Viewpoints June 2015 - The Vault from Nicolet National Bank

Global analysis designed to keep you abreast of the latest economic and market changes.
June 2015
Last month, the biggest developments in the financial markets
occurred in the fixed income and monetary policy arenas. After
various maturities of European sovereign debt dipped into negative
interest rates following the start of European quantitative easing
(QE), these interest rates rebounded sharply during the last month.
This was in reaction to both better economic data and a resulting
increase in inflation expectations. German 10-year bund yields,
for example, have increased from their low of 0.08% on April 20
to around 0.65% one month later. Even though rising interest rates
historically have been viewed as a potential headwind to growth and
risk taking, this increase reflects a reduced fear of deflation. It also
provides a clearer runway for the European Central Bank (ECB)
to continue its bond buying program through the targeted date of
September 2016, allaying concerns about an early termination.
While the market continues to vacillate on when the Federal
Reserve will start raising interest rates, we’ve become increasingly
confident that the Fed is poised to move. Recent comments by Fed
Chair Janet Yellen and New York Fed President William Dudley
increase our confidence that the Fed is predisposed to move off
its long-standing zero-interest-rate policy, and just needs the
environment to be supportive enough for it to start. The solid May
nonfarm payroll report supports the notion that the U.S. economy
is improving from the slow first quarter, but softer data in areas
such as retail spending paint a more sober picture. On balance, we
think U.S. growth will outperform the market’s relatively nervous
In contrast to the weak start to the year for the United States,
Europe grew at an annualized 1.6% pace in the first quarter. Even
though this is a solid start, we continue to think the market has
become too bullish on the strength of the cyclical bounce that
Europe is currently enjoying. The outlook for emerging-market
growth importantly will be tied to the success of China’s current
stimulus efforts. Responding to a string of disappointing data,
Chinese leadership has moved to cut interest rates and bank reserve
requirements, and to provide a liquidity program to relieve the
banks of troubled municipal debt. Even though these programs
likely will help provide some downside support to growth, we think
it will be insufficient to boost emerging-market economic growth
above investor expectations.
Sources: Northern Trust Asset Management, Bloomberg
111 N. Washington Street • Green Bay, WI 54305-3900 • 800.369.0226 •
■ First-quarter earnings per share (EPS) in 2015 are beating estimates
by the widest margin since 2012.
■ Excluding energy, EPS growth of 7% remains supportive.
More than 90% of S&P 500 companies have reported first-quarter
earnings, and results are coming in significantly better than previously
lowered market expectations. Even though revisions were negative
going into the reporting season, first-quarter results are still lower than
what was expected at year end 2014. Overall, first-quarter earnings are
coming in flat compared to last year, though earnings are up 7% yearover-year excluding the energy sector (where EPS are down more than
50%). Overall sales growth of -3% reflects the weak energy results;
sales growth, excluding the energy sector, was 2%. Full-year 2015 EPS
estimates have improved, reversing the recent trend, but by only half of the
magnitude of the first-quarter beat. With foreign exchange and oil price
effects abating somewhat recently, estimates could prove conservative
as we move through 2015, supporting the performance of equities.
Sources: Northern Trust Asset Management, Bloomberg
■ Economic reports are turning positive, especially in weaker
peripheral economies.
■ The euro’s decline from its highs last year should provide further
Even though European equities retreated during the last month, there’s
been continued improvement in the underlying economy. The Purchasing
Managers’ Index (PMI) held steady in April at 53.9 from March’s strong
quarter-end number of 54, which was confirmed by first-quarter 1%
real gross domestic product (GDP) growth. Moreover, within the PMI
report, there was notable strength in the weaker peripheral European
economies of Spain and Italy, which rose to nine-year and 10-month
highs, respectively. Despite the euro’s recent strength, it’s still down
15% to 20% from its highs last year. The lagged effect of a cheaper euro,
along with lower energy prices and credit growth, should continue to
provide stimulus. While equities should recognize these positives in the
long term, the short to intermediate term could be volatile as structural
economic reform efforts continue and the Greek debt negotiations drag on.
Sources: Northern Trust Asset Management, Bloomberg
■ Japanese bank lending is growing at an uninspiring 2.8% rate.
■ Regional bank lending is growing at a healthier 4.2% clip.
The Nikkei Index traded relatively flat during the last month as
investors looked for evidence of sustainable growth. There’s no
shortage of stimulus, as Abenomics increased the Bank of Japan’s
(BOJ’s) balance sheet another 10 trillion yen in April, and the
stimulus is likely to total 360 trillion yen by next year, or roughly
75% of GDP. Despite this unprecedented accommodative monetary
policy, bank lending is growing only 2.8% year-over-year, which
is leaving investors unconvinced of prospects for healthy and
consistent growth. However, regional bank lending, which focuses
more on smaller businesses, grew at a healthier 4.2% during the last
year. These regional banks account for 45% of lending. Therefore,
any credit growth acceleration in the regional arena could have a
meaningful contribution to money velocity, the achievement of the
BOJ’s 2% inflation target, and consequently, a constructive backdrop
for equities.
111 N. Washington Street • Green Bay, WI 54305-3900 • 800.369.0226 •
■ Chinese policy continues to evolve to combat its growth slowdown.
■ We expect continued moderately disappointing emerging-market
Chinese authorities have been actively working to offset China’s continued
growth slowdown, most recently through a series of policy rate reductions
and adjustments to bank reserve requirements. The People’s Bank of
China (PBOC) has begun promoting a liquidity program that allows banks
to swap local loans for bonds issued by the PBOC. New money supply
growth has been slowing, which could help improve banks’ willingness
to lend. Meanwhile, the ripple effects of China’s slowing growth continue
to hinder growth in its key suppliers. Even though growth remains solid
in Asian emerging markets, it has ground to a standstill in Latin America
and Europe, the Middle East and Africa (EMEA). Emerging-market stocks
have enjoyed a bounce this year along with other out-of-favor markets
— but improved economic momentum is likely required for sustained
■ Global listed infrastructure stock composition goes beyond just the
utilities sector.
■ Allocations within the energy and industrials sectors help buoy returns.
The global utility sector was up more than 16% in 2014 (with U.S.
utility stocks up nearly 30%), driven largely by falling interest rates. The
euphoria of 2014 has corrected somewhat in 2015, resulting in negative
returns in the sector, but the broader global listed infrastructure asset
class has generated positive returns. While heavily exposed to the utilities
sector, global listed infrastructure also has meaningful allocations to the
energy sector (e.g., pipelines) and industrials (e.g., airports), which have
fared better year-to-date. The combination of high-cash-flow assets from
these different sectors provides a return stream worthy of direct inclusion
in a diversified portfolio. We remain strategically allocated: conscious
of elevated valuations, but attracted to the 3.5% dividend yield in a low
interest rate environment.
■ High yield fund flows recently have been volatile.
■ Outflows have been concentrated in exchange-traded funds (ETFs).
High yield mutual fund flows have been volatile during the past month,
with substantial outflows totaling -$3.77 billion in the three weeks
ended May 8. The -$2.75 billion outflow for the week ended May 8
was the largest on record. ETFs have driven the recent fund flows. The
accompanying chart shows that actively managed fund flows have been
relatively stable and haven’t had a negative trend. Even with ETF outflows
and a material interest rate move, high yield has traded in a one-point
range and is only a quarter point from the high of the period. The market
yield has remained in a 28 basis points range and is currently 20 basis
points tighter than at the start of this period. Recent fund flows have been
more reflective of ETF dynamics than a general shift in asset allocation by
high yield investors, and we remain constructive on the asset class.
111 N. Washington Street • Green Bay, WI 54305-3900 • 800.369.0226 •
■ Yield differentials between U.S. Treasuries and German bunds hit a
25-year high.
■ The relative value of U.S. Treasuries may keep yields suppressed.
From 2007 until mid-2013, the spread between U.S. Treasuries and
German bunds remained fairly tight, with a few short-term dislocations.
Amid prospects of a U.S. recovery, the Fed began to position itself to end
its QE program in 2013, causing spreads between Treasuries and bunds to
widen. Because of low growth and deflationary pressure, the ECB rolled
out a QE program of its own, causing yields across Europe to fall and
U.S.-German spreads to widen further. Additionally, global investors have
poured money into U.S. dollar-denominated debt, as the relative value
of U.S. Treasuries has been attractive. Amid a global economic outlook
that remains challenged, we believe this may cause yields on U.S. debt to
remain suppressed.
■ Europe’s recovery appears more than transitory.
■ Politics may remain in focus after the United Kingdom’s general
Economic conditions in Europe have improved sharply, and forwardlooking indicators suggest that this is more than transitory. Sovereign bond
yields have rebounded significantly with 10-year German bund yields
at a six-month high. However, the sell-off should be constrained by the
ECB’s large purchase program, as euro-area government bonds remain
in negative net supply. Risks surrounding Greece will also remain in play
until a long-term solution is established. In the United Kingdom, markets
appeared to welcome the surprise election result in which the Conservative
Party swept into government with a majority. The absence of political
upheaval has helped the pound sterling appreciate, but investors remain
attentive to when the Bank of England may raise rates. Political risks may
return to the fore as the devolution of “U.K. Ltd.” appears unavoidable as
a referendum on European Union membership remains likely.
■ The PBOC eases policy again, as corporate default concerns are on the
■ The BOJ keeps monetary policy unchanged.
With China’s first dollar corporate bond default, markets are reminded of
the extent of the slowdown in the country’s domestic property market and
its economy more broadly. Against a target growth rate of 7% in 2015,
the PBOC’s decision to cut bank reserve requirements again in April was
unsurprising, and more stimulus is in the cards. While the BOJ maintained
its monetary stance at its April meeting, markets focused on the bank’s
downgrades to its growth and inflation outlooks. Even though Japanese
equity markets suggest that sentiment is high, economic data has been less
robust — labor market indicators remain subdued and corporate sector
activity is similarly benign. Oil prices remain relatively low, but as the
effects of high oil prices 12 months ago on inflation calculations disappear,
the authorities will be under pressure once again to show they can sustain
111 N. Washington Street • Green Bay, WI 54305-3900 • 800.369.0226 •
We think the key issues for the markets in coming months are the improvement in U.S. economic momentum and the eventual rise of
the Fed funds rate. Even though it’s our base expectation that the Fed will increase rates starting in September, we wouldn’t rule out a June
hike should strong data provide the opening for the Fed. Regardless of the starting date, we expect the Fed to be gradual in its long-term
pace and think the Fed funds rate will eventually top out around 2% in 2017. Each interest rate cycle has its unique attributes, and the zero
interest rate policy and QE that defined this cycle make it unique. But if history is any guide, a moderate rise in the Fed funds rate that’s in
line with market expectations and is done concurrently with solid economic growth should be absorbed by the markets.
While we think the Fed is itching to get the first rate hike behind it, the ECB and the BOJ remain in ultra-easy mode. The recent
backup in European interest rates has probably been received with mixed reviews by the ECB. Even though it likely facilitates the bank’s
QE program, the resulting strength in the euro works counter to the bank’s stimulus plans. While predicting currency moves is always
a challenging endeavor, we feel the odds continue to favor the strength of the U.S. dollar over its major counterparts because of the
differential in the monetary policy outlook. We identified a positive risk case this month, tied to the surprisingly strong showing by the
Conservative Party in the United Kingdom’s election. As the United Kingdom considers a referendum about its EU membership in 2017,
we think there’s some chance that negotiations move toward granting EU countries some increased measure of independence — which
could help improve economic performance.
We made no changes to our tactical asset allocation recommendations at this month’s policy meeting. Financial market returns have
been reasonably strong so far this year, led by European, Japanese and Chinese equities. After underperforming in recent years, the
rebound in international equities is a welcome reminder of the benefit of a globally diversified portfolio. While our recommended tactical
overweight to U.S. equities and underweight to the developed markets outside the United States and emerging markets have detracted from
performance, our recommended underweights in fixed income have offset this drag. We’re hesitant to chase these outperforming markets on
a tactical basis, as investor sentiment has shifted rapidly this year. Especially as it relates to Europe, the valuation discount has narrowed,
and continued outperformance is more reliant on relative economic outperformance going forward.
The asset allocation process develops both long-term (strategic) and shorter-term (tactical) recommendations. The strategic returns
are developed using five-year risk, return and correlation projections to generate the highest expected return for a given level of risk. The
objective of the tactical recommendations is to highlight investment opportunities during the next 12 months where the Investment Policy
Committee sees either increased opportunity or risk.
The asset allocation recommendations are developed through the Tactical Asset Allocation, Capital Markets Assumptions and
Investment Policy Committees.
Past performance is no guarantee of future results. Returns of the indexes also do not typically reflect the deduction of investment management fees,
trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved.
This newsletter is provided for informational purposes only and does not constitute an offer or solicitation to purchase or sell any security or commodity.
Any opinions expressed herein are subject to change at any time without notice. Information has been obtained from sources believed to be reliable, but its
accuracy and interpretation are not guaranteed.
ViewPoints reflects data as of 5/14/15.
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111 N. Washington Street • Green Bay, WI 54305-3900 • 800.369.0226 •