SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy. The main article for this April edition, "The Emerging Market Mindset," highlights how with the Fed taper and the U.S. economy slowly recovering, the emerging markets economies have suffered. Other geo-political events have caused great stress and uncertainty to the emerging markets economies and their investors. However, emerging markets are still expected to grow in the long-term.
The Emerging Market Mindset
Judy Lee, Portfolio Advisor
During times of economic uncertainty, the typical investor develops a flight to quality mentality shying away from what may be perceived as ‘riskier investments.’ With the recent slowdown of Fed asset purchases resulting in improving labor conditions and moderate domestic economic growth, global investor reactions have been a mixed bag. As the U.S. economy continues to improve, treasury investors aim for higher yields while emerging market investors weigh the relative value of their investments. By way of the predominate flight to quality choice, performance of treasury securities should continue to benefit from further uncertainty in the emerging markets, particularly on the short-end. Treasury yields out to two years have been relatively stable with a slight upward trend since the beginning of Fed taper, indicating a firm investor appetite for treasuries. Should negative global events continue to garner headlines, we anticipate a continuation of “risk-off” trades, thus benefiting fixed income investors.
Emerging markets experienced a strong and steady track record in the first half of the decade largely fueled by massive monetary easing programs of central banks. Investor money penetrated the global markets throughout the great financial crisis in hopes of better returns as global fixed income yields raced to the bottom. Fast-forward to 2014 and we have, what used to be a global ‘shining star,’ an asset class that has failed to perform in line with expectations for the past five years.
Since the Fed announced the cut back in monthly stimulus in December 2013, we have seen a heavy sell-off in emerging markets as investors pull back from the sector. Fed tapering is expected to wrap-up before the end of the year, which means ‘easy money’ will soon dissipate from the markets, raising concerns of a downturn in global economic growth and further currency depreciation.
In an attempt to remedy currency depreciation, emerging markets such as Turkey, Brazil, and South Africa have now taken steps to tighten their monetary policy. However, fiscal and structural changes must also be taken into consideration to successfully sustain and fuel the growth of an economy. Concerns surrounding the economic slow-down in both China and India, coupled with rising tension between Russia and Ukraine have also caused much angst in global markets.
As the conflict between Russia and Ukraine continues, along with the sanctions imposed by the U.S. and EU, the future of the situation is unclear even with Putin confirming that he will not be stepping into additional Ukrainian territory following the annexation of Crimea. Although Russia is currently in a weak economic state, the uncertainty of Russia’s next moves has caused the markets to be on edge but we believe the outcome should not have a huge detrimental impact to the markets.
Garnering attention as the world’s largest emerging market, China may perceive a slow-down in growth as unsettling, yet it may actually be a step in the right direction. The slow-down can be attributed to many factors, such as weak export numbers and low demand for raw materials. However, there are other related factors that may facilitate the long-term growth of China’s economy and help it transform into a self-sustaining economy. One factor is the shift of mentality from being an export-driven economy to being a consumer-driven economy. With a forecast of less than double-digit growth, China is attempting to structurally change their economy to position themselves for the future and become drivers of their own growth. Actions have also been taken to limit the large role that the Chinese government plays in the economy. The recent corporate bond default in China has undoubtedly added some nervousness to the markets as the usual solution, in such cases, would be to receive a bailout from the Chinese government. By allowing the bond to default, this may have actually been a small but necessary step to change the economic landscape. In order to build a sustainable economy, the focus should be heavily weighted on fundamentals rather than dependent on temporary solutions.
Despite negative news in the global arena, emerging markets are expected to re-build their foundation and grow in the long-term. In the meantime, investors should expect to continue to see growing demand for ‘risk-free’ investments as the flight to quality mentality takes center stage once again. Overall, with inflation nowhere in sight, rates are expected to remain relatively low, despite any near term pickup in the U.S. As the Fed continues to taper and the domestic economy continues on its slow and steady path to recovery, there are present opportunities to add value to investor portfolios on the short-end of the yield curve.
Credit Vista: Continued Stress Tests
Sook Kuan Loh, CFA, Sr. Credit Risk & Research Officer
As expected, all but one U.S. bank1 participating in the Dodd-Frank Act stress tests, passed the tests. Generally, benign economic conditions leading to lower absolute stresses and stronger balance sheets are likely among the reasons for the excellent results from the banks. Though the absolute stresses were lower, the stress tests were still robust as it included stressed scenarios beyond the recent financial crisis. This year’s round of stress tests added 12 more banks from prior year’s including bank holding companies with total assets greater than $50 billion and foreign banks, with a total of 30 bank holding companies participating in the 2014 exercise.
Some large U.S. banks have let on that their financial performance for first quarter of 2014 may be lackluster compared to prior year’s performance. The banks’ performances are likely impacted by the largely muted market events in the earlier part of the year, but this should be balanced by the heightened market activity subsequent to Yellen’s first FOMC meeting as a Chairperson on March 18 to 19.
European banks are currently undergoing similar reviews and stress tests with 128 euro area banks undergoing an Asset Quality Review and 124 banks in the European Union undergoing stress tests later this year. Results are expected to be released by October. Although it is uncertain what the outcome of the review and stress tests will be, these exercises conducted by the regulators should strengthen the banking systems in both the euro area and United States. We believe that the banks on SAM’s Approved Issuers List will fare relatively well in the reviews as the banks have taken the right steps to improve asset quality and strengthen their balance sheets.
Economic Vista: Improving Steadily
Jose Sevilla, Portfolio Manager
The February employment report was better than expected, coming in at +175,000 (149k expected). The previous two months were revised higher. The unemployment rate rose to 6.7 percent but for good reasons – a 0.2 percent increase in the labor force.
As expected, the Fed made no change to the Federal Funds target rate of 0 to 0.25 percent. The Fed also continued to taper by announcing another $10 billion reduction in monthly bond purchases to $55 billion from the original amount of $85 billion. Unless there are significant changes to the economic data, officials will likely continue tapering its bond purchasing program in measured steps, however reiterated that it is in no preset course. The one major change was the Committee overhauled its forward guidance and dropped the 6.5 percent unemployment rate as a threshold for raising interest rates. The Committee will now look to a wide range of more qualitative data to determine interest rate changes.
The housing market is still far from normal as imbalances remain between housing supply and buyer demand. However, the sector has seen some positive news of late as the pipeline of foreclosures have shrunk, new delinquencies have declined, and home prices have surged.
Wholesale inventories increased 0.6 percent in January, higher than expectations, but there was an unexpected 1.9 percent monthly decline in wholesale trade sales, the largest since March 2009. The weather contributed to the build-up in auto inventory, as auto inventories rose 2.2 percent, while auto sales rose only 0.1 percent. As we move into spring, the delayed buyers should come back and help boost sales to make up for the recent slowdown.
Retail sales rose 0.3 percent in February, but were revised lower the previous two months. Core retail sales, which excludes motor vehicles, building materials and gasoline, is a direct input into GDP. Core February sales showed 0.3 percent increase, while January was revised down and December remained unchanged.
Trading Vista: Money Markets Still Anchored
Hiroshi Ikemoto, Money Market Trader
In Janet Yellen’s first meeting as Chairman of the Federal Reserve Open Market Committee, the Fed announced another $10 billion reduction in monthly bonds purchased to $55 billion from the original amount of $85 billion and left the federal funds target rate unchanged at 0 to 0.25 percent. The bond market sold off as investors focused on the increased median fed funds interest rate, which went from 0.75 percent to one percent by the end of 2015. The benchmark two-year Treasury note increased 10 basis points to 0.42 month-over-month, while the one-year Euro Dollar Synthetic Forward Curve, (EDSF) increased four basis points month-over-month. Credit spreads for both industrial and financial issues remained unchanged with Agencies still trading right on top of similar maturing Treasury notes. The longer end of the curve seems to be holding steady with the ten-year note ranging from 2.65 percent to 2.75 percent for March and the 30-year actually tightening a bit with yields hovering in the 3.55 percent range.
Year-to-date, corporate issuance is up seven percent versus 2013 with $286.5 billion being issued, mainly in the five to ten-year range. However, the lack of secondary supply again is the main factor in prices in the short-end, with many institutions staying within two-year maturities and bidding up on any paper with any type of yield. With the Fed announcing changing the forward guidance to more qualitative factors, we should see the longer maturities becoming slightly more volatile while the very short end will still be anchored by the near zero Fed funds rate.
1. Zions Bancorporation failed the stress test as its Tier-1 common ratio was projected to fall below 5 percent under the severely adverse scenario prescribed by the Federal Reserve. Zion subsequently resubmitted its capital plans to include additional actions that will reduce risks and/or increase its capital to cause Zions’ capital ratios to meet or exceed minimum capital ratio required.
SVB Asset Management, a registered investment advisor, is a non-bank affiliate of Silicon Valley Bank and member of SVB Financial Group. Products offered by SVB Asset Management are not FDIC insured, are not deposits or other obligations of Silicon Valley Bank, and may lose value. This material, including without limitation to the statistical information herein, is provided for informational purposes only. The material is based in part on information from third-party sources that we believe to be reliable, but which have not been independently verified by us and for this reason we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction.