Economic Backdrop

Financial markets were relatively resilient in October despite some high-profile negative turns in the ongoing sagas of major developed economies. The U.K.’s negotiating position and timetable came into greater focus as Prime Minister May set a March 2017 deadline to start her nation’s formal withdrawal from the European Union (EU), which could still be subject to parliamentary debate depending on the outcome of an imminent court ruling. She also reasserted the centrality of a sovereign immigration policy to the negotiations, which presents a seemingly insurmountable roadblock to continued participation in the common market, thereby increasing the likelihood of a Hard Brexit. Both sterling and the euro weakened against the U.S. dollar, with sterling falling to the lowest level since 1985 (excluding the lows hit during a flash crash early in the month that nevertheless set markets on edge).

The U.S. presidential election provided a welcomed distraction, however, as the tone of the race deteriorated alongside a series of “October surprises” that painted both candidates in a terrible light. U.S. equities declined and volatility increased to finish October at its highs for the month. The U.S. Treasury yield curve steepened as rates rose across all maturities (yields move inversely to prices), with long-term rates increasing in greater magnitude than short-term rates. Crude-oil prices (WTI Cushing and Brent) crested mid-month at their highest levels since summer 2015, before sliding to end October more than 9% below their highs.

The Bank of England (BOE) and U.S. Federal Reserve (Fed) did not have meetings on monetary policy in October, although the former was forced to fend off rumours that Governor Mark Carney was considering his resignation with a statement that he remained committed at least until Brexit negotiations conclude in 2019. The Fed’s early November meeting is not expected to produce any changes, but another mid-December rate hike remains a real possibility based on the latest Fed projections. The European Central Bank (ECB) and Bank of Japan (BOJ) both announced no changes to benchmark rates or asset purchases. The latter’s yield-curve targeting policy produced a short-term rate of -0.1%; whether this helps achieve the BOJ’s stated goal of igniting inflation remains to be seen.

U.K. construction activity edged upward in October, surprising expectations for slower growth and continuing to put distance between this summer’s post-Brexit vote contraction. Manufacturing growth moderated, but remained safely above the slowdown territory of a few months ago. The unemployment claimant count rate ticked upward to 2.3% in September, while the June-August average unemployment rate and year-over-year earnings were unchanged. Third quarter economic growth was a better-than-anticipated 0.5%, but has moderated since the Brexit vote.

Eurozone manufacturing growth accelerated in October, thanks to increasing new and backlog orders, and a preliminary survey of services growth also improved. Economic sentiment retained the prior month’s energy in October, improving at both the industrial and consumer levels. Consumer prices increased by 0.5% for the year through October, according to a provisional reading; while admittedly low for a full-year measure, this marks the sixth consecutive advance. Overall economic growth continued apace, at 0.3% for the third quarter and 1.6% year over year.

An early reading of U.S. manufacturing activity in October showed promising growth as orders and output hit one-year highs, while consumer confidence settled as the concerns about future job prospects outweighed the current positive sentiment on rising incomes. New jobless claims hit their lowest levels in more than 40 years during October and remained near those levels for the month, following an uptick in the September unemployment rate to 5.0% after adding fewer jobs than expected. The overall economy expanded by a better-than-expected 2.9% annual rate in the third quarter, the fastest pace in two years.

Market Impact

Global fixed-income markets fared poorly during October, as reflected by the Bloomberg Barclays Global Aggregate Index, and most major market segments were negative. U.S. high-yield bonds continued to lead, and were the only positive performing part of the fixed-income market during October. U.S. asset-backed securities were essentially flat, U.S. Treasury Inflation-Protected Securities (TIPS) were marginally negative, and losses in U.S. mortgage-backed securities were modest. U.S. dollar-hedged (which seeks to reduce U.S. dollar-related volatility) global non-government debt, U.S. investment-grade corporate fixed income, and local-currency denominated emerging-market debt had middling losses, while U.S. Treasurys, dollar-hedged global sovereign securities, and foreign-currency-denominated (external) emerging-market debt declined somewhat more steeply. Unhedged global non-government debt performed poorly, and unhedged global sovereign securities suffered the worst overall drop.

Global equity markets declined in October, as reflected by the MSCI AC World Index (Net), with negative performance across every global sector besides financials. Materials experienced the most modest slide, while information technology, utilities and energy also had comparatively small losses. Healthcare had the sharpest decline, followed at a distance by telecommunications and consumer staples. Latin America and peripheral Europe had a strong month, with Brazil leading at the country level, followed by Egypt, Chile, Hungary and Mexico. The Czech Republic, Austria and Greece also performed well, as did Poland and Spain. The deepest losses came from Belgium, Israel and Finland, followed by Denmark, New Zealand and Switzerland.

Index Data (October 2016)

• The MSCI AC World Index (Net), used to gauge global equity performance, declined by 1.70%.
• The Bloomberg Barclays Global Aggregate Index, which represents global bond markets, fell by 2.78%.
• 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”, increased in the month, moving from 13.29 to 17.06.
• WTI Cushing crude oil prices, a key indicator of movements in the oil market, fell from $48.24 a barrel at the end of September to $46.86 on the last day in October, setting an intra-month high of $51.60 on 19 October.
• The U.S. dollar strengthened relative to sterling, the euro and yen, and ended October at $1.22 versus sterling, $1.10 against the euro and at 105.1 yen.

SEI’s View

There are many things over which investors can lose sleep: Brexit-related stresses, disenchantment with free trade, ineffective monetary policy, pressure on corporate profit margins, severe debt burdens, and intense political uncertainty. But our over-arching investment stance remains unchanged. As long as central banks pursue aggressively easy policies in a world mostly characterised by slow economic growth (not recession) and mild inflation pressures, any pullback in the price of riskier assets should be limited.

In general (and especially as it pertains to the U.S.), we continue to view equity-market corrections as buy-on-the-dip opportunities. One reason for maintaining this point of view is our belief that the U.S. economy is on fairly solid ground. It’s true that growth in overall business activity continues to disappoint, but household finances are in good shape as a result of expanding employment and incomes as well as the bull market in stocks, bonds and home values. There is little reason to expect a serious slowing in consumer spending.

We also expect the change in business inventories  — the most volatile part of GDP, which has slowed in recent quarters — to rebound in the quarters ahead, supporting a reacceleration in overall U.S. GDP into the 2.5%-to-3.0% range.

Our main concern for the U.S. is weakness in business investment, which has negative implications for productivity. Slowing labour productivity growth and an acceleration in labour compensation growth is a bad combination. Since companies have been unable to raise prices sufficiently, the downward pressure on profit margins appears chronic. As this pressure intensifies, we expect companies will become more aggressive in their attempts to push through price increases.

This uptick in inflation, combined with the tightening labour market and slow-but-steady pace of economic growth, seems to have tipped the balance in favour of a hike in the federal funds rate, probably in December. Fed policymakers conceded recently that interest-rate normalisation will take years to accomplish, leaving little room to cut rates aggressively in the event of a recession. Investors remain sceptical that the central bank will even achieve its stated objective of pushing its policy rate to the upside. As a result, risk assets should continue to be well supported. Although equity valuations remain elevated, they still appear reasonable relative to those of high-quality bonds.

The U.S. presidential election will have an impact on the economy and financial markets in the months and years ahead. Yet, we firmly believe that it would be a mistake to base even a short-term investment strategy on picking a winner in November; this would require accurate predictions on the policies proposed by the new president, whether they become laws, and how they would impact the economy and financial markets.

With regard to the U.K., many observers have been surprised by the resiliency of its economy, although it is way too soon to sound the all-clear. The BOE has pre-emptively cut its base rate to the lowest level in the multi-century history of the central bank, and restarted its quantitative-easing programme and previously successful funding-for-lending scheme. On the fiscal policy side, the new Chancellor of the Exchequer scrapped his predecessor’s austerity plans and is expected to introduce a new budget that abandons any notion of achieving a budgetary surplus by the end of the current parliament. In all, U.K. economic policy has shifted dramatically toward easing well before the negative effects of Brexit can be felt. However, while no one knows what a final Brexit agreement will look like, we suspect it will be nowhere near the position being pushed forward by various U.K. leaders. Given this uncertainty, we think investment is likely to slow in the months ahead.

Eurozone exports and imports are in decline. Household spending is growing faster than other areas of the economy, as is the case in the U.S. and the U.K., but Europe’s consumer rebound remains considerably less robust in comparison with these two countries. Although the labour market has certainly improved over the past three years, the country-by-country levels remain wildly disparate. This is especially so for the youth unemployment rate.

We’re concerned that it’s just a matter time before another crisis tests the cohesion of the eurozone. It’s possible that the Italian constitutional referendum, to be held 4 December, could provoke such a crisis. If the vote goes against the government, Prime Minister Matteo Renzi may be forced to make good on his promise to hold elections. Unfortunately for him, polls show that the Italian electorate is in a cantankerous mood.

If the Five-Star Movement, currently the most formidable Italian opposition party, were to win power, the impact would be far more earth-shaking than the Syriza party’s January 2015 victory in Greece. Italy’s economy is some seven times greater than that of Greece, so one can only imagine how markets will react to the possibility of an Italian threat to leave the euro framework. ECB President Draghi knows he has a potential problem on his hands. He continues to reassure investors that the central bank has the will, the tools and the ability to improve the eurozone’s fortunes.

The Japanese economy still lacks momentum despite fiscal stimulus packages, structural reforms and extremely aggressive monetary policy initiatives. Industrial output has trended lower over the past three years, hurt by the slowdown in global trade, and although the country’s merchandise trade balance has turned positive, this is merely the result of imports falling faster than exports.

On the positive side, housing construction is running near a cyclical high. The unemployment rate, which is structurally much lower than in other developed countries, has continued to settle. Nominal wages remain stuck near zero, however, and inflation expectations have been nearly impossible to nudge to the upside. Our Asia-focused portfolio managers are heartened by improvements in corporate governance and the use of capital. Additionally, the latest fiscal-policy initiative is a significant one, with new spending amounting to ¥7.5 trillion. In the current fiscal year, stimulus is expected to reach 4.5% of GDP.

We think China’s economy will continue to reaccelerate in the near term. Although the country’s growth rate remains below trend, we are beginning to see an improving trajectory following two and a half years of slowdown. The renminbi has depreciated steadily, and while this has not reinvigorated exports, it appears to have stopped its two-year decline. Domestic economic growth in China has been relatively stable this year; the country continues to evolve into a services-oriented economy, with that sector now accounting for more than half of GDP. Housing activity also has picked up. The question now becomes whether government economic policy flips back toward structural reform and economic rationalisation and away from stimulus, given that business activity looks to be in a less fragile state than a year ago.

Before the global financial crisis, the U.S. and China were the primary growth engines of the world. Those engines are sputtering when compared to their pre-crisis performance. We think it’s possible that India eventually will become a third major engine of global growth. In the past year, its GDP growth was greater than China’s. While its population is nearly as large, India is growing faster and is much younger. As India institutes economic, financial and legal reforms, it has the potential to grow rapidly for a long time.

Our inclination is to favour equities and higher-yielding debt securities at the expense of developed-economy sovereign bonds that have extremely low or negative yields. Within equities, we prefer value and aggressive-growth characteristics over stability. In bonds, we favour securitised credit, bank loans and other credit-related trades.

Index Definitions

Bloomberg 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.

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

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

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

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

Bloomberg 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.

Bloomberg 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.
• Bullish: Bullish refers to a positive view on the markets whereby investors are anticipating economic and market growth.
• Federal funds rate: The Federal funds rate is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight in the U.S.
• High-yield debt: High-yield debt is rated below investment grade and is considered to be riskier.
• 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.
• Peripheral eurozone countries: Peripheral eurozone countries are those nations in Europe’s common-currency area that were hit hardest by the sovereign debt crisis (most notably Greece, Ireland, Italy, Spain and Portugal).
• 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.
• Yield curve: The yield curve represents differences in yields across a range of maturities of bonds of the same issuer or credit rating (likelihood of default). A steeper yield curve represents a greater difference between the yields. A flatter curve indicates the yields are closer together.