Capital Markets Outlook
Get in gear for a rate increase
Greece's debt crisis is less a market issue than a geopolitical puzzle.
The Fed may act without warning, but the risk is tolerable.
Asset class diversification will remain attractive as Fed policy normalizes.
Jason Vaillancourt and Bob Kea, Co-Heads of Global Asset Allocation, offer their outlook for corporate earnings growth.
Ex-energy, earnings growth is still positive
Jason Vaillancourt and Bob Kea, Co-Heads of Global Asset Allocation, offer their outlook for corporate earnings growth.
Download: Capital Markets Outlook (PDF)
- Market themes
- Equity views
- Fixed-income views
Arrows in the table indicate the change from the previous quarter.
Source: Putnam research, as of 6/30/15. Past performance is not indicative of future results.
Greece's debt crisis is less a market issue than a geopolitical puzzle
The economics and politics of debt continue to rivet markets. As we go to publication this quarter, the path forward for Greece remains uncertain, but it is important to keep its size in perspective. Greece represents less than 2% of eurozone nominal GDP. The three Greek stocks that are constituents of the Stoxx 600 Index represent about 0.10% of the index market cap. To say that there has been a mismatch between the space dedicated to Greece in the financial press and the actual size of Greece's economy and financial markets would be a severe understatement.
However, beyond the cost of a default to institutions that have funded Greece, such as the International Monetary Fund (IMF), European Central Bank, and the European Financial Stability Facility, important geopolitical questions are involved. The eurozone's actions toward Greece will be a signal to other periphery countries, many of which have already undergone painful reforms. And Greece has important geostrategic significance given its location as the doorstep to Europe from the Mediterranean at a time when Europe is dealing with widespread refugee and illegal immigration issues. Allowing a country to leave the currency union could put the euro, as a global reserve currency, on a slippery slope. Europe's response to this — and to future crises that bring the idea of permanent membership into question — will have wide-reaching implications for all of these geostrategic issues.
The Fed may act without warning, but the risk is tolerable
While the Fed chose to pass on the June opportunity to make their first increase in the target federal funds rate in nine years, the question at this point for 2015 is clearly when, and not if, an increase will happen, despite the pleadings of the IMF to delay tightening. We offer two key observations with respect to comparisons with previous tightening cycles. First, we should not expect a "heads up" from the Fed one meeting ahead of the rate increase. In the minutes from the FOMC's April meeting, there was a brief discussion about the prospects of delivering a "warning" before the liftoff, and most of the committee opposed the idea:
"Participants discussed the merits of providing an explicit indication, in post-meeting statements released prior to the commencement of policy firming, that the target range for the federal funds rate would likely be raised in the near term. However, most participants felt that the timing of the first increase in the target range for the federal funds rate would appropriately be determined on a meeting-by-meeting basis and would depend on the evolution of economic conditions and the outlook."
— Minutes of the Federal Open Market Committee, April 28–29, 2015 (federalreserve.gov)
Second, an increase could come without warning because there is no such thing as typical conditions for the start of a rate hike. An analysis of conditions in place at the beginning of previous tightening cycles illustrates that there is no clear-cut trigger along any of the dimensions of the Fed's dual mandate. The obvious point to be made here is that the current recovery is firmly established and several metrics are far past the point at which previous rate hikes have begun.
Asset class diversification will remain attractive as Fed policy normalizes
Managers of multi-asset portfolios are often asked for their outlook for returns, but we think that a topic that deserves equal attention, and rarely gets it, is the correlation between stocks and bonds. This one statistic provides a breadth of information about the value of diversification at any point in time, but like expected returns, all we ever really have is an ex-ante estimate of what the correlation will be going forward. For the purposes of risk management and portfolio construction, yesterday is largely irrelevant.
Over the past 15 years, we have enjoyed a period in which the price correlation between stocks and bonds has mostly been quite negative. Simply put, when one zigs, the other zags. In contrast, however, during the 20 years prior to 2000 — during the equity bull markets of the 1980s and 1990s — this correlation was mostly positive.
There are a number of theories for why the correlation may have switched signs in 2000, but in our view the main cause was a series of market crises, beginning with the 1997 Asian currency crisis, continuing with the 1998 Russian default, and punctuated by the crash of the technology sector in 2000. With these successive crises, the world drifted perilously close to outright deflation.
At least another partial contributor moving global markets close to the edge of the deflationary abyss was a miscalculation on the part of the world's major central bankers. After experiencing periods of very high inflation in various parts of the world in recent decades, it became accepted dogma that central banks should strive for price stability. The problem with price stability is that, taken literally, it implies a zero inflation rate, which of course means no margin for error on the downside because the result would be actual deflation. Most central bankers these days would publicly suggest that a 2% rate of inflation is about as close as they want to get to stable prices. In addition, depending on several other factors like the volatility of prices, real economic growth, and demographics, even a 2% target might be too low, courting deflation risk.
Today, with deflation less of a concern, and with the world's central banks perhaps less focused on price stability, some investors question the wisdom of balanced strategies. Skeptics reason that higher policy rates will translate into strongly negative returns for bonds of all kinds. What's more, as the Fed's confidence grows that we are moving back toward its inflation target, the correlation between stocks and bonds could again become sustainably positive, taking away the diversification benefit.
We have a different view. We do not anticipate negative results for bonds or the loss of the diversification benefit any time soon. As we survey the bond market, we continue to find pockets of opportunity that we think can persist for a while longer. Both prepayment and credit risk of all kinds still appear somewhat attractive. And if the next tightening cycle plays out at all like the last one in 2004–2006, longer-dated bonds could still provide some ballast to riskier assets in portfolios. We find positive carry, measured simply by the slope of the yield curve, to be strongly associated with positive excess returns to duration.
At the same time, we doubt that the world has moved far enough away from deflation to warrant a shift back to a positive correlation between stocks and bonds. While we would agree that NAIRU (Non-Accelerating Inflation Rate of Unemployment) is likely higher than it has been in previous U.S. business cycles and therefore could stoke wage inflation, we argue that inflation trends are still very global in nature. Plenty of excess labor and manufacturing capacity around the world can help restrain inflation. Also, as we have pointed out before, the tremendous amount of debt still in the system provides a deflationary force. The result is that bonds continue to help diversify multi-asset portfolios and bring overall volatility down.
Asset class views
U.S. equity: Market advance slows in early 2015.
Our outlook for U.S. stocks remains mixed as valuations are approaching the top quartile of their historical averages. Although market gains have been modest year to date, we believe investors should be especially cognizant of the risks in a bull market that has entered its seventh year. One of the biggest surprises in the first half of 2015 has been the lack of significant market volatility. This is somewhat unusual in light of the higher valuations and more mixed sentiment from investors about macroeconomic conditions and difficulties in a number of markets outside the United States. The low volatility in the U.S. equity market is an observation we have made for several quarters, and some would argue that a market as calm as this one may give way to turbulence ahead.
In terms of earnings growth for U.S. corporations, we continue to believe that 2015 will be difficult, despite better-than-expected growth in the first quarter. In our view, lower oil prices, wage pressures, and the strong U.S. dollar are likely to continue to pressure second- and third-quarter earnings. Once these headwinds diminish, we may see improvement in corporate profitability, perhaps as early as the final quarter of 2015.
Despite challenges to earnings growth and an added degree of caution around valuations, we are focusing our research on a number of areas that could be rewarding for U.S. equity investors. These include sectors such as industrials, which is poised to benefit from a pickup in non-residential construction spending, and financials, where stocks are relatively inexpensive and may perform well in the early stages of a rising-interest-rate environment. Health-care stocks, despite their notable outperformance, still offer attractive valuations relative to their long-term prospects, in our view. The exception is biotechnology, where valuations may be stretched. And, while oil prices have recovered somewhat, energy remains one of the most controversial — and attractively valued — U.S. equity sectors.
Non-U.S. equity: China prompts concern, but developed markets appear attractive
Unlike the end of 2014 and the first quarter of 2015, the second quarter saw stabilization — and some retracement — across foreign exchange markets and in the price of commodities like oil. The euro and the yen had dropped in value against the dollar in prior quarters, but then more recently moved in relatively tight ranges. Also, some emerging-market currencies that had been extraordinarily weak versus the U.S. dollar stabilized, with the Russian ruble, for example, recuperating a fair amount. Oil, too, seemed to find a new floor near $60 per barrel, which is 50% above its late-winter lows, but still almost 50% below its prior year highs. From our perspective, these seeming equilibriums helped some market participants refocus on more durable questions, like the health of corporate earnings in the first quarter — which we found to be relatively strong.
We considered the possibility of crisis in Greece, which has been with us for years, as we have considered it in the past: Given its size and the unsurprising nature of this crisis, Greece poses little contagion risk for other countries in the eurozone. So by itself, we think Greece may prove to be a dramatic non-event, while the real risk lurking backstage is China. China's economic slowdown and its market bubbles — in real estate, in the frothy Chinese stock market, and in its shadow banking system — have the power to create a vortex of problems throughout Asian emerging markets. However, there are some areas in the Chinese and Asian markets that we like. Technology is a good example.
We expect economic data to continue to improve in Europe, the United Kingdom, and Japan, but we think emerging markets face a number of economic and market risks. We also think equity valuations in both Europe and Japan are more attractive than in other asset classes. And in our view, the weaker euro and yen, as well as lower oil prices relative to 2014 levels, will continue to provide a boost to corporate profits.
In addition, we think that European QE (quantitative easing) and the pursuit of structural reforms in Japan will continue to help the markets, and that government-imposed regulatory changes and companies' specific restructuring will also enhance the health of certain industries.
M&A activity may also continue to be a strong driver for stocks. In our view, company boards are feeling the competitive pressure to participate in M&A, which is broadly positive for earnings growth. In terms of sectors, M&A is sweeping across the markets: Energy, semiconductors, health care, consumer staples, telecommunications, and materials are some of the more notable sites of significant M&A activity. In addition, this is taking place in a variety of developed markets, including increasingly in Japan and Europe.
Fixed income, investment-grade: In a growing economy, the Fed's decisions remain a wild card
Although first-quarter gross domestic product (GDP) growth was disappointing, we remain positive on the U.S. economic recovery. We believe the first-quarter slowdown was largely the result of many transitory effects, including harsh winter weather that constrained consumer spending in many parts of the country, the negative impact on the trade balance resulting from the sharp rise in the dollar, labor-related shipping delays in West Coast ports, and an adjustment in capital investment in response to the steep plunge in oil prices. Economic growth appeared to rebound in the second quarter, and we still believe U.S. GDP is on track to grow at a 2.5% to 3% annual rate in the months to come.
The Federal Reserve has indicated that it no longer wishes to give specific guidance on the timing of policy changes, and instead has declared that its strategy now depends on incoming data. Using this conditionality as our guide, we think it's likely that, as U.S. core inflation re-emerges, the central bank may implement its first rate increase in September. If the economy continues on a trajectory broadly similar to what we expect, we believe the Fed could hike rates again a second time before year-end. While this is our view currently, there are possible factors that could slow this pace. For example, weaker-than-expected employment and consumer spending data could stay the Fed's hand. Renewed dollar strength could also cause the Fed to delay, since a stronger dollar would make U.S. exports less competitive and dampen the profits of U.S. multinational companies, potentially hampering U.S. growth. In any event, when the Fed does begin raising rates, we think it will proceed cautiously in an effort to avoid stoking excessive volatility in the financial markets.
High yield: Credit risk remains attractive, but technical indicators have weakened
Economic growth appeared to be rebounding in the second quarter, and underlying fundamentals, such as employment, continued to provide support for high-yield bonds, in our view. That said, we are generally cautious in our outlook for the market's technical (supply and demand) backdrop. This caution is partly due to seasonal factors, since high-yield issuance typically declines during the summer, and partly due to the impending shift in Fed monetary policy, possibly later this year. Overall, however, we think the asset class may provide attractive returns relative to other fixed-income alternatives.
As of May 31, 2015, the high-yield default rate was 1.88%, which is very low by historical standards. Looking ahead, we believe defaults may remain muted for an extended period of time, although sustained weakness in certain groups within the energy sector, as well as metals/mining, could cause defaults to rise.
U.S. tax exempt: Likely rate increases encourage a more defensive posture
Given expectations for a Fed rate increase, economic trends in the broader U.S. economy, and supply/demand technicals in the municipal market place, we continue to manage the portfolios with a defensive bias. Along with recent out-flows from municipal bond funds as well as negative headlines associated with Puerto Rico, the City of Chicago, and the State of Illinois, we are positioned for modestly higher rates going forward. That said, we continue to see pockets of investment opportunities particularly in the essential service revenue sectors such as higher education, health care, transportation, and utilities. The portfolios have a little less duration sensitivity than those in their Lipper peer groups. We accomplish this posture in part by holding a slightly higher cash position to help shelter the portfolios from price pressures while also providing some liquidity to allow us to act swiftly should timely investment opportunities present themselves. Given our longevity in the business and our experience through many market cycles, we have learned that there are still opportunities to invest during a rising-rate environment. As nervous investors react to the headlines, rather than fundamentals, markets can become disjointed and create opportunities to buy bonds at attractive spreads.
Commodities: No threats to the strong dollar.
After two quarters of relative stability, commodities have again entered a period of renewed volatility. These pressures come from both the supply side and demand side. Demand weakened on fears about the meltdown in the Chinese stock market and about Greece exiting the eurozone. These issues continue to call into question the expected bounce in global growth in the second half of 2015 that many market participants had expected, despite the fact that demand for base metals in China has actually fallen off significantly. Individually, the Chinese stock market and Greece have little potential to influence the path of the real economy, but combined they could seep into market psychology and create a self-fulfilling, generalized risk-off event.
The more significant issue is likely the supply-side of the equation — energy supplies remain high. The initial response by producers in North America to the precipitous drop in oil prices during the second half of 2014 was to reduce rig counts, with the expectations that lower output would soon occur. Instead, the production declines never materialized because only marginal wells were scaled back, while production costs at operating rigs have continued to decline owing to technology advances. Consequently, North American production merely plateaued at an elevated level while OPEC and other non-OPEC production continued to climb. It's now clear that while energy consumption has stayed relatively stable in the developed world, supply has continued to expand. Add to that cocktail some optimism around the Iran nuclear talks having the potential to lift that country's oil export sanctions, and it creates the possibility of a new round of selling across the commodity complex. We do not expect quick resolution to any of these issues and continue to recommend underweight positions in commodities overall.
Currency: Though less ascendant, the dollar still holds advantages
Within active currency strategies, our U.S. dollar position is a more modest overweight. The pillars for U.S. dollar strength are based upon relative growth outperformance and the subsequent implications for attractiveness of U.S. assets and relative monetary policy. The U.S. growth story has stabilized at more moderate levels, but on a relative basis it is not the standout leader as other major economies have seen improvement as well. The United States is regaining equity market leadership, and it remains an attractive destination for fixed-income capital with the Bank of Japan (BoJ) and the European Central Bank (ECB) actively purchasing local government debt.
While maintaining this long-term view on the dollar, we note that the euro has some short-term advantages. Growth in the eurozone has stabilized at modest levels. The ECB policy remains easy. The current situation in Greece remains fluid and provides a great deal of volatility for the single currency. A more benign outcome (which is our base case) in which Greece agrees to additional austerity measures and receives a new financial assistance program from creditors should see the single currency move higher in the short run. A Greek exit would likely cause quite a bit of financial market volatility and would require the official sector, particularly the ECB, to ensure the monetary policy transmission channel remains functional through even more extensive purchases of sovereign debt (on top of its current QE program), which should see the single currency drop precipitously.
While still at a disadvantage versus the dollar, the British pound sterling benefits in the near term from U.K. growth levels remaining solid. Although inflation and inflation expectations have come down considerably, they appear to have reached a trough. Additionally, the labor market data is showing signs of wage pressure, and the hawks on the Bank of England Monetary Policy Committee could start to voice the need for rate hikes in coming meetings.
Regarding the Japanese yen, we still favor a modest short. BoJ Governor Kuroda continues to highlight that the BoJ does not have any intention to ease the policy near term given the current economic and price conditions, explaining that the decline in core CPI inflation is temporary and could be reversed in line with oil price developments. Most importantly, Kuroda stresses that the BoJ will not hesitate to adjust the policy if fundamental price trends change and if the early achievement of the inflation target is found to be difficult. This very easy policy (and expectations that more will be needed) coupled with the Fed lifting rates sooner and faster than the market expects should continue to keep pressure on the yen.