Three months ago, investors were unsure whether May’s weak US payrolls number was a one- off blip or the start of the kind of slowdown in corporate hiring that can often trigger a recession. We now know that the weak May data was not a sign of things to come, with US payrolls having grown by an average of over 200,000 per month during the past three months.
Consumption remains the engine of the US economy and consumer confidence has risen to a new post-crisis high. The housing market also continues to show signs of recovery, with new home sales up 20% over the last year and house prices up 5%.
EXHIBIT 1: ASSET CLASS AND STYLE RETURNS (LOCAL CURRENCY)
Source: J.P. Morgan Asset Management, Barclays, Bloomberg, FactSet, MSCI. REITs: FTSE NAREIT All REITs; Cmdty: Bloomberg UBS Commodity Index; Global Agg: Barclays Global Aggregate; Growth: MSCI World Growth; Value: MSCI World Value; Small cap: MSC World Small Cap. All indices are total return in local currency. Data as of 30 September 2016.
Back in January, the typical member of the Federal Reserve’s (the Fed’s) key policy committee was expecting to raise the policy rate four times in 2016. But this quarter saw the US central bank delay yet again, though the Fed Chairwoman, Janet Yellen, did remark that the case for a rate rise had “strengthened in recent months”. The combination of an improving US economy and a lack of policy tightening has supported markets over the quarter. If this benign flow of economic data continues, we would expect the Fed to raise rates in December.
By then, we will know the result of the US Presidential and Congressional elections. Though Hillary Clinton has been in the lead in national polls for most of the race, her lead narrowed over the summer and the race is now considered too close to call in key battleground states such as Florida and Ohio. Financial markets are not currently pricing in a strong possibility of a Trump victory, but if the Brexit vote should have taught investors anything, it is that political sentiment in a nation’s financial capital is not always a good reflection of the views of the nation as a whole. As with the UK referendum, the short-term market reaction to a Trump win could be dramatic. Our core scenario, though, is continued political gridlock, which would be fairly harmless for the economy and neutral for markets.
EXHIBIT 2: WORLD STOCK MARKET RETURNS (LOCAL CURRENCY)
Source: J.P. Morgan Asset Management, FactSet, MSCI, Standard & Poor’s, TOPIX; data as of 30 September 2016. All indices are total return in local currency.
Another factor supporting markets this quarter has been the relatively benign initial response to Brexit from the UK economy and a growing confidence among investors that any fallout from the decision is likely to be local rather than global. This has helped global equity markets to recover from their initial post-referendum losses, while the large fall in sterling has helped support UK equities. Significant economic risks remain for the UK, especially given the government’s apparent willingness to see the UK leave the single market for goods and services. Surveys indicate businesses are significantly more cautious and less likely to invest following the referendum. But other data - including consumer confidence and PMI surveys— have bounced back after falling in the month after the vote and appear to be holding up well.
EXHIBIT 3: FIXED INCOME SECTOR RETURNS
Source: Barclays, BofA/Merrill Lynch, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. IL: Barclays Global Inflation-Linked; Euro Treas: Barclays Euro Aggregate Government - Treasury; US Treas: Barclays US Aggregate Government - Treasury; Global IG: Barclays Global Aggregate - Corporates; US HY: BofA/Merrill Lynch US HY Constrained; Euro HY: BofA/Merrill Lynch Euro Non-Financial HY Constrained; EM Debt: J.P. Morgan EMBI+. All indices are total return in local currency. Data as of 30 September 2016.
In Europe, the big news this quarter has focused around concerns in the banking sector. Bank shares fell sharply in the wake of the Brexit vote, but are now moderately higher than at the start of the quarter. We think it highly unlikely that any systemically important bank in Europe will fail in the near future. The bank that really matters in Europe, the European Central Bank, has commenced its corporate bond purchase programme and is likely to announce that it will extend its asset purchase programme beyond March next year. This should help to keep European government and corporate funding costs at very low levels. The biggest risk facing the eurozone over the coming quarter would be if the Italian referendum on constitutional reform led to prime minster Matteo Renzi’s resignation, although this is not our core scenario. Those predicting that the UK will be just the first of several countries to vote to leave the European Union should remember that current polling shows more than half the population is in favour of the euro in France, Italy, Germany, Spain and Greece.
EXHIBIT 4: FIXED INCOME GOVERNMENT BOND RETURNS
Source: FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. All indices are J.P. Morgan GBIs (Government Bond Indices). All indices are total return in local currency. Data as of 30 September 2016.The other big announcement of the quarter came from the Bank of Japan (BoJ), which will now aim to overshoot its 2% inflation target, despite the fact it has been struggling to get anywhere near 2%. To help the Japanese financial sector and prevent the yield curve flattening or even turning downwards, as it did earlier in the year, the BoJ also promised to keep the 10-year yield on Japanese government debt at 0.0%. This is symbolically significant, given global debates about the continued power of extreme monetary policy. But we are sceptical that the BoJ will be able either to raise inflation meaningfully or to reverse the recent appreciation of the yen.
EXHIBIT 5: INDEX RETURNS FOR SEPTEMBER (%)
Source: MSCI, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management; data as of 30 September 2016.
It is now eight years since the failure of Lehman Brothers and the economic recovery is clearly maturing, especially in the US, but we think it is too early to call the end of the cycle. However, capital returns for many asset classes between now and the end of the year are likely to be constrained, not just by the stage of the cycle, but by the strong performance we have already seen in 2016.
With no recession imminent, we think investors are likely to continue to own risk assets as a source of income, even if they don’t expect significant capital appreciation. Equities are often an under-appreciated source of income and we find the current yield on UK equities particularly attractive. We are also attracted to US equities with high dividend, but low payout ratios. Finally, within equities, we believe that many of the headwinds for emerging market (EM) equities are blowing less forcefully, as dollar appreciation has halted, EM growth is firming and commodity prices may have found a bottom. Given the risks that remain, we favour a relatively defensive, income-focused approach to EM equities.
Within fixed income, we believe that investors will continue to seek yield and that select local EM debt now looks attractive, given the attractive yields available and the likely bottoming of some EM currencies. We also continue to believe that the carry available on high-yield debt remains attractive given that default rates outside of the energy sector remain low. But as ever, it will pay to be active in this sector and selectivity is key.
While continuing to own risk assets and seek income, we take seriously the risks to the outlook from politics, high corporate debt levels in China, over-extended property markets in some parts of the world and the rising medium-term risk of a recession as the cycle matures. The clear implication is that investors should be balancing their risk assets with absolute return strategies to provide some downside protection to portfolios and, potentially, broader diversification.