Putnam Outlook Q3 2013
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The Fed’s tapering talk could cause more volatility. In a steady economy, deflation lurks. Risk assets deserve the benefit of the doubt.
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Putnam Outlook Q3 2013
- 1. Q3 2013 » Putnam Perspectives Capital Markets Outlook Putnam’s outlook Arrows in the table indicate the change from the previous quarter. Underweight Smallunderweight Neutral Smalloverweight Overweight Asset class EQUITY U.S. large cap l U.S. small cap l U.S. value l U.S. growth l Europe l Japan l Emerging markets l FIXEDINCOME U.S. government l U.S. tax exempt l U.S. investment-grade corporates l U.S. mortgage-backed l U.S. floating-rate bank loans l U.S. high yield l Non-U.S. developed country l Emerging markets l COMMODITIES l CASH l CURRENCY SNAPSHOT Dollar vs. yen: Dollar Dollar vs. euro: Dollar (from neutral last quarter) Dollar vs. pound: Dollar (from neutral last quarter) The Fed’s tapering talk could cause more volatility. If anyone doubted that policy moves markets, skyrocketing bond yields in the second quarter helped resolve the debate. At the beginning of May, the yield of the 10-year Treasury was close to 1.6%, near historic low levels. By the end of June, the yield had risen to approximately 2.6%, still remark- ably low in historical terms, but 57% higher in the space of only seven weeks. Rising yields caused volatility in spread sectors and global bond markets, and eventually even dragged the S&P 500 down from record high levels. Yield movements like this are rare, espe- cially when the economy is growing below its capacity and generating little inflationary pressure. The markets were reacting to signals that the Fed might begin tapering its monthly asset purchases of $85 billion. In June, Fed Chairman Ben Bernanke announced a possible reduction in these purchases by $10 billion each month, beginning later this year, with the entire program ended by mid 2014, if the economy continues to behave as the Fed currently forecasts. We regard the jump in yields during the second quarter as an overreaction to the tapering plan, given current economic perfor- mance. It demonstrated just how much sway policymakers have over the fortunes of inves- tors in the near term. The communication strategy employed by the Fed will be a critical component of monetary policy as we move forward. Foreshadowing the introduction of tapering was likely meant, at least in part, as a deliberate way to reintroduce volatility to the bond market. Volatility, like yields, had Key takeaways • The Fed’s tapering talk could cause more volatility. • In a steady economy, deflation lurks. • Risk assets deserve the benefit of the doubt. Jason R. Vaillancourt, CFA Co-Head of Global Asset Allocation
- 2. 2 Q3 2013 | Capital Markets Outlook recently touched all-time lows in both realized and implied terms. The Fed faces a task all the more daunting because of its massive footprint in the bond market. Currently, the Fed is on pace to own nearly a quarter of the liquid bond market by mid 2014. Despite an improving economy, as we get closer to actual policy changes we anticipate a greater degree of market turbulence than what investors may have grown accustomed to over the past several quarters. We also find the current setting attractive for identifying oppor- tunities, because we have a long-term view and invest actively to take advantage of changing market conditions. In a steady economy, deflation lurks. Based on its internal dynamics, the U.S. economy continues to be one of the most attractive for investors. One of the key pillars of support for the U.S. economy has been the housing market. Dynamics of the housing market include low prices, low mortgage rates, high pent-up demand due to rising household formation, and institu- tional investment into a strong rental market. Of these, only mortgage rates have hit a bump in the road, as the surge in bond yields has pushed rates higher. However, rates still appear low when viewed over a longer time horizon, and we think conditions favor continued strength. The performance of the economy so far in 2013 is all the more impressive because of the drag imposed by fiscal policy contraction. Payroll taxes increased January 1, and the federal budget sequester went into effect in March. The sequester takes its biggest bites from GDP during the third quarter, and so the ultimate impact on factors like business investment, consumer spending, and the job market would likely start to show up in the data very shortly, if they are to show up at all. Fortunately, credit channels to businesses have opened wider as well, and this also encourages optimism. Credit expansion constitutes a major difference between the United States and Europe, where constrained credit continues to inhibit recovery, particularly in peripheral markets. Credit is also emerging as an issue in China, where bank lending rates skyrocketed during the second quarter. The biggest fundamental story for investors and policy makers in 2013 continues to be the steady decline in the unemployment rate. Although the final estimate of first- quarter GDP was revised down by a significant amount, the economy has on average produced monthly payroll gains of over 200,000 per month in 2013. That has trans- lated into a decline in the unemployment rate from 8.2% to 7.6% over the past year. Figure 1. �The Fed’s words lifted yields and bond market volatility Yield of the 10-year Treasury and volatility of the U.S. Treasury MOVE Index, 12/31/12–7/5/13 1.5% 2.0% 2.5% 3.0% 30 60 90 120 1/1312/31/12 4/133/132/13 5/13 6/13 7/5/13 U.S. 10-year Government Bond Yield U.S. Treasury Volatility Index (MOVE Index) We regard the jump in yields during the second quarter as an overreaction. Source: Bloomberg. The MOVE© (Merrill Option Volatility Expectations) Index reflects a market esti- mate of future Treasury bond yield volatility, based on the average implied volatility across a wide range of outstanding options on the 2-, 5-, 10-, and 30-year U.S. Treasury securities.
- 3. PUTNAM INVESTMENTS | putnam.com 3 One troubling trend behind this impressive decrease in unemployment is that the labor force participation rate has not risen, as it normally would at this point in the cycle. This anomaly is likely due to the fact that the United States, like most developed economies, is beginning to experience the effects of an aging population. This key statistic bears closer attention as we continue to be on the lookout for signs of deflation. Risk assets deserve the benefit of the doubt. Viewing policy issues and market fundamentals together, we favor continuity in investment positioning going into the third quarter. Equities and high-yield credit, we believe, offer more attractive total return potential than other interest-rate risk and inflation-sensitive assets, including TIPS and commodities. We also have a some- what sanguine view of looming U.S. policy risks. Although Congress and the President will likely face off again to raise the debt ceiling, rising tax receipts have reduced the political sensitivity of the deficit. We do not antici- pate theatrics that will derail the economy. Similarly, any tapering by the Fed — either real or implied — is unlikely to raise the risk of recession. On a global scale, we regard U.S. and Japanese equities to be among the most promising assets. The reforms launched by Japan’s prime minister Shinzo Abe have sparked both controversy and volatility in equity, currency, and debt markets. However, we believe Abe appears poised to consolidate his grip on policy in July’s elections to the Diet’s upper house, which should allow him to follow through on the “third arrow” of his agenda, adding structural reforms to the monetary and fiscal policy changes already instituted. Given that structural change would bring the deepest and most sustainable benefits, we favor a tilt toward Japanese equities as these poli- cies make their way into legislation over the next several months. Importantly, expectations are low for true and sweeping reforms, so any progress on this front would likely generate a positive surprise. We have less optimism for Europe and emerging markets. While the threats of a European deleveraging event or a hard landing in China remain severely dimin- ished, we have some concerns about credit conditions in European peripheral markets and in China’s banking sector. Meanwhile, China’s economic deceleration is quite clear, and has implications for a range of other emerging markets linked to China by trade. One consequence has been a drop in commodity prices this year, which has contributed to the underperformance of emerging markets. Overall, the world is still starved for yield-generating investments as the major central banks keep policy rates extremely accommodative. Their efforts are at least partially in response to the fact that deflation remains a threat to the global economy. So long as policy measures can prevent deflation, portfolios should favor equity and other risk assets over more interest-rate-sensitive bonds. Figure 2. �Buying a home is easier today than it has been in more than a generation National Association of Realtors Home Affordability Composite Index, 1/31/89–4/30/13 100 125 150 175 200 225 19921/31/89 200420001996 2008 2012 4/30/13 Dynamics of the housing market include low prices, low mortgage rates, high pent-up demand, and insti- tutional investment. Sources: Bloomberg, National Association of Realtors. An index above 100 signifies that a family earning the median income has more than enough income to qualify for a loan on a median-priced home.
- 4. 4 Q3 2013 | Capital Markets Outlook Asset class views Equity U.S. equity In late May, shortly after closing at an all-time high, the S&P 500 Index pulled back sharply following a Fed policy meeting that signaled a possible cutback in the Fed’s bond-buying program. In the weeks that followed, stocks declined more than 6% before recovering in the final days of the quarter. A notable shift from the previous quarter was a pull- back in the performance of defensive stocks. As investors became more confident about an improving U.S. economy, they appeared willing to take on more risk, and cyclical stocks rebounded. We regarded this development posi- tively. As equity markets focus more on fundamentals and valuations, the opportunity to achieve returns at the indi- vidual stock level appears greater than it has for some time. Despite relatively sluggish revenue growth for U.S. busi- nesses, our outlook is constructive for corporate earnings. In our view, the bulk of profitability is the result of struc- tural improvement and is likely to be sustainable over time. In addition, relatively low levels of durable-goods spending and factory utilization suggest that profit margins have yet to peak and can move higher from current levels. While it is important to consider the potential impact of rising interest rates on U.S. equities, we don’t view this as a significant risk. At the close of the quarter, long-term rates still remained near all-time lows, and rising short-term rates can be beneficial for equity performance, in part because they typically signal an improving economy. Despite a slightly less bullish stance overall, our view remains constructive for U.S. equities, and for the universe of cyclical stocks in particular, which has yet to fully rebound and continues to offer many exploitable opportunities. Non-U.S. equity Rising interest rates, declines among dividend-paying stocks, and an outflow of capital from emerging markets all accelerated after the Fed’s announcement in mid June, and sapped global equity market strength. Despite these macro fears, we see exciting funda- mental developments among non-U.S. equities in terms of product cycles, business model improvement, and break- through technologies. Innovation is happening across a variety of sectors, and may hold important implications for companies’ top-line growth. This cuts across tradition- ally innovation-driven areas, such as biotech, and newer zones of innovation like “big data.” But it extends as well to more stable industries, such as food and beverage, where Figure 3. �People staying out of the job hunt might be a sign of an aging workforce U.S. Labor Force Participation Rate, 12/31/89–6/30/13 62% 64% 66% 68% 199212/31/89 200420001996 2008 2012 6/30/13 The labor force participation rate has not risen as it normally would at this point of the cycle. Source: Bureau of Labor Statistics. This rate represents the percentage of the civilian population participating in the labor market, either employed or seeking jobs.
- 5. PUTNAM INVESTMENTS | putnam.com 5 MARKET TRENDS Index name (returns in USD) Q2 13 12 months ended 6/30/13 EQUITY INDEXES Dow Jones Industrial Average 2.92% 18.87% S&P 500 2.91 20.60 MSCI World (ND) 0.64 18.58 MSCI EAFE (ND) -0.99 18.62 MSCI Europe (ND) -0.51 18.86 MSCI Emerging Markets (ND) -7.88 2.87 Tokyo Topix -0.05 16.64 Russell 1000 2.65 21.24 Russell 2000 3.08 24.21 Russell 3000 Growth 2.19 17.56 Russell 3000 Value 3.14 25.28 FIXED INCOME INDEXES Barclays U.S. Aggregate Bond -2.33 -0.69 Barclays 10-Year Bellwether -4.57 -4.20 Barclays Government Bond -1.88 -1.51 Barclays MBS -1.96 -1.10 Barclays Municipal Bond -2.97 0.24 BofA ML 3-Month T-bill 0.02 0.11 CG World Government Bond ex-U.S. -3.44 -5.72 JPMorgan Developed High Yield -1.26 9.74 JPMorgan Global High Yield -1.76 9.47 JPMorgan Emerging Markets Global Diversified -5.64 1.11 S&P LSTA Loan 0.19 7.32 COMMODITIES S&P GSCI -5.93 2.04 It is not possible to invest directly in an index. Past performance is not indicative of future results. new products are having an enormous impact on compa- nies’ future growth potential, and where new consumer packaging ideas can revitalize mundane and well-worn consumer products by changing how they are delivered to customers. Two zones of risk to watch are Japan and China, which will rely on the sustainability of the weak yen and avoiding an excessively damaging slowdown. We are also attentive to risks in Europe, which we expect may experience flat growth but could generate a positive economic surprise. In short, despite potential bumps in the road to Europe’s recovery, we believe there is an opportunity in the making among European stocks. Fixed income U.S. fixed income The Fed’s comments about reducing its asset purchase program generated significant interest-rate volatility in the United States, changing the opportunity set for fixed-income investors. Spread sectors — meaning sectors that trade at a yield premium to U.S. Treasuries — which had been buoyed by the massive liquidity created by the Fed’s purchases, sold off, with emerging-market bonds getting hit particularly hard. Global government bonds also fell, although not to the same degree as sectors with greater risk. Despite the rapid increase in yields, we believe the broader U.S. economic recovery remains on track and should continue at a moderate pace, as recent data have been a bit better than expected. We also believe that the U.S. housing recovery will continue apace, although mortgage rates moved higher during May and June. In our view, home sales are improving because of stronger economic activity and better consumer confidence, not because of mortgage rates. In mortgage credit, following the liquidity-driven sell-off, we have found opportunities attractive enough in non-agency residential mortgage- backed securities to begin rebuilding positions during June, seeking to benefit from their improved relative value supported by solid fundamentals. As investors adjust their expectations about when the Fed will actually begin tapering its asset purchases, we expect continued volatility in interest rates and yield spreads. However, we think it’s unlikely that they are going to suddenly spike dramatically higher. As a result, we believe the environment for corporate credit and other risk-based fixed-income categories may continue to be favorable. In term structure, we think the better opportunities exist among short- to intermediate-maturity securities, as opposed to long-term bonds. Within investment-grade corporate credit, we like bonds issued by banks and other financial institutions, as well as utilities. High-yield spreads, after backing up during the second quarter, offer more attractive value, we believe.
- 6. 6 Q3 2013 | Capital Markets Outlook Non-U.S. fixed income The global macroeconomic environment, though less solid than the United States, appears to be stable, with the exception of China, where weaker growth and high consumer debt levels have created challenges for a government that is trying to stim- ulate domestic demand. We continue to see challenges more broadly for developing economies, hampered by both the strength of the U.S. dollar and the anticipation for less stimulus from the Fed. In Europe, peripheral eurozone economies have performed better than we anticipated, thanks to sharply lower interest rates in those countries. Core European economies were somewhat weaker than we expected, but data near the end of the quarter from Germany, the Netherlands, and Switzerland were encouraging. While we think the degree of increase in global rates during the quarter was more than the current economic environment warrants, leaving less impetus for near-term increases, we continue to believe global rates are likely to move higher over the medium- to longer-term horizon. Tax exempt Although the municipal market experi- enced a notable sell-off along with most fixed-income asset classes from May into June, we continue to have a constructive outlook and believe munis still offer a good option for investors seeking tax-exempt income. Although significant outflows have compounded the sell-off in municipal bonds, typically in July and August reinvestment demand becomes more favorable; and total supply is down 11.5% year-over-year through the end of June. This could bolster the supply/demand picture. Aside from isolated credits such as Detroit and Puerto Rico, fundamentals within the municipal market are generally improving. It is likely that factors such as interest rates and the direction of the economy could continue to influence market activity. A degree of uncertainty over tax policy has been clarified, as income tax rates for 2013 are now certain. However, other policy issues that can affect the value of municipal bonds remain unresolved, including federal budget sequestration, the debt ceiling, and the potential for broader tax reform. We are monitoring developments in these areas. As has been our strategy for some time, we continued to favor essential service revenue bonds over local general obligation bonds. From a credit-quality perspec- tive, overall default rates remain low. In our analysis, the A-rated and BBB-rated segments of the market continue to offer attractive relative value opportunities. We generally favor higher-yielding sectors and issues with below-average sensitivity to interest rates. Commodities Our commodity outlook has turned pessimistic. The asset class generally behaves with more momentum than reversion, and we are coming off a very weak second quarter. Beyond the negative momentum, the weakness in emerging markets represents a very problematic signal for commodities. While the outlook might be negative, there are two major sources of upside risk. Geopolitical concerns are at a high point in the Middle East, with political tensions in Egypt and continued strife in Syria. Egypt represents a risk above and beyond the general area instability, as any disruption to the Suez Canal has the potential to cause a supply shock for energy markets. The other source of upside risk for commodities is the continued correlation with equity markets. While they have fallen from recent highs, the strong correlations suggest that commodities will outperform as an asset class in the event of a risk rally. To reconcile the two countering views, we advocate a more modest underweight to the asset class. Currency We favor long positions in the U.S. dollar. Over the medium term, the U.S. dollar should be supported by a relatively better growth outlook, a gradual reduction in the pace of accommodation by the Federal Open Market Committee, and the effect of forward guidance about the first rate hike in 2015. For the euro, as well, we favor a slight long position, but not against the U.S. dollar. The single currency remains supported by healthy trade flows — the eurozone is set to run a current account surplus exceeding 2% of GDP this year. We are moderately pessimistic on the British pound sterling given prospects for a continued easing policy. In the Japanese yen, we expect renewed weakness. Over the medium term, the Bank of Japan is expected to increase easing, and this should provide further impetus for the U.S. dollar to rally versus the yen. Emerging-market currencies remain over-owned in a world where the U.S. term structure is likely to grind higher, we believe. Amid lower levels of global growth and lower commodity prices and inflation, emerging-market central banks have shifted into easing mode. With weaker current account surpluses in emerging markets, large capital outflows are a major risk for emerging-market currencies.
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