Signs of inflation will raise the stakes for the Fed’s policy communications. Favorable conditions for leveraged strategies could reverse quickly. Reasonable valuations and the Fed’s policy goals continue to support risk assets.
Putnam Perspectives: Capital Markets Outlook Q3 2014
Q3 2014 » Putnam Perspectives
Capital Markets Outlook
Arrows in the table indicate the change
from the previous quarter.
U.S. large cap l
U.S. small cap l
U.S. value l
U.S. growth l
Emerging markets l
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
Dollar vs. euro: Favor dollar (unchanged from last quarter)
Dollar vs. pound: Favor pound (from favor dollar last quarter)
Dollar vs. yen: Favor dollar (unchanged from last quarter)
• Signs of inflation will raise the stakes for the
Fed’s policy communications.
• Favorable conditions for leveraged strategies
could reverse quickly.
• Reasonable valuations and the Fed’s policy
goals continue to support risk assets.
Jason R. Vaillancourt, CFA
Co-Head of Global Asset Allocation
Signs of inflation will raise the stakes
for the Fed’s policy communications.
As July began, the attention of global markets
was a bit distracted by the quadrennial ques-
tion of which nation would win the World
Cup. However, now that the tournament has
concluded, by far the most pressing issue for
global markets for the remainder of the third
quarter will be the mounting challenge for the
U.S. Federal Reserve to keep reinforcing its
“optimal control” framework in the face of higher
The Fed has a dual mandate under the law: to
pursue policies that promote full employment and
price stability. But many years into the recovery,
we are, in the Fed’s view, still far from full employ-
ment. The idea behind optimal control is that the
Fed will be more tolerant of adverse moves in one
objective if it is still far from achieving the second
objective. In the current case, this means the Fed
is willing to tolerate a little bit of inflation because
it believes there is still quite a bit of slack in the
labor market. In particular, the Fed has noted that
real earnings, or wages adjusted for inflation,
have started to stagnate recently.
The constant reinforcement of the “easier for
longer” message by the Fed has contributed to
keeping both short rates and overall market vola-
tility very low. As we move through the balance
of the year, continuing to reinforce that message
runs the risks that at some point, markets may
come to view the Fed as being behind the curve
and needing to tighten policy faster than what
is currently discounted in market prices. This
scenario would cause short rates and volatility
across asset markets to rise quickly.
Fundamental inflation measures look set to
rise steadily over the next several months, in our
view. Indeed, inflation “surprises” have already
risen dramatically, in that inflation data have come
in above economists’ expectations (Figure 1).
Q3 2014 | Capital Markets Outlook
Rising inflation data would put upward pressure on short-term rates. As we have said in the past, rising short rates in
and of themselves do not necessarily present a problem for the real economy. Indeed, there is a link between real rates of
interest and real economic growth. With growth clearly improving since last winter, rates should move higher.
Favorable conditions for leveraged strategies could reverse quickly.
For risk assets, such as stocks and high-yield bonds, the potential for volatility comes as the Fed struggles to handle the
communication challenges about its policy steps. It is unwinding the extraordinary policies that have been in place for
several years (Figure 2). This long period of cheap money and low volatility has created favorable conditions for many
market participants to reach for yield in a leveraged fashion.
Figure 1. Inflation surprises have risen in 2014 —
what the Fed calls “noise” may be an emerging trend.
— U.S. Inflation Surprise Index
1/12 6/12 1/13 6/13 1/14 6/14
Source: Putnam. The U.S. Inflation Surprise Index is a quantitative measure of aggregate
inflation data surprises relative to market expectations. A large positive or negative
reading of the index points to accumulation of greater or less inflation than expected.
“I think recent readings on,
for example, the CPI index
have been a bit on the high
side, but I think…the data
that we’re seeing is noisy.
inflation is evolving in
line with the Committee’s
expectations [for] a
gradual return in inflation
toward its 2 percent
— Janet Yellen
Chair, U.S. Federal Reserve,
speaking at the June 18, 2014
FOMC press conference
Figure 2. Volatility of stocks, Treasuries, and currencies
has fallen to multi-year lows.
— MOVE Index (LH scale)
— VIX Index (RH scale) — CVIX Index (RH scale)
8/01 1/03 1/05 1/07 1/09 1/11 1/13 6/14
Source: MOVE (Merrill Lynch Option Volatility
Estimate) is a yield curve weighted index of
the normalized implied volatility on 1-month
Treasury options. VIX (The Chicago Board
Options Exchange SP 500 Volatility Index)
reflects a market estimate of future volatility,
based on the weighted average of the implied
volatilities for a wide range of strikes. CVIX
(Deutsche Bank Currency Volatility Index)
measures the implied volatility of currency
markets calculated based on the 3-month
implied volatilities of nine major currency pairs.
Depending on how
quickly the Fed makes
further policy moves,
this low-cost funding
and low volatility could
PUTNAM INVESTMENTS | putnam.com
Depending on how quickly the Fed makes further
policy moves, this low-cost funding and low volatility
could vanish quickly. In turn, this would make it more
difficult to exit leveraged carry trades, since everyone
might head for the exit at the same time. Statements by
members of the Fed have the potential to trigger a race
to the exits. While many market participants know that
equity volatility (both realized and implied) has been
very low, another major force driving these so-called
carry trades comes from officials at both the International
Monetary Fund (IMF) and the Bank for International
Settlements (the BIS is essentially the central bank for
the world’s central banks), who have recently dropped
not-so-subtle hints to central banks to be more vigilant in
their oversight of so-called macroprudential supervision.
In other words, low-interest-rate policies meant to foster
recovery might also be creating conditions for taking
undue risks with carry trades.
As an example, a carry trade can involve currencies.
An investor can borrow money in a country that sports
low interest rates and invest the borrowings in short-term
deposits in another currency that offers higher interest
rates, and earn the interest-rate differential. Amid low
volatility, this can be a stable source of returns. Figure
3 shows an example of a hypothetical carry trade using
currencies of G-10 countries since 2009, when the Fed
lowered the federal funds rate to 0–0.25%. Rather than
using more extensive types of leverage, the figure simply
shows the returns available from long positions in high-
interest currencies and short positions in low-interest
currencies. The risk is that sooner-than-expected changes
in interest-rate levels could trigger volatility.
What’s more, the Fed’s communication challenge has
also been slightly complicated by the mid-June comments
by Bank of England (BoE) Governor Mark Carney that rate
hikes in the United Kingdom “could happen sooner than
markets currently expect.” This statement from the head
of the BoE serves as a reminder that the world’s major
central banks are no longer working closely together in
pursuing the same policies, as they had been for much of
the period since the 2008 crisis.
It is also a reminder that the extraordinarily low vola-
tility in the markets during recent quarters is likely not a
permanent feature. In addition, with geopolitical tensions
multiplying — in Iraq, Syria, Ukraine, Nigeria, and the East
and South China Seas — it is certainly easy to envision the
VIX rising from the 7-year low to which it recently sank.
Reasonable valuations and the Fed’s policy
goals continue to support risk assets
Still, despite the uncomfortable and eerie calm, and
despite how well the old “sell in May and go away” adage
has worked in each of the past four years, there are still
encouraging signs suggesting that it’s too early to give up
on risk assets. For one, the Fed has been transparent in
telling markets its exact intentions over the past several
years. Thus, if Janet Yellen says that the FOMC will keep
easy policies in place until real wages rise comfortably,
then there is no reason to doubt it.
Figure 3. Cumulative total return of hypothetical
G-10 currency carry trade, 1/1/09–6/30/14
For illustrative purposes only.
1/09 1/10 1/11 1/12 1/13 1/14 6/14
Source: Putnam. G-10 currencies are the
Australian dollar, British pound, Canadian
dollar, euro, Japanese yen, New Zealand dollar,
Norwegian krone, Swedish krone, Swiss franc,
and U.S. dollar. The hypothetical performance
is based on daily rebalancing of the currency
This long period of cheap
money and exceptionally
low volatility has created
favorable conditions for
many market participants
to reach for yield.
Q3 2014 | Capital Markets Outlook
In addition, corporate balance sheets remain in excel-
lent condition by historical standards, with the economy
just now entering a phase of self-reinforcing growth driven
by capital expenditures.
Finally, many risk assets like equities and high yield are
still priced quite rationally given their fundamentals and
the current phase of the business cycle. They no longer
have the tailwind of being cheap, but we also do not
believe them to be terribly expensive either. In short, it
makes sense to maintain positions in risk assets, though
it does open the possibility of seeing some excitement
during the summer months, well after the entertainment
of the World Cup has ended.
Asset class views
U.S. equity In a relatively calm quarter, U.S. equities
continued their notable advance. As June came to a close,
the SP 500 Index posted its fifth consecutive month —
and sixth consecutive quarter — of gains. While equities
performed well, the most defining characteristic of the
market was its lack of volatility. There were few nega-
tive macroeconomic events to unnerve investors and no
significant pullbacks for equities.
It was a constructive quarter for the U.S. economy, as
clear signs of improvement emerged after the previous
quarter’s contraction. SP 500 earnings growth has
been stronger than we expected, particularly for cyclical
businesses that had been pressured by harsh weather
conditions early in the year. In addition, earnings expec-
tations for the remainder of 2014 have not changed, a
positive development considering the soft first quarter.
While we would not describe earnings potential as explo-
sive, we believe there is room for improvement as long as
economic growth remains supportive.
A heightened level of merger-and-acquisition activity
has also been favorable for U.S. equities. We view it as a
sign that investors believe the deals will be accretive and
can stimulate growth for the companies and the economy.
Looking to the second half of 2014, we are mindful of the
length and magnitude of the current bull market, and
are taking a slightly more cautious approach to portfolio
Non-U.S. equity We feel that international stocks offer
numerous opportunities to investors at the present time.
Valuations, earnings recoveries, and restructuring oppor-
tunities all continue to make the case for international
stock investing fairly compelling.
We believe gradual healing for Europe is under way.
With positive external factors, including improving U.S.
growth, stable growth in China, and incrementally recov-
ering global corporate confidence, our outlook for Europe
and other developed-market equities is quite positive.
Notable risks for global markets include the potential
for softer economic data from China as well as various
political transitions in emerging-market countries such
as India, Indonesia, and Brazil. Political change is rarely
a seamless process, so there is room for economic and
In addition, a number of emerging-market countries,
including India, Indonesia, Brazil, Russia, and Turkey, have
had to raise interest rates to stem capital outflows from
their countries. Ultimately, this can have a negative impact
on growth, so we remain watchful with respect to these
risks and continue to be on the lookout for opportunities.
Other geopolitical risks remain. The situation in Ukraine,
for example, has effectively become a civil war. Iraq, too, is
in crisis, as is Sudan, where ethnic tensions have similarly
destabilized economic progress and political coherence.
Having said that, although geopolitical crisis appears to
have become the norm, the opportunities in international
stocks outweigh many of the risks, in our view.
Global fixed income As 2014’s second quarter came
to a close, it appeared that the U.S. economic environ-
ment was transitioning to a more normal growth pattern.
In our view, U.S. gross domestic product (GDP) growth
could increase to 3% to 3.5% during the second half of
the year, which we believe would put upward pressure
on interest rates. Globally, we expect the United States
and the United Kingdom will be the economic growth
leaders, while the European Central Bank (ECB) continues
to provide liquidity to eurozone economies as it seeks to
stimulate growth in that region.
Though we expect U.S. rates to move higher through
the year, the ECB’s recent policy moves may affect that
trajectory. Many investors globally are looking at the U.S.
rate spread relative to Germany as a constraint on U.S.
yields moving higher. Over the past decade or so, U.S.
rates have generally not traded more than 125 basis points
over German rates, which is approximately where the
spread is today. The European Central Bank is unlikely to
stop providing liquidity very soon, which may keep a lid
on European rates and, market participants feel, conse-
quently slow the ability of U.S. rates to move higher.
PUTNAM INVESTMENTS | putnam.com
We believe the economic backdrop in the quarters
ahead will be supportive of riskier fixed-income assets.
That said, there are global risk factors we are watching,
including recent developments in Iraq and their possible
effect on oil prices. Additionally, we continue to monitor
the situation in Ukraine as well as the transition in China
to a slower-growth phase of its economic cycle. Volatility
has been relatively low among most financial assets, and
spread markets have generally returned to pre-2008
levels, which, in our view, suggests the markets may be
more vulnerable to shocks and surprises.
In terms of portfolio positioning, we plan to continue
emphasizing sectors that have benefited from increased
liquidity, such as commercial mortgage-backed securities
and non-agency residential mortgage-backed securities.
However, the yield advantage over Treasuries offered by
these sectors is not as great as it was, and with certain
central banks potentially raising rates in the medium term,
the liquidity in these areas of the market could diminish.
We are cognizant of this risk and, as a result, have slightly
increased cash positions in select portfolios while
modestly reducing overweights in these sectors.
U.S. tax exempt Despite the strong start for municipal
bonds in 2014 and our belief that the credit outlook for
municipal bonds appears solid given improvement in U.S.
growth, we still remain cautious and believe that there
could be some volatility surrounding supply/demand
factors and interest rates in the coming months. With
regard to tax policy, we think comprehensive tax reform
is unlikely at least until after the 2014 mid-term elections.
Over the longer term, we believe federal deficits and pres-
sures around social programs will likely contribute to the
ongoing debate for broader tax reform, which could affect
the value of municipal bonds.
As we witnessed in 2013, municipal bond prices can
be influenced by a host of factors — most notably, the
direction of U.S. Treasury rates; headline risk, as we saw
in Detroit and Puerto Rico; and municipal bond flows.
Against this backdrop, we plan to maintain a defensive
duration posture because we believe that the municipal
bond market’s attractive returns thus far in 2014 can
be attributed primarily to a combination of lower rates
and strong market technicals. Nevertheless, we believe
the ebb and flow of the markets present inefficiencies
that create attractive investment opportunities. We see
our fundamental research as the key to unlocking these
opportunities and providing return potential.
The second quarter was very different from the first
quarter for commodities markets. The agriculture and
livestock sub-sectors posted strong returns in the first
quarter, but sharp reversals for key contracts occurred in
the second quarter. The GSCI Wheat Excess Return Index
fell 20%, and the GSCI Corn Excess Return Index declined
17%. These markets had rallied toward the end of the first
quarter because of military tensions in Ukraine, but that
situation has unsettled markets much less during the
course of the second quarter. Instead, another source of
geopolitical risk emerged, as the destabilization in Iraq
caused strong returns for crude oil and related energy
contracts, with the GSCI Light Crude Excess Return Index
up 6% for the quarter. While the supply of oil has not yet
been meaningfully disrupted by the insurgency in Iraq,
there is a consensus that the risk of future disruptions has
Market trends 12 months
6/30/14Index name (returns in US$) Q2 14
Dow Jones Industrial Average 2.83% 15.56%
MSCI EAFE (ND) 4.09 23.57
MSCI Emerging Markets (ND) 6.60 14.31
MSCI Europe (ND) 3.30 29.28
MSCI World (ND) 4.86 24.05
Nasdaq 7.42 34.15
Russell 1000 5.12 25.35
Russell 2000 2.05 23.64
Russell 3000 Growth 4.86 26.75
Russell 3000 Value 4.89 23.71
SP 500 5.23 24.61
Tokyo Topix 5.35 12.26
FIXED INCOME INDEXES
Barclays Government Bond 1.34% 2.08%
Barclays MBS 2.41 4.66
Barclays Municipal Bond 2.59 6.14
Barclays U.S. Aggregate Bond 2.04 4.37
BofA ML 91-day T-bill 0.01 0.05
CG World Government Bond ex-U.S. 2.64 8.88
JPMorgan Developed High Yield 2.46 12.60
JPMorgan Emerging Markets
Global Diversified 4.76 11.63
JPMorgan Global High Yield 2.74 12.30
SP LSTA Loan 1.38 5.59
SP GSCI 2.69% 10.40%
Q3 2014 | Capital Markets Outlook
We continue to advocate for neutral positioning in
commodity markets. Our signals continue to be weak,
with momentum and roll yield metrics below their histor-
ical averages. Risk as measured by commodity-related
implied volatility indices remains low, and we would not
be surprised to see risks increase in these markets. With
geopolitical tensions still high, we do not feel that prices
adequately reflect these risks. This is not the time to take
an aggressive position in either direction, in our view.
Within active currency strategies, we now favor a
small long position in the U.S. dollar. The outcome of
the June FOMC meeting was largely as expected: The
taper continued, the post-meeting statement was little-
changed, the 2015 and 2016 interest-rate forecasts were
revised somewhat higher and the longer-term forecast
somewhat lower, and Yellen’s press conference continued
to indicate no urgency to step back from highly accom-
modative monetary policy. As a result, future monetary
policy remains very much data dependent. If growth and
inflation rebound soundly, as we expect, the FOMC view
is likely to be challenged and rate hikes will begin to get
priced in sooner, which should be supportive of the U.S.
dollar over the course of the year.
The euro position remains an underweight. Over the
past month, the ECB agreed to cut its deposit rate below
zero, provide new four-year Longer-Term Refinancing
Operation loans in September and December, stop
sterilizing its Securities Markets Program bond purchases,
and work on options for buying private-sector asset-
backed securities in future. All of these measures
appear sufficient to cap the single currency in its current
1.35–1.40 range against the dollar, and the anticipated
developments in the U.S. story should help to push this
value down over the coming months.
The British pound sterling positioning remains a
modest positive. Bank of England Governor Carney
signaled in a June speech that interest rates may need
to rise earlier than markets were anticipating. He subse-
quently highlighted that the economy continues to have
more slack to absorb before interest rates need to rise.
Also, while the pace of job creation has been strong, wage
growth had been softer than expected. This somewhat
puzzling outlook should be viewed as preparing the
market for earlier tightening but at a more gradual pace,
and eventually arriving at a lower terminal rate than past
A quite modest underweight position to the Japanese
yen remains after an extended period of being neutral. We
expect that the Bank of Japan will have to do more, which
should provide further impetus for the U.S. dollar to move
higher versus the yen. However, Bank of Japan Governor
Haruhiko Kuroda remains optimistic around the recovery in
the economy and the trajectory of recent inflation data. He
remains clear that if growth is weaker than expected and
inflation does not accelerate, then the BoJ will do more.
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