Investors Play Wait-and-See with the Economy, Fed
The U.S. equity markets continue to trade in a relatively narrow range, remaining near all-time highs. Investors have been seeking clearer signs of economic acceleration following somewhat disappointing recent data—including higher-than-expected jobless claims, lower-than-expected factory orders and weaker-than-expected GDP growth in the second quarter. Investors were encouraged late last week by the news that the U.S. generated 255,000 new jobs in July—a much better number than was expected.
Due to recent conflicting signs about the health of the economy, investors are now essentially split about whether the Federal Reserve Board will raise short-term interest rates this year. (In fact, the probability of a Fed rate hike in 2016 currently stands at almost exactly 50%.)
Overseas, the Bank of England unleashed a broad package of economic stimulus measures last week in a pre-emptive move to offset negative effects of the Brexit vote on the UK economy. Part of that stimulus includes the BOE’s first interest rate cut in seven years.
Meanwhile, oil prices fell to a three-month low last week before rebounding. Commodity investors expressed concerns about the outlook for the global economy and about the continuing oil supply glut that has kept current U.S. oil inventories near their highest seasonal levels on record.
GAIN: Active Asset Allocation
In general, U.S. equities (and emerging markets) continue to show strength relative to developed international markets. As earnings season continues in the U.S., results within the technology and healthcare sectors have been better than expected. However, European markets continue to struggle against a backdrop of slow economic growth, concerns over the health of the banking sector and uncertainty about the potential impact of Brexit.
In the fixed-income markets, 10-year U.S. Treasury rates rose following the better than expected jobs data. Our portfolios remained overweight corporate bonds, which continue to offer an attractive balance between risk and return in the current low-rate environment.
After two soft weeks for oil prices, the commodity stabilized at around $40 per barrel on better than expected news about U.S. gasoline inventories. Oil prices may trade in a relatively narrow range for the next several quarters as supply levels quickly adjust to changes in prices and demand.
PROTECT: Risk Assist
Equity market volatility continues to be exceptionally low, with realized volatility for the S&P 500 at 4% (versus its historical average of around 14%). Essentially, the magnitude of advancing stocks is being matched by the magnitude of declining stocks, creating very small movements at the broad index level.
One way we can measure this is with a tool called implied correlation. It assesses the correlation implied by option prices on indices (like the S&P 500, the Nikkei 225 and the Euro Stoxx 50) versus option prices on the underlying stocks in those indices. Currently, the three-month implied correlation for the S&P 500 is at 43%, versus 65% for the Euro Stoxx 50. This suggests that investors expect European equities to trade much more in line with each other, while expecting U.S. stocks to exhibit a fair amount of divergence.
In light of continued low volatility, we have unhedged more Risk Assist models in recent weeks.
SPEND: Real Spend
Realized volatility in the equity markets has been lower than usual lately, while realized volatility in the fixed-income markets has remained roughly in line with its longer-term range. In this environment where stock and bond volatility levels are behaving similarly, some Real Spend models are exhibiting higher volatility relative to the overall equity market than they typically do.
As greater volatility eventually returns to the equity markets, however, we believe Real Spend portfolios should be well positioned to guard against that higher volatility due to overweight exposures to dividend paying stocks and preferred stocks. These two asset classes generally exhibit relatively low volatility during periods when overall equity market volatility is on the rise.