Last year was undoubtedly a stellar one for equity markets. The S&P 500 shot up close to 32 percent, S&P Euro 350 was up close to 26 percent, and the MSCI World rewarded investors with close to a 27 percent return.
Bond markets, on the other hand, fared badly. Witnessing their first pullback since 2009, bond markets left many onlookers to profess the end of the bull market rally in this relatively stable asset class.
The massive run-up in risk assets during the second half of last year and the positive economic projections that followed had many analysts forecasting another great year for risk assets. To much surprise, year-to-date returns on most global equity indices are currently flat, while bond markets are massively outperforming. What is causing this lackluster performance in risk assets and the bond markets to recoup more than half their 2013 losses? Has the world changed that much in the last six months, or are there other structural forces at play?
Some have pointed to the sluggishness in emerging markets and weak world trade data for China, the eurozone and Japan given their contribution to world GDP. The near crumbling of the Ukraine government and possible economic upheaval could strain relations between the world economic powers. Still, others have pointed to the inherent fundamental and technical factors known to drive risk assets over time.
Economic data suggests world trade volumes are on trend to expand at a similar pace to the last three years, certainly not unique to 2014. The geopolitical developments in Ukraine could admittedly cause some disruption; however with Ukraine’s contribution to World GDP at 0.2 percent, the impact would most heavily be felt among their closest trading partners versus a worldwide phenomenon.
Despite the stagnation in world GDP growth for the first quarter, most of the economic data remains elevated above 2013 levels. This weakens the argument that fundamental factors are the primary drivers of recent distortion in risk assets. Even with the fall off in industrial production in the U.S. during April, small business optimism hit a six-year high. The Institute for Supply Management’s reports on both manufacturing and services further reflect solid growth in the world’s largest economy.
Consumption factors also remain quite positive, with large-scale improvements on the job front giving a much-needed boost to disposable income. The wealth effect from housing and the rise in equity prices last year lends itself to an improving balance sheet within households and an increased capacity to borrow. With the leap in housing starts in April, improvement in bank loans to businesses and rise in investment intentions should bode for capacity utilization. The U.S. national accounts are undoubtedly benefiting from all the economic activity. With an improving fiscal position, a rebound in second quarter GDP to an annualized rate of 3 percent is certainly in the cards.
Yet, despite the positive outlook evidenced in the economic data, investors are well aware that low volatility and aggressive central bank policies remain the key drivers of financial markets. The Federal Reserve’s commitment to its zero interest rate policy even beyond quantitative easing, coupled with the muted level of inflation, have kept downward pressure on bond yields. The uneven recovery in Europe has contributed little to aid the global economy. Now, at this stage in the game, the European Central Bank is considering lowering its main refinancing rate in an effort to spur economic activity. A further cut in rates or the possibility of negative rates could signal a weaker pace of recovery for this highly important market.
There is much anecdotal evidence to suggest not much has changed in the U.S. economic landscape since last year. Besides, where there are changes, the world’s largest economy appears to be on much firmer footing. The lackluster performance in risk asset prices appears to be driven by esoteric factors. Following the significant move in risk asset prices in 2013, it is not uncommon for investors to engage in profit taking or rebalance the assets within their portfolios. Is it possible then, that what started as a peripheral by-product of rising markets has caused a “herd” mentality with everyone rushing to the exit? Since prices are determined by investors, who at times view the world from a short-term perspective, any temporary distortion in the risk/reward trade-off should certainly come as no surprise.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information. Statistics and Data Source: Bloomberg LP., U.S. Bureau of Labor Statistics.