- In recent weeks, investors have been contending with two trends: anxiety over a change in Fed policy and evidence of a slowdown in the global economy.
- While global growth is likely to remain below historic norms, it is not collapsing. This suggests that investors should be positioned for a slow growth environment, not another recession.
- This, in turn, implies taking some selective risk in asset classes that have become less expensive as a result of the sell-off.
- One example of an asset that warrants another look: U.S. high yield bonds.
Another Down Week
Stocks and other risky assets continued to sell off last week. The Dow Jones Industrial Average lost 2.73% to close at 16,544, the S&P 500 Index fell 3.10% to 1,906 and the Nasdaq Composite Index dropped 4.44% to 4,276. Meanwhile, the yield on the 10-year Treasury dropped from 2.44% to 2.28%, as its price correspondingly rose.
In recent weeks, investors have been contending with two trends: anxiety over a change in Fed policy and evidence of a slowdown in the global economy. Our view is that while global growth is likely to remain below historic norms, it is not collapsing. This is an important distinction because it suggests that investors should be positioned for a slow-growth environment, not another recession. This, in turn, implies taking some selective risk in asset classes that have become less expensive as a result of the sell-off. One example of an asset class that warrants another look: U.S. high yield bonds.
Solid Growth in the U.S., Too Little Elsewhere
Last week witnessed further selling of risky assets. Global equities are now down roughly 8% in dollar terms from their summer highs, with emerging market stocks, U.S. small caps and oil all in correction territory (in other words, they have declined 10% or more). Recent market weakness has also led to significant outflows from equity funds. For the week ended October 8, nearly $13 billion came out of equity funds.
At the same time, investors have been buying so-called safe-haven assets. So, while investors were selling stocks, they moved $16 billion into bond funds and roughly $47 billion into money market funds. Since bond yields drop as prices rise, the recent spate of bond buying has pushed the yield on the 10-year Treasury note down to 2.28%, its lowest level since June of 2013.
Ironically, last week's stock selling could have been driven by the paradox of a little too much growth in the U.S. and too little everywhere else. A strong U.S. economy continues to suggest a Fed tightening sometime in the first half of 2015. At the same time, the rest of the world appears to be decelerating, with a few notable exceptions, such as India. This trend was highlighted last week in a report by the International Monetary Fund (IMF). The IMF reduced its estimates for global growth and raised the likelihood of another recession in the eurozone.
Why the sudden concern over Europe? European economic activity has been decelerating for a variety of reasons: declining exports to Russia, the slowdown in the market for Chinese capital and luxury goods, and weak labor dynamics –– all of which are contributing to a loss of confidence.
However, there are some bright spots in Europe. A few countries, one being Spain, are benefiting from structural reforms. Throughout the continent, demand for consumer credit appears to be rising. Finally, the weakening in the euro should help European exporters and provide some tailwind for the eurozone. All this suggests that while Europe is unlikely to boom anytime soon, any further slowdown should be modest.
Investing in a Slow-Growth Scenario
While we don't expect another global recession, the last few weeks illustrate why the world economy is still going to be defined by relatively meager growth. This has significant implications for investors and suggests looking for assets that can still do well in the slow-growth environment, such as large- and mega-cap companies, which have been significantly outperforming smaller companies.
At the same time, the current environment presents the opportunity to take another look at asset classes that had sold off and now look more attractive. One such asset class that had come under pressure, but is now looking relatively appealing, is high yield bonds. The yield difference between high yield bonds and higher-quality, lower-yielding U.S. Treasuries (known as the spread), has widened out to the highest level in a year. This indicates high yield bonds offer better value and yields now than just a few weeks ago. Given that corporate America remains strong and default rates low, high yield now looks likely to provide a reasonable level of income relative to the rest of the fixed income market
When QE Ends, What's in Store for Munis?
With quantitative easing expected to end in the near future, Peter Hayes explains his view on how changing market conditions will impact municipals.
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