Shifts in Major Asset Classes

Yogi Kraja
April 21, 2016

Under the leadership of Chairwoman Janet Yellen, the Federal Reserve Board (Fed) is on track in managing its dual mandate of stable prices and unemployment. With a strong U.S. dollar and slowing global economic output, lower commodity prices have not helped the Fed’s case in raising interest rates, leaving investors plenty of opportunity to adjust their inflation expectations.

The Federal Reserve’s Impact and Inflation

Since the 2008 financial crisis, the Fed has been at the forefront of stabilizing the financial markets, instilling confidence and liquidity into a system that was rattled by what is considered the worst financial crisis since the Great Depression. With price stability and full employment as its dual mandate, the Fed has influenced domestic interest rate policy while remaining aware of the ramifications its policies might have on other countries and regions around the globe. Overall, U.S. economic sentiment and growth remain positive, albeit subdued, the risk of a recession remains low, and with stable financial conditions, the Fed remains cautiously optimistic.

Since the “Great Financial Crisis,” under the guidance of the Fed, the unemployment rate in the U.S. has steadily decreased and now stands at 5 percent — a level considered to be “full” employment and within the Fed’s long-run target. Meanwhile, consumer inflation has been hovering at 1.8 percent, just below the Fed’s 2 percent target. Given these positive changes in price stability and employment, the Fed initiated a measured rate increase of short-term interest rates in December 2015 of 25 basis points. At that time, market participants expected several more rate hikes over the course of 2016.

Since the Fed’s December meeting, global financial market volatility appears to have encouraged the Fed to alter its intended course of interest rate increases. In addition, the relatively strong position of the U.S. dollar versus other major currencies and the continued decline of energy prices also appear to have contributed to the Fed’s decision to delay further rate increases, at least in the short term. There is a growing divergence between the Fed and other major central banks, as the European Central Bank (ECB) and the Bank of Japan (BOJ) have taken aggressive monetary policies to reduce the pressures on their banking systems to instill confidence and lending and raise inflation expectations. One unorthodox method used by several central banks has been the introduction of so-called “negative interest rates” in which member banks pay interest to hold their reserves with central banks. These policy moves have contributed to some confusion among certain investors. Along with the policy stumbles of the Chinese government in guiding its economy earlier this year, volatility in the financial markets increased with the CBOE Volatility Index (VIX) trading at more than 32 in mid-January, and even the domestic equity large-cap proxy index — the S&P 500 — shed nearly 12 percent by mid-February. However, most global stock markets recovered strongly in March, thanks in part to the Fed’s “wait-and-see” message.

Based on data from the Fed, consumer inflation expectations remain low, as evidenced on a five-year or 10-year basis. Going five years forward, the market expectation is for inflation to hover around 1.5 percent, while the 10-year breakeven rate of inflation is expected to be around 1.3 percent. These inflation expectations have fueled investor speculation that the markets are underpricing inflation and have bid up Treasury inflation-protected securities (TIPS) with the Barclays US Treasury US TIPS TR Index up 3.8 percent year to date through April 12, 2016.

Global Economic Growth and Commodity Prices

Global recovery continues but at an ever-slowing and increasingly fragile pace. In addition, several stresses of noneconomic origin threaten economic activity. For 2015, the International Monetary Fund (IMF) estimates that emerging markets accounted for more than 70 percent of global growth.1 If one accepts the premise that China, now the world’s largest economy on a purchasing-power-parity basis, has been the source of global economic growth, the IMF World Economic Outlook for 2016 is quite subdued on overall aggregate global growth. In large part, the slowdown in China’s economic growth, with its slowing imports and exports, has been a drag on emerging markets as an asset class.

China is navigating a momentous but complex transition toward more sustainable growth based on consumption and services. Ultimately, that process will benefit both China and the world. Given China’s important role in global trade, however, bumps along the way could have substantial spillover effects, especially on emerging market and developing economies.2 According to the IMF, emerging market countries are expected to grow (real GDP) at 4.1 percent in 2016 and 4.6 percent in 2017, compared to developed countries’ growth projections of 1.9 percent for 2016 and 2 percent for 2017. Chinese growth is expected to slow from 6.9 percent in 2015 to 6.5 percent in 2016 and 6.2 percent in 2017.3

Further, falling commodity prices, especially oil prices, have been a source of downward pressure on commodityexporting countries in the emerging markets space. Contraction in the GDP of some Latin American countries, such as Brazil and Venezuela, as well as oil-producing countries in the Middle East and Russia has been underway and is expected to continue over the next year.

U.S. monetary policy has been no friend of emerging nations, as potential increases in U.S. yields and a strong U.S. dollar have a negative impact on national debt, especially in those developing countries that issued local debt in U.S. dollars. Paying back the bonds with a weak local currency is straining many emerging countries. This situation would deteriorate further if U.S. interest rates rise.

Nowhere have price dynamics of supply and demand been more prominent over the past few years than in commodities, especially oil. In the first quarter of 2016, commodities remained subdued, but crude oil’s freefall was halted in February and is struggling to move back into the lower $40-a-barrel range. The short-term and intermediateterm future for crude oil in particular remains quite uncertain and volatile as long as inventories are elevated and drilling in excess of consumption continues. For a perspective, consider that the average annual United States petroleum exports increased from 1.8 million barrels per day in 2008 to 4.7 million barrels per day in 2015.4

Globally, total oil production has grown steadily since 2009, averaging 90 million barrels per day through 2015, while consumption has averaged 89 million barrels per day for the same period.5 China comprised 12 percent of total average annual world consumption, while average annual consumption from the U.S. represented nearly 21 percent of global supply6.

While global oil prices have historically been driven by supply-and-demand factors, an additional strong influence on oil prices is the relative position of the U.S. dollar against other major world currencies. For much of the second half of 2014 and all of 2015, the dollar was in a period of dramatic strengthening against other currencies. Some of the strength can be attributed to expectations of tighter monetary policy in the U.S. The knock-off effect to crude oil prices is that oil is traded in U.S. dollars, and, thus, all participants must use more of their local currencies to purchase oil and to keep purchasing power parity in check.

From a pricing perspective, low oil prices would impact consumers in a favorable manner, as lower oil consumption costs tend to shift spending toward discretionary items. The increase in economic activity would impact output in a favorable manner and would be another source of economic expansion.

However, the 2015 IEA World Energy Outlook’s (released in November 2015) central scenario is for the oil market to rebalance supply and demand such that by 2020 the IEA sees crude oil trading at $80 per barrel.7 The IEA notes that the short investment cycle of “tight” oil is changing the way markets operate, making it difficult to forecast future oil prices. An alternative scenario from the IEA calls for oil to hover around $50 per barrel until the end of this decade and then rise gradually going forward — a scenario based on lower global growth, a more stable Middle East, continued high production from OPEC nations and a resilience in non-traditional oil production in the U.S. Big questions remain on the pace of China’s energy consumption growth and the level to which India can ramp up its energy infrastructure.

Emerging market stress could rise further, also reflecting domestic vulnerabilities. For instance, an additional bout of exchange rate depreciations could further worsen corporate balance sheets, and a sharp decline in capital inflows could force a rapid compression of domestic demand. A protracted period of low oil prices could further destabilize the outlook for oil-exporting countries.

The global economy continues to evolve into one that is highly integrated and dynamic between countries and regions. Over the past decade, many economies and financial markets have become highly correlated with one another. This is a challenge for local investors (say, in the United States) whose personal liabilities and consumption are based in the local currency. Investing in domestic financial assets — the so-called “home bias” — remains a strong preference for many investors. However, it is hard to ignore the dynamics of global investing and the many opportunities that exist across the globe. Of the major asset classes, risk assets have performed well on a year-to-date basis.

The performance detailed above is merely a snapshot in time, and questions will remain whether such momentum will continue. Notice that bond funds also performed well, but as investors continue to reset their inflation expectations, inflation-sensitive assets can find demand. For now, one thing is clear: The markets will continue to respond to central bank policies, and investors can quickly fall back in love with asset classes once momentum shifts.

In the long run, an investment policy plan would consider risks and opportunities wherever they are, and a global allocation could provide both stability and opportunity.

 

Disclosures:

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1. IMF. World Economic Outlook – Too Slow for Too Long, April 2016. http://www.imf.org/external/pubs/ft/weo/2016/01/pdf/text.pdf

2. Ibid.

3. Ibid. http://www.imf.org/external/pubs/ft/weo/2016/01/pdf/text.pdf

4. EIA. March 2016 Monthly Energy Review http://www.eia.gov/totalenergy/data/monthly/pdf/mer.pdf

5. EIA. International Energy Statistics. https://www.eia.gov/cfapps/ipdbproject/IEDIndex3.cfm?tid=5&pid=53&aid=1

6.
EIA. International Energy Statistics. https://www.eia.gov/cfapps/ipdbproject/iedindex3.cfm?tid=5&pid=53&aid=1&cid=regions,&syid=2008&eyid=2015&unit=TBPD

7. IEA. World Energy Outlook 2015. http://www.worldenergyoutlook.org/weo2015/

 

 

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