October proved to be another solid month for equities globally. Most regions we invest in delivered positive returns led by Japan up 4.6%; the emerging markets up 3.5%; and the United States up 2.3%. Europe excluding the UK ended up as the laggard yet still gained 0.4%. Within the U.S. large caps outpaced small caps and cyclical sectors (e.g. consumer discretionary industrials and information technology) well outpaced defensive sectors (telecommunications and consumer staples). We are now past the historically weakest part of the year. During the month fixed Income did very little: most segments such as 10-year U.S. Treasurys, high yield and senior loans were flat.
Economic data fully supported the strength of equities during October. Purchasing managers across the globe remained in an upward trend. In the U.S., cyclical activity such as construction spending and durable goods were reported better than expected. Retail sales and the employment report were affected by the hurricanes. Inflation readings were at least turning from their relative downward trend. Core personal consumption expenditures were a little bit better but well below the Federal Reserve target.
In our view, policy will drive markets going forward. Monetary policy in the U.S., UK and Europe will be marginally tightened over the course of the next 12 months at varying paces. We don’t think this necessarily represents a challenging growth-policy trade-off phase yet, since the economic data are solid and corporate earnings are powering ahead. Central bank speeches and nuanced statements will serve as good guideposts.
Currency markets are on our mind as well. The U.S. dollar continued September’s trend and appreciated in October but at a slower pace. The dollar strengthened against the euro and yen and broadly against the emerging markets. The upside of dollar strength is that it will help keep inflation, low which should keep the Fed from having to tighten monetary policy abruptly.
This is the first year since 2010 where a meaningful contributor to returns can be explained by strong earnings delivery versus price/earnings multiple expansion. We see this as a sign of health for the equity market. Earnings revisions are another sign of an equity market rally on firm footing. The three-month global earnings revision ratio climbed to a seven-year high in October, with every major region except the U.S. witnessing improvement. While we don’t dismiss lightly the U.S. lack of improvement, we note the strength within the U.S. is with foreign-exposed stocks. Management guidance has remained positive through Q3 earnings season and we see that corporations are planning to spend more on capital expenditures, which is corroborated by the Philadelphia Fed Survey of Capex Intentions. Our Voya U.S. Earnings Indicator is pointing to just over 10% earnings growth for the next 12 months.
The fixed income market is broadly positive for equities as well. Real yields — U.S. Treasury yields minus inflation — are very low and financial conditions are easy. It is a far more challenging position for equities when real yields are climbing and financial conditions are tightening. With unemployment at 16-year lows and real rates also low, we see an environment that is favorable for equities but possibly not for bonds. Therefore, we maintain our negative view on duration. Within credit, we like the flexibility that leveraged loans give the portfolio against rising short-term interest rates. Credit spreads in the broader high yield market look expensive to us.
Our strategy is to focus on asset classes and parts of the market that are cyclically geared to growth. In our view that goes squarely to global equities. While outright price/earnings multiples are stretched, not all measures give the same signal. If we look at the earnings yield (which is the inverse of the P/E multiple) or free cash flow yield, they well outpace what is currently available in fixed income. We are maintaining our positions in the emerging markets and U.S. small caps. During October we continued to rotate our equity position toward Japan, while hedging the currency back into U.S. dollars. Prime Minister Abe had a decisive win in the election and it is clear that monetary policy will continue to be highly accommodative. The equity market has agreed, and the Nikkei index has finally broken through 22,000, which has not happened since 1996. There are a number of positives, but we continually look for potential pitfalls to financial markets. The transition to a new Federal Reserve chairman next year is top of mind, as is the view that inflation can stay low indefinitely, despite tightening of the labor markets. We are holding our high quality fixed income assets as a buttress against either of those potential pitfalls.
Multi-Asset Strategies and Solutions Team
Voya Investment Management’s Multi-Asset Strategies and Solutions (MASS) team manages the firm’s suite of multi-asset solutions designed to help investors achieve their long term objectives. The team consists of 25 investment professionals who have deep expertise in asset allocation, manager selection and research, quantitative research, portfolio implementation and actuarial sciences. Within MASS, the Asset Allocation team, led by Barbara Reinhard, is responsible for constructing strategic asset allocations based on its long-term views. The team also employs a tactical asset allocation approach, driven by market fundamentals, valuation and sentiment, which is designed to capture market anomalies and reduce portfolio risk.
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