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Aon Retirement and Investment Blog

Second Quarter 2015 Market Review and Outlook

Equity returns vary widely by region, with Japan as a winner and the Eurozone a loser
Most regions suffered losses in local currency terms over the quarter as rising bond yields and worries over Greece's sovereign debt crisis unnerved equity markets. The MSCI World Index returned -0.5% in local currency terms but US dollar weakness over the quarter brought this return up to +0.5% for unhedged US investors. In US dollar terms, Japan and the UK were the strongest performers (3.1% and 3.0% respectively), whilst emerging markets provided a modest positive return as well (0.8%).
US economic data showed signs of improvement from Q1
After receding slightly in Q1 due to bad winter weather, economic activity showed signs of picking up in Q2. The closely watched manufacturing sector ISM index rebounded from March's reading of 51.5, the weakest level seen since May 2013. Meanwhile, labour markets continued to be strong. Non-farm payrolls showed an addition of over 200,000 jobs to the US economy in both April and May, and the unemployment rate fell to 5.4%, a post-crisis low, in April. The lower oil price and stronger dollar over the previous year continued to weigh on CPI inflation, which remained below zero up to the most recent reading in May. On a more promising note, core CPI (ex. food and energy) held fairly firm above 1.5%, indicating that the lack of inflationary pressures may simply be down to transitory factors. Positive momentum in the housing market continued, with the NAHB housing market index hitting a post-crisis high of 59 in June. Sales of existing and new homes rose by 9% and 19% respectively over the twelve months to May. These economic data lend credence to the view that Q1's growth stumble was mostly down to bad weather, and that growth should rebound in the remaining parts of the year. However, we still think that the US will grow at a rate below long-term trends over the medium term.
Strong dollar and zero inflation keep the Federal Reserve cautious on hiking rates
Even as economic data picked up in the US, the Federal Reserve (Fed) remained cautious, still citing dollar strength as a drag on import prices and, therefore, on inflation. Despite continuing strong gains to the US jobs market and low unemployment, tepid wage growth remained an important part of the Fed's argument that there is still slack in labour markets. The revised Fed's "dot plot" reinforced this view, with a small decrease in interest rate rise expectations since the prior release. Futures pricing shows that investors pushed back expectations of the date of the first interest rate rise by roughly 3 months during the quarter. However, futures markets have been prone to taking a dovish stance. Indeed, the median "dot plot" is over 1% point higher than futures pricing for the Federal Funds Rate for the end of 2017. Our view on Fed rate hikes is broadly in line with market expectations in the next year or so, but we sit within the slightly more hawkish camp for interest rates further down the line.
A Greek tragedy?
After embarking on widely anticipated quantitative easing in Q1, economic data was mixed during the ensuing months. Manufacturing PMIs generally picked up over the quarter, hinting at a revival in economic activity. On the other hand, both the German IFO index and France's INSEE survey fell in June. Despite the lack of any strong economic momentum, the euro appreciated against the US dollar on the back of a falling bond yield differential between US and European bonds. The bear market in bonds came even after the ECB announced that it would accelerate some of its sovereign bond purchases in order to avoid the summer liquidity drought. Throughout the quarter, events in Greece grew gradually more pressing as intense negotiations between Greece and their creditors failed to gain any significant positive ground. Eventually, on the last day of the quarter, Greece officially missed one of its payments to the IMF, and the road ahead remains very uncertain.
Japanese equities outperform despite only modest economic data
After Japan's economy was left reeling in 2014 from the first of two planned sales tax hikes, Japanese economic data generally beat expectations in Q2 2015, although these expectations were fairly pessimistic given 2014's weak run of economic data. Japan's massive quantitative easing program (which pumps ¥80tn per year into the Japanese economy) has yet to make a meaningful positive impact on the economy, whilst the other two of Prime Minister Abe's "three arrows", robust fiscal policy and structural reform, are also struggling to push the economy in the right direction. After being broadly stable in Q1, the yen depreciated against the US dollar in May. Renewed yen weakness and positive economic surprises allowed Japanese equities to firmly outperform other regions in local currency terms, but returns were more in line with the rest of the pack on a common currency basis. However, even after their stellar performance over the last twelve months (in local currency terms), Japanese equities still look undervalued relative to other developed markets. This, combined with domestic equity buying, improvements in corporate governance, and positive earnings expectations, means that we still have a positive view on Japanese equities relative to other developed markets.
Style and size returns showed little variation
Returns were very similar for US small cap and large cap stocks as stronger domestic growth favoured small caps, but US dollar weakness over the quarter played into the hands of larger stocks. Our negative view on small cap relative to large cap has moderated, but given its higher beta, we are reluctant to take a positive stance relative to large cap, which should fare better in a high volatility environment. After growth stocks raced ahead of value in the US in Q1, the two markets effectively moved in lockstep through Q2. According to the Russell 1000 sub-indices, both value and growth stocks returned 0.1%.
Emerging market returns stabilize
The MSCI Emerging Markets Index beat most developed markets in local currency terms, but underperformed both the UK and Japan in common currency terms. Global pessimism over the Greek debt crisis played its part, but a firmly dovish monetary policy stance from the bulk of emerging economies helped offset the outlook for rising interest rates in developed economies. Chinese stocks got off to a flying start to the quarter on bets on further monetary easing - the MSCI China Index returned 16.6% in local currency terms during April before a flurry of poor economic data releases eroded most of the market's rise. Emerging European stocks also performed well initially, buoyed by a rally in oversold Russian stocks. Looking ahead, we still think that emerging markets' economic recovery will be slow and that EM currencies will remain vulnerable, but the medium-term outlook is brighter.
Rising Treasury yields made a tough environment for bond investors
Global bond yields rose over the second quarter, bringing 10-year US Treasury yields a full 80 bps up from their 2015 lows and back to mid-2014 levels, causing the Barclays US Treasury 20+ year total return index to fall by 9.1%. The reason for this large move is not clear cut, but can in part be explained as a rebound from the large yield declines of 2014 and the swift rise in European bond yields. The Barclays Global Aggregate Index returned -1.2%. Meanwhile, in the corporate sector, high yield outperformed credit on a global basis, returning 0.9%, versus -1.6% for investment grade credit.
Bunds bear the brunt of the bond bear market
Government bond yields in Germany, France, Spain and Italy all rose by approximately 1% point, at the same time that the ECB had just began purchasing Eurozone sovereign bonds to the tune of €60bn's worth per month! There are likely technical factors behind the move (such as traders unwinding carry trades), but with central banks following divergent monetary policy across the globe, heightened bond volatility may well be here to stay. The Barclays Euro Agg total return index fell by 4.3% in euro terms, equivalent to a 0.8% fall in USD terms. The sovereign debt sub-index returned -5.4% (-1.9% in US dollar terms), underperforming the corporate sector, which returned -2.9% (0.7% in US dollar terms).
* All return figures are in US dollar terms unless otherwise stated.

Sources:               DataStream and publicly available through MSCI
                             US Federal Reserve

Note: All returns are gross

 Josh Cooper is an asset allocation specialist in Aon Hewitt’s Global Asset Allocation Team in London.  

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs.Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case, nor should it be treated as investment advice. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.

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