@AmyMagnotta, CFA, Senior Investment Manager, Brinker Capital
Developed market equities have had an impressive run so far in 2013, while fixed income, emerging markets and commodities have lagged. After telegraphing a tapering of asset purchases, the Fed surprised investors on September 18 with a decision to keep the quantitative easing program in place, wanting to see greater clarity on economic growth and a waning of fiscal policy uncertainty before reducing the level of asset purchases.
Asset prices moved immediately higher in response to the Fed’s decision; however that served to be the high-water mark for equities for the quarter. Then concern over U.S. fiscal policy surfaced and has weighed on markets over the last few weeks. Unlike in previous years, deals to raise the debt ceiling and fund the government will result in limited fiscal drag; however, the headlines will serve to increase market volatility over the short term.
U.S. equity markets posted solid gains in the third quarter, led by small caps and growth-oriented companies. High-yielding equities continue to lag. Developed international equity markets meaningfully outpaced U.S. markets in the quarter, with most countries generating double-digit returns. As a result, the gap of outperformance for U.S. markets has narrowed for the year. Emerging economies have been negatively impacted by the discussion of the Fed reducing liquidity, slower economic growth and weaker currencies. While emerging markets equities rebounded in the third quarter, as a group they are still negative for the year with Brazil and India especially weak.
Interest rates continued their rise to start the quarter, with the 10-year Treasury note briefly hitting 3% in the beginning of September. Rates then began to move lower, helped by an avoidance of conflict in Syria and the postponing of Fed tapering. All fixed income sectors were positive in the third quarter, led by high-yield credit. Year to date through September, high yield has produced gains, while all other major fixed income sectors are negative. Outflows from taxable bond funds have slowed significantly in recent weeks, so the technical backdrop has improved somewhat.
We believe that interest rates have begun the process of normalization, and over the long term, the bias is for higher interest rates. However, this process will be prolonged and likely characterized by fits and starts. The Fed will soon face the decision to taper asset purchases again later this year, with the earliest action in December. Despite their decision to reduce or end asset purchases, the Fed has signaled short-term rates will be on hold for some time. Rising longer-term interest rates in the context of stronger economic growth and low inflation is a satisfactory outcome. Our fixed income allocation is well positioned with less interest-rate risk and a yield premium versus the broad market.
However, we continue to view a continued rapid rise in interest rates as one of the biggest threats to the U.S. economic recovery. The recovery in the housing market, in both activity and prices, has been a positive contributor to growth this year. Stable, and potentially rising, home prices help to boost consumer confidence and net worth, which impacts consumer spending in other areas of the economy. Should mortgage rates move high enough to stall the housing market recovery, it would be a negative for economic growth.
We continue to approach our broad macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we move into the final months of the year, and a number of factors should continue to support the economy and markets.
- Monetary policy remains accommodative: The Fed remains accommodative (even with the eventual end of asset purchases, short-term interest rates will remain low for the foreseeable future), the ECB stands ready to provide additional support if necessary, and the Bank of Japan is embracing an aggressive monetary easing program in an attempt to boost growth and inflation.
- Global growth strengthening: U.S. economic growth has been sluggish, but steady. The manufacturing and service PMIs remain solidly in expansion territory. Outside of the U.S. growth has not been very robust, but it is positive. China appears to have avoided a hard landing.
- Labor market progress: The recovery in the labor market has been slow, but stable. Initial jobless claims, a leading indicator, have declined to a new cycle low.
- Housing market improvement: The improvement in home prices, typically a consumer’s largest asset, boosts net worth, and as a result, consumer confidence. However, another move higher in mortgage rates could jeopardize the recovery.
- U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash that could be reinvested or returned to shareholders. Corporate profits remain at high levels and margins have been resilient.
However, risks facing the economy and markets remain, including:
- Fiscal policy uncertainty: After Congress failed to agree on a continuing resolution to fund the government, we entered shutdown mode on October 1. While the economic impact of a government shutdown is more limited, the failure to raise the debt ceiling (which will be reached on October 17) would have a more lasting impact. A default remains unlikely in our opinion, and there will be little fiscal drag as a result of a deal, but the debate does little to inspire confidence. The Fed continues to provide liquidity to offset the impact.
- Fed mismanages exit: The Fed will soon have to face the decision of whether to scale back asset purchases, which could prompt further volatility in asset prices and interest rates. If the economy has not yet reached escape velocity when the Fed begins to scale back its asset purchases, risk assets could react negatively as they have in the past when monetary stimulus has been withdrawn. The Fed will also be under new leadership next year, which could add to the uncertainty. However, if the Fed does begin to slow asset purchases, it will be in the context of an improving economy.
- Significantly higher interest rates: Rates moving significantly higher from here could stifle the economic recovery.
- Europe: While the economic situation appears to be improving in Europe, the risk of policy error still exists. The region has still not addressed its structural debt and growth problems; however, it seems leaders have realized that austerity alone will not solve its issues.
Risk assets should continue to perform if real growth continues to recover despite the higher interest rate environment; however, we expect heightened volatility in the near term. Valuations in the U.S. equity market remain reasonable while valuations abroad look more attractive. We continue to emphasize high-conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.
Some areas of opportunity currently include:
- Global Equity: Large-cap growth, dividend growers, Japan, frontier markets, international microcap
- Fixed Income: MBS, global credit, short duration
- Absolute Return: closed-end funds, relative value, long/short credit
- Private Equity: company-specific opportunities
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The views expressed above are those of Brinker Capital and are not intended as investment advice.