Despite a turbulent first half of the year, the outlook for financial markets now appears in some ways oddly similar to how it looked at the beginning of 2016 though it has somewhat deteriorated. The similarities include above average equity valuations, feeble earnings growth, and low volatility indices, suggesting complacency about global risks.
What has turned worse over the first six months is that the yields on alternatives to equities are lower, which suggests that there is less likelihood of bonds continuing to outperform equities as they have in three of the last four quarters (see exhibit 1 below). Equity market investors will need to focus on those areas where earnings growth potential justifies the high multiples paid, while investors in fixed income will be left taking more credit and duration risk than they may be comfortable with.
Exhibit 1: Market metrics
|High yield corp.||8.1%||6.0%|
- Valuations are next-twelve-month P/E for MSCI World Index.
- Earnings growth is trailing twelve-month EPS growth.
- Volatility is five-day average of VIX (S&P 500) and VSTOXX (EuroSTOXX 50) volatility indices.
- US Treasury and bond yields are five-day average for 10-year benchmark bonds.
- Investment grade (IG) corporate and high-yield corporate bond spreads are five-day average of yield-to-worst for Barclays global indices.
Sources: FactSet, Chicago Board Options Exchange, Deutsche Börse, Bloomberg, Barclays as of 24 August 2016
In this series of four articles I am going to review the situation and our investment strategy in each of the world’s major economic regions (Europe, USA, Japan and emerging markets). I will start with Europe:
The investment case for the outperformance of European equities relative to US equities has been premised on relatively low margins and the tardy eurozone economic recovery finally gaining steam. Both factors suggest European corporate profit growth should outpace that in the US as margins rise more in Europe and Europe’s GDP growth accelerates.
Those arguments are just as valid today as they were six months ago, but the MSCI Eurozone index has nonetheless underperformed the MSCI US index by over 10% year-to-date (local currency terms). A key reason for the divergence has been the persistent reluctance of the US Federal Reserve (Fed) to raise interest rates. As expectations for the next increase in the federal funds rate kept moving further into the future, the anticipated drag on US equities from tighter monetary policy failed to appear (see Exhibit 2).
Exhibit 2: Relative equity returns and US interest rate expectations
Note: Equity indices are price returns in local currency terms
Sources: CBOE, BNP Paribas Investment Partners as of 24 August 2016
We still believe, however, that the Fed is likely to raise interest rates at least once between now and the end of the year, which should finally signal the end of the laggard performance of eurozone equities.
Negative yields on most eurozone government bonds and yields below 1% on eurozone corporate bond aggregates suggest that positive total returns will be difficult to achieve unless the European Central Bank (ECB) significantly expands its quantitative easing (QE) programme and manages to push yields even lower. We do anticipate an extension of the current programme beyond March 2017, but not a move away from the “capital key” – in other words that the ECB will continue to buy government bonds in proportion to each country’s contribution to the capital base of the central bank.
European bonds, as measured by the Barclays Pan-European Aggregate index, have outperformed European equity markets so far this year, but it will be a difficult trick to repeat. The dividend yield on the MSCI Europe index is near 3.7% (when inflation is close to zero), and earnings estimates have been rising, in contrast to the EPS downgrades from analysts in the first part of the year.
Returns on UK gilts may well continue to outpace eurozone government bonds through the rest of 2016. Expectations are high that the Bank of England (BoE) will re-launch its quantitative easing programme, which will help push gilt yields lower. Even with the fall in UK bond yields since June, they are still trading at a far wider spread than when the BoE was last running a QE programme (see Figure 2). There are concerns that the rally in gilt yields could reverse as sterling declines and inflation rises.
Recent credit agency downgrades highlight the risk that the creditworthiness of UK debt may continue to fall due to more fiscal stimulus packages and debt issuance in contrast to the previous moves toward lower debt-to-GDP levels. The positive income from gilts compared to negative yields on many eurozone government bonds should nonetheless offset those risks, in our view.
Exhibit 3: Gilts vs. eurozone government bond spread
Source: Barclays, BNP Paribas Investment Partners as of 24 August 2016
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.