October 9th, 2014 | By Nick SargenDuring the past quarter, financial markets were primarily influenced by a divergence in economic performance between the U.S. and U.K. economies, each of which registered solid growth, while the euro-zone and Japan remained weak. This development reinforced expectations that policymakers in the U.S. and U.K. could begin tightening monetary policies by mid-2015, while the European Central Bank (ECB) and Bank of Japan would keep monetary policies accommodative for the foreseeable future.
These expectations, in turn, contributed to a strong showing of the U.S. dollar, which appreciated by about 8% against the euro and Japanese yen, respectively, and by 6.5% on a trade-weighted basis. At the same time, U.S. bond yields rebounded off their lows, with the 10-year Treasury closing the quarter at 2.50%, up from an interim low of 2.34%, but well below the 3% threshold at the beginning of this year. Returns for the Barclays Aggregate Index were little changed for the quarter, leaving the year-to-date return at 4.1%. Meanwhile, the U.S. stock market powered to a record high, with the S&P 500 Index at one point surpassing the 2000 level, before closing the quarter near 1975, generating a total return of just under 8% for the first three quarters.
Looking ahead, the key issues for the U.S are whether the economy will maintain growth of 3% for the balance of this year and into 2015, and how the Fed will respond if unemployment continues to decline. In Europe, investors are waiting to see how the ECB will respond if its latest initiatives fail to boost credit expansion and/or concerns about deflation continue. In Asia, there are lingering questions about the effectiveness of Abenomics in Japan and the direction of Chinese monetary policy if the economy falls short of the 7.5% growth target.
Heading into the third quarter, there were legitimate concerns about whether the U.S. economy had stalled in the first half of the year. Subsequent data, however, showed the economy rebounded in the second quarter, posting solid growth of 4.6%, following a weather-induced slump in the first quarter. While growth for the first half of this year was below the 2.2% trend rate since recovery began in mid-2009, economic growth for the third quarter is estimated to be in the vicinity of 3% fueled by strong business capital spending. The consensus forecast calls for that pace to be maintained into 2015, although housing activity has not taken off and stronger consumer spending is contingent on higher wage growth.
Evidence of a pickup in economic activity is also apparent from a host of indicators for the manufacturing and services sectors and for the labor market, where weekly jobless claims recently have fallen below pre-crisis levels of 2007. At the same time, the unemployment rate has fallen to 5.9% from 6.7% at the beginning of the year, while the U-6 measure that includes part-time workers who are seeking full employment has declined to 11.8% from 13.1%.
In light of these developments, market participants continue to expect the Federal Reserve will commence tightening monetary policy around the middle of 2015, with a possibility the date could be moved forward if labor market conditions continue to improve. In her testimony to Congress, Chair Janet Yellen indicated the Fed would look at a host of labor market indicators in making its determination, as well as taking inflation into account. Some observers have noted that interest rate forecasts by FOMC members are generally higher than what is priced into the bond market. However, key Fed officials have indicated that investors should not read these forecasts as a guide to Fed policy. We concur with this assessment and believe the Fed will err on the side of caution rather than tighten prematurely, especially with inflation running well below the Fed's target.
In contrast to the United States, the euro-zone disappointed in the second quarter as overall growth was flat and the German economy, which had been the leader in the region, faltered. Moreover, activity in the euro-zone does not appear to have improved in the third quarter. Meanwhile, headline inflation recently dropped to 0.3% and the core rate is hovering below 1%, which has generated concerns that the euro-zone is at risk of slipping into deflation. Adding to these concerns, measures of inflation expectations have fallen in recent months as the slump in the euro-zone has lingered.
In late August, Mario Draghi signaled that the ECB would act to stimulate the economy, and the central bank followed with a series of measures in September. This included lowering the ECB's main lending rate close to zero, while the rate it pays on bank deposits was set deeper into negative territory, to -0.2% from -0.1%. The intent is to discourage banks from sitting on idle reserves and to prompt them to lend to businesses. (Previously, banks had been reducing their loan exposures and repaying borrowings from the central bank). In addition, the ECB announced a form of quantitative easing, whereby it will purchase asset backed securities and covered bonds. For the time being, it is refraining from buying European government bonds out of deference to Germany, but market participants believe it could embark on such a program at some point if the economy fails to respond.
Our assessment is that the euro-zone is in a classic "liquidity trap," in which bond yields are approaching their lower limit, and further actions by the central bank will have only marginal impact on the economy. There is one clear benefit from the recent policy easing – namely, the euro has weakened considerably against the U.S. dollar, and in our judgment is likely to continue to decline. Currency depreciation is an effective channel to bolster the euro-zone economy by stimulating net export growth, while also countering the threat of deflation via higher import prices.
By comparison, economic activity in Asia has been mixed. Japan's economy faltered in the second quarter, posting a 7.1% annualized decline in real GDP, while China posted growth of 7.7% and other Asian economies registered solid growth. The headline figures for Japan and China, however, mask deeper issues that investors are trying to fathom.
In the case of Japan, for example, the GDP figures for the first two quarters were distorted by an increase in Japan's national excise tax from 5% to 8%, effective at the beginning of April. Japanese households responded by accelerating their purchases to avoid the tax hike, which caused growth to surge in the first quarter, and then plummet in the second quarter. The latest readings suggest the economy rebounded moderately in the third quarter, but there is uncertainty about the outlook for 2015, as another two-point increase in the sales tax is planned for next October. Polls have showed that about two-thirds of the electorate is against the second-round tax hike; consequently, it could be scrapped if the economy fails to improve materially. Meanwhile, the Japanese yen has come under renewed pressure.
The situation confronting China's policymakers is one in which they are seeking to balance the goal of achieving a 7.5% target growth rate, while also reining in credit expansion, so as to circumvent a bubble in the property market. Thus far, the central bank's stance has been to maintain a relatively tight policy, in which interest rates were allowed to rise to choke off credit demand. There is growing evidence, however, that the Chinese government is concerned the economy could soften more than it wishes, and news reports are being floated that the current head of the central bank is about to be replaced. While markets undoubtedly would respond favorably to a relaxation of monetary policy, a key issue over the long-term is how much interest rate liberalization will be permitted. It is critical for China to phase out distortions, where deposit rates are set at low levels that penalize households, and which effectively subsidize businesses that are inefficient. This objective, however, is likely to be pushed down in prioritization should the economy fail to achieve growth of 7%.
Following the 2008 Global Financial Crisis, monetary policies in the industrial countries were geared to bolster the respective financial systems and pave the way for economic expansion. This resulted in the major central banks pursuing unorthodox policies in which their balance sheets expanded multiple times, and financial markets moved in tandem with one another. More recently, however, the divergence in economic performance between the United States, the euro-zone, and Japan has resulted in more varied financial market performance. This is most evident in the foreign exchange markets, where the U.S. dollar has appreciated significantly.
In positioning U.S. bond portfolios, we remain moderately underweight in duration and overweight in credit exposure relative to the benchmark, considering that the economy has regained momentum and Fed tightening may be less than a year away. At the same time, we recognize that weakness in Europe has dragged their yields to record lows and is likely to constrain the rise in U.S. yields that would otherwise occur. Finally, we are maintaining a moderate overweight position in equities relative to bonds in balanced portfolios, while also recognizing that the U.S. equity market no longer is cheap.