The hunt for positive growth momentum and attractive valuations is starting to shift investors’ focus away from the US and towards more regionally diversified exposure, where the scope for catch up appears greater.
May was a good month for returns from both equities and fixed income. Ongoing investor optimism about the economic outlook supported risk assets, with developed market stocks delivering returns of 4.5% over the month. Global bonds also generated positive performance of 1.3%, with markets still anticipating rate cuts this summer albeit with some divergence in the timing between the US and Europe.
Expectations of falling interest rates favoured Growth sectors, which outperformed Value sectors by 2.4% points. Small cap stocks regained some momentum, generating returns of 4.6%, broadly in line with large cap peers.
After peaking in April, oil prices retreated during May. However, broader commodity indices still delivered positive returns of 1.8%, with global demand remaining solid and ongoing conflicts in both the Middle East and Ukraine.
While the US economy remains in solid shape, data released in May pointed to some signs of moderation, with capital spending and home sales both trending sideways. Flash Purchasing Managers’ Index (PMI) data was the bright spot for the month, with the manufacturing component rising to 50.9 while services rose to 54.8. After falling in April, US equities rebounded with monthly returns of 5.0% in May, supported by better-than-expected first quarter earnings results across a number of sectors.
In Europe, PMI data released during the month confirmed that economic activity is improving. Services sectors continue to act as the key pillar of strength, although there were also signs of a recovery in manufacturing. First quarter GDP was confirmed at 0.3% quarter-over-quarter, and corporate profits surprised to the upside. The reacceleration in the economy, coupled with relatively low valuations, is starting to attract the attention of international investors. In May, European equities excluding the UK returned 3.6% while UK equities returned 2.4%.
There are also some encouraging signs of improvement across Asian economies, albeit with some caveats. Chinese data is generally surprising to the upside, which has also coincided with a rebound in the equity market. Despite this improving optimism, the details of the recovery are less convincing as continued weakness in domestic demand necessitates a reliance on strong export growth. Challenges in the real estate sector remain unresolved, creating some doubts about the sustainability of the Chinese rally.
In Japan, currency weakness is usually received positively by the export-heavy equity market. Yet with the extremely low levels of the Japanese yen now starting to weigh on consumer sentiment, Japanese stocks were one of the weakest performers regionally in May, returning 1.2%.
Given the increasingly desychronised nature of regional economies, central bank policy expectations are also starting to diverge.
In the US, disinflationary trends are stalling, with price pressures in services sectors looking particularly sticky. The latest inflation release showed only a modest slowing in headline and core categories, bringing year-over-year (YoY) rates down to 3.4% and 3.6%, respectively. The minutes of the May Federal Open Market Committee (FOMC) meeting reinforced concerns about the lack of further progress on disinflation, with any hopes of an imminent rate cut now fading. However, Chairman Powell’s pushback against the potential for further rate hikes helped US Treasuries rally over the month, with 2-year and 10-year yields falling by 17 and 19 basis points, respectively.
In the eurozone, the European Central Bank (ECB) is more confident about the economy’s disinflationary path, with wage growth continuing to moderate despite activity recovering. In May headline and core inflation accelerated to 2.6% and 2.9% YoY respectively. Despite this upside surprise, slowing inflation over the last few months has enabled the ECB’s governing council to signal a high degree of confidence that rates will be cut in June, even if the path thereafter remains less clear.
UK headline inflation fell meaningfully in April to 2.3% YoY but services inflation remains high at 5.9%, making any hopes of a June rate cut from the Bank of England appear premature. Meanwhile, the situation facing the Bank of Japan stands in stark contrast to its western peers. Rate hikes appear necessary to support an extremely weak currency, but too much tightening risks threatening the return of reflation.
Divergent monetary policy and uncertainty around the path of interest rates is likely to remain a source of volatility for government bond markets for some time. Yet investors must remember that the reset in yields over the past two years means that bonds’ dual role in a portfolio – income and diversification against a growth shock – has been restored, even if yields look set to remain very sensitive to incoming data.
At a sector level, solid corporate fundamentals have helped keep credit spreads well anchored and investment grade credit was one of the stronger performers over the month. EM debt also posted strong returns of 1.8% over the month, with several EM central banks having already begun their easing cycles.
Conclusion
In aggregate, economic data released in May tempered concerns of overheating in the US economy and showed signs of a rebalancing in economic momentum. Corporate fundamentals remain in good health, and the next move for interest rates in the West is still likely to be lower, even if there is some divergence in timing across regions. While these factors should be supportive of risk asset valuations, the hunt for positive growth momentum and attractive valuations is starting to shift investors’ focus away from the US and towards more regionally diversified exposure, where the scope for catch up appears greater.