Voya Multi-Asset Perspectives - August 2017
July proved to be a good month for equities globally. The S&P 500 index gained 2.1%, U.S. mid- and small-cap stocks kept pace with large caps, which is a change as they have been lagging virtually all year. U.S. large cap growth recaptured its leadership with a gain of 3.0% and U.S. large value gained 1.1%. Outside the United States, Europe was up 3.0% in U.S. dollar terms. But the real winner was emerging market equities, which rose 5.6%, boosted by renewed dovish central bank messaging from the U.S. and Europe. Within fixed income, high yield gained 1.1% and leveraged loans 0.6%, whereas U.S. Treasury 10-year yields were broadly unchanged.
The theme that is pervading the markets is growth. Inside the U.S., it’s good but not great. We see strong job growth with the nonfarm payrolls three-month moving average now adding 194,000 jobs per month, on par with last year’s pace of gains; but pending home sales and auto sales are proving to be weak links in the story. The pace of strength in Europe has been more impressive: business confidence surveys in Germany are at record high readings and in France at their best levels in five years.
Watching the currency markets will be important going forward. The U.S. dollar, which had been on a tear last year, has given up all of its 2016 gains and has been weakening quickly. It helps U.S. megacap companies that earn revenues overseas, but a currency which weakens too fast can cause inflationary pressures to bubble up and make the Federal Reserve act to tighten policy far faster than the markets anticipate.
On the back of strong equity returns in 2017, we now are entering the seasonally weakest two months of the year — August and September — with very low levels of volatility. While there are plenty of issues that could spark near-term equity weakness, such as geopolitical tensions in Asia or a contentious stand-off to raise the U.S. debt ceiling, we know that those are episodic in nature and asset class returns on a longer term view are driven by policy and probabilities of recessions. Let’s take each in turn.
Policy, specifically monetary policy, has been a critical driver of bond returns this year. The Federal Reserve has raised interest rates twice in 2017 and is clearly signaling a move to reduce the size of its balance sheet, probably starting in September. Employment conditions are tightening yet remain below the Federal Reserve’s stated level of unemployment above which inflation rises. But wage growth is tame and inflation has been surprising to the downside for the past few months. This has taken center stage in the bond market, causing 10-year yields to rise through the first quarter, only to fall back through much of the spring and summer with the weaker inflation data. Therefore, we see this tightening cycle as a very gradual process that likely will have a number of digressions associated with it. In terms of fiscal policy, its path will be governed by the mood of politics in Washington. The difficulties to pass health care legislation are a preview to just how challenging it will be to pass meaningful tax reform.
According to our Voya indicators, the probability of a recession is relatively low: current readings put it at about 3.2% over the next 12 months (Figure 2). Financial conditions have eased meaningfully over the past year. This is supportive for growth over the following two to three quarters. It gives the markets a cushion which may be helpful, as we are likely to see peaking of indicators such as purchasing managers and possibly Conference Board Leading Economic Indicators.
With a benign tightening cycle thus far, a low probability of recession and good but not spectacular growth, we are in a goldilocks environment at least for the near term. Asset flows into bonds have totaled $222 billion versus $147 billion for equities. That is not the making of big equity inflows that signal major market tops. While the pace of equity gains may slow as we make it through the year, we expect emerging markets to be able to sustain their leadership. The softening of the U.S. dollar should provide a marginal boost to U.S. corporate earnings and be supportive of equity prices. Risks include an all-time low in volatility which forces volatility sellers to increase leverage; this could cause a short-term pull-back, but earnings strength and easy financial conditions tell us it would be a pull-back to stay invested through, as sentiment readings are not at frothy levels.
Multi-Asset Strategies and Solutions Team
Voya Investment Management’s Multi-Asset Strategies and Solutions (MASS) team manages the firm’s suite of multi-asset solutions designed to help investors achieve their long term objectives. The team consists of 25 investment professionals who have deep expertise in asset allocation, manager selection and research, quantitative research, portfolio implementation and actuarial sciences. Within MASS, the Asset Allocation team, led by Barbara Reinhard, is responsible for constructing strategic asset allocations based on its long-term views. The team also employs a tactical asset allocation approach, driven by market fundamentals, valuation and sentiment, which is designed to capture market anomalies and reduce portfolio risk.
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