High volatility in currencies and interest rates (which we’ve discussed at length recently, including in our Topical Webinar Currencies and Fixed Income: The New Volatility) has spilled into global equity markets in the past two weeks. The primary driver cited by major media outlets has been the ongoing standoff between Greece and its Troika creditors.
While these negotiations are important in their influence on the future structure of the European Monetary Union (EMU), we do not view them as the source of near-term volatility they are purported to be. Nearly all Greek debt ownership has been shifted to public institutions, so in the event of a Greek default or exit from the EMU, the European banking system will not be directly impacted. Therefore the immediate threat of contagion is limited, and the European Central Bank’s quantitative easing program started in March will provide support against other indirect negative impacts. Furthermore, the Greek economy is simply too small for any negative internal impact there to have a major impact on the global economy.
Instead, we view the recent events in China to be the primary cause of recent global equity volatility. After a stunning rally in Chinese equities, up nearly 160% from their January 2014 low to their high in June 2015 as measured by the Shanghai Composite, the index has fallen by more than 30%. The true decline is likely in the neighborhood of 40%, but it is difficult to know because the Chinese government has halted trading on a significant portion of Chinese stocks. One benefit of the stock market rally was to stimulate domestic consumption through the so-called “wealth effect,” a policy measure that has likely been thwarted by the recent selloff.
The US economy, on the other hand, has rebounded from its first quarter lull and is likely to grow by more than 2% in the second quarter. US inflation expectations have likewise rebounded from their January low of 1.05% to currently 1.57%, as measured by the 5-year breakeven inflation rate. And outside of Greece, Europe is mostly doing well, too. Germany just released a strong export report, and Spain continues to outpace growth expectations for 2015. The US and Europe continue to grow in the face of global headwinds, mostly emanating from emerging markets.
We hold a large position in developed market equities and have relatively lower exposure to fixed income. Overall, our GTA portfolio holds 32% dollar denominated fixed income, 24% US equities, 34% international equities, 8% alternatives, and 2% cash and equivalents. We favor equities to fixed income, and have limited our foreign currency and commodity exposure.
Our exposure in fixed income is limited to dollar denominated securities. We hold positions in high yield bonds, preferred stock, long duration US treasuries, and dollar denominated emerging market debt. This gives us exposure to spread product and the long end of the interest rate curve while avoiding foreign currencies.
International equities have been hit especially hard in the recent selloff, but have still outperformed their US peers year-to-date. We expect this outperformance to continue in the second half of the year, and have maintained our large foreign equity allocation.
Despite the recent selloff in Europe, we expect the ECB’s quantitative easing program to continue to drive European equity outperformance. We have split our European equity exposure evenly between hedged and unhedged with respect to the Euro in order to minimize the impact of high currency volatility. Spanish equities in particular are attractive after underperforming in recent years, and provide very good relative value to other Eurozone equities.
We hold positions in Japanese equities, in both yen- hedged and unhedged forms. Favorable policy will continue to support Japanese equities, and we expect them to maintain their outperformance.
We hold a position in mortgage REITS. We do not expect the interest rate curve to flatten too severely in the intermediate term, which should support mortgage REITS.
*Emerging Markets allocation overlaps with regional allocations
**Excluding GTA’s 42% fixed income, alternative, and cash positions
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