Global equities performed strongly in August, aided by the S&P 500 index which passed the 2,000 mark for the first time. In the US, sentiment was boosted by upwardly-revised GDP data, with the economy growing at an annualized rate of 4.2% in the second quarter of 2014. The US macroeconomic data contrasted with the data released in Europe, where preliminary Italian Q2 GDP was reported at -0.2% quarter on quarter and sentiment surveys also disappointed. In this environment, and perhaps counter- intuitively given the strength in equity markets, core government bonds also performed robustly as speculation grew that weaker economic news could encourage the European Central Bank to launch its own bond-buying program. In the event, the ECB cut its main interest rate by 10 basis points in early September and made a firm commitment to purchases of asset-backed securities (ABS), but stopped short of announcing purchases of government bonds.
In the US, benchmark 10-year bond yields rallied from 2.56% on 31 July to just 2.34% at the end of August. UK, French and German benchmark 10-year bond yields also declined during the month. Emerging market debt, as measured by the JP Morgan EMBI+, also registered gains, although the asset class could not keep pace with the rally in core debt markets as the geopolitical crisis in Ukraine continued, with Russia retaliating to Western sanctions by banning the import of a range of Western products. In commodity markets, the Bloomberg Commodity index registered a total return of -1.1% in US dollar terms in August.
Looking forward, investor attention is likely to remain focused on Europe and the macroeconomic challenges there. We certainly believe that the low bond yields seen in markets such as the US and UK reflect concerns of deflation and potential full-blown quantitative easing in Europe, rather than the generally positive US and UK domestic economic data. While we are encouraged that the ECB has committed to ABS purchases, we would question the potency of interest rate reductions. Interest rates have been low in Europe for a prolonged period but this has not stimulated the economy or inflation. What needs to be addressed is whether the transmission mechanism is in place to move the liquidity from the ECB to the real economy. Given that some action from the ECB had already been flagged, we do not expect the impact of the ECB’s measures to be revolutionary. Nonetheless, the policy moves should give investors more confidence in the ability of the ECB to meet its mandate, and the possibility of outright QE still remains. The immediate impact of the ECB’s moves has been to weaken the euro further, which should help Europe’s exporters and many of the stocks that we invest in.
In terms of our multi-asset portfolios, we have made one small change to our asset allocation in recent weeks, by moving US equities from neutral to overweight. Valuations for US stocks are broadly comparable to those observed before the Global Financial Crisis. If the Global Financial Crisis had occurred due to the overvaluation of equities rather than the faulty foundations upon which the global financial architecture was by then built, this measure of valuation would be of significant concern. As it is, the relative valuation of US equities compared to other regions appears somewhat unremarkable as the outperformance of US equities has moved more or less in step with the outperformance of US earnings – keeping the ratio of forward price/ earnings ratios relatively stable over recent years. Moreover, the US remains free of the macroeconomic concerns that continue to dog Europe, and a stronger dollar should help to keep inflation in check given that the consumer accounts for the bulk of the economy. We remain positive on the outlook for equities overall, with US companies alone having implemented $159 billion of buybacks in Q1 2014.
In fixed income, we remain cautious on core government bonds and continue to see better opportunities in corporate credit, including high yield. Against expectations, core government yields have remained very low this year and therefore high yield continues to stand out as offering relatively attractive levels of income in what is still a near-zero-interest-rate world. We are constructive on UK commercial property as capital values continue to improve, supply is constrained in a number of areas and the asset class continues to offer an attractive real yield.
Monthly economic and market commentary by Mark Burgess, CIO at Threadneedle