Credit market stability is essential for cyclical improvement
Risk sentiment has continued to recover in recent weeks after more soothing words from the Federal Reserve and on increasing expectations for cyclical improvement across the globe. Amidst a declining volatility backdrop and elevated equity flows, U.S. equities in particular have continued to grind higher; with the S&P 500 making a new high at 1695 (+19% YTD). Sectors such as financials, industrials and energy have continued to outperform. In spite of softer Q2 corporate revenue announcements, economic bellwethers such as General Electric, Emerson Electric, and United Technologies signaled an improvement in global industrial orders. In addition, U.S. regional manufacturing surveys and European/Emerging Market economic surprise indices have indicated sequential improvement. Lastly, the recent G20 meeting in Moscow signaled a renewed focus on growth and labor recovery initiatives.
From our perspective, credit market stability will play an important role in fueling the next leg up in the global economic cycle. For example, China has to execute on its financial reform efforts in order to prevent excess credit growth. In Europe, a back-up from fiscal austerity efforts has to be replaced with credible growth initiatives. In addition, incremental efforts are needed by the ECB and other national central banks in order to unclog the Eurozone’s credit channel. Perhaps more critically, the Federal Reserve faces the challenge of maintaining a balance between real economic growth and financial stability. Evidenced by the June spike in interest rate volatility, the Federal Reserve plays a key role in channeling global monetary liquidity and capital flows e.g. in emerging markets. Domestically, the Federal Reserve also plays a key role in supporting the housing recovery and in promoting consumer confidence i.e. via an improvement in household wealth perceptions.
As discussed in past articles, the Federal Reserve’s quantitative easing policy is not a panacea; especially if the banking system is not converting excess reserves into lending. Yet, the Fed certainly plays a key role in preventing deflationary pressures by promoting risk taking in key sections of the economy e.g. the housing market. Despite the recent rise in mortgage rates (4.3% for 30 Year Fixed), we still expect a slow and steady housing recovery, especially as housing activity is still subdued from a multi-decade perspective. In terms of our investment strategy, we remain focused on low duration non-agency MBS. We continue to shy away from longer duration assets such as high grade corporate debt and closed-end bond funds. In light of a potential September tapering of asset purchases by the Federal Reserve, we prefer to avoid interest sensitive asset classes.
On the global front, we are encouraged by some improvement in cyclical indicators in Europe and Emerging Markets. We highlight below the relative tightening of the ECB’s balance sheet vs. the Federal Reserve’s. Further easing by the ECB could be a potential cyclical catalyst for Europe in the coming quarters. A sustained cyclical recovery would be beneficial to our equity exposures in industrials, energy and technology sectors. The energy sector continues to enjoy fundamental strength on the back of somewhat tighter global supply conditions. In industrials, we maintain our preference to late-cycle end markets such as commercial aerospace and energy/power equipment. From a portfolio perspective, we continue to balance our cyclical exposures with more secular earnings growth themes i.e. via the healthcare and technology sectors.
In conclusion, we continue to be open-minded and realistic with regard to the evolution of the global business cycle. We recognize that credit market stability will be a key ingredient for the next leg up in the global business cycle. Policy execution will continue to play a critical role in promoting financial market stability. From a portfolio structure perspective, we continue to favor low duration non-agency MBS and cash rich large-cap equities that have a history of dividend growth.
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (article), will be profitable, equal any corresponding indicated historical performance level(s, or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter (article) serves as the receipt of, or as a substitute for, personalized investment advice from Edge Wealth Management, LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request.