A core element of our 2015 Outlook issue centered on the notion of diverging growth rates amongst the world’s economies. Our view: cascading from the fracturing growth paths would be a divergence in interest rate policy and currency movements of the world’s leading economies.
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Indeed, looking at 2015 GDP forecasts, this notion is holding up well, as the following table reveals. (Figure 1)True to form, interest rates are beginning to prefigure the inevitable divergence of central bank policy. (Figure 2)
Evolving expectations concerning central bank policy are beginning to manifest themselves in rising volatility in those asset classes that tend to be linked to interest rates. Consider the following chart, which maps rolling 30-day volatility of the nine asset classes at the core of our investment philosophy. (Figure 3) In this case, we focus on the US market, since it is where interest rates are likely to rise. Note volatility is lifting in commodities, real estate, investment grade debt, and government bonds. While the Fed struggles with a coherent model to judge its interest rate policy, investors appear to be making decisions and acting accordingly. For the world’s largest economy, the cycle appears to be finally turning. Should it be a surprise that an economy that achieves a 3% plus growth rate with an unemployment rate pressing on the level associated with full employment not have a cost of money that starts with a zero?
Equity market performance has sharply diverged this year. Europe, the area we highlighted as the most attractive bloc to place new money, has staged impressive local currency gains fuelled by the latest iteration of the European Central Bank’s quantitative easing program. To wit, the Euro Stoxx 50 Index has gained almost 14% this year.1 By extension, equity markets in the currency bloc have been on a tear: Germany, 16.2%; France, 15.1%; Italy, 17%; Ireland, 14%.2
The U.S. has been the laggard market in local currency terms as the 1.9% rise in the S&P 500 has been weak by comparison. But for euro-based investors, currency gains from the rising dollar have been an enormous boon by boosting returns to 11.3
As we expected, a cheaper euro is beginning to exert itself on the revenues of euro zone companies, as companies in the Euro Stoxx Index reporting fourth-quarter earnings are showing encouraging growth signs. With 146 of the 294 companies reporting as of February 24th, roughly 74 companies reported revenue surprises, while 39 had negative surprises. Wind appears to be gathering at the backs of investors in European shares.4
The US market is a more nuanced picture. As mentioned above, gains in the US market have been muted so far this year. This should not be surprising, since large-cap US equities have advanced roughly 54% since the end of 2012.5 Large companies will be under increasing pressure to prove they can durably grow both the top and bottom line. However, the picture remains quite positive for the small- to midsized publically traded companies, as they have demonstrated the ability to achieve this feat.
As the momentum for US interest rates to rise gathers steam and the unthinkable becomes inevitable, investors should remember the future flash the “taper tantrum” of 2013 offered. Markets outside the fixed income complex that were impacted were emerging market equities and publically traded real estate. If past is prologue, this is where investors should be looking to make adjustments ahead of the Fed.
1 Bloomberg for period of December 31, 2014 through March 4, 2015.
2 Indexes for Germany, France, Italy, and Ireland are Deutsche Boerse AG German Stock Index, CAC 40 Index, FTSE Italia All Share Index, and the Irish Stock Exchange Overall Index, respectively for the time period December 31, 2014 through March 4, 2015, Bloomberg.
3 Bloomberg, same period as above.
5 The S&P 500 Index total return from December 31, 2014 through March 4, 2015, Bloomberg.
Past Performance does not guarantee future results. An investment cannot be made directly in a market index.