DR.CHENJIAZI ZHONG

In Brief

• A rebound in U.S. economic data strengthened the Fed’s case for a rate hike in June; the Fed outlined a plan to reduce the balance sheet.
• European growth surprised to the upside; data indicated that the eurozone’s recovery may be gaining momentum.
• The UK election resulted in a hung parliament, creating uncertainty about the path ahead for Brexit negations.
• Emerging market equities, bonds and currencies delivered strong performance in May, adding to their stellar start to the year.
• China’s sovereign debt was downgraded by Moody’s Investors Service for the first time since 1989, due to the country’s rising liabilities and slowing growth.

A healthy U.S. employment report bolstered the Fed’s comments in May that the weakness seen in the first quarter was likely transitory. The economy added 211,000 jobs in April and the unemployment rate fell to 4.4%, alleviating some fears over the anemic 79,000 increase in jobs in March. Retail sales also rebounded, rising 0.4% and outpacing the prior 0.1% gain, as strength in the labor market and a 2.5% increase in hourly wages supported consumption. Against this backdrop, the Fed’s meeting minutes revealed that another rate hike could be appropriate soon, and outlined a plan to reduce the balance sheet by slowly and predictably ending reinvestments of maturing securities.

While the political turmoil contributed to a brief period of elevated market volatility, most risk assets recovered to end May higher. Investor unease over geopolitical events was apparent in May, particularly the controversies surrounding the administrations in the U.S. and Brazil. The seemingly inexorable trend higher in risk markets prevailed as equities globally gained and credit spreads tightened. The VIX also reflected the short-lived nature of the downturn in markets during May as it reached both its highest intraday level in 2017 and its lowest level since 1993.

The drivers of the recent equity market gains have changed from those that initially pushed equity markets higher following the U.S. election, while the “reflation trade” immediately following President Trump’s election focused on financial and energy companies, which have struggled more recently. The gains in May were driven by technology companies with strong earnings growth, as well as more rate-sensitive sectors like utilities as interest rates have fallen.

The expansions in Europe are robust, with all key segments of the economies participating in the upswing. The European economy grew at an annualized pace of 1.8% in the first quarter. The European Central Bank removed a reference in its statement to a potential rate cut but maintained its dovish policy stance. It lifted its growth forecasts but trimmed its inflation outlook.

Overall market reaction in the U.K. was muted. The British pound weakened and UK domestic stocks fell. Oil prices touched one-month lows on a surprise rise in U.S. crude stockpiles. Undeterred by weak oil, weekly flows into emerging market debt and equity funds logged their longest positive run since 2013.

The MSCI EM Equity Index returned 16.6% through the end of May, nearly double the return of the S&P 500 over the same period, while emerging markets local debt and currencies delivered returns in the high single-digits. With developed market rates trending lower and concerns over protectionism waning, investors have re-focused on improving emerging markets fundamentals, and investment flows have followed. Despite a fresh political scandal in Brazil, investors remain drawn to attractive yields in the sector as inflation abates and countries such as Russia and Brazil emerge from recession.

Moody’s Investors Service downgraded China’s sovereign debt for the first time since 1989, citing rising liabilities and slowing growth. China’s downgrade to A1 from Aa3 by Moody’s Investors Service on May 24 was not too surprising since both Moody’s and Standard & Poor’s had warned in March 2016 that they were reviewing China’s ratings. The market impact of the downgrade is also limited: China has not issued sovereign external debt for more than a decade, and local currency bonds are not included in the widely tracked global indexes yet, so there was no index-related selling. Chinese policymakers may now feel a sense of urgency to intensify regulation of the huge shadow banking system, maintain a hawkish monetary policy stance and somehow restore fiscal discipline. Although positive from a structural standpoint, such a policy shift could put more pressure on Chinese growth, financial markets and commodities prices in the coming year.

New Bond Issuance: The Active Management Advantage

When new bonds come to market, the alpha potential available to active managers is significant.

1. New bond issues are a more frequent and much bigger share of the market. Over the past three years, newly issued bonds represented more than 20% of the capitalization of the U.S. corporate bond market. In contrast, equity IPOs were less than 1% of U.S. equity market capitalization during the period. This is logical because whereas common equity is typically a perpetual security, bonds have finite maturities.
2. New bond issuance represents a consistent source of alpha potential. Active bond managers typically buy new issues when they come to market, often a week or more before the securities enter the index at the start of the month. This matters because new bonds tend to come to market at a slight discount to outstanding issues, hence the alpha potential active managers can access.
3. While passive managers sometimes wait to buy: They risk tracking error if prices move before the bonds join the index; managers also may face limits in how much off-index exposure they can hold. After all, the goal of passive managers is not to beat the index but to replicate and match its performance.
4. Active managers can pick and choose. Even though most new bonds come to market with a concession, active managers do not necessarily buy them. Passive managers, by contrast, have an incentive to buy all bonds that enter the index, regardless of price.

Further, size matters. Bigger managers often have an advantage in accessing new bonds, especially for larger deals. With billions of dollars of bonds to sell, investment banks create distribution syndicates. Individuals running syndicate desks may rely on a smaller pool of large investors to obtain lead orders and ensure there is ample interest to proceed quickly with the new issue, before borrowing rates rise. The 10 largest buyers received about 45% of the offering, with the top five buying about a third.

Other Thoughts

• Broad-based, trend-like growth and favorable financial conditions combine to create a supportive backdrop for risky assets. With the U.S. economy progressing into late cycle, recent divergence between bond yields and equity markets raised some concerns, but that rates should resume their upward path in the second half of 2017.
• U.S. credit is unlikely to outperform stocks, while it should still beat government bonds.
• A diversified regional equity exposure is best suited to benefit from the pickup in global growth. At the margin, investors may favor Japanese, European and emerging market equities and keep a modest exposure to the U.S., with the UK the least preferred region.
• Core European bonds look set to lead global yields higher over the latter part of the year, so investors should remain modestly underweight global duration, while the improving growth trends outside the U.S. markedly reduce the risk of a renewed, damaging surge in the U.S. dollar.