Don’t Fight the Central Banks

June 14, 2014 | By Rick Golod

Executive summary

Global equities continued to advance in May and early June and, in my opinion, could continue to rally through the summer. Although global central banks are on divergent paths, liquidity remains ample and economic data is likely to remain positive for the most part, providing continued support to equity prices.

  • Overweight US. The US economy seems to have recovered from its first-quarter weather woes, despite fear signals from the bond market. The unexpected Treasury rally appeared to be driven by technical and other forces rather than economic conditions. With that, I remain bullish on US equities.
  • Neutral weight Europe. The European Central Bank's (ECB) unprecedented move to push the deposit rate into negative territory grabbed headlines but ultimately may have little economic benefit, in my opinion.
  • Overweight Japan. The second half of the year looks more favorable for Japanese equities, with the Bank of Japan (BOJ) likely implementing another round of quantitative easing (QE) between July and October.
  • Underweight emerging markets. A lack of fundamental improvement continues to make emerging market equities' risk-reward profile look relatively unattractive.

Global liquidity is likely to remain high

Lower interest rates, an expected easing of financial conditions by the ECB, and better-than-expected economic data out of the US moved global equity prices up 1.8% in May and another 1.1% in the first week of June. Japan, up 4%, was the best-performing region in May, followed by emerging markets, up 3.3%, and the US, which was up 2.2%. For the year to date, European equities have led, but were up only 0.2% in May. Equity market performance is represented by the MSCI All Country World Index (ACWI), MSCI Japan Index, MSCI Emerging Markets Index, MSCI USA Index and MSCI Europe Index, respectively.

I believe a powerful summer rally is beginning and investors may not be adequately positioned for it. Positive economic data announcements in the months ahead are likely to move investors off the sidelines and propel equity markets higher. I believe investors should consider taking advantage of lower rates in US Treasuries to reposition portfolios.

US: Overweight

Despite signs of an ongoing economic recovery, the yield on the 10-year Treasury declined 22 basis points in May. Typically, a price rally (as yields fall, prices rise) in the bond market signals concern that difficult times, such as heightened equity volatility or an impending recession, may lie ahead.

Yet, the US economy is on good footing, as reflected in the following data reports:

  • The Conference Board's Leading Economic Index (LEI) increased according to its latest reading in April and stands at the highest level since December 2007.
  • The smoothed Economic Cycle Research Institute (ECRI) Weekly Leading Index reached a 10-month high.
  • The National Federation of Independent Business (NFIB) Small Business Optimism Index reached the highest level since October 2007.
  • The Rasmussen Consumer Index also hit an all-time high reading on May 20.
  • Unemployment claims are at the lowest levels in seven years, and job gains have exceeded 200,000 four months in a row.
  • The nation also has the most people working since the pre-recession peak, and the average workweek for manufacturing is at the highest levels since July 1945, when manufacturing capacity was near war-time peaks.
  • The Institute for Supply Management (ISM) Manufacturing Index, one of the best gauges of the economy, is at 55.4 — which is historically consistent with real (inflation-adjusted) GDP growth of 4% annualized.

Given such economic data, it's hard to make the case that the fixed income market is accurately forecasting an economic slowdown. Rather, it appears that the Treasury rally reflects a confluence of events.

I agree with Invesco Fixed Income's Chief Strategist Rob Waldner, who believes that the Treasury rally was prompted by speculative trading activity; increased demand from China that was coupled with tighter supply (as the US government owns the majority of government bonds); Treasury bonds' more attractive risk-reward profile relative to European sovereign bonds; rebalancing by institutional investors; and investor confidence that the Federal Reserve (Fed) is likely to maintain its zero interest rate policy for the next few years.

Furthermore, bond yields have fallen for noneconomic reasons in the past. Seven times in the past 35 years, when yields have declined, GDP growth averaged nearly 4% the following year and has never fallen below 2.8%.

I believe fixed income prices may have hit their high-water mark for the year, whereas equities appear to have further upside.

I am bullish about US equities for the following reasons:

The Dow Theory — This theory maintains that a bullish trend is confirmed if both of its averages (industrial and transportation) reach new highs, and it currently appears to be signaling further upside. Recently, both the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average reached new highs, and since 2004, the DJIA has been 94% correlated to the direction of the transportation sector.

Accommodative Fed policy — The S&P 500 Index seems to have reconnected to Federal Open Market Committee (FOMC) rate policy. And when has it ever paid to "fight the Fed"? Currently, the S&P 500 Index is 100% correlated with the Fed's balance sheet. Despite Fed tapering, the FOMC's balance sheet is expected to expand $450 billion in 2014.

Investor sentiment — Last month, the percentage of investors indicating a neutral sentiment in the American Association of Individual Investors (AAII) Investor Sentiment Survey reached the highest level in 10 years. In other words, over the last decade, there have never been so many investors who were confused on what to do with their investments. I believe better-than-expected GDP growth in the second quarter could move investors off the sidelines and into the equity market.

Multiple expansion — Equity market rallies that have been primarily driven by multiple expansion (price-earnings ratio, or P/E) have tended, historically, to last years — not months or quarters. For example, in the 1950s, multiple expansion was the primary driver of equity gains for seven years. Beginning in 1980, multiple expansion was the primary driver for 14 years, only to be interrupted during the 1994 correction, and continuing from there for another six years. In the past, when multiples were expanding and earnings rising, the average S&P 500 Index return was 24.2%. Keep in mind past performance is no guarantee of future results.

What's more, S&P 500 profit margins reached a record high of 10.0% in the first quarter. Consensus earnings revisions spiked higher in May as analysts upgraded their earnings outlook for the year. This is positive for future equity returns.

It has been difficult to determine which asset classes and/or sectors will continue to lead the market. Last month's decline in interest rates contributed to the outperformance of growth stocks over value stocks and large caps over small caps.

Investors should consider using this weakness to increase small cap and value stock exposure. Small caps broke above important technical levels last month, resuming their uptrend, and look positioned to potentially trade higher. If interest rates have reached the low for the year, the financial sector is likely to trade higher as interest rates move higher. I favor deep value managers that own large-cap companies as well as small-cap managers with concentrated portfolios.

Europe: Neutral weight

Thus far, extremely accommodative monetary policy hasn't benefited all nations in the eurozone, with bank lending in the region still shrinking despite record-low bond yields. In early June, ECB President Mario Draghi unveiled some unprecedented measures intended to encourage lending to consumers and nonfinancial businesses.

The ECB is the first central bank to cut its deposit rate to a negative number, essentially charging banks to keep their money at the ECB in an effort to motivate banks to lend more.

This is Mr. Draghi's most dramatic action since announcing in 2012 that the ECB would "do whatever it takes" to save the euro. A lackluster economic recovery, with the region being just 50 basis points away from deflation, likely prompted the ECB's recent action.

However, despite all the attention, I believe the negative deposit rate will likely have a negligible economic impact. In theory, a negative deposit rate should discourage banks from depositing money at the ECB because they would have to pay for that privilege. However, banks have already reduced their overnight deposits by 96% from the March 2012 peak. Removing the remaining funds will hardly make a difference in boosting economic growth.

That said, Europe continues to follow the same road to recovery as the US, but using a different vehicle. The US administered multiple rounds of quantitative easing (QE), and Europe is upping its game as well. Just as the US faced risk of a double-dip recession and potential deflation in 2011, Europe is up against the same risks today.

I can't stress this enough — I believe many of the same investment themes that produced above-average risk-adjusted returns in the US are likely to produce similar results in Europe. A lack of economic growth tends to motivate investors to seek high-dividend-paying stocks. This should benefit investment strategies such as "Dogs of Europe" (owning the highest-yielding stocks) and "Dividend Aristocrats" (owning companies that have increased their dividends annually for many years), although these strategies do carry their own risks. Additionally, low-quality, small-cap stocks could benefit from Europe's near-record equity risk premium.

Whether Mr. Draghi's latest package stimulates credit growth remains in question. In my opinion, if it weakens the euro/dollar exchange rate, then I would say "mission accomplished."

Japan: Overweight

Japanese equities appreciated 4% in May, helped by stronger manufacturing activity, a weakening yen (finally) and expectations of a corporate tax cut.

For the year to date, Japan is the only major equity market to correct. On a 12-month forward P/E basis, Japan hasn't been this undervalued relative to developed markets in 20 years. Such cheapness is attractive to me, especially if the currency risk is mitigated.

In my view, the Nikkei 225 Index is likely to continue to trade higher in the second half of the year, as corporate tax cuts are announced, Japan rebalances its government pension fund to increase equity exposure, and additional QE occurs, possibly between July and October.

Emerging markets: Underweight

Emerging market equities also caught a bounce in May. Investors added to positions as lower US interest rates helped reduce the risk of higher borrowing costs within the emerging markets and provided additional liquidity. Expectations for improving economic growth in Europe also bolstered sentiment for emerging market stocks.

While those factors appear likely to benefit emerging markets in the short term, fundamentals have yet to improve.

In my view, the largest economies still face considerable challenges:

  • Brazilian stocks were up 15% from recent lows, but the country looks headed for a recession. Brazilian exports fell 5.5% on a monthly basis in May and 14% since their January peak, likely due to a rising currency and slower growth in China. Despite the economic slowdown, the central bank has tightened rates by 375 basis points because of rising inflation. In addition, Brazil is struggling with plunging business confidence, stagflation, structural problems and social unrest.
  • India is enjoying the honeymoon season after the landslide election of Prime Minister Narendra Modi, who promises reforms and investment to stimulate growth. However, much of the good news appears to be already priced into the market, which is up more than 20% year-to-date as represented by the S&P BSE SENSEX.
  • The People's Bank of China may have lowered reserve requirements to boost liquidity, but the move has lost its efficacy. The central bank has also tightened lending standards. Slower credit growth does not bode well for China's economy, which is 48% driven by investment. Weakening investment growth means fewer jobs and possibly social unrest. Additionally, China faces excess capacity and slower overall economic growth.

Furthermore, despite beliefs to the contrary, in my opinion, export growth seems unlikely to bolster China's economy. In the past 24 months, exports are down 33% to Latin America and down 10% to emerging Asia.

The problem that I see in emerging markets is interconnectivity. For instance, when China slows, copper prices tend to decline. When copper prices decline, consumer confidence in Chile, a major copper producer, tends to fall. Weakening consumer confidence in Chile tends to reduce spending, dampening demand for exports from China.

I believe the current rally may present an opportunity to reduce positions and move capital into developed markets, as the asset class remains in a downtrend with an overall unfavorable risk-reward outcome. Investors should carefully consider opportunities on a country- and stock-specific basis.

Final thoughts

The "Big Three" central banks (US, Europe and Japan) are keeping the liquidity spigots open. However, while the US is dialing down its liquidity pressure, Europe is gradually increasing liquidity and Japan is pursuing a "fire hose" approach.

When the GDP growth rate exceeds the 10-year Treasury rates, the excess liquidity tends to find its way into global risk assets, especially when central banks are adding to that liquidity. I believe equities may be the primary beneficiary of excess liquidity, with developed markets likely outperforming emerging markets.

Regional positioning depends on risk tolerance and time horizon. Investing in the US appears to be the relatively most conservative approach, and the returns will likely reflect the relatively lower risk. In my view, Japan offers the next best opportunity because of its current valuations. Europe may have the most upside of any developed market, but its upside is uncertain. Emerging markets have both the greatest upside/downside potential and the greatest risk, in my opinion.



Sources: Invesco; All data and information provided by Invesco as of June 11, 2014, unless otherwise noted. Additional sources include: Bank of America/Merril Lynch, May 16-June 2, 2014; Bloomberg LP, April 25-June 8, 2014; Gluskin Sheff, May 21-June 4, 2014; Cornerstone April 1-June 3, 2014; MNI, June 6, 2014; Thomson Reuters Datastream, June 1-June 14, 2014; Yardeni Research, Inc., June 2, 2014; Goldman Sachs, April 24, 2014; Morgan Stanley, June 9, 2014.

The opinions referenced above are those of Rick Golod as of June 11, 2014, 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. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions, there can be no assurance that actual results will not differ materially from expectations. Past performance is no guarantee of future results.

All investing involves risk including the risk of loss. Diversification does not eliminate this risk.
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The S&P 500® Index is an unmanaged index considered representative of the US stock market. The MSCI All Country World Index (ACWI) is a free-float-adjusted market-capitalization-weighted index designed to measure the equity market performance of developed and emerging markets. The MSCI Europe Index is a free-float-adjusted market-capitalization-weighted index designed to measure the equity market performance of the developed markets in Europe. The MSCI Japan Index measures the performance of Japan's equity market. The MSCI USA Index measures the performance of the US equity market. The MSCI Emerging Markets Index is a free-float-adjusted market-capitalization index designed to measure equity market performance of emerging markets. The Conference Board Leading Economic Index (LEI) is an economic indicator used to forecast changes in the business cycle based on a composite of 10 underlying components (including data on employment, manufacturing, consumer expectations, stock prices, money supply, interest rates, among others). Economic Cycle Research Institute (ECRI) Weekly Leading Index is an economic indicator used to forecast turning points in the economic cycle, similar to LEI but updated more frequently. The National Federation of Independent Small Businesses (NFIB) Index of Small Business Optimism gauges small business economic trends by surveying small businesses in the NFIB's membership on their expectations about business conditions, capital expenditures, hiring and sales. The Rasmussen Consumer Index measures consumer confidence on a daily basis. The Institute for Supply Management (ISM) Manufacturing Index is a commonly cited gauge of manufacturing conditions based on surveys of more than 300 manufacturing firms conducted by the ISM. The Dow Jones Industrial Average is a price-weighted index of the 30 largest, most widely held stocks traded on the New York Stock Exchange. The Dow Jones Transportation Average is a price-weighted index of 20 US transportation stocks. Correlation measures the degree to which two variables move in tandem with one another. The American Association of Individual Investors (AAII) Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish and neutral on the stock market for the next six months. Price-earnings (P/E) ratio, also called multiple, is a common valuation metric for stocks that compares a stock's share price to its per-share earnings. Equity risk premium is the excess return investors expect as compensation for assuming the risk of the equity market. The European Central Bank (ECB) is the central bank responsible for the monetary policy of the European Union. Forward price-earnings (PE) ratio is one measure of the price-earnings ratio that uses forecasted earnings (usually for the next 12 months or the next full fiscal year), rather than current earnings, for the calculation. The Nikkei 225 Index (or Nikkei Index) is a price-weighted index measuring the top 225 blue chip companies on the Tokyo Stock Exchange and is commonly considered representative of Japan's stock market. The S&P BSE SENSEX is an index measuring the performance of the 30 largest, most liquid stocks across key sectors in the Indian stock market. A Dividend Aristocrat is a company that has continuously increased the amount of dividends it pays to its shareholders. To be considered a dividend aristocrat, a company must typically have raised dividends for at least 25 years. Dogs of Europe is the European version of the "Dogs of Dow" investing strategy that consists of buying the 10 DJIA stocks with the highest dividend yield at the beginning of the year. Gross Domestic Product (GDP) is the monetary value of all finished goods and services produced within a country's borders in a specific time period, usually calculated on an annual basis. A basis point is a unit that is equal to one one-hundredth of a percent.