCI China index rallied by more than 15%, driven by improving global sentiment and speculation on Shenzhen-Hong Kong Connect. Although MSCI China index looks cheap compared to it’s A-share peers, it is currently trading at close to its five-year high in P/E terms, while firsthalf earnings thus far point to softening fundamentals. Meanwhile, recent macro data released showed weakening momentum as recent stimulus measures fade. With Shenzhen-Hong Kong Connect, brokers and asset managers and their investors should be the biggest beneficiaries in the long term, though the potential risk/reward return has been reduced after the recent rally.
Wilfred Son Keng Po is Managing Director and Portfolio Manager of Asia ex-Japan Equities at PineBridge Investments.
This information is for educational purposes only and is not intended to serve as investment advice. This is not an offer to sell or solicitation of an offer to purchase any investment product or security. Any opinions provided should not be relied upon for investment decisions. Any opinions, projections, forecasts and forward-looking statements are speculative in nature; valid only as of the date hereof and are subject to change. PineBridge Investments is not soliciting or recommending any action based on this information.
CC-BY-SA-2.0, FlickrPhoto: BNP Paribas Investment Partners. The Other Key Messages from the Fed at Jackson Hole
At the 25-27 August Jackson Hole Symposium, US Federal Reserve Chair Yellen broke little new ground – beyond confirming that the case for a US rate rise had strengthened – and suggested the policy-setting Federal Open Market Committee was generally satisfied with its strategy for interest-rate normalization, the available monetary policy tools to combat future recessions and the overall policy framework. We find this message somewhat disheartening.
Given the FOMC’s limited space to cut short-term rates, a persistently low equilibrium policy rate and the likely challenges of relying on asset purchases and forward guidance, we had hoped to see some evidence of greater openness to change. Overall, we are left with a sense of ‘business as usual’. If this is indeed the case, it implies a Fed that may be unprepared to counter another recession aggressively should potential growth and equilibrium policy rates remain depressed.
What messages did we glean from Yellen‘s remarks? What can we say about the overall approach to policy normalization, the policy toolkit for supporting growth and inflation in different states of the business cycle, and considerations for the longer-term policy framework?
A US rate rise this year is highly likely
Data has evolved since the surprisingly weak May payrolls report in a manner that is consistent with the Committee’s expectation for moderate growth, the continued strengthening in the labor market and the gradual firming of inflation. In light of this, Yellen believes that “the case for an increase in the federal funds rate has strengthened in recent months.” We had already assigned a 75% probability to a rate increase this year, so Yellen’s remarks were not particularly surprising.
Still, the decision to address the near-term policy outlook at a conference focused on longer-term policy considerations suggests that the Committee has grown more confident in the economy’s performance and is marginally concerned by somewhat complacent market pricing of the path of policy rates. We still see December (45%) as the somewhat more likely timing than September (40%) for a rate increase given below-objective core inflation and the risk management considerations discussed below, but we will revisit these probabilities after the August payrolls report. Another strong number (225 000 private-sector jobs) in combination with firming wages and a decline in the unemployment rate could suffice to tip us into the September camp, though we would caution that the next policy meeting is not until 20-21 September.
Neutral policy rate still targeted when core PCE inflation hits 2%
Overall, we find this disappointing. As discussed in a previous note, we see compelling reasons for the Committee to hold off on raising rates at least until there is more convincing evidence of inflation moving towards mandate-consistent levels. As the July PCE inflation data confirmed, this is just not the case at present (see Exhibit 1).
Exhibit 1: Personal Consumption Expenditures (PCE) excluding food and energy, the Fed’s preferred gauge of US inflation, remains well below the central bank’s two percent (January 2012 – June 2016)
The reasons include constrained policy options at the lower bound, growth risks that are still tilted to the downside, low inflation expectations and uncertainty about the current and future level of the equilibrium policy rate. In practice, the Committee will likely tolerate inflation rising somewhat above two percent. But policy-setting could achieve better outcomes if the current strategy explicitly allowed for (or even sought) inflation above two percent over the medium term, which would reinforce that the Committee treats the inflation objective symmetrically.
Absent such a shift, investors are likely to continue to expect inflation to run below two percent on average over the coming years. Two percent inflation will continue to be viewed as a policy ceiling, implying an actual inflation objective somewhat below this level.
Peak policy rate: perhaps only be about 150bp away
Judging from the Fed’s June Summary of Economic Projections, the Committee on average sees the longer-run policy rate at three percent, or one percent in real terms. However, both in her June press conference and again at Jackson Hole, Yellen suggested that the equilibrium real policy rate might not rise above its current level near zero for many years. Specifically, she noted at Jackson Hole that “the average level of the nominal federal funds rate down the road might turn out to be only two percent”. If this is indeed the case, we are likely to see a continued flattening of the Committee’s median projected interest-rate path in future projections.
Asset purchases and forward guidance are no longer unconventional
With a persistently low equilibrium policy rate and the continued aversion to taking the policy rate into negative territory, the FOMC will have limited scope to ease policy through rate cuts even if it succeeds in raising rates all the way back to a neutral policy setting (from a loose policy now) before the next recession. Asset purchases (possibly including a wider range of financial market instruments) and forward guidance will remain the primary policy tools. One implication is that right-sizing the Fed’s balance sheet – returning to a situation in which the Fed’s assets largely align with currency in circulation – is unlikely to occur for well over a decade.
Cautious optimism on the efficacy of asset purchases and forward guidance
Overall, Yellen struck a tone of optimism on the ability of the Fed to provide future economic stimulus largely through asset purchases and forward guidance, even noting that simulations of various policy options show that these tools can provide better outcomes for employment and inflation than cutting the policy rate deeply into negative territory.
Still, she noted a number of reasons for caution in relying on these tools – model simulations may overstate the effectiveness of asset purchases and forward guidance when rates are already low; these tools may need to be taken to extremes to be fully effective; and such use may increase financial stability risks.
Cautious rate normalization and eventual tolerance of an inflation overshoot
Yellen’s note of caution on relying on asset purchases and forward guidance to fight future recessions has implications for current policy normalization. Even if the Committee’s strategy has not changed, in practice the FOMC will be very careful to avoid unduly restrictive policy-setting to lower the possibility of having to revert to asset purchases and forward guidance.
Any weakening of key economic indicators, tightening of financial conditions or heightened risks to global growth will likely lead the Committee to delay policy normalization, as has been the case for much of this year. If the downside risks rise meaningfully, the Committee will likely remove its tightening bias – and possibly begin cutting rates – more quickly than it traditionally has.
All of this implies that the Committee will be more tolerant of inflation overshoots. Should global disinflationary pressures wane, the ‘new normal’ could be one in which inflation averages above two percent, even if growth hovers around trend.
The longer-run policy framework is unlikely to change
Two weeks ago, President Williams of the Federal Reserve Bank of San Francisco created quite a stir by suggesting possible changes to the FOMC’s policy framework including a higher inflation target and price-level or nominal GDP targeting. Yellen acknowledged these ideas as ‘important subjects for research’, but emphasized the Committee is not actively considering such changes. Thus absent a recession, we see little scope for a meaningful rethink of the policy framework.
We find this disappointing, to say the least. In an environment where the policy rate is still close to the effective lower bound and the neutral rate remains significantly depressed by historical standards, the Committee has a responsibility from a risk management perspective to carefully examine possible changes to their operating framework that could deliver better outcomes for growth and inflation when the next recession inevitably hits.
Column by BNP Paribas Investment Partners written by Steve Friedman.
