This July was a more turbulent time for investors than broad asset class performance numbers may suggest. Although global equities as a whole ended the month roughly flat, and major government bond yields moved only moderately lower, both asset classes saw significant intramonth swings. Emerging-markets equities began to underperform in earnest, and most commodities prices took another large leg down.
The U.S. dollar showed some renewed signs of strength, and major yield curves began to flatten again. Developments were broadly consistent with our views of core investment drivers this year: a strengthening in developed-markets economies, led by the U.S., counterbalanced by a still difficult economic picture for emerging markets; and the start of a monetary tightening cycle in the U.S. in the second half of the year, with ongoing monetary easing across most of the rest of the world.
Events during the month did little to clarify the exact timing of the first U.S. rate hike in more than nine years. Amid mixed progress for the U.S. economy, the Federal Reserve’s July policy statement nodded toward further improvement in the labor and housing markets, while keeping the characterization of growth of household spending as “moderate.” But there were no changes to the Fed’s policy stance, and it remained hedged on the timing of impending rate hikes.
In our view at J.P. Morgan Asset Management, the chance of a rate hike in September remains at roughly 60 percent. A lower-than-expected employment cost index reading and GDP growth numbers released late in the month did little to resolve the interest rate call. A significant upward revision to first quarter growth was counterbalanced by slightly disappointing headline growth data for the second quarter. On the other hand, price gains were stronger than expected. The July employment report also came in close to expectations and did not significantly shift the odds of a September rate hike. In any case, the Fed has recently been strongly signalling that rates will rise in 2015, gradually quashing the chances of a 2016 initial hike. This should support the curve flattening bias in our portfolios as that process unfolds.
As for Greece, the country’s long-running crisis came to a head in early July, with the country only narrowly avoiding exit from the euro zone. The deal eventually struck was stricter than what had gone before, making the passage of numerous economic reforms a precondition for even the start of negotiations on a third bailout package. The problem seems to have been kicked down the road yet again — as ever, the question is, For how long? Although the relatively harsh deal may actually bode well for the attitude of Greece’s creditors going forward, it leaves Greek domestic politics under considerable strain. Early elections could quickly bring the issue back into market focus. This latest crisis round seems to have had limited economic impact outside of Greece. With the European Central Bank standing ready to intervene, peripheral bond yields have remained contained and bank deposits rock solid. Early indications suggest some damage to European consumer confidence but with business confidence unaffected. Thus our positive outlook for the European economy and risk assets over the medium term remains intact. In the near term we take a slightly more cautious view of European equities until we are convinced the deal in Greece will prove durable.
The slump in Chinese equities that started in June continued to occupy headline space in July, but the market stabilized and the declines partly reversed early in the month on the back of increasingly aggressive intervention by the authorities. Volatility and weakness returned toward the end of the month, and it remains to be seen whether further intervention will be required. The knock-on effect on the Chinese economy is unclear. A relatively limited share of household wealth is invested in the stock market. Consumer confidence seems unscathed, but the latest Chinese purchasing managers’ index readings suggest renewed weakness following the stabilization in hard economic activity data during the second quarter.
When we look more broadly across emerging markets, equity weakness was widespread in July. This reflected the ongoing litany of weak economic data, particularly from emerging Asia and Brazil, as well as the impact of the approaching liftoff in U.S. interest rates. The latter was also visible in renewed weakness of emerging-markets currencies against the U.S. dollar and the continuing downdraft in emerging-markets growth-driven commodities. These developments further reinforce our negative stance on emerging-markets equities in our portfolios.
In our Multi-Asset Solutions portfolios we maintain a pro-risk stance, but we have tactically lightened our overweight position in equities in view of rising volatility as the U.S. interest rate liftoff approaches and as significant risks play out in Greece and China. Accordingly, we have reduced overall risk to below-normal levels.
We maintain our long-standing conviction to be underweight emerging-markets equities in favor of overweight positions across equities in developed economies. Our medium-term view on global duration remains broadly constructive, as we see little risk of a rapid sell-off in duration in the coming months.
As we near the turn in U.S. interest rates, we have tactically neutralized this position. Our expectation for renewed flattening of yield curves — in the U.S. in particular — remains in place, and with bond markets now once again moving in that direction, we remain underweight the front end of the U.S. curve, albeit in somewhat reduced size to account for the risk that the Fed might postpone its rate hike to later in the year. We continue to hold a positive medium-term view on credit, but our portfolios are neutrally positioned in high-yield at the moment, given ongoing worries about liquidity and the fallout from low oil prices. In currencies, our views are largely unchanged: We are positive on the U.S. dollar, although we expect that the focus of its strength is likely to keep shifting toward emerging-markets currencies. We maintain a negative stance on commodities, driven by subdued demand from emerging economies and robust commodity supply growth.
Patrik Schöwitz is a strategist in the global multiasset group at J.P. Morgan Asset Management in London.
