This article was released on July 12, 2016. Find our latest market and economic insights here.
For all the uncertainty following Brexit (as if the future had been foreseeable before it), it is clear that the West is not on autopilot, and that investors will need to carefully weigh sentiment of an increasingly populist bent to get a wide and balanced view. Luckily, this is not impossible, and a disciplined process with a long-term focus should continue to see investors through. The BMO Multi-Asset Solutions Team’s disciplined process is to develop views through a framework of valuation, the economy and both monetary and fiscal policy. Here is a brief summary of the factors we are weighing in determining our views looking into the third quarter of 2016.
Climate of increased political risk
The Brexit Leave vote and the growing populism across Europe and in the U.S., on both sides of the political spectrum, make it clear we are in a climate of increased political risk. The key for investors may lie in sorting out at what point social sentiment transmits into market movements. As former U.K. Prime Minister Tony Blair wrote after the Brexit vote: “It was already clear before the Brexit vote that modern populist movements could take control of political parties. What wasn’t clear was whether they could take over a country like Britain. Now we know they can.”
The sources of populist energy are known: slower-than-desired growth, immigration, and nationalist sentiment amid globalization. Whether and when they will create deep market events is less known. In Europe, the divergence continues between less productive European economies, mainly in the south, and more economically competitive countries in the north. The Greek debt crisis has not been solved — only outshone by other headlines. Spain’s youth unemployment rate, which has decreased somewhat in the past four years, remains a high 45% as of April 2016.
There has also been a bifurcation in GDP among European countries along similar lines: German and Italian GDP, rising in tandem between 2009 and 2011, have since parted ways — Germany on the rise, Italy falling. Italy has suffered from a euro that is overvalued compared to what a hypothetical Italian lira would be, yet Italy lacks the ability to manipulate the euro as it might have the lira. Germany has benefited from a euro that is undervalued compared to what a Deutsche Mark would be, boosting its export-oriented economy.
Connected to the U.K.’s concerns over immigration, the migrant crisis threatens Europe, with both short-term and long-term consequences. There could be long-term positive consequences — if a population boost meets with the right skills development, the influx of workers could be an engine of growth for areas like Germany and Scandinavia. But this potential outcome can seem distant and abstract, and the market invariably focuses on the short-term consequences, which look mainly negative. The crisis has caused a backlash, in the U.K. and Germany, for example, and some worry about potential disinflation, as a less educated workforce could help lower wages in the short term, contributing to a broader malaise.
After Brexit, the potential of contagion among EU members is real. Debt in Greece, unemployment in Spain and rising nationalism in France could ignite the same desire for referendums on EU membership just witnessed in the U.K. Most radically, there is the possibility of international retrenchment and isolationism — torn trade agreements, protectionist trade policies — and in general a rejection of the premise of cooperation and open trade that has come to define the global economy.
Multinational companies have been clear about their hesitancy to invest further in the U.K., and possibly the EU, due to political uncertainty clouding the future. A further delay in Brexit negotiations will only spur these companies to divert their supply chain out of the region, exacerbating the economic woes.
Reducing international developed equity
Part of our original thesis for our slight overweight to international developed equities was that economic growth was recovering in Europe and that the potential for upside surprises had increased as expectations had fallen so low. Following the Brexit vote in the U.K., we see significant risks to this view; we have accordingly reduced our international developed equity holdings and increased our U.S. equity holdings.
Two of the risk events that we identified at the inception of the view appear to have come to fruition: a destabilization of the eurozone and the questioning of the efficacy of central banks. We are concerned about the rise of populism globally and particularly its potential impact on the politics of Europe. This is not an issue that monetary policy can address, and thus we may be coming closer to the point at which further central bank easing will no longer be productive (and could potentially be counterproductive).
In the U.S., unemployment remains low, but a growing divide in median real wages between those with and without college degrees potentially reflects conditions similar to those fueling populist sentiment in Europe. Rhetoric throughout the past U.S. election year has framed this and other divisions in wealth in terms similar to those in Europe: it is the fault of globalization and bureaucracy.
Yet the U.S. remains on pretty solid footing. Equities remain attractive compared to government bonds. Inflation remains low, yet stable, and there is less fear of deflation. Despite one disappointing payroll number in May, the U.S. labor market is slowly improving. U.S. GDP growth for the first quarter of 2016 was 1.1%, while U.S. consumer spending rose in April and May, by 1.1% and 0.4%, respectively. The consumer, remember, dictates approximately 70% of U.S. economic activity as measured by GDP.
The question in the U.S. will likely be whether and how populist sentiment on the right and the left translates into real fiscal policy decisions: protectionism, trade barriers, tax increases.
High-yield bonds still strong
Earlier in 2016 we increased our position in high-yield bonds, when spreads were nearly 800 basis points over government bonds. We increased our position on a risk-adjusted basis, funding the purchase out of a mix of equities and cash. Our rationale for liking high yield, then as now, is its attractiveness from a valuation perspective and the low probability of a default cycle. More broadly, we find continued easy monetary policy to be supportive of risk assets and believe the search for yield in today’s climate of low interest rates should continue to support high yield.
Since our move, spreads have fallen to the low 600s, and we find the position to have been a boon for us. Spreads of high-yield energy bond yields have fallen by roughly 50% since mid-February, from 1600 to 800 basis points, encouraged by the recovery of crude oil. Overall, high-yield bond yields have fallen a good 300 basis points. High yield has in fact been the best performing major asset class of 2016 so far, beating equities on both an absolute basis and a risk-adjusted basis. And with another six months in 2016, and factoring in additional coupon payments, high yield is looking at a potential 12% return by the end of the calendar year, assuming yields remain unchanged.
Though we discuss more and more whether high yield is now fairly valued, given the narrowing spread, we still find reason to favor high yield. Spreads of around 600 basis points are still attractive, and we believe the slight spread widening in late June was a broad risk reduction rather than a significant change in fundamentals, as virtually all sectors moved in tandem. Going forward, we will monitor default rates for jumps and leading indicators for deterioration, but we expect high yield to stay attractive in a slow-but-steady growth environment with low inflation and low interest rates.
Core bonds still yield little
Core bonds have become increasingly overvalued as yields have fallen, and we remain uncomfortable holding core fixed income: we continue our underweight in this area. Fed expectations have swung wildly throughout 2016, though the net result is a lower likelihood of a hike in U.S. short-term interest rates. The swing in expectations surrounding the May payroll report announced in early June comes to mind: expectations for a June rate hike went from 22% to 4% within a day following the announcement of weaker-than-expected non-farm payroll numbers on June 3. Expectations for a hike in December dropped from 76.6% to 58.5% in the same time frame. Subsequently, hike expectations plummeted following the Brexit results, with the futures market now predicting less than a 50% chance of hike through the end of 2017.
It was not surprising to hear Fed Chair Janet Yellen caution against giving so much credence to one factor of many, as she did in statements to Congress later in June. As Fed guidance becomes more data dependent, it will mirror the ups and downs of disparate sources of data as they roll in. Amid this short-term noise, all to little effect, it can be difficult to even distinguish Fed guidance from the movements of the markets.
We are not sure you can add value by betting on individual Fed meetings, and we think it speaks to the need to look at a more medium- to long-term horizon. In the U.S., as in Europe, it is also reasonable to question the real usefulness of central bank policy and look to potential fiscal policy initiatives, be they toward or away from global integration, for signs of future growth.
Negative rates no stranger now
Lower rates for the medium term make it easier for individuals and corporations to borrow money, so much so that lenders are now paying for the privilege in the form of negative interest rates. We mentioned last quarter that $7 trillion, or about 25%, of government bonds were in negative yields. In the second quarter this number increased, with the German 10-year bond the newest member of the negative yield club, along with some European corporate bonds.
As we look to the third quarter of 2016 we remain comfortable with our modest overweight to equities, though we are now more concerned about international equities — particularly in Europe, but also in Japan. In both we see further tail risks. We have reduced our international equities holdings, as we don’t feel the two risks to our central views — uncertainty in Europe and diminished central bank efficacy — have fully played themselves out yet and are not yet priced in. We remain ready to review this position, however, as circumstances change.