Capital Markets Outlook
The correction raised questions, but the fundamentals look solid
Correcting the misinterpretations of the third-quarter correction
Global indicators point toward continued growth
Risk assets appear attractive with caution for emerging markets
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 9/30/15. Past performance is not indicative of future results.
Correcting the misinterpretations of the third-quarter correction
Volatility returned to global markets during the summer months, reaching the highest levels in years. The VIX Index rose to its highest level since October 2011 while the S&P 500 Index gave up 6.4% and the MSCI World Index (ND) fell 8.5% in the quarter.
Anyone trying to understand the cause of this renewed volatility was poorly served by media headlines and reports, in our estimation. It is important to step back and gain a more accurate perspective on the third-quarter correction before calibrating portfolio strategies.
We see three interrelated possibilities for interpreting the correction: First, to place it in context, there were the usual comparisons of the duration and magnitude of the current bull market to historical norms. This interpretation took form with headlines about the number of trading days since a previous 10% correction had occurred.
A second possibility is that the correction was a reaction to the Federal Reserve's long-communicated plans to raise the federal funds rate off the zero bound for the first time in seven years. From this perspective, the end of policy accommodation would also mean the loss of the moderating effect that it had on volatility.
The third possibility is that markets were discounting a downturn in the global economy. This view gained adherents in the weeks following the correction, based on a more pessimistic assessment of the economic slowdown in China. Fears that China would import fewer commodities and fewer consumer goods was seen as a problem that could spill over to both developed and emerging markets.
The Fed unintentionally fueled pessimism by passing on the opportunity to begin normalizing monetary policy in September.
The Fed unintentionally fueled the pessimism associated with the third possibility by passing on the opportunity to begin normalizing monetary policy in September. Markets dislike uncertainty, and the Fed's communications coming out of its September meeting cast new doubt on the reliability of the interest-rate expectations it had been setting. What's more, the Federal Open Market Committee's statement and Janet Yellen's post-meeting press conference cited "international developments" as a reason for holding off on rate increases, a rare acknowledgement of any consideration outside of the institution's dual mandate.
In assessing these three possibilities, we think it is important in turn to understand the "international developments" the Fed mentioned. We see a confluence of three developments that are, quite possibly, unrelated. The first is the selloff of class A shares listed on China's stock exchanges; second is the drop in commodity prices, including oil, in particular; and third is the devaluation of the yuan.
The turmoil in China's A shares began in June and persisted for much of the summer. It was preceded by a breathtaking rise in the number of retail brokerage accounts in China and the amount of margin lending to those accounts. The official numbers may even have been understated due to the amount of shadow lending that takes place outside the official, regulated accounting practices.
While the plunge in prices was unquestionably serious, we do not believe it was a case of a market anticipating a future downturn. We saw another factor at issue. The initial declines in the A-share market came on the heels of an announcement by Morgan Stanley Capital International (MSCI) that it would not be including mainland Chinese equities in the MSCI Emerging Markets Index (ND). This decision meant that a new source of demand for A shares would not be materializing in the near term.
While the plunge in China's A-share prices was unquestionably serious, we do not believe it was a case of a market anticipating a future downturn.
As for energy, the narrative in the media is that a bursting bubble in the Chinese stock market and a severe selloff in the price of energy must be evidence of an emerging hard landing in the Chinese economy. Here again, there is evidence of some key supply-side events that are so uncanny in their timing that they cannot be ignored. Oil prices reacted to the June 5 OPEC meeting and its subsequent decision to maintain current output levels, and to the July 14 Iran nuclear agreement, which may allow Iranian oil supplies back on to world markets.
Perhaps the greatest misperception, we believe, surrounds the People's Bank of China's (PBOC) devaluation of the yuan on August 11, 2015, which served as the trigger for the plunge in equity prices that spread to markets worldwide. Many commentators declared the start of new currency wars, depicting the devaluation move as a desperate, last-ditch effort to help revive the export sector of a collapsing Chinese economy.
Let's keep this devaluation in perspective. Through the end of September, the currency's value had fallen by less than 3% from where it stood before the move. A devaluation this small provides little stimulus to exports. We therefore regarded it as reasonable to believe the justification provided in the PBOC's announcement — that it was moving in the direction of a market-driven valuation for the currency as a show of good faith on its intentions toward the International Monetary Fund (IMF). China is keen to have the yuan included in the IMF's Special Drawing Rights (SDR) basket and counted among the world's major reserve currencies. For inclusion, the IMF requires that a currency be both "widely used" and "widely traded." The steps that China has taken to widen the bands around which it allows the currency to "float" may now be enough for the IMF to acquiesce.
Through the end of September, the yuan's value had fallen by less than 3% from where it stood before the devaluation.
The devaluation, like the drop in oil prices and in China's A shares, have been widely misunderstood, we believe. Any conclusion based on these misperceptions that the world economy is in peril would be flawed.
Global indicators point toward continued growth
The models and factors that we monitor to assess the health of the global economy continue to paint a relatively stable picture, albeit with a slight tick down in recent months within global manufacturing. But we have seen these slight cyclical variations manifest themselves many times over the past five years. In each case, staying the course has been the correct call, and we continue to believe that strategy will be the correct one in the current environment. We would point to the continued strength of services and the developed-market consumer as particular areas of strength to offset the somewhat bad news in the industrials sector.
Risk assets appear attractive, with caution for emerging markets
We are marginally and tactically more bullish on risk assets heading into the fourth quarter based on valuation driven by the recent pullback. There will be a greater amount of focus on the third-quarter earnings season to clarify corporate views on what managements are seeing in emerging markets. In addition, seasonal patterns tend to be more favorable into the end of the year. In general, we continue to favor developed markets over emerging markets.
Asset class views
U.S. equity: All eyes on earnings after jump in volatility
U.S. equities endured their most challenging quarter in years, and the market's extraordinary advance of previous quarters came to an end with significant volatility. The turbulence peaked in August with some of the biggest swings in the history of the market, including a historic 1,000-point intraday plunge for the Dow Jones Industrial Average on August 24. Stocks recovered from the August lows and ended the quarter with a decline of 6.4%, as measured by the S&P 500 Index.
A downturn was not particularly surprising. For several quarters, we have observed that equity valuations were approaching the top quartile of their historical averages, and we believed that investors should be cognizant of the risk of a market correction. Although such turbulence can be unsettling, we now see many investment opportunities that were nonexistent just a few months ago.
The two greatest pressures on corporate profitability have been the strong U.S. dollar and weak oil prices.
As we anticipated, 2015 is also shaping up to be a fairly weak year in terms of earnings growth for U.S. corporations. So far, profits for S&P 500 companies have been flat to modestly positive. The two greatest pressures on profitability have been the strong U.S. dollar and weak oil prices. More than 40% of the profits of S&P companies come from international markets. The strong dollar has hurt many of these businesses, which rely on revenues from markets with much weaker currencies. And the negative effects of plummeting oil prices can expand beyond oil and gas companies to the wide array of industries that provide products and services to them.
Our outlook for U.S. stocks remains mixed. It is quite likely that volatility may persist as we face a few headwinds, including concerns over struggling emerging markets, especially China, the world's second-largest economy. Also, the equity market continues to wrestle with uncertainty over the timing and potential impact of an interest-rate hike by the Federal Reserve. We believe it is pretty clear that the Fed wants to raise interest rates, but also wants to ensure it is done at a time when the U.S. economy can support it. As we approach the next several Fed meetings, it will be critical to monitor U.S. gross domestic product growth, inflation pressures, and the strengths and weaknesses of non-U.S. economies. There are many variables in the equation, and it is a considerable challenge for the Fed. As for the impact of a rate increase on stocks, we could see some short-term volatility at the outset. However, history shows that equities tend to perform well when interest rates are rising from very low levels.
Non-U.S. equity: Optimism for Europe and Japan, doubt for China
China's surprise currency devaluation sparked the recent selloff in global equities, but market observers are still struggling to gauge the true level of China's economic distress. Ominously, the Chinese government employed a variety of policy tactics, including interest-rate cuts, stock market interventions, and more spending, but these efforts to restimulate growth and calm investors generally failed to halt the market rout. So while it is difficult to say if the worst is over, we think it warranted to expect more volatility in the months ahead.
A severe deceleration in China has negative implications for markets around the world. Some of the implications are knowable and hence easier to model; others are much harder to predict. The Chinese slowdown of the past several years has had increasingly large effects on the country's key trading partners — most notably, Asian emerging markets and Brazil — and we think it is likely to spread further around the globe. The good news is that, unlike the financial crisis of 2008, which spread relatively quickly, China has given rise to an economic contagion that has spread more slowly. Some estimates suggest China's debt increased by nearly $20 trillion since 2008, but the vast majority of that debt is owned domestically; consequently, the ability for financial contagion to spread quickly is low.
In August, the yuan devaluation had a surprising impact on S&P 500 companies. The health-care sector, for example, was particularly hard hit as the increase in equity volatility caused by China led to selling in the sector. In addition, investors who had long positions relative to the U.S. dollar and short positions relative to the euro — which was a common trade — were hurt as the dollar sank while the euro strengthened following China's currency move.
At some point in late 2015 or early 2016, we expect the Fed to raise interest rates. The market expects this, too, and this has bolstered the consensus view that the dollar will continue to rise. This development would also exert upward pressure on China's currency, the yuan, which would consequently depress China's export sector. That may cause more trouble for China's growth outlook and thus contribute to more volatility across global markets.
International investors should also be aware that the era of European austerity has led to political polarization, with the proliferation of far right as well as far left parties. In addition, the huge wave of refugees from places like Syria, Iraq, and Eritrea has put, and will continue to put, added pressure on the political environment in Europe. In our view, this amplifies certain risks for investors in European stocks — including, most prominently, the risk of an increasingly fractured eurozone.
Unlike the financial crisis of 2008, which spread relatively quickly, China has given rise to an economic contagion that has spread more slowly.
Overall, however, there are reasons for optimism in the near term. We expect, for example, that economic data will slowly continue to improve in Europe, the United Kingdom, and Japan. In this context, we remain open to adding new positions in international and global portfolios whenever our fundamental research uncovers compelling investment opportunities.
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 signs of price rebound
While price momentum and roll yield, the most important quantitative signals for the broad commodity market, continue to look negative, we somewhat temper that view with risk to the upside from recent levels. However, the supply picture remains a concern. In the energy sector, supply overhang and the perception of possibly more supply coming on line in 2016 have been the drivers of the double-digit percentage fall in front-month crude oil futures. And while rig counts in the United States have declined markedly, production has not responded as quickly. After three years of domestic crude output growing at over 17% per annum, we would need to see a stronger supply response or evidence of global growth re-accelerating to become bullish.
Currency: Dollar advantages likely to persist
Within active currency, our U.S. dollar position is a slight overweight. The pillars for U.S. dollar strength are based upon relative GDP growth outperformance, the subsequent implications for the attractiveness of U.S. assets, and relative monetary policy. U.S. real yields remained near the highest levels over the past several years and should remain elevated. 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 developed economies have seen improvement as well. In aggregate, this is a headwind to a rate hike by the Fed. When coupled with a weaker inflation outlook, the timing of liftoff is less certain and the path of rate hikes is lower than the Fed currently expects. If the U.S. labor market, GDP growth, and core inflation progress as we expect over the medium term, the market will have to adjust its Fed outlook and price a more aggressive path of rate increases. This should lift short-term rates in the United States and continue to support the broad U.S. dollar over the course of the coming year.
If risks to growth persist, the ECB could alter the size, composition, and duration of its quantitative easing.
The euro positioning remains a modest short, mainly versus the British pound. Growth in the eurozone has stabilized at modest levels, but forward-looking indicators show no acceleration. At the latest meeting of the European Central Bank (ECB), bank president Mario Draghi said it was too early to tell if renewed downside risks to growth would last, and he emphasized that the ECB could alter the size, composition, and duration of its quantitative easing. Europe's low nominal rates, coupled with the ECB sovereign bond purchases and investors moving toward riskier assets, should contribute to driving capital out of Europe, providing a modest downtrend for the euro over the medium term.
The British pound sterling positioning is a slight long. In the United Kingdom, growth levels remain solid, and while inflation and inflation expectations have come down considerably, they appear to have troughed. Additionally, labor market data are showing signs of wage pressure, which will prompt the hawks on the Monetary Policy Committee to start voicing the need for rate hikes in the coming meetings. However, U.K. politics argue for waiting to move until after the Fed does.
We are modestly short the Japanese yen. Bank of Japan Governor Haruhiko Kuroda continues to argue that inflation would reach the 2% target around the first half of fiscal year 2016 without additional easing. However, the likelihood of achieving this target looks quite low. The recent shift in the U.S. dollar–China yuan currency regime adds further impetus for the Bank of Japan (BoJ) to take action, as the trade-weighted yen has now appreciated and Japan, much like the United States, will import core-goods disinflation from China. The timing and composition of the BoJ policy change are quite hard to predict, but Kuroda has shown that he understands that the BoJ will need to surprise the market in order to ease financial conditions by weakening the currency.