Global equity markets experienced volatile trading but moved higher overall during March. Key influences included the crisis in the Ukraine and Russia’s annexation of Crimea, concern over China’s economic and financial prospects, and the outlook for monetary policy in the US. Tensions between Russia and the West over the Ukraine rose ahead of a referendum in which Crimea voted to re-join Russia, but subsequently eased. Disappointing economic figures from China included an unexpectedly large fall in exports of 18% in February, dashing hopes that foreign trade will drive the slowing economy. The first Chinese domestic bond default, which took place in early March, also hurt investor sentiment. However, sentiment toward China recovered late in the month when Premier Li Keqiang said that Beijing was ready to boost the economy.
In fixed income markets, the yield on the 10-year treasury ended March at 2.72% compared to the 2.67% level seen at the end of February. However, yields experienced considerable volatility over the period, reflecting the crisis in the Ukraine, concerns over China’s economic outlook and jitters over US monetary policy. The latter followed remarks by Janet Yellen, the new head of the Federal Reserve, indicating that US interest rates would rise sooner than expected. However, markets subsequently regained their composure. On the other side of the Atlantic, Portugal’s 10-year yields slipped below the 4% mark for the first time in four years towards the end of March. Spanish and Italian bond yields also touched multi-year lows after investors interpreted remarks by a European Central Bank official as indicating that the bank would consider adopting quantitative easing to relieve the eurozone’s problems. Spanish 10-year bonds fell to 3.23% on the final day of trading in March, while the yield on comparable Italian bonds declined to 3.29%.
Meanwhile sentiment towards emerging markets in general has improved. The J.P. Morgan EMBI+ Index (on a total-return basis) delivered a positive return of 1.37% over the month and 3.45% over the quarter, while emerging market equities have also rebounded. The MSCI Emerging Markets Index (total return, local currency) gained nearly 2% in March, although it remains slightly down over the quarter. However, we are concerned about the outlook for China. In the past few years the country has seen an explosion in credit, facilitated by the shadow banking system as retail investors have been enticed into an array of savings products, where the underlying investments are often opaque, promising heady returns. It is clear that the authorities are now concerned about this situation and investors are surely going to see an increasing number of these funds being declared bankrupt. The growth in credit in China has been very rapid and it is difficult to find examples of such occurrences ending well. At best we are likely to see a material reduction in China’s growth rate, but the outcome could be far worse. Clearly the prolonged underperformance in Chinese equities has discounted some of these concerns, and valuations are low relative to other markets. However, the unwinding of the Chinese credit bubble could severely test China’s financial system, and unnerve investors more generally.
Consequently we have decided to halve our overweight to equities and move to a neutral position in cash. We will remain overweight in equities as valuations are largely reasonable, although less compelling than was once the case. We have also decided to increase our underweight to Asian equities on the concerns over China, and increase our overweight to Japan in the belief that the impact of the consumption tax will be less damaging than is feared. Although we remain overweight in equities, it would be fair to say we are less optimistic than we have been. Within fixed income, core yields are going to grind higher, and there is much less value in credit given how far spreads have tightened. Only emerging markets appear to offer any real value, but given the risks in terms of China, geopolitics and the macroeconomy, we are wary of increasing our weighting at present. The good news is that this environment is likely to continue to provide opportunities for stock pickers, which we should be able to exploit.
Monthly investment comment by Mark Burgess, CIO at Threadneedle
