For most asset classes, July was a far better month following the May/June correction. Soothing words from the Fed Chairman Ben Bernanke, and other central bankers, allied to a palpable improvement in recent economic and survey data in much of the developed world, regalvanised investors. Government bond yields rose only moderately in the US and eased back in the UK and EU, corporate spreads narrowed, while stock markets in the US, UK and Europe all produced significant rebounds. Even commodity indices rose!
Financial markets had been spooked by fears of an earlier-than-expected rise in interest rates but, to a large extent, these concerns were allayed by the Fed’s attempts to separate the provision of greater transparency in policy thinking from an actual change in policy. The ECB also tried its hand at “light” forward guidance which initially only muddied the water. In the end, most central banks managed to convey the message that short rates will continue at or below current levels for some considerable time, indeed probably through 2015, albeit with inflation provisos.
Fixed Income
In the fixed income markets, trends in government yields were mixed and investors in US treasuries had to field further modest losses as yields tacked higher. Elsewhere, yields in the UK and EU core and periphery edged lower while JGB’s were little changed.
The prior huge overvaluation of government bonds has diminished significantly with the 100-basis-point rise in treasury yields and fundamentally-based “fair value” concepts staging a welcome return. While the prospect of QE tapering in September should, to a large extent, be priced in there is still scope for a pick-up in volatility around the event.
Perhaps a little worryingly for the Fed, investors returned to some of their favoured trades with a relish. In corporate credit, for example, riskier ends of investment grade and high-yield debt led prices higher and spreads narrower, while surveys showed a significant extension of aggregate longs in credit and funds received renewed inflows.
The extent of the relative moves in US corporate bonds has resulted in high yield outperforming investment grade by a very sizeable 7% year-to-date. This is because many investors continue to believe that it is some of the riskier areas of the bond market that are best positioned to benefit from an acceleration in the US economy while being better able to absorb the effects of higher interest rates.
Emerging market debt recovered but by nowhere near the extent of US high yield, as investors remained cautious of emerging market assets in general. Positioning in emerging market debt still suggests that it may take several more months for the market to stabilise.
Stocks & Shares
Following the May/June setback, leading equity markets had either recovered all, or a large part of, the decline by the end of July. Indeed, the MSCI World Equity index, which by 24 June had corrected 8.9% from its 21 May peak, has since rebounded 8.9% and is up 14.2% year-to-date.
Developed markets led the revival; in order of performance, Europe, the UK and the US all rallied in excess of 5% during July. A stronger yen and some disappointment with corporate results caused significant profit taking in Japan late in the month, while emerging markets remain tainted near term by a catalogue of ongoing concerns. Valuation levels, however, are beginning to attract some bargain hunting.
In terms of the internal dynamics of the main stock markets, the improving economic outlook and the easing of QE fears unsurprisingly resulted in general outperformance from cyclical sectors and the financials, while mid/small caps beat large caps in all the main markets. Equity fund flows turned positive once more, except in emerging markets, and investors were encouraged by the further easing in VIX, the volatility index, which reverted towards the lows for the year.
Commodities
Following a number of poor months for many commodities, returns from the main composite indices were positive in July. As is now normal, however, the components were mixed with energy and precious metals up 3-4% while agriculture, led by corn, fell 4% and industrial metals eased modestly.
Of note during the month, the WTI/Brent crude oil spread finally corrected itself, returning to near parity – the trade only required patience. Gold bounced as the “bugs” returned but it was interesting to hear Fed Chairman Bernanke’s take on gold, which must surely have struck a chord with many investors: “No one really understands gold prices” and neither did he.
Within agriculture, the corn price continued to decline, falling under $5/bushel, some 40% below its year-ago high, and is set to remain under pressure should the benign weather conditions continue given the sizeable increase in corn acreage.
Currencies
As in most other areas, volatility died down in currency markets in July and the trend reversal in the dollar persisted through much of the month. The prior dollar rally had taken the DXY index (trade-weighted dollar) from 80.6 in mid-June to 84.6 by July 9 – a gain of 5% – but it ran out of steam on Bernanke’s more dovish recent comments. DXY eased back to 81.4 by the end of July, a 2% decline over the month. Economic newsflow from the UK, the euro area and Japan was also generally better than expected, providing some support for their domestic currencies. Most of the dollar’s weakness was versus the yen and euro, however, as sterling/dollar ended the month unchanged.
A number of the emerging market currencies rallied strongly but not in those still easing or with large imbalances, such as the Australian dollar, Brazilian real and Indian rupee, all of which ended the month at or close to new lows to the US dollar. Since April, the AUD has lost 15%, the real 14% and the rupee 11%.
Commercial Property
While the improving trend in the UK commercial property market has been evident for some time, June marked an inflection point with the 0.2% gain, the first significant increase in capital values for over two years, contributing to a total return of 0.8%. Industrials and offices stood out while retail continued to record a small capital value loss.
The most persuasive part of the turnaround story in property values, however, is that growth is now also coming from outside the M25. The UK economic recovery and much higher yields are attracting a greater flow of investors to the main regional cities but, as ever, selectivity remains key.
Asset Allocation
From an asset allocation perspective, perhaps the most interesting topic, at least for those who have been equity bulls and government bond bears, is the phenomenal returns this trade has produced year-to-date. For UK investors, equities have returned around 18%, while UK All Maturities gilts have declined 3%. In the US, equities have outperformed treasuries by a staggering 23%, all in just seven months! Over 20% equity/bond relative outperformance is a rare event.
For those fund managers and investors who have profited so much from this trade there must now be a considerable temptation to neutralise positions and lock in gains. And who could blame them? Going forward, this trade will likely prove far less remunerative and increasingly volatile.
The other two big winners year-to-date were corporate bonds over government bonds, at 3% or so, and UK commercial property over cash and government bonds, also around 3-4%. In fact, nearly anything against governments bonds, with the exception of commodities.
