Taper: Trick or Treat?
The Federal Reserve's (Fed) decision not to taper the pace of its bond buying, known as quantitative easing (QE), was a positive surprise for global equity markets. The markets rallied again after the federal government's 11th-hour deal to end the shutdown and temporarily raise the debt ceiling. But risks remain. Investors should evaluate risk/reward opportunities on a region-by-region basis.
- Overweight US. I'm optimistic about the backdrop for the US equity market. A slowly improving economy, diminishing fiscal drag, seasonal trends and Fed liquidity bode well for stocks, especially small caps, growth stocks and cyclical sectors. However, a rotation in market leadership from growth stocks to value stocks is likely on the horizon.
- Neutral weight Europe. European valuations may appear overvalued on the whole, but the market is bifurcated between stocks that are deservedly cheap and those that are expensive and well known, in my view. Investors need to be more selective.
- Overweight Japan. Continued yen weakness may be supportive of Japanese equity prices, although the Fed's taper delay could be disruptive in the short term.
- Underweight emerging markets. Emerging market equities may be boosted by the continuation of QE, but I see more downside risks to emerging market economies, especially those that are commodity driven.
Beware policy uncertainty
Despite media noise about the potential impact of a US default if the debt ceiling weren't raised, the equity market was relatively sanguine during the federal government's budget and debt limit stalemate. In the past month, the S&P 500 Index stock price volatility — as measured by the Chicago Board Options Exchange Volatility Index, known as VIX — peaked on Oct. 8 at 20.34, below the five-year average and about half the level reached during the previous debt ceiling crisis in 2011.1 The S&P 500 Index corrected no more than 4%, and on Oct. 17, the day after the debt deal, it closed at 1733, surpassing the previous high of 1725 set on Sept. 18.2
That said, the temporary resolution funds government spending only through Jan. 15 and suspends the debt limit through Feb. 7. As I pointed out in my Oct. 11 blog, "Move On, Markets, It's Only a Gaper's Delay," this temporary fix will likely keep political uncertainty elevated and hold the lid on equity appreciation. Furthermore, the Fed's taper timeline has likely been extended until after March 2014 as it awaits more convincing data that the US economy is on a sustainable growth trajectory.
This has a range of implications for global equity investors:
- Global equity markets may respond positively to the US government's budget deal if the equity risk premium — the excess return investors expect for investing in stocks — declines and the world economy accelerates.
- The Organisation for Economic Cooperation and Development (OECD) Composite Leading Indicator (CLI) — a proxy for future global growth — edged higher in August (the latest data available), to the highest level since March 2012.3 It was the second monthly increase and the largest yearly gain since March 2011.3
- The increase in the breadth of individual country CLIs reached new highs as well, indicating broader-based global growth.3
- The Baltic Dry Index has broken out to the upside, which is further confirmation of a world on the rebound.4
Lack of change in the Fed's policy opens the door for a shift in regional asset class performance. Investors should consider the risk/reward opportunity for each region.
I believe long-term investors have these reasons to be optimistic about US equities:
- The debt ceiling showdown is behind us for now, although it posed more risk to equity traders than equity investors. Historically, the equity market, as measured by the S&P 500 Index, traded 11% higher one year after previous government shutdowns since 1976.5
- The global and US economies should continue to slowly strengthen. US consumers' disposable income may increase as energy prices decline into the holiday season, and auto and housing sales are likely to continue to improve.
- Although third- and fourth-quarter corporate earnings could come in on the low side of expectations, the fiscal drag is expected to diminish next year, which could support corporate revenue and earnings growth in 2014.
- The Fed's expanding balance sheet is re-emerging as a key driver of stock prices. The S&P 500 Index is now 94% correlated to the Fed's balance sheet, as measured for the past five years.6 Once again, I maintain liquidity may likely trump fundamentals until it doesn't - when the Fed begins tapering.
- Since 1942, seasonal trends have suggested higher stock prices going into year end.7
- Technically, a break above 1720 for the S&P 500 Index sets the stage for further upside in the market, in my opinion.
To be sure, there is a risk of temporarily disappointing economic data from the negative effect of the furlough on government workers' incomes and consumer confidence/spending. However, the potential negative impact on the economy will likely keep Fed tapering on hold until early after the first quarter of 2014, which bodes well for equity prices.
Liquidity-driven markets have tended to reward risk taking and momentum investing, in my experience. As a result, small-cap stocks may likely outperform large caps, growth stocks could outperform value and cyclical sectors may outperform noncyclical sectors. Growth stocks may benefit from a weakening dollar environment. The Russell 1000 Growth Index has the highest percentage of multinationals, which derive a considerable portion of their revenues from overseas. The Fed's delay in tapering its bond purchases has led to dollar weakness — down 4.35% in the third quarter.8 That said, eventually Fed tapering is likely to lead to higher interest rates and dollar strength. During the past 10 years, a rising dollar environment has historically favored value stocks over growth.9
For now, interest rates are likely to remain range bound, gauging by the dramatic decline in mortgage refinancing and new mortgage applications when the 10-year Treasury yield reached 3%. The Invesco Fixed Income team estimates the 10-year Treasury could trade between 2.25% and 3% over the next three to six months.10
Furthermore, the Cleveland Fed's five-year forward breakeven inflation rate, historically a strong predictor of the 10-year Treasury note yield, is rising. The two have had a 99% historical correlation since 1985.11 The current level of the breakeven rate is 1.75%, the highest level since July 2011, when the 10-year Treasury traded between 2.9% and 3.2%.11
Equity investors need to distinguish between before- and after-taper portfolios — those positioned for the next six to nine months before taper versus those positioned for the next one to three years after taper, when interest rates are higher and the dollar is stronger.
Europe: Neutral weight
My position on Europe hasn't changed since last month. The end of the European recession doesn't mean a return to growth. Without additional fiscal stimulus, too many banks with too much debt and a lack of credit growth will likely limit future economic growth. In my opinion, austerity measures instituted to improve competitiveness outside of Germany and the UK were insufficient.
The European Central Bank's (ECB) monetary policy is very different from those of the US and Japan in that the ECB's balance sheet is contracting, while the other two are expanding. The 25% decline in the ECB's balance sheet since the June 2012 peak is hardly stimulative and helps explain the continued strength in the euro/dollar exchange rate, which works for Germany but not for the other eurozone countries, in my opinion.12
Since the June 24 bottom, the MSCI Europe Index has appreciated 19.5% in local currency terms and 23% in US dollar terms as of Oct. 16, 2013, and European equities have experienced record capital inflows recently.13 In hindsight, it seems I missed an opportunity to invest in a region where equity valuations were cheaper than in the US and economic data were getting "less bad."
However, I have concerns about European equities, including:
- Valuations look problematic. The market is bifurcated between very cheap stocks that deserve to trade at low multiples because they lack growth prospects and expensive stocks that tend to be well-known blue chips that everybody either already owns or wants.
- Investors have been paying a higher multiple for companies whose earnings are being downgraded. The MSCI Europe ex UK Index forward earnings composite fell 25.7% from the summer of 2011 through the summer of 2012 and has been flat since then.14 Therefore, the jump in stock prices has been attributable to an increase in the forward price-earnings (PE) ratios from 10 to 13.14
- Despite a recent increase in the eurozone's manufacturing purchasing managers indexes (PMIs), the Net Earnings Revisions Index for the MSCI Europe ex UK Index remained in negative territory in August, meaning that more earnings were being revised downward than upward.14
- The MSCI Europe Index is dominated by financial stocks, which look unattractive to me right now.
To some observers the overall index may be undervalued relative to the US, but I believe it takes more selectivity to avoid a potential downward surprise. Investors may be better served by seeking managers with concentrated portfolios who are known to be stock pickers, not index huggers.
The lack of Fed tapering could lead to temporary dollar weakness, which could negatively affect Japanese stock prices in the short run. I would use any weakness in Japanese equity prices to add to positions.
I still believe the Bank of Japan (BOJ) will be successful in weakening the yen/dollar exchange rate, and the Nikkei 225 Index remains 97% correlated to the direction of the yen/dollar exchange rate.15
My main concern is Japan's inflation rate, which has triggered every bear market over the past 20 years.16 The BOJ wants some inflation but not too much. A weaker currency will increase the inflation rate at some point and become problematic. Investors should consider an investment vehicle that provides participation in the Nikkei 225 or Topix indexes but minimizes currency risk.
Emerging markets: Underweight
I haven't changed my recommended relative allocation in emerging markets, even though the seasonality of returns and the lack of tapering could benefit emerging market asset class performance.
The Fed's taper delay reduces pressure on US interest rates and tends to weaken the dollar, which are both positive for emerging market equity returns, in my view. The Fed's inaction brought risk taking back to the forefront, which could further benefit emerging market equity performance. However, I'm concerned by the disconnect in some key drivers of emerging market equity performance, including:
Equity investors should remain selective in adding positions in this region, as valuation levels have risen, and economic data could disappoint. Once tapering begins, the US dollar should strengthen, depressing commodity prices and leading to emerging market equity underperformance. Investors in this asset class may want to steer clear of commodity-exporting companies.
The relative allocations are based on my risk/reward outlook for each region, not necessarily on which equity markets I believe may rise and fall. In summary:
- I would overweight the US equity market because of the likely continued economic recovery, the quality of corporate balance sheets and the continued accommodative monetary policy. Growth stocks may exhibit relative outperformance in the near term, but I believe investors should consider a value overweight as the prospect of Fed tapering gets closer to fruition.
- Outside the US, most European stocks look fully priced to me, but I like large-cap, high-dividend-paying companies. I expect the dollar to strengthen over the euro over the next few years, providing these European multinational companies a pricing advantage that could lead to an upward earnings surprise. European small-cap companies also look interesting to me because they tend to be highly levered and benefit from improving global growth.
- Japanese equities still look like they have more upside, in my opinion, as the currency continues to trade lower.
- Emerging market equities have been rebounding, but I'm afraid fundamentals could fall short and limit upside from current levels. Stock selection is critical to future success when investing in the emerging markets, in my opinion.
The opinions referenced above are those of Richard Golod as of October 21, 2013, and are subject to change at any time due to changes in market or economic conditions and may not necessarily come to pass. These comments are not necessarily representative of the opinions and views of other Invesco investment professionals. The comments should not be construed as recommendations, but as an illustration of broader themes. Past performance is no guarantee of future results.
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