- Investors continue to move to "safe" assets in both stocks and bonds.
- Global bond yields could remain lower for the foreseeable future.
- We see greater relative value in solid growth stocks with attractive free cash yields.
It’s difficult to find clarity and predictability in today’s markets. The signals from currencies, equities and fixed income markets are confounding, to say the least.
Throw in market reactions to central bank meetings, the upcoming U.S. election, economic data reports and violence around the world, and one could get dizzy from the ups and downs. A month ago, we would have included the U.K.’s referendum on membership in the European Union, but even the surprise vote to “Brexit” was digested by markets within only a few days. The full economic and political ramifications of the vote still hang in the balance, but no matter. While we continue to believe the risks of the precarious foundation of global debt are real, the timing of a potential upheaval is less clear and markets seem content to shrug off the risks and grind higher. In the meantime, they will continue to take their cues from high-frequency economic data, potential central bank policy responses to the data and China’s stance on domestic investment.
Seeking safety in equities
Despite new highs in equity markets and record lows in developed sovereign bond yields, there is still enough investor anxiety to pile into “safe” assets and these are some of the best performers year to date. The factors that have been rewarded and have momentum are quality, dividend yield and low volatility. While these are desirable qualities, the sectors with these attributes – consumer staples, utilities and telecoms – typically are not considered growth sectors and normally don’t lead the market higher in non-recessionary times.
While the headwinds from the stronger U.S. dollar year over year may be easing and could improve from here, earnings growth still is tough to come by, causing price/earnings multiples to increase. Identifying “value” is more difficult. Second-quarter earnings reports are just getting under way, but some investment banks have had better-than-expected results as fixed income and currency trading benefitted greatly from the Brexit volatility.
We think the dollar is worth watching now since it is no longer weakening; multinationals could see a renewed struggle post-Brexit. Although the aggregate reaction seems muted, some companies – particularly in areas of machinery/ construction – are taking a “wait-and-see” approach and postponing their spending plans until conviction about the environment increases.
Fixed income yields: all about flows
Credit markets are just as confounding as equities. Early in the third quarter, Bloomberg reported that roughly $10 trillion of sovereign global debt had a negative yield. The U.S. Federal Reserve has not ruled out implementing a negative interest rate policy in dire economic circumstances in an effort to stimulate demand. Global central banks have purposefully suppressed the risk-free rate in the years following the financial crisis by using their balance sheets to purchase bonds and, in the case of the Bank of Japan, real estate investment trusts and exchange-traded funds. These actions were meant to suppress interest rates to a level that pushed investors into riskier assets to find yield. As we can see from the performance of equities during this period, investors have been rewarded for that move.
In addition to lowering the risk-free rate, the European Central Bank (ECB) now is compressing credit spreads. At the end of the second quarter, the ECB began buying European corporate bonds as an expansion of its quantitative easing (QE) program. It also announced a Corporate Sector Purchase Program in March as an extension of its asset purchases. That may in part be because the ECB cannot purchase bonds lower than –40 basis points and there is concern the number of sovereign bonds available for purchase is dwindling. Since the ECB is now targeting investmentgrade euro-denominated debt with this program, we think the perceived risk by credit investors will surely be lower.
It has become more difficult to interpret the signal of narrowing credit spreads in this environment. Typically credit spreads narrow when the default risk is reduced and that usually happens during an expansion. Today, the magnitude of flows from pension plans and insurance companies into the U.S. bond market is causing a similar result.
Credit deals were extremely quiet in the days ahead of Brexit and spreads immediately following the vote did not widen as much as expected. Since then, both investment grade and high yield deals have generally traded tighter. The demand is clear in the completed deals that were several times oversubscribed, and in the squeeze on yields. U.S. credit spreads in both investment grade and high yield are at the tightest levels in two years.
All of this means global bond yields could remain lower for the foreseeable future, especially at the long end. They seem expensive to us and we’re not ready to dive in, though we are keeping a close watch.
Given this backdrop, the Fund’s allocations are similar to those at the end of the second quarter: just over 55% in equities, 12% in U.S. Treasuries, 7% in gold and 25% in cash.
Although a U.S. recovery in some ways appears long in the tooth, it is hard to argue against a growth rate of around 2% for the medium term. The state of U.S. consumers continues to improve on solid, if slowing, payroll growth; decent and perhaps slightly accelerating wage growth; and cleaner balance sheets. We see from the housing data that demand is there from consumers because of low mortgage interest rates, lower household leverage and more willingness by banks to lend. The issue is a lack of supply, which also keeps rent prices elevated, though those increases have slowed recently.
The Fund continues to suffer from the market's emphasis on lowvolatility investment strategies and the outperformance of “bond proxies” within U.S. equities – stocks most correlated with the 10-year U.S. Treasury yield. Those stocks have attained relative valuations rarely seen in history while their growth counterparts have become cheap by comparison. We are hesitant to capitulate and believe the relative tailwind these stocks have felt is unlikely to continue indefinitely. We see greater relative value in solid growth stocks with attractive free cash yields.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s portfolio managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through August 2016, are subject to change based on market conditions or other factors, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.
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