Economic Backdrop

Investors were mostly treated to hospitable conditions in May: equity markets began on a soft note but rallied late in the month, and energy prices continued to recover ― even amid renewed dollar strength (relative to the euro and yen) ― ahead of an Organization of the Petroleum Exporting Countries meeting in early June, although fixed-income market performance was mixed.

Short-term U.S. Treasury yields increased (yields and prices move inversely) as the U.S. Federal Reserve expressed a desire to increase benchmark rates if and when conditions warranted (although a disappointing U.S. jobs report dampened expectations for a move over the next few months). The European Central Bank’s (ECB) 2 June monetary policy announcement offered a reminder that two stimulus measures introduced in March ― corporate-bond purchases and targeted long-term repo operations (bank loans) ― would begin in June. The Bank of England’s Monetary Policy Committee decided unanimously to maintain its current stance as the European Union referendum loomed, while a late May meeting in Japan of leaders from Group of Seven (G7) major developed-economy nations produced a communique that also highlighted concerns over potential Brexit fallout.

A welcomed jump in U.K. services sector activity during May put space between April’s survey, which had reported the slowest growth in more than three years. Manufacturing clawed its way slightly out of contraction territory in May, while construction growth decelerated. May year-over-year sales volumes improved following a significant drop in April, although expectations for June were lacklustre given the Brexit spectre. Retail-level sales were strong in April, however, offsetting a prior slump and jumping ahead year over year. Inflation was mixed according to the latest data for April, with consumer price growth remaining subdued despite firming at the producer level, particularly within input prices (which were still sharply negative year over year). The labour market stabilized in March and April, with unemployment declining slightly and wages posting modest improvement. Economic growth expanded by 0.4% in the first quarter, driven primarily by household consumption.

In Europe, Consumer confidence had its largest month-over-month improvement in more than two years during May, and business sentiment was strong regarding the retail and construction sectors. Manufacturing remained in slow-growth mode during May, while services activity improved on a recent dip in an otherwise sustained expansion. Retail sales were flat in April after a sharp drop in the previous month, with a notable decline in German activity holding back overall sales. Consumer prices were marginally lower on the year ending in May, due primarily to lower energy prices; the core measure (which excludes energy and other items like food) was edged higher, but remained far short of the ECB’s target. The unemployment rate remained at 10.2% in April, masking improvement in France and Spain, while Germany was unchanged and Italy lost ground; youth unemployment also moderated. First-quarter economic growth was modestly slower than expected, at 0.5%, and 1.5% year over year. Flagging activity among goods producers was primarily responsible for the downward revision.

The U.S. unemployment rate slid to 4.7% in May alongside a declining pool of labour market participants, as job growth dropped to its slowest pace since 2010. Consumer spending jumped in April with the greatest gain in almost seven years, due in large part to automobile and services sales. Income also rose significantly in April, possibly contributing to an improvement in consumer sentiment during May to its best reading in almost a year. Manufacturing activity expanded slowly in May after industrial production advanced in April at the highest rate since late 2014. Consumer prices increased in April by the most in more than three years due to a recent recovery in oil prices. Revised first-quarter economic growth showed an improved expansion of 0.8% attributable to an increase in residential investment and exports.

Market Impact [1] 

The global fixed-income market declined in May amid U.S. dollar strength that put downward pressure on non-U.S. dollar denominated securities. U.S. high-yield bonds remained the strongest performing fixed-income segment, followed by U.S. dollar-hedged (which seeks to reduce U.S. dollar-related volatility) global sovereign securities. Dollar-hedged global non-government debt was also positive, while U.S. mortgage- and asset-backed securities were only marginally so. Local-currency denominated emerging-market debt had the deepest losses due in significant part to dollar strength, as its foreign-currency-denominated (external) counterpart was just modestly negative. Unhedged global sovereign and non-government debt declined, as did U.S. Treasury Inflation-Protected Securities (TIPS). U.S. investment-grade corporate fixed income had minimal losses.

Global equity markets, as reflected by the MSCI AC World Index (Net), advanced modestly during May. Greece was the top-performing country, followed by the Philippines, Ireland and Belgium. India, the U.S. and Taiwan had strong returns, as did Denmark and the Netherlands. Brazil and Turkey delivered the poorest performances, while Colombia and South Africa were also deeply negative. Global sector performance was led by information technology, healthcare was a distant second, and consumer staples had a small gain. Materials had the steepest decline, followed by energy. Industrials, utilities, telecommunications and consumer discretionary all had losses, while financials were only slightly negative.

Index Data (May 2016)

• The MSCI AC World Index (Net), used to gauge global equity performance, advanced by 0.13%.
• The Barclays Global Aggregate Index, which represents global bond markets, declined by 1.34%.
• The Chicago Board Options Exchange Volatility Index, a measure of implied volatility in the S&P 500 Index that is also known as the “fear index”, decreased in the month as a whole, moving from 15.70 to 14.19.
• WTI Cushing crude oil prices, a key indicator of movements in the oil market, moved from $45.92 a barrel at the end of April to $49.10 on the last day in May.
• The U.S. dollar strengthened relative to the euro and yen, and was unchanged against sterling. The U.S. dollar ended May at $1.46 versus sterling, $1.11 against the euro, and at 110.9 yen.

SEI’s View

One of our bedrock macroeconomic assumptions has been that the world will avoid a generalised recession, managing to continue muddling through. We believe a synchronised global recession that drags most countries into negative gross domestic product territory remains a low-probability event, and if our forecast holds, the rally in risk assets should be able to build on itself. Certainly, there are good reasons to view the glass as half empty. Monetary policy appears to be losing effectiveness in Europe and Japan. Combined with an increasingly febrile political environment in the U.S. and other countries, as well as widespread sovereign and corporate over-indebtedness, it is easy to see why market strategists are still a cautious lot. But we think too much emphasis has been placed on the weaknesses of the global economy, while the brighter spots have been mostly ignored. Most major countries remain in an expansion phase despite sustaining a growth scare over the past year. The main areas of concern can be found in emerging markets, especially in commodity-producing countries.

On a sector basis, it’s obvious energy and materials have been the primary drag, but it’s a mistake to assume that a contraction in these industries will lead to a downturn in advanced, service-based economies. Even in light of recent oil-price strength, the spike in energy sector layoffs has been nearly offset by the improving trend in the construction trades as housing activity comes back to life.

The bottom line: We continue to believe that global economic growth will grind its way higher, led by the advanced and commodity-consuming emerging economies (including China and India). Although China’s debt is a concern, the bulk is owed by state-owned enterprises to quasi-state-owned banks. Only a small fraction is held by foreign investors. The central government’s debt ratio is rather low, and households are not highly leveraged either.

Another bedrock assumption of ours has been the conviction that central-bank monetary policy will remain highly expansionary on a global basis. Even in the U.S., where economic growth and inflation appear more entrenched than in most other countries, it is unlikely that interest rates will be pushed higher in an aggressive manner. A more interesting question is whether central banks have reached the end of their policy effectiveness. This issue has come to the forefront in 2016 as the Bank of Japan, and then the ECB, implemented radical policy prescriptions only to see markets react negatively. In both Europe and Japan, government bond yields now are negative out to 7 and 10 years, respectively. If there is an overvalued asset in the world it is a negative-yielding government bond. European corporate bonds, too, have begun edging into negative-yield territory following an announcement by the ECB of its intention to serve as a buyer in that market starting in June.

And yet the yen and the euro have gained against the greenback on a year-over-year basis. This resiliency runs counter to our own expectation that a widening interest-rate differential between the U.S. and those two countries would keep the greenback strong. If the dollar’s weakness continues, it would have far-reaching consequences for global assets. It would, for example, be positive for commodities as well as emerging-market debt and equity.

It’s hard to make a fundamental case for this dramatic turn in the fortunes of emerging-market equities. Earnings per share (EPS) for the constituents of the MSCI Emerging Markets Index have collapsed over the last two years in U.S. dollar terms, a performance that correlates closely with the bear market in commodity prices. We need to see stronger global economic growth, improved trade flows and additional supply discipline from commodity producers. The sharp improvement in investor sentiment might be enough to keep the rally going in the short run, but it’s not enough for a sustained bull market.

At this point, we see better prospects for a durable earnings revival in the U.S. than elsewhere. The stalling of the dollar’s appreciation against other currencies in the past year suggests that U.S.–based multinational corporations and import-sensitive industries should see some relief from negative currency translations and declining import prices. Given the economic and political uncertainties, markets will remain difficult to navigate. We lean in a bullish direction, mainly because we are confident that the world economy will exhibit modest growth and that central banks around the world will do “whatever it takes” to coax their economies to grow and push inflation in an upward direction. Safety and stability still look expensive, as do government fixed-income securities. We like U.S. risk assets because the fundamentals seem better than most, although political dysfunction is becoming an increasing worry. Meanwhile, the sharp recovery in emerging-market debt and equity and high-yield securities underscores the fact that beaten-down areas can come roaring back with little advance warning. Under these circumstances, diversification seems a better strategy than concentrated positions as trends shift back and forth in almost random fashion.

Index Definitions

Barclays Global Aggregate Bond Index is an unmanaged market-capitalization-weighted benchmark that tracks the performance of investment-grade fixed- income securities denominated in 13 currencies. The index reflects reinvestment of all distributions and changes in market prices.

Bank of America Merrill Lynch U.S. High Yield Master II Constrained Index is a market-value weighted index of all domestic and Yankee (foreign U.S. dollar-denominated) high-yield bonds, including deferred interest bonds and payment-in-kind securities. Its securities have maturities of one year or more and a credit rating lower than BBB-/Baa3 (the minimum threshold for investment-grade bonds) but are not in default. The Index limits any individual issuer to a maximum of 2% benchmark exposure.

Barclays Global Treasury Index tracks local currency denominated government debt of investment grade countries. The index represents the Treasury sector of the Barclays Global Aggregate Bond Index.

Barclays Global non-Treasury Index tracks local currency denominated non-government investment grade debt. The index represents the non-Treasury sector of the Barclays Global Aggregate Bond Index.

J.P. Morgan GBI-EM Global Diversified Index tracks the performance of debt instruments issued in domestic currencies by emerging market governments.

J.P. Morgan EMBI Global Diversified Index tracks the performance of external debt instruments (including U.S.-dollar-denominated and other external-currency-denominated Brady bonds, loans, Eurobonds and local market instruments) in the emerging markets.

Barclays U.S. Mortgage Backed Securities Index measures the performance of U.S. investment-grade fixed-rate mortgage-backed securities.

Barclays U.S. Asset-Backed Security Index measures the performance of U.S. investment grade fixed-rate asset-backed securities.

Barclays 1-10 Year US TIPS Index measures the performance of inflation-protected public obligations of the U.S. Treasury that have a remaining maturity of one to ten years.

Barclays Investment Grade U.S. Corporate Index is an unmanaged index composed of U.S. investment-grade corporate bonds.

Glossary of Financial Terms

• Asset-backed securities: Asset-backed securities are a type of securitised debt that are backed by loans, leases or credit card debt, but not mortgages. Securitised debt consists of a portfolio of assets, such as mortgages or bank loans, which have been grouped together and repackaged as individual securities.
• Bear market: A bear market refers to a market environment In which prices are generally falling (or are expected to do so) and investor confidence is low.
• Bullish: Bullish refers to a positive view on the markets whereby investors are anticipating economic and market growth.
• Defensive sectors: Defensive sectors are less sensitive to movements in the broad market and therefore tend to tend to have more stable performance.
• Fundamentals: Fundamentals refers to data that can be used to assess a country or company's financial health such as amount of debt, level of profitability, cash-flow, inventory size etc.
• High-yield debt: High-yield debt is rated below investment grade and is considered to be riskier.
• Macroeconomic: Macroeconomic refers to the broad economy of a country or region, or the global economy.
• Mortgage-backed securities: Mortgage-backed securities are made up of multiple mortgages packaged together into single securities. These can be comprised of commercial or residential mortgages. Agency means that the debt is guaranteed by a government-sponsored entity, while non-agency means that it is not.
• Treasury Inflation-Protected Securities: Treasury Inflation-Protected Securities are U.S. Treasury securities issued at a fixed rate of interest but with principal adjusted every six months based on changes in the consumer price index.

Important Information:

Past performance is not a guarantee of future performance.

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[1]in USD, Global Bonds = Barclays Global Aggregate Bond Index, U.S. High Yield = BofA Merrill Lynch U.S. HY Master II Constrained, Global Sovereign Securities = Barclays Global Treasury Index, Global non-Government Debt = Barclays Global non-Treasury Index,  Emerging Markets Debt (local currency) = JP Morgan GBI EM Global Diversified, Emerging Markets Debt (external currency) = J.P. Morgan EMBI Global Diversified, U.S. Mortgage-Backed Securities = Barclays U.S. Mortgage Backed Securities Index, Asset-Backed Securities = Barclays US Asset-Backed Security Index, U.S. TIPS = Barclays 1-10 Year U.S. TIPS Index, U.S. Investment-Grade Corporate = Barclays Investment Grade U.S. Corporate.