Global stock markets hit a severe air pocket during the last couple of trading days of June as the ongoing Greek crisis took an unexpected turn, leaving indexes showing little progress over the first half the year. Fixed income markets ended slightly lower over the same period after experiencing a persistent headwind of rising interest rates. Though it appears there has been little to celebrate so far in 2015, several important developments have occurred which may create more opportunity in the months ahead. We are focused on three trends, in particular.
First, the US economy is continuing its momentum of recent years after a rebound in growth during the second quarter, driven by auto sales and increased housing demand. With the unemployment rate at 5.3% and signs that wages are beginning to grow, it is becoming increasingly difficult for the Fed to justify keeping short-term interest rates at zero percent.
The decline in energy prices and rise in the dollar over the past twelve months have restrained inflation expectations, providing a longer runway for the Fed to normalize monetary policy. Therefore, outside of an unforeseen shock, there is an increased likelihood economic expansion in the US will continue for a while, even though it may not be as consistent or as strong as in previous cycles.
Second, select international exposure appears to be in the early stages of a bull market. Therefore, our quantitative models and investment judgment have made us reluctant to agree with the consensus view that European stocks offer a compelling opportunity. This isn’t the case with Japan, however, where we are more constructive. There is a commitment to enact genuine structural change with a greater focus on shareholder value in Japan. In short, we think currency-hedged Japanese stocks continue to offer not only value, but also the catalyst for faster earnings growth.
Third, there are clear signs of stress surfacing in certain global credit markets which need to be avoided, notably Greece, China, Puerto Rico, and in high yield bonds and energy-related debt securities (as the oil price appears to be retesting the lows it set earlier this year). Since we are not at all surprised by the deteriorating circumstances, we have negligible direct exposure to these areas. We have written extensively about the Greek drama and why it has led us to be more skeptical about the sustainability of the European stock rally we’ve seen this year. We eliminated our exposure to Emerging Markets in the first quarter due to concerns about China and our unwillingness to be hasty in calling the bottom of oil and other commodity prices.
To put everything in perspective, it is helpful to remember Greece has the same GDP as Connecticut (which is twice that of Puerto Rico), and China represents roughly 2% of the global stock market index (as measured by the MSCI All Country World index), despite an economic contribution to global GDP of nearly 15%.
As a result of the Greek crisis, we are watching several indicators which may warn that contagion from these stresses could be spreading to other areas, namely:
- European bank credit default spreads;
- Government bond yields of peripheral European nations; and
- US high yield spreads.
The unfolding drama in Greece may turn out to be especially momentous for the long-run viability of the European Union.
In summary, continued US expansion and normalizing US monetary policy; greater (but select) international exposure; and the avoidance of specific credit market stresses are three key trends we will watch as we position strategies in the months ahead.
 The US dollar has rallied over 5% against a broad basket of currencies this year.