The divergent path of monetary policy in the US versus the rest of the developed world influenced asset class performance in February. US equities outperformed bonds as a strengthening economy lent support to the case for Fed tightening.1 Meanwhile, international equities enjoyed a lift off the back of increased central bank accommodation.2
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Developed Markets Equities
After a bumpy first month of the year, equity markets found a clear direction in February. US large caps rose 5.8% during the month, while their European counterparts gained an impressive 7.4%.3 Japanese equities kept pace with a 6.41% rise.4 US equities reflected the strength of the economy and better-than-expected earnings results. Rising wages, lower oil, and a stronger dollar are powering the biggest engine of the US economy: consumers. Meanwhile, European and Japanese markets felt the warmth of quantitative easing. Japanese exports rose the most in over a year in January, which spurred confidence that a weak yen would continue to benefit Japanese companies.5 European equities rallied in anticipation of the ECB’s sovereign bond purchases. Positive economic surprises provided additional support: the euro-area composite PMI reached a seven-month high in February,6 German consumer confidence rose,7 and credit standards eased for the third consecutive quarter.8 Markets largely shrugged off geopolitical worries spurred by the Greek debt negotiations and the Russia and Ukraine conflict.
We remain Overweight Developed Markets Equities. In the US, improving labour markets and lower oil prices should translate into increased consumption and growth, which should bode well for stocks, both large and smid cap. In Europe and Japan, accommodative monetary policy should create more liquid capital markets, helping to stimulate activity in the regions. Weakening of the euro and the yen versus the dollar should also increase demand for exports. Finally, UK equities warrant a closer look at current valuations. (See The UK equities landscape article in our last issue.)
Emerging Markets Equities
Developed Markets Equities were not the only winners in February. Emerging Markets (EM) Equities returned 3.1% during the month.9 Gains were fairly broad-based. Emerging Asia equities enjoyed the benefit of lower commodity prices, while Russian equities rebounded on the stabilisation of oil prices. Greek equities also snapped back as funding was secured for the next four months, while a reform agenda is agreed upon with the troika.10
We maintain a Neutral weight on Emerging Markets Equities. While tightening in the US may temporarily pressure EM equities, this should be offset by stronger external demand from developed markets, particularly from US consumers armed with a stronger dollar. Wide disparity in valuations bodes well for actively managed vehicles. Markets on the import side of the commodity trade should outperform.
Yields are starting to rise in anticipation of a rate hike
US stock and bond performance diverged in February11, with bond returns feeling the pressure of rising yields. US 10-year Treasury yields were up 50 basis points at their peak in mid-February, as job gains pushed up the likelihood of a rate increase. In her testimony to Congress, Janet Yellen was optimistic about the economy and labour market, but pointed to sluggish wage growth, the low labour participation rate, and falling inflation as reasons to remain cautious. Ms. Yellen posited that in the coming meetings, the Fed will be removing the word “patient” in describing its approach to rate hikes, and then enter a phase in which rate hikes are possible at any meeting.12 Meanwhile, in Europe, sovereign bond yields fell further (some even turning negative) after the ECB’s announcement of its asset purchase plans.
We remain either Underweight or Neutral fixed income assets. In the US, rising rates will hurt fixed income investors, especially those with passive, long-duration exposure. Meanwhile, in Europe, yields do not have much further to fall, especially in light of some being in negative territory already.
High Yield and Emerging Markets Bonds
Emerging Markets Bonds were flat in February.13 With a stronger US dollar and a more volatile geopolitical landscape, yields do not seem to compensate for the additional risk.
We are Underweight Emerging Markets Bonds due to an unfavourable risk-return profile in light of geopolitical concerns, the potential for continued currency volatility, and impending tightening in the US.
US High Yield Bonds outperformed US Investment Grade and US Government Bonds, after underperforming in January.14 The higher coupons help to offset the duration risk associated with the expectation of rising rates. We are Neutral on US High Yield Bonds.
REITs gave back some gains in February after a long-running streak of outperformance.15 The appeal of REIT dividends is waning as the interest rate hike looms. We are Neutral on REITs. While the transition to a normalised interest rate environment could put downward pressure on prices, a stronger US consumer and lower oil should bode well for many REITS sectors, such as retail and apartments.
Oil prices still under pressure but moderating
Oil prices traded sideways for most of February, ending the month at almost $63 per barrel. Support for prices came from announced capital expenditure cuts by US producers and a decline in active rig counts. Industrial metal prices declined during the month. Copper prices rebounded due to the expectation for stimulus in China and production disruptions in Chile. Meanwhile, precious metal prices declined, as the US dollar continued to strengthen and pressure mounted on the Fed to raise rates.16
We are Underweight Commodities, as a stronger dollar, slowing global demand, and excess supply, in some sectors, will continue to put pressure on prices.
Alternative Trading Strategies
Our Overweight to most Alternative Trading Strategies is a hedge against anticipated variability in asset prices, as markets adjust to the decreased pace of US monetary stimulus and eventual rate increases. Global Macro funds and Managed Futures have benefitted from a pickup in volatility, particularly in the energy sector and currencies, since late 2014.17
Investing involves risk including loss of principal. International investing involves a greater degree of risk and increased volatility. These risks are magnified in emerging markets.
1 Source: Bloomberg, as of February 27, 2015. US equities represented by Russell 1000. US bonds represented by Barclays US Aggregate Total Return Index.
2 Source: Bloomberg, as of February 27, 2015. International equities represented by MSCI World Index.
3 Source: Bloomberg, as of February 27, 2015. US Large Caps represented by Russell 1000 Total Return Index. European equities represented by Euro Stoxx 50 Index in local currency.
4 Source: Bloomberg, as of February 27, 2015. Japanese equities represented by Nikkei 225 Index in local currency.
5 Source: Bloomberg, as of January 31, 2015.
6 Source: Bloomberg, as of February 28, 2015.
7 Source: Bloomberg, as of February 28, 2015.
8 Source: European Central Bank, as of January 20, 2015.
9 Source: Bloomberg, as of February 27, 2015. Emerging Markets Equities represented MSCI Emerging Markets Total Return Index.
10 Source: Bloomberg, as of February 27, 2015. Emerging Market country equity returns represented by MSCI Indices.
11 Source: Bloomberg, as of February 27, 2015. US equities represented by Russell 1000. US bonds represented by Barclays US Aggregate Total Return Index.
12 Source: Bloomberg, as of February 25, 2015. Janet Yellen’s testimony to Congress.
13 Source: JPMorgan, as of February 27, 2015. Emerging Markets Bonds represented by JP Morgan GBI-EM Total Return Diversified.
14 Source: Bloomberg, as of February 27, 2015. US Government Bonds represented by Barclays US Treasury Index. Investment Grade Bonds represented by Barclays US Aggregate Corporate Index. ; US HighYield Bonds represented by Barclays US Corporate High Yield Bond Index.
15 Source: Bloomberg, as of February 27, 2015. REITS represented by FTSE NAREIT US – ALL Equity REITs Index.
16 Source: Bloomberg, as of February 27, 2015. Commodities represented by Bloomberg Commodity Index. Sub-sectors represented by Dow Jones Indices.
17 Source: Bloomberg. Returns as of January 30, 2015 for: Event Driven Strategies, Global Macro, Relative Value Strategies, and Managed Futures. Global Macro Strategies by Barclay Hedge Fund Global Macro Index; Relative Value Strategies by HFRI Relative Value Index; Event Driven Strategies by Dow Jones CS Event Driven Index.
Past performance does not guarantee future results. An investment cannot be made directly in a market index.