Amy Magnotta, CFA, Senior Investment Manager, Brinker Capital
The impressive run for global equities continued in October. While U.S. and developed international markets have gained more than 25% and 20% respectively so far this year, emerging markets equities, fixed income, and commodities have lagged. Emerging markets have eked out a gain of less than 1%, but fixed income and commodities have posted negative year-to-date returns (through 10/31). While interest rates were relatively unchanged in October, the 10-year Treasury is still 100 basis points higher than where it began the year.
After the Fed decided not to begin tapering asset purchases at their September meeting, seeking greater clarity on economic growth and a waning of fiscal policy uncertainty, attention turned to Washington. A short-term deal was signed into law on October 17, funding the government until mid-January 2014 and suspending the debt ceiling until February 2014. With the prospects of a grand bargain slim, we expect continued headline risk coming out of Washington.
The Fed will again face the decision to taper asset purchases at their December meeting, and we expect volatility in risk assets and interest rates to surround this decision, just as we experienced in the second quarter. More recent economic data has surprised to the upside, including a +2.8% GDP growth rate and better-than-expected gains in payrolls. Despite their decision to reduce or end asset purchases, the Fed has signaled that 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.
However, we continue to view a rapid rise in interest rates as one of the biggest threats to the 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 macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we approach the end of the year, with a number of factors supporting the economy and markets.
- Monetary policy remains accommodative: The Fed remains accommodative (even with the eventual end of asset purchases, short-term interest rates are likely to remain near-zero until 2015), the ECB has provided additional support through a rate cut, and the Bank of Japan has embraced 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.
- Labor market progress: The recovery in the labor market has been slow, but stable. Monthly payroll gains have averaged 201,000 over the last three months.
- Inflation tame: With the CPI increasing only +1.2% over the last 12 months, inflation in the U.S. has been running below the Fed’s target level.
- Equity fund flows turn positive: Equity mutual funds have experienced inflows of $24 billion over the last three weeks, compared to outflows of -$12 billion for fixed income funds. Continued inflows would provide further support to the equity markets.
- 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 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:
- Fed mismanages exit: The Fed will soon have to face the decision of when 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. 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 current levels could stifle the economic recovery.
- Sentiment elevated: Investor sentiment is elevated, which typically serves as a contrarian signal.
- Fiscal policy uncertainty: Washington continues to kick the can down the road, delaying further debt ceiling and budget negotiations to early 2014.
Risk assets should continue to perform if real growth continues to recover even in a higher interest rate environment; however, we expect continued volatility in the near term, especially as we await the Fed’s decision on the fate of QE. Equity market valuations remain reasonable; however, sentiment is elevated. Our portfolios are positioned to take advantage of continued strength in risk assets, and 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 high yield credit, short duration
- Absolute Return: closed-end funds, relative value, long/short credit
- Real Assets: MLPs, company specific opportunities
- Private Equity: company specific opportunities
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