Fed to markets: see you in December
Quote of the week
The Lead Story: The Fed enters a new era
The past week was dominated by the Federal Reserve’s September 20 decisions to begin reducing its massive bond portfolio accumulated in the wake of the 2008 financial crisis and to keep its target interest-rate range unchanged.
In its policy statement and in Fed Chair Janet Yellen’s post-meeting press conference, the Fed spoke to both hawks and doves. On the hawkish side, because the Fed views the U.S. economy’s recent string of low inflation readings as transitory, policymakers still plan to raise rates in December. In contrast, doves pointed to commentary that the Fed’s tightening timetable may end sooner than markets expect. As for the Fed’s balance-sheet strategy, Yellen stuck to her June script, which called for a gradual unwinding of its $4.5 trillion portfolio of U.S. Treasury and mortgage-backed securities. More perspective on the Fed’s meeting can be found here.
The yield on the 10-year Treasury closed at 2.26% on September 22, up from 2.20% to start the week and 2.05% on September 7. Broadly speaking, fixed-income investors remain upbeat, as evidenced by positive flows into investment-grade and high-yield corporate bond funds, and emerging-markets debt offerings. A larger chunk of the flows went into actively managed funds, for which late-cycle investing can create significant opportunities. In coming weeks, inflation gauges will come into sharp focus, as markets assess the timing and pace of the Fed’s projected path for interest-rate hikes.
In equity markets, the S&P 500 Index eked out a 0.1% gain for the week. Europe’s STOXX 600 Index was in slightly better form (+ 0.66% in U.S. dollars), helped by an uptick in economic data. For the year to date, this index has returned 23.8%.
In other news: Emerging-markets stocks still look like a good deal after their hefty rise
Emerging-markets (EM) equities are in the midst of a well-supported, broad-based rally. The unhedged MSCI Emerging Markets Index is up 30.9% for the year to date through September 21, dwarfing the S&P 500’s otherwise impressive 13.4% return. After such a sudden advance, investors might think EM equity valuations have become rich, but that’s not the case. EM shares plunged 32% from August 2014-February 2016. This rebound has largely erased that loss.
Valuations, meanwhile, have not ballooned thanks to especially strong upward earnings revisions: the MSCI Index’s forward price-to-earnings ratio is currently at 12.7x versus 11.8x in January. For 2017 as a whole, we expect EM earnings growth of about 20%, roughly double that of the S&P 500.
Also promising has been the broad participation among EM equity markets. Poland (+48.8%), the star performer, has been ably joined by Turkey, India, Korea, and much of Latin America, all of which have returned around 30%. Only Russia (-1.3%) is in negative territory.
On a sector level, Technology (+54.5%) leads the way, marking a stark reversal from prior EM rallies that saw banks and energy companies outperform amid higher interest rates and the “reflation trade.” This time around, a number of EM central banks are in easing mode—in contrast to the Fed and, sometime soon, the European Central Bank. Tech stocks tend to perform well when borrowing costs are low.
Our bottom line is this. EM equities, thanks to their great run, are not as cheap as they were to start the year. But from an asset-allocation perspective, we firmly believe they have a place in a well-diversified portfolio.
Below the fold: Robust leading indicators temper so-so housing data
The Conference Board’s index of leading economic indicators rose in August for the eighth straight month. Although the recent hurricanes’ economic impact has not yet been fully reflected, August’s gain is consistent with continuing growth in the U.S. economy for the second half of the year.
Meanwhile, according to the NAHB/Wells Fargo index, homebuilder confidence dipped in September from August’s downwardly revised reading. The damaging weather intensified concerns about finding skilled workers—an ongoing struggle in the construction industry. Despite this month’s drop, builder confidence is still on firm ground, and we expect the housing market to extend its gradual recovery.
Also on the housing front, existing home sales (-1.7%) fell in August for the fourth time in five months, dragging down their year-over-year gain to a mere 0.2%. Sales have been restrained by a combination of inadequate supply of homes and high home prices. Housing starts (-0.8%) also slipped in August, but building permits, a forward-looking indicator, jumped to their second-highest total in 10 years.
Across the Atlantic, the Eurozone’s economy ended the summer on a strong note. Manufacturing and service-sector activity hit a four-month high in September, according to Markit’s “flash” (preliminary) Purchasing Managers’ Index. Encouragingly, the euro’s ascent provided only a modest drag on exports. The faster pace of business activity, which was accompanied by rising price pressures, should boost expectations for the European Central Bank to begin dialing back its monetary easing measures sooner rather than later.
The Back Page: Investing in emerging markets isn’t just about equities
Just as EM equities have outpaced their U.S. and Eurozone counterparts, EM debt has delivered solid performance, too. Year to date through September 21, local currency, global sovereign bonds have returned 15.5% , while U.S. dollar-denominated, sovereign diversified debt has gained 8.9%, as measured by respective JP Morgan indexes.
After several challenging years, a broad-based resurgence is taking place across the developing world. Annual economic growth is expected to outpace that of developed markets (DM) by over 3% through 2020, debt-to-GDP ratios are generally lower than those in DM, and EM corporate balance sheets are healthier than they’ve been in years. Against this supportive backdrop, the EM debt market has nearly doubled in size, from $11 trillion in 2010 to a formidable $20 trillion.
As an asset class, EM debt offers a range of potential benefits, including diversification among an array of countries and currencies, low correlations to U.S. Treasuries and equity markets, and the opportunity to generate attractive yields all along the credit-quality continuum. Investors seem to be noticing. According to Morningstar, net flows into EM market bond funds are approaching $9 billion year to date through August 31.
To learn more about considerations for EM debt investors, see our white paper, “Emerging Markets Debt: A New World in Fixed Income,” scheduled for publication on September 26, 2017.