The Federal Reserve increased the Fed Funds rate as expected in September to a range of between 2% and 2.25%. Bond markets are assigning a 72% probability that the Fed will increase rates at its December meeting with two further rate increases for 2019.
Risk-on was the flavor of the month as equities, emerging market bonds and commodities all outperformed. The S&P 500 gained 0.4% while the Nikkei powered ahead 5.5%, lifted by improving corporate profits, a healthier economy and a weaker Yen. US and Japanese stocks lead all major markets through 2018. The German DAX declined as concerns over the political rhetoric out of Italy with regards to the country’s recent budget weighed heavily on European markets. Italy’s populist government set a 2019 budget-deficit target of 2.4% that was much higher than the market was expecting, to be gradually reduced to 2.1% in 2020 and 1.8% in 2021.
US Treasuries declined as global macro threats de-escalated, with yields rising to 3.16%, the highest levels since July 2011. The US set Chinese trade tariffs at 10%, potentially rising to 25% next year but leaving room for negotiation; while a new NAFTA agreement, now known as the USMCA (standing for the US-Mexico-Canada Agreement and nothing to do with the US Marine Corp), was signed at the final hour. The JP Morgan Global Aggregate index fell -0.8% while emerging markets rebounded strongly. EM hard currency bonds gained 2.8% while local currency bonds rose 2.1%. High yield continued its gains for the year, up 2.5% YTD, and is the only fixed income sector in the black for 2018.
Not much has changed in our allocation recommendations over the past quarter. At the beginning of Q2 we moved Cash to Overweight at the further expense of fixed income. We believed then, as we do now, that the 40-year bond bull market had officially ended and that rather than provide a safe-haven, fixed income would be a driver of portfolio losses. The end of bond purchases by the Fed and ECB may produce further losses as liquidity dries up at the same time inflation finally rears its head. This slowing of liquidity (and resulting shortage of Dollars) is possibly a reason behind the rout we have seen in emerging market securities.
We maintain a neutral weighting in Equities. US stocks maintain their risk-on sentiment supported by generally solid corporate earnings and limited spillover from EM volatility. We have removed our tilt towards emerging market stocks in the face of such negative momentum, recognizing that although valuations are at a relative extreme, they may overshoot even further before reverting to the mean.
As we wrote over the summer, with its shorter duration and higher coupon, US high yield bonds are poised to outperform other fixed income sectors in this rising rate environment as long as defaults remain low. We maintain our long-held underweight recommendation in long-dated fixed income which continues to suffer as both real interest rate and inflation expectations move higher. We view cash and cash equivalents as an attractive alternative to longer-dated government and corporate bonds.
Within Alternatives, we recommend overweight positions in Managed Futures/CTAs and Market Neutral strategies as a form of portfolio insurance. Private Credit also remains an asset class of interest. In June we downgraded Gold to underweight until its technical picture improves.
US industry ETF inflows totaled $87bn in Q3 according to Blackrock’s iShares, bringing year-to-date new assets to $347bn. Equity inflows outpaced bonds by nearly 3x, gathering $60bn or over 70% of Q3 flows. This was in contrast to Q2 where US equity and fixed income products each saw roughly similar net inflow activity.
Within US equities, Tech remains the leader in sector flows YTD, with $6.8bn of net inflows but Healthcare was the star sector gathering $6.7bn of inflows in Q3. Spurred in part by the White House’s benign Drug Pricing “Blueprint” in May, the healthcare sector has started to gain momentum relative to the broader U.S. equity market.
Fixed income inflows were led by US credit and US Treasury exposures, which took in $9.0bn and $6.7bn respectively. investment grade ETFs saw the lion's share of fixed income creation activity in Q3, despite continued outperformance by High Yield.
Emerging market equity ETFs resumed net inflows in Q3 as the U.S. dollar rally stabilized in July. China has been the clear leader for the year with $3.8bn of net inflows.