Economic Backdrop

The first quarter was a quarter of firsts: the first instance of negative-yielding 10-year government bonds by a major economy (in Japan), the first time WTI oil prices ― a key indicator of movements in the oil market ― fell back to their 2003 levels (in January, and then again in February), and the worst first ten trading days of the New Year in history (as measured by the performance of the S&P 500 and the S&P 90, its predecessor, since 1928). Of course, conditions improved dramatically starting in mid-February, propelling the S&P 500 and oil prices to small full-quarter gains.

The Bank of England’s Monetary Policy Committee (BOE) and the U.S. Federal Open Market Committee (FOMC) ― the less-dovish cohort of major central banks ― lowered their sights on tighter monetary policy during the quarter. The BOE registered two unanimous votes to hold benchmark rates firm, a departure from prior votes that typically featured hawkish dissenters favouring an immediate hike. The FOMC tentatively confirmed market expectations for fewer rate hikes this year than previously projected. The European Central Bank (ECB) and Bank of Japan (BOJ) ― the more-dovish set ― deepened their commitments to easy policy. The BOJ adopted a negative benchmark rate and continued asset purchases apace, while the ECB treaded further into negative rate territory and expanded its asset-purchase programme. Both, however, confronted unenthusiastic market responses as their currencies firmed relative to the U.S. dollar following their announcements. Finally, the People’s Bank of China (PBOC) began the quarter by guiding the yuan-U.S. dollar exchange rate lower, and then making a significant capital commitment to its banking system. The PBOC also rebalanced its reserve requirement ratio during the quarter by ending preferential treatment for some banks and then lowering the broad ratio in an effort to stimulate bank lending. China’s securities regulator was also busy in early January, first introducing, and then quickly discontinuing, circuit breakers intended to limit large intraday swings on its mainland stock exchanges.

U.K. manufacturing muddled through the first quarter, with growth sliding to a 34-month low in February and recovering only marginally in March. Retail sales began the year with a jump in January, followed by a small slide in February; retail-sector surveys indicate February’s weakness could continue into March. Claimant count joblessness declined in both January and February, and coupled with a gain in average year-over-year earnings growth for the November-January period, implied a firming labour market. Weak inflation remained pervasive: core consumer prices registered a 1.2% year-over-year increase in January and February, while producer prices remained below their year-ago levels. Fourth-quarter economic growth was revised slightly higher, to 0.6%, and 2.1% year over year, due primarily to household consumption.

Eurozone services sector growth improved over the full quarter, weakening in February before gaining impressively in March. Manufacturing activity followed a similar, albeit more subdued path, with a more protracted growth slowdown during February and a March reacceleration that failed to overtake its January level. Consumer prices gave ground during the course of the quarter, starting in January with the highest year-over-year increase in seven months, before decreasing in February and March. Consumer sentiment slid to its lowest level during the quarter since late 2014, joined by flagging confidence in industry, services and construction. Fourth-quarter economic growth held at 0.3%, and 1.6% year over year.

U.S. manufacturing growth claimed modest gains by quarter-end, propelled by a jump in export orders. Retail sales started the quarter on firm footing, before retreating in February; consumer confidence surveys for March, however, support expectations for retail-sector strength. The employment picture improved during the quarter, with notable earnings increases in January and March, large payroll additions in February and March, and a slow-but-steady increase in the participation rate (although the unemployment rate rose to 5.0% in March after falling to 4.9% in January). Core consumer prices began to approach the FOMC’s target, with core consumer prices increasing 2.3% in February year over year and core personal consumption expenditures measuring 1.7% in the years to January and February. Revised fourth-quarter economic growth registered an annualised 1.4%, an improvement due to increased consumer spending on services.

Market Impact

Fixed-income markets had a positive first quarter measured from start to finish, with a high degree of return variability due primarily to regional exposure, the impact of the U.S. dollar’s relative weakness, and the positive influence of rising oil prices on higher-risk market segments. Local-currency-denominated emerging-market debt was the top performer by a substantial margin, deriving the lion’s share of its gain from a March rally. Global sovereign securities also delivered an outsized return during the quarter, followed by strong performance from foreign-currency-denominated (external) emerging-market debt. Global non-government debt performed very well, trailed closely by U.S. investment-grade corporate fixed income, U.S. dollar-hedged (which seeks to reduce U.S. dollar-related volatility) global sovereign securities, and U.S. Treasury Inflation-Protected Securities. U.S. high-yield bonds performed well, after climbing back from losses through February, followed closely by U.S. Treasurys. Dollar-hedged global non-government debt also delivered respectable returns, trailed only by U.S. mortgage- and asset-backed securities, which were positive as well.

Global equity markets, as reflected by the components of the MSCI AC World Index (Net), rose slightly over the full first quarter, masking significant volatility. Latin America was the best-performing region, claiming the top three country-level advances (Brazil, followed by Peru and then Colombia). Eastern Europe also hosted several top-ten performers (Turkey, Hungary, Russia and Poland), while Southeast Asia had a high concentration of countries that delivered double-digit returns for the quarter (Thailand, Malaysia and Indonesia). The peripheral eurozone countries populated the ranks of the poorest performers, with Greece and Italy ranking worst and second worst, respectively. Israel also suffered a double-digit slide, while Japan, Egypt and Switzerland delivered notably negative performances as well. Finland, China, Ireland and Spain rounded out the bottom-ten performances for the quarter. Global sectors were mostly positive, led by traditionally defensive sectors but followed closely by their most cyclically-sensitive counterparts. Utilities had the best performance, followed by telecommunications, energy and materials. Consumer staples and industrials also delivered strong returns, and information technology was positive as well. Healthcare had the most deeply negative return, and financials performed poorly, while consumer discretionary was down slightly.

Index Data (First Quarter 2016)

• The MSCI AC World Index (Net), used to gauge global equity performance, rose by 0.24%.
• The Barclays Global Aggregate Index, which represents global bond markets, advanced by 5.90%.
• 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 quarter as a whole, moving from 18.21 to 13.95, but peaked at 28.14 on 11 February.
• WTI Cushing crude oil prices, a key indicator of movements in the oil market, moved from $37.04 a barrel at the end of December to $38.34 on the last day in March, falling to a 13-year low of $26.21 on 11 February.
• The U.S. dollar strengthened against sterling during the quarter, but weakened against the euro and yen despite the accommodative monetary policy actions from the ECB and BOJ. The U.S. dollar ended March at $1.44 versus sterling, $1.14 against the euro, and at 112.4 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. While it certainly looks as if the boom in U.S. shale oil production is turning into a bust, the rising number of associated layoffs has been nearly offset by the improving trend in the construction trades as housing activity comes back to life. Total non-farm payrolls, meanwhile, appear to be growing near the upper end of the historical range.

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 recent months as the BOJ, 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 9 and 10 years, respectively. If there is an overvalued asset in the world it is a negative-yielding government bond.

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 is sustained, 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 30% since mid-2014 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. In all, we see underlying U.S. earnings growth on a per-share basis in the 5-to-9% range over the next 12 months, and look for equity prices to appreciate in the same neighbourhood.

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.

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.
• Bull market: A bull market refers to a market environment in which prices are generally rising (or are expected to do so) and investor confidence is high.
• Cyclical: Cyclical sectors or stocks are those whose performance is closely tied to the economic environment and business cycle. Managers with a pro-cyclical market view tend to favour stocks that are more sensitive to movements in the broad market and therefore tend to have more volatile performance.
• Dovish: Dovish refers to the views of a policy advisor (for example at the Bank of England) who has a positive view of inflation and its economic impact and thus tends to favour lower interest rates.
• 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.
• Hawk: Hawk refers to a policy advisor, for example at the Bank of England, who has a negative view of inflation and its economic impact and thus tends to favour higher interest rates.
• 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.

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).

Important Information:

Past performance is not a guarantee of future performance.

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