Monique Frederick, Butterfield
Whether you believe the performance of certain asset classes is logical or not, exponential growth and demand for high yield assets best characterize current market trends. After numerous rounds of quantitative easing and years of accommodative central bank policies, the rise in emerging markets and high yield, and to a limited extent U.S. equity markets, is simply fueled by a search for yield.
Immediately following the financial crisis, investors were content with low yields while patiently waiting for markets to stabilize. That patience ran out quite some time ago. After seven years of a zero interest rate policy, the Fed only managed to raise rates 25 basis points last December. What’s holding the Fed back? Lack of inflation is one influential element.
The Phillips curve suggests that as an economy reaches full employment, inflation should emerge as a corollary of wage growth. Instead, despite the fact that unemployment has fallen steadily in most advanced economies over the past three years, significant slack remains in labor markets. If you were to ask investment professionals, economists and the Fed if inflation currently exists, they could all point to statistics confirming that inflation has been significantly below the Fed’s 2 percent medium range target and essentially non-existent. The Fed’s preferred inflation gauge, which excludes food and energy costs, has hovered between 1.31 percent and 1.7 percent in the last three years, most recently settling at 1.57 percent. As long as inflation remains below the target, the Fed is more comfortable focusing on other economic forces, delaying an interest rate hike even further.
With a 50 percent probability, the likelihood of a Fed rate hike this year is still up in the air. Even if it did occur, a 25 basis point hike barely moves the needle. Consequently, conservative fixed income investors are faced with some genuinely unattractive investment options, including low or even negative yielding government bonds. These negative yielding fixed income instruments have surged tenfold to $10.84 trillion from a mere $1.66 trillion at the start of the year. With that kind of proliferation of negative yielding assets and the fact that time and patience are two very uncommon attributes, it is not surprising to see a shift in capital flows. The relentless search for yield has propelled both high yield bond ETFs and emerging market funds higher, with the latter experiencing nearly $19 billion in inflows year to date. Emerging markets are further showcasing their best performance in years contributing to their irresistibility even more. The JPMorgan EMBI Global Core index is an excellent case in point, rallying 15 percent year to date, the most since 2009.
The equity bull market we experienced in the last seven years previously enticed investors to adjust their risk profiles in favor of greater equity allocations. However, for those institutional investors with a high fixed income allocation and a restrictive mandate, a marginally greater allocation to equities may not have been enough to attain their investment objectives. Naturally, investors are willing to adjust their appetite for risk by climbing up the proverbial risk curve.
Despite the current state of the market, we know that all good things do eventually come to an end. By now, we also know that the unexpected sometimes lasts a lot longer than expected – zero interest policy is an excellent example. In 2008/09 few market participants would have anticipated a federal funds rate below 1 percent five years later, let alone in 2016. Yet, here we are today with a Fed funds rate at 50bps and a 61 percent cumulative five-year return in what could be considered the lowest risk and lowest expected return instruments – U.S. Treasuries 10 years and up. So, while emerging market and high yield funds are the stars of 2016 year to date, when this trend reverses, the fallout could be quite painful. At this stage in the cycle “caution over courage” is the prudent, pre-eminent philosophy, with limited doses to these asset classes versus jumping in with both feet.
Sources: U.S. Department of Labor – Bureau of Labor Statistics, Bloomberg L.P.
Disclaimer: The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information.