Expectations for a December rate hike may hurt the prospects for outperformance from defensive sectors as we move towards the Fed’s December monetary policy meeting.
International Equity
International equities managed to eke out slight gains on the month, with notable losses coming from Asia (Japan and China). Developed International equities, as measured by the MSCI EAFE Index, gained +1.25% on the month. Those gains were surpassed marginally by Emerging Markets, as measured by the MSCI EM Index, which gained +1.32% during the period.
Single countries such as the United Kingdom, as measured by the FTSE 100 Index, and Hong Kong, as measured by the Hang Seng Index, outperformed both benchmarks, gaining +1.80% and +1.82% respectively on the month. Notable laggards were Japanese shares, as measured by the Nikkei 225 Index, and Chinese issues, as measured by the Shanghai Composite Index, which lost -2.0% and -2.5%, respectively.
It should also be noted that at a regional level, the Eurozone, as measured by the MSCI EMU Index, squeaked out a +0.04% gain on the month, but is still down more than -2.5% on the year, underperforming both Developed International (+2.2%) and Emerging Markets (+16.3%) equities by a wide margin.
This comes largely as political and economic uncertainties, as well as dwindling growth prospects have held back Eurozone equity performance. At the sector level, global Energy and Technology shares were the month’s best performers, gaining +2.96% and +2.76%, respectively, as oil prices rebounded and a flurry of M&A activity propelled Tech shares.
The worst performing sectors during the period were global Financials, which fell -0.93%, as company specific woes from the likes of Wells Fargo in the U.S. and Deutsche Bank in Germany dragged down the sector as a whole.
Continued regulatory risks surround Wells Fargo (the largest bank in the U.S.) and Deutsche Bank (owner of the largest derivatives book in the world) as it relates to potential regulatory action and fines. At some point these shares and the sector as a whole should become buyable; however, the sizeable uncertainty around the sector and interest rates are likely to hold the sector back in the near term.
Lastly, on a valuation basis, it is becoming harder to find good value outside of the U.S. given that most major international indices trade above their 10-year average price to earnings multiples; however, on a relative value basis Emerging Markets continue to look appealing, even after a more than +16% gain YTD.
Fixed Income
The bond market was once again held hostage to an increasingly divided Federal Open Market Committee, which elected to hold off raising rates at its September meeting.
Fed Chair Janet Yellen cited soft business fixed investment and an inflation rate running below target as reasons for holding off on a rate hike in September; however, notably three FOMC members voted in favor of hiking 25 bps, and the odds for a December hike are now close to 60%.
Following the meeting, the MOVE Index touched a one and a half year low, reflecting a growing investor complacency pervading the bond market. Of equal importance to the Fed meeting was the Bank of Japan’s latest confab in which it meaningfully altered it’s monetary policy agenda, choosing to target the yield curve rather than pursuing increasingly negative interest rates. Recognizing that its negative interest rate policy was hurting bank profits, BOJ Governor Kuroda chose to target the shape of the yield curve, targeting a 0.0% rate for the Japanese 10-year note.
This shift in monetary policy coming on the heels of the ECB’s decision to refrain from further increasing its QE program, is seen as perhaps marking the turning point in this era of global central bank quantitative easing. The US 10-year Treasury note saw its yield surge from 1.53% to 1.73% during September as investors positioned for what could be the bottom in global interest rates.
A stable equity market and continued strong demand for bonds has contributed to a strong year for high yield debt with the ML US High Yield Master II Index climbing +0.65% in September and up +15.3% YTD. Junk-rated spreads to government bonds have declined throughout 2016 after peaking in February at +888 bps, now checking in at +510 bps.
With the 10-year average spread of 634 bps over Treasuries, high-yield bonds, like the equity market itself, appears to be priced for perfection, with any unanticipated spike in the corporate default rate likely to deal investors a serious setback.
For now default rates ex-energy remain modest, in no small part due to the large issuance of cov-lite and other issuer friendly debt seen over the past decade. While we don’t anticipate any near-term stress in this space, we would be on guard, favoring the higher end of the non-investment grade spectrum of securities.
Alternative Investments
Alternative investments fared well in September, given the headline event risks on the calendar at the beginning of the month. The Federal Reserve decided to keep interest rates at rock bottom levels in September, which caused the Dollar, as measured by the DXY index, to sell off slightly.
The Dollar finished the month down -0.6%, and is now down -3.2% on the year as the Fed has yet to tighten monetary policy after forecasting four rate hikes this year back in December 2015. The selloff in the Dollar caused Gold to rally, with spot prices closing the month at $1,316/ounce up +0.5% on the month. Gold prices have fallen in recent months, but are nonetheless up +24.0% on the year.
Real Estate Investment Trusts (REITs), as measured by the FTSE NAREIT All REIT Index, also sold off during the month, falling -2.0%. While the decline in REIT shares was modest, the asset class still managed to perform worse than other high yielding equity sectors such as Consumer Staples (-1.46%), Telecoms (-0.93%), and Utilities (+0.46%).
On a year to date basis, REITs have gained +9.3%, ranking the sector 7th out of the now 11 GICS sectors, as REITs were broken out from the Financial sector this month. The Bloomberg Commodities Index gained +3.1% on the month, thanks to a +7.9% gain in West Texas Intermediate (WTI) crude oil.
Crude gains came mostly towards the end of the month as OPEC member nations agreed to a production cut of 750,000 barrels per day. While OPEC did manage to come to an agreement, the timing of implementation and size of the output cut are likely not to be as impactful as headlines profess. This is largely due to the fact U.S. shale producers are now the marginal producer and have been increasing production for weeks.
Not to mention that OPEC members have never been known to actually adhere to their own quotas or mandates, historically disregarding them to gain a competitive advantage against their rivals (i.e. Iran and Saudi Arabia).
Last week’s jawboning by OPEC oil ministers likely comes too late, with cuts likely be too small to cause crude prices to surge anytime soon. On the currency front, the Pound continued to weaken versus the U.S. Dollar, finishing the month at $1.30 USD/GBP, down from $1.44 USD/GBP six months ago pre-Brexit. The Pound is likely to come under increasing pressure in the near term as U.K. lawmakers plan for a formal exit from the European Union (EU).
Over the weekend, PM May announced that Article 50 will likely be enacted in early 2017, with a full exit from the EU unlikely until closer to 2020.
With years of uncertainty ahead for the U.K., and by extension the rest of Europe, both the Pound and Euro could continue to come under pressure against political and economic uncertainties, stagnating growth, and continued quantitative easing (QE) from both the Bank of England (BoE) and the European Central Bank (ECB).