Economic and Market PerspectivesQ3 2015
U.S. Economic Overview
Second quarter domestic and international economic data points appeared far more positive on balance relative to numbers released in the first quarter. Still, asset class returns were muted as investors worried about the impact of rising interest rates on bond prices, and the potential ramifications from failed bailout talks between Greece and its creditors. Price trends in oil and the dollar reversed during the quarter, relieving pressure in areas of the market that had been hurt by the dramatic price action that occurred over the preceding three quarters. After dipping below $45 per barrel in the first quarter (from a high of $107 last July), oil (West Texas Intermediate) rebounded early in the second quarter and traded at approximately $60. The U.S. dollar’s break from a long-running streak of appreciation, meanwhile, was welcomed by domestic exporters. Over the same period as oil's decline, the greenback had appreciated 25% against a trade-weighted basket of currencies.
When the Music Stops
Economic history contains many instances of booms and busts. Some of these dramatic moves happen quickly, while others occur over longer periods of time. Often, the cause of a boom can be tied back to unfettered credit expansion, where the availability of cheap money allows the least creditworthy of borrowers to benefit unduly. In Greece's case, the creation of the European Monetary Union (of which Greece became a member in 2001), coupled with dubious financial engineering created a low cost borrowing environment that helped the country grow at an unsustainable level. Inevitably, the gravitational forces of economic fundamentals prevail in these situations and the music stops. In Greece's case, the run lasted approximately eight years before investors finally began to understand the full magnitude of the country's meager fundamentals. Only then did right sizing begin.
Optimism for a deal between Greece and its creditors faded quickly in the final days of the second quarter, as the troika (International Monetary Fund, European Central Bank and European Commission) held the line on its demand for continued austerity. This, in turn, led Greece’s leadership to call for a surprise referendum on the troika's proposed conditions for further lending to the beleaguered nation. Since defiant Prime Minister Alexis Tsipras' Syriza party came to power in January, a stalemate has seemed almost inevitable. Frustrated with years of austerity measures, the Greek electorate was desperate to push back, even if it meant taking their country to the brink of default or beyond. So what does this mean for the European economy and capital markets? The good news is that the probability of a negative outcome (i.e. Greece leaving the Eurozone) has been modeled and prepared for by most market participants. After all, the saga is going on its fifth year. The bad news is that a country leaving the Eurozone remains without precedent (or plan), and thereby lacks any historical context. Beyond short-term market turmoil and an expected flight-toquality trade, there is little absolute certainty as to how a 'Grexit' plays out.
Facing such uncertainty, investors need to keep two important facts in mind. First, Greece represents only about 2% of the EU’s total GDP – decidedly on the periphery of the region's economy. Second, the Europe of 2015 is far more stable than the Europe of 2010. Today, other highly indebted Eurozone countries, such as Spain and Ireland, are actually sources of hope rather than concern, which implies (but does not guarantee) limited contagion risk. To be sure, Greece is faced with a paradoxical dilemma, one which is charged with increasing amounts of emotion: Release itself from the shackles of austerity and face life outside the Eurozone (and no doubt a painful transition); or submit to the status quo and accept that the value of EU membership is worth the price of near-term pain. In our view, the current trajectory of the situation amounts to a bump in the road to recovery for Europe (albeit a fairly sizeable one), but not a fallen bridge.
Money Makes the World Go Round
European economic policy decisions announced and implemented in first quarter 2015 continued to impact the U.S. economy throughout the course of second quarter 2015. The European Central Bank's (ECB) decision in January to institute a €1.3 trillion quantitative easing program (QE) had an immediate and dramatic impact on world markets even before actual bond purchases (€60 billion each month through September of 2016) commenced on March 9th. The impetus for instituting a monetary stimulus program came in December of 2014, when the European region’s annual inflation rate turned negative, falling to -0.2 percent. The aftermath of the January QE announcement saw the Euro's value weaken in tandem with falling yields on the German 10-year government bond (commonly known as the "Bund"). Investors sold this global bond proxy, converted their proceeds into U.S. dollars and then purchased higher yielding U.S. 10-year Treasuries, causing the dollar to increase in value and the U.S. 10-year yield to fall. This trade hit its crescendo in April of 2015, when the German 10-year Bund yield fell to a low of 0.07%.
The strengthening dollar had the effect of dampening U.S. GDP growth in the first quarter, thanks to a widening domestic trade deficit caused by the increasing cost of exports. This, plus other transitory factors (severe winter weather and a labor dispute at west coast ports), brought economic growth to a halt and pushed out Fed rate hike expectations from June to September or December of 2015. Midway through the second quarter, though, Keynesian economic theory appeared to score another empirical victory. A spate of encouraging European economic data points, most notably a preponderance of purchasing manager indices (PMIs) showing signs of accelerating business activity, prodded the ECB to hike its economic growth estimates for the Eurozone. This positive change in both data and outlook caused the euro to trend higher, in lockstep with the 10-year German Bund yields. By mid-June the Bund reached a yield nearing 1% and the euro had appreciated against the U.S. dollar to $1.13, from $1.06 in mid-May.
With the trend of an appreciating dollar seemingly exhausted, the U.S. economy regained traction over the course of the second quarter. Strong back-to-back monthly payroll numbers for April and May indicated that positive momentum was building for increased economic output. After a slight contraction in the first quarter (-0.2%), the possibility of 3% quarterly GDP growth for the remainder of 2015 seemed to be a very reasonable expectation. May's employment report showed job growth across a broad set of sectors, though mining continued to struggle due to the fall in oil prices. In concert with a tightening labor market, anecdotal evidence and data also showed that labor costs are rising. Such conditions are expected to provide even the dovishly-inclined Fed the cover it needs to begin the "liftoff" from the zerobound monetary policy which has been in place since 2008. Much like conditions in Europe, a renewed outlook for economic growth in the U.S. lifted 10-year Treasury yields from 1.93% on March 31, 2015, to 2.37% by mid-June, shadowing the rise in 10-year Bund yields. The Fed, in an attempt to avoid spooking investors, has been particularly strident in saying that rates will increase slowly once policy tightening begins.
Opening our Wallets
In last quarter's Economic and Market Perspectives, we pondered whether the consumers' hesitation to ramp up their spending (despite extra savings at the gas pump) was a lingering response to the trauma caused by the Great Recession, or simply an involuntary pause due to yet another rough winter. Our conclusion tended toward the latter explanation, and second quarter data appeared to prove that view to be true. With personal incomes on the rise and savings from lower gas prices burning a hole in consumers' pockets, Americans shopped with a vengeance. In fact, personal spending in May rose 0.9%, the largest monthly gain in nearly six years. Evidence of a reinvigorated consumer also showed up in the University of Michigan's June sentiment index, which climbed to 96.1 after retreating from an 11-year high in January.
As encouraging as these signs may be, we must observe this positive data with a certain degree of skepticism. Could these elevated levels of consumer spending and confidence be driven by pent up demand, which will dissipate later in the year? An unusually slow recovery has trained even optimistic economists to be cautious when predicting the renaissance of the American consumer. Tepid inflation suggests businesses still lack the demand necessary to raise prices, though consumers, supported by rising incomes, appear to be on more stable footing. Further evidence of the longevity of rising consumer demand can be found in an increase of bigger ticket purchases such as cars, homes and other major household items.
Second Quarter Economic Highlights
- Monthly non-farm payroll growth figures rebounded from an unexpected slump in March. Aided by a decline in labor force participation, the headline unemployment rate dropped to 5.3%, its lowest level since April 2008.
- First quarter GDP growth came in virtually flat, at -0.2%, largely attributed to a number of transitory headwinds, which included exceptionally cold winter weather and labor disruptions at west coast ports. A strong dollar also impacted the trade deficit by making exports more expensive for foreign buyers.
- Consumer income and spending accelerated during the quarter. May retail sales increased 1.2%, as the savings rate declined. Seasonally adjusted annualized monthly auto sales, meanwhile, reached 17.7 million in May, a level not seen since 2005.
- Reinvigorated job growth and spending are indications that a 3% growth rate for the second quarter is probable. Barring a major disruption in current trends, the Fed appears set to begin raising short-term interest rates as soon as September.
Fixed Income OutlookBy:David Wines
The second quarter of 2015 can be characterized as a period in which bond market gyrations, both at home and abroad, were the result of an attempt by the ECB to spur growth via quantitative easing. By pledging to purchase approximately €60 billion in fixed income assets per month through September of 2016, the ECB hoped to drive down yields, while pushing investors into riskier equities and higher yielding bonds. The program's effect was immediate and dramatic: Investors bid up equity markets throughout Europe, while selling off their fixed income holdings and using the proceeds to invest in higher yielding instruments like the U.S. 10-year Treasury.
By creating a strong synthetic demand for bonds, QE also pushed down the value of the euro, as sellers converted their euro denominated proceeds into dollars in order to play the widening spread between U.S. Treasuries and high quality European sovereign credits. Early in the quarter, this trade pushed the German 10-year Bund to a low of 0.07% while weakening the euro against the U.S. dollar, which touched $1.07 in early April. The lower euro had the beneficial effect of spurring European exports, which helped push nearly 75% of global PMIs to readings above 50, a level that indicates an expansionary economic environment. In response, the ECB lifted its growth estimates for 2015, 2016 and 2017. The improved economic forecasts, meanwhile, had a significant impact on European sovereign yields, as evidenced by the 10-year German Bund yield moving up to 0.76% at the close of June.
Fixed income volatility during the second quarter was not solely a European phenomenon. Harsh winter weather in the first quarter and anemic consumer spending (even in the face of falling oil prices) set the stage for tepid U.S. non-farm payroll numbers at the start of the second quarter, and revisions to first quarter GDP numbers, which were lowered from 0.2% to –0.2%. With data points that failed to suggest the sort of steady "march to growth" that would necessitate a Fed rate hike in June, the U.S. 10-year Treasury rallied strongly. The move was enhanced by foreign buyers selling into QE demand and converting their proceeds into dollars, which were then used to buy higher yielding U.S. debt securities. The combined effect took the 10-year Treasury yield to a low of 1.86% on April 1st.
By mid-quarter, though, signs of increased economic activity in both the U.S. and Europe caused the U.S. 10-year Treasury yield to back up to 2.48% in early June. Growing wage pressure and stronger-than-expected non-farm payroll numbers for April and May seemed to suggest momentum was building, while lessening fears of secular stagnation. This, in turn, shifted expectations from a weak outlook to one where better job growth, higher wages and modest inflation would push the U.S. economy into the 2-3% growth range over the balance of 2015, a significant departure from the weak -0.2% growth witnessed in the first quarter.
Greek Influence on Bonds, or Lack Thereof
While the uncertainty surrounding Greece's debt negotiations caused substantial equity market volatility, the impact on the U.S. Bond market was more muted. The "Flight to Quality" trade, which typically takes place during periods of economic and/or political uncertainty, simply did not manifest itself, thanks in part to the onset of Europe’s QE program. In fact, there was actually a "Flight from Quality" in Europe, as investors sold sovereign credits but showed a diminishing appetite, as the quarter progressed, for putting the proceeds into the U.S. This suggested European investors felt more comfortable staying in their home currency (and away from the already strong dollar), as U.S. bond yields appeared to be headed higher while European economies seemed to be stabilizing. Over the course of the second quarter, this caused the spread between 10-year U.S. Treasuries and 10-year German Bunds to fluctuate dramatically (at times by as many as 40 basis points), though most of the widening was due to Bund yields rising more rapidly than the 10-year Treasury. We consider Greek uncertainty’s minimal impact on U.S. rates to be further evidence that U.S. rates are poised to grind higher.
No changes were made to our third quarter fixed income positioning, while overall duration strategy remains slightly short of benchmark. This reflects an expectation that the economy will continue expanding at a reasonable pace over the balance of the year, driving job growth higher and unemployment lower. The net result should be modest upward pressure on inflation, which increases the probability that the Fed will begin tightening monetary policy later in the year. This should cause the yield curve to flatten as the year progresses, with short-term rates climbing more rapidly than longer-term yields.
Equity OutlookBy: Derek Izuel
Despite a bout of fatigue over seemingly endless discussions on the topic, we have keen interest in the unfolding Greek crisis given our overweight position in European equities. While the ECB’s enhanced QE program offers investors some protection from falling bond prices in the event of vanishing private sector demand, equities have no such implicit protection. Still, we see little reason for worry. Multiple episodes of this ongoing saga have allowed Europe’s governments and investors to factor both a Greek government debt default, and the country's potential exit from the European Union and its common currency, into decision making. With an economy the size of Oregon, the loss of Greek economic output is of little significance to resurgent Eurozone activity. More importantly though, unlike the initial stages of the crisis, very little Greek debt is now owned by European banks.
Volatility indices have expressed the market's softened concern quantitatively. The VIX index, a measure of implied future U.S. equity market volatility in option prices, stands at 18, a moderate level when compared to the 26 it reached last October when the energy market faced turmoil. European measures of equity market volatility have also indicated the wall of worry is not quite as high this time around. The VSTOXX, the European version of VIX, climbed to 32. This level is similar to what was reached last October, but far less than the 50 it saw during the 2012 chapter of the Greek saga.
We do not want to downplay the significance of Greece's troubles within the context of a broader European economic dynamic. Still, we believe that like many crises, markets will react negatively to the initial uncertainty, but will ultimately refocus on the improving economic and corporate fundamentals across the region once the crisis is resolved.
Watch Out Below
Chinese equities, on the other hand, have decidedly entered bubble territory. It is estimated that in the month of March alone, some five million new investment accounts were opened by Chinese investors who had grown fearful of the declining domestic real estate market and were looking for an alternative place for their savings. Enabled by recently enacted financial reforms that have made trading equities significantly easier, and spurred by record levels of margin debt, domestic investors have driven up the Shanghai and Shenzhen equity indices more than two-fold between mid- November and mid-June.
Recently, as illustrated in the chart above, the bubble may have popped. The Chinese version of what former Fed Chairman Allen Greenspan would call "irrational exuberance" faded quickly as the Shanghai and Shenzhen indices sold off 25% in the last two weeks of the quarter. Investors trading on the adage "don’t fight the Fed" (or in this case the Peoples Bank of China) are beginning to fear that the same rate cuts that triggered the speculative run-up in equity prices may not translate to the sort of economic benefits that have occurred in past easing cycles. In last quarter’s Economic and Market Perspectives, we noted that the Chinese economy is predominately driven by capital investment, and the failure of an accommodative central bank to stabilize declining growth confirms that the transition from an investment-based economy to a more consumption-based economy is likely to be a difficult one.
As important as China is to global emerging market equities (representing roughly 25% of the MSCI Emerging Markets Index), a challenging economic evolution combined with falling share prices are still no reason to spurn emerging market equities in their entirety. Rather, it is important to keep in mind that the "A-share" (Shanghai and Shenzhen) exchanges are dominated by domestic Chinese investors, and provide only limited access to foreigners. Although, the market is a useful proxy to gauge domestic Chinese sentiment, it is a less accurate indicator of external investor views on the prospects for Chinese companies. In the above chart, the gold line represents the performance of Chinese stocks listed on the Hang Seng exchange in Hong Kong, known as "H-shares," which are widely accessible to global investors. Returns (and valuations) there, despite similar exposure to Chinese corporate fundamentals, have been much more subdued. As a component of the global emerging market equity benchmark, the Hang Seng index's performance is more indicative of China’s effect on emerging market equity performance.
Having been the most favored home for risk capital over the past six years, U.S. stocks will likely require renewed earnings growth to compete for capital going forward. As returns through the first half of the year have shown, investors currently favor areas of the global equity market that have the wind at their back and the most room for improvement. We expect this trend to continue, though the key question is whether improving U.S. economic conditions will lead to stronger corporate earnings growth, and renewed competitiveness in global equity markets. Intuitively, the answer to this question would seem to be 'yes,' but in reality, the relationship between an improving economy and stock market returns is not quite as strong as one might expect.
Equity markets, like individual stocks, are valued based on assets and future earnings discounted at a market rate adjusted for risk. A stronger economic environment is typically accompanied by higher interest rates, which mean future earnings are worth less in present value terms. Furthermore, as the economy improves top-line revenue growth will typically follow suit, though a corresponding increase in expenses (primarily via labor costs) often puts significant pressure on profit margins.
Despite an improving domestic economy and political challenges in the Eurozone, we continue to favor developed non-U.S. equities with an emphasis on Europe. Staying true to our equity investment philosophy, we have sought to avoid more richly valued areas of the global equity market, while embracing asset classes where the market may be overreacting to real or perceived risk.
In developing markets, where equity valuations have also appeared attractive relative to the U.S. market, we were underweight based on the belief that the structural and cyclical economic tides were moving out of favor. Recent data suggests at least the cyclical economic tides may be shifting into a more positive direction, and we have therefore moved back to an equal weight position.
David Wines, CEO and Chief Fixed Income Officer
Derek Izuel, Chief Equity Officer
James St. Aubin, Head of Investment Strategy
HighMark Capital Management, Inc.
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