Consensus estimates for global economic growth for 2015
have come down, and we share the view that the pace
of acceleration is likely to slow. Still, we expect the global
economy will continue to expand during the second half
of the year, albeit at a subdued pace. The most significant
potential risks to our outlook for growth include: the
Federal Reserve making a policy mistake by raising rates
too aggressively and not being able to backtrack if
deflationary forces persist, a hard landing for China, and
a failure of quantitative easing in Europe to boost GDP
and stem deflationary pressures. At this point, we believe
it is more likely than not that these risks can be avoided,
and accordingly, equities and convertible securities can
continue to advance.
We believe the U.S. will also expand modestly during
the second half of the year, with GDP accelerating from
the first half of the year. Employment data has been
encouraging, corporate earnings growth is healthy, and
inflationary pressures are contained. We expect the U.S.
dollar will be range-bound through the remainder of the
year (Figure 4), with the potential to move slightly higher
due to divergent monetary policies.
The energy sector hindered the economy during the first
half of 2015, but oil prices have stabilized from their more
volatile levels of earlier this year, and the amount of rigs in
service continues to decline. Prices will likely be rangebound
through year end, as well. The shale industry,
rather than OPEC, is now the marginal producer of oil in
the global markets. Because of the shale industry’s shorter
production cycles, as oil prices rise, shale producers
can quickly ramp up capital spending (i.e., production),
keeping a cap on oil prices.
FIGURE 4. DOLLAR LIKELY TO REMAIN STRONG
Source: Federal Reserve Bank of St. Louis. The Trade Weighted Dollar Index tracks the value of the dollar against major trading partners (Euro Area, Canada, Japan, UK, Switzerland, Australia and Sweden).
FIGURE 5. GLOBAL UNCERTAINTIES AND FALLING GLOBAL YIELDS DRIVE U.S. YIELDS DOWN
With continued quantitative easing through the balance
of the year in the euro zone and Japan, we expect global
sovereign yields will remain low, suppressing the 10-year
Treasury yield (Figure 5). We believe the Treasury will
generally stay in a 2.0% to 2.5% range through year end. If
Greece cannot meet the deadlines put forth by its creditors
under the proposed bailout plan or if market participants’
view of China becomes more pessimistic, the markets could
swing back to a risk-off phase, bringing the yield range
back down below 2.0%. Conversely, if global growth and
inflationary pressures increase in the second half of the
year, 10-year yields could inch back above 2.5%.
While U.S. economic data is favorable on the whole, the
Federal Reserve’s timeline for raising rates will also reflect its view of global economic conditions, which remain lackluster.
We believe the Fed will begin raising rates before year end,
provided that job gains maintain their current pace and
absent any acute geopolitical shocks. As noted, we believe
that a Fed policy mistake is one of the greatest potential
threats to the global economy, although this is not the
outcome we anticipate. When increases begin, we expect
a more measured pace with intermittent increases rather
than the steady rate increases of the Greenspan-led Fed in
the early 2000s, consistent with the current Fed leadership’s
commitment to a data-driven approach, combined with
the Fed’s intent to limit the rise in the U.S. dollar.
Opportunities in the U.S. Markets. We see continued
upside in U.S. equities. Although a strong dollar has
had a negative impact on 2015 estimated guidance,
we expect S&P 500 earnings growth of 5% to 6% for
2016. As we have discussed in the past, the wide spreads
between equity yields and borrowing costs should
fuel a continuation of the record buyback and merger-and-
acquisition activity, providing support to equity
The earnings yields of equities remain extremely attractive
relative to U.S. Treasury bond yields. At +370 basis
points, the current spread between S&P 500 earnings
yields (6.1% on forward 2016 estimates) and a 10-year
Treasury yield of 2.4% places equity valuations in the
cheapest third since 1950, based on data from Empirical
We maintain a particularly constructive outlook on
growth stocks. During the first half of 2015, markets
rotated to growth sectors (Figure 6), and we believe this
rotation has more room to run. We expect growth stocks
will continue to outperform value stocks, given narrow
valuation spreads, high relative cash flow returns, and
a high level of innovation across sectors. Additionally,
in our view, the current economic cycle may extend
for several more years, and growth has historically
outperformed in mid-to-late-cycle periods (Figure 7).
In this environment, we are maintaining an emphasis
on secular growth companies, including overweights
to information technology, health care, and consumer
discretionary, while underweighting defensive areas
of the market, such as consumer staples, utilities, and
FIGURE 6. TRADITIONAL GROWTH SECTORS HAVE TAKEN BACK MARKET LEADERSHIP
Past performance is no guarantee of future results. Source: Bloomberg.
FIGURE 7. GROWTH STOCKS HAVE TYPICALLY OUTPERFORMED LATE CYCLE
Source: Empirical Research Partners Analysis. Equally weighted data used for the lowest two quintiles of priceto-
book ratios compared to growth stocks.
The economic recovery remains fragile and we expect
continued volatility over the next several months.
We may see pronounced market dislocations due to
concerns, including not only those centered on Greece,
but also elsewhere, such as Russia. Nonetheless, we
believe a number of factors can support core Europe
over the next nine to 12 months, including the liquidity provided by the ECB (Figure 8), reasonable valuations,
and stabilizing-to-improving fundamentals. To
capitalize on these cyclical tailwinds, we have sought to
identify companies that are beneficiaries of QE (such as
asset reflation and exporters). We have also maintained
our focus on secular growth opportunities throughout
The growing focus on the political divide in the euro zone
has contributed to rising apprehension about the longterm
sustainability of a single currency union. We also
view the emphasis on monetary policy, rather than fiscal
policy, as contributing to long-term growth headwinds.
However, even if Greece fails to meet the conditions
put before it—whether over these next weeks or in the
years to come—the probability of an economic or market
contagion is far less than in years past.
Compared with just a few years ago, the euro zone is in a
much better position to contain Greece’s economic woes.
The total private investor and bank exposure to Greece
has fallen to €34 billion versus nearly €250 billion in 2012.
The ECB has more firepower and a range of tools at its
disposal, including quantitative easing, outright monetary
transactions (OMT) and targeted long-term refinancing
operations (LTROs). Meanwhile, countries like Spain,
Portugal, Ireland and Italy have made progress on austerity
and fiscal reform measures and are now starting to see
economic green shoots. The euro zone’s economy has
also benefited in recent quarters from weaker commodity
prices, a weaker euro, and improved liquidity conditions.
FIGURE 8. AGGRESSIVE EASING BY ECB
Source: GaveKal Dragonomics, François-Xavier Chauchat ,“Not The Usual QE,” February 26, 2015.
Although Japanese economic data remains mixed,
activity continues to surprise on the upside (Figure 9),
with the weak yen supporting exports and overseas “Japan at an Inflection Point,” we are particularly
optimistic about trends in corporate governance,
including a focus on increased shareholder transparency
and a pickup in stock buyback activity (Figure 10, page
6). Japan’s growing ties with the U.S. are also positive,
reflecting U.S. vested interest in a strong Japan to
counter the growing geopolitical reach of China (not
unlike the U.S.–European partnership forged following
WWII). At the same time, data increasingly suggests
Japan is well positioned to benefit from Chinese tourism
and related consumption.
Japanese equities have outperformed on a relative basis
year to date, and while valuations look comparatively
less attractive as a result, we still see significant upside
in many bottom-up opportunities among companies
that are allocating capital more efficiently for the
first time in several decades. Equity purchases by the
Government Pension Investment Fund should provide
continued support to Japanese stocks, as should increased
participation from smaller public funds. Looking longerterm,
we are closely monitoring the shift from domestic
household saving to equity investing, which could provide
an even more powerful tailwind. Japanese households
have approximately $7 trillion in savings deposits—nearly
one-and-a-half times the size of the domestic equity
market. (For perspective, households in Japan have more
than 50% of their assets in deposits, compared to 35% in
Europe and less than 10% in the U.S.)
Many investors remain concerned that when the Fed
begins raising interest rates, a repeat of the “taper
tantrum” will inevitably follow. While there will likely be
volatility, we believe emerging markets can perform well,
provided rates rise because global growth is improving.(Emerging markets have historically provided higherbeta
exposure to global economic growth.) Higher U.S.
rates could negatively impact a carry trade that has
provided capital to emerging markets by putting pressure
on liquidity and valuations, but a number of emerging
markets are arguably better positioned today. The taper
scare of 2013 provided several emerging markets with the
impetus to begin fiscal and economic reforms, and many
have been successful in positioning their economies for an
eventual rise in global rates. Increased currency reserves
and lower inflationary pressures (including lower oil prices)
have equipped several emerging markets with more
monetary flexibility to manage short-term dislocations in
FIGURE 9. SURPRISES ON THE UPSIDE FROM JAPAN
Past performance is no guarantee of future results. Source: GaveKal Data/Macrobond.
FIGURE 10. JAPAN: STRUCTURAL REFORMS PROVIDE A CATALYST FOR
Source: J.P. Morgan, “Japan Equity Strategy,” February 3, 2015, using data from Bloomberg and J.P. Morgan.
We also would note the 2013 taper tantrum was a
“shock” to the financial markets, as investors did not
know the timing or magnitude of future Fed policy. With
the Fed now telegraphing a slow and shallow rate path,
the markets should be better prepared for an eventual
change in monetary conditions. Finally, with both the Bank
of Japan and the ECB engaged in aggressive quantitative
easing, the carry trade is likely more diversified and less
dependent on low U.S. rates.
China. Although the Chinese economy is decelerating and
near-term negative momentum is a concern, China is still
growing at a faster rate than most of the world. The policy
backdrop is positive, with accommodative monetary policy
and government policies supporting asset reflation. Of
course, we are closely watching what happens in the wake
of the recent sell-off in Chinese equities. At this point,
we believe a hard landing is a lower probability outcome.
The Chinese government has many tools at its disposal to
support near-term stability and economic growth, and we
view it as a favorable sign that the People’s Bank of China
did not need to step in during the market sell-off. As we have discussed in recent blogs (including “Perspectives
on China’s Market Meltdown: Long-Term Opportunity
Remains”), the Chinese government is fully committed to
expanding its economic and military influence across Asia
and globally. It is also dedicated to transitioning the Chinese
economy from investment-led growth to consumption-led
growth and from the public sector to the private sector.
Also, while recent equity losses have been very steep, the
net wealth created in the Chinese equity market over the
past year remains positive.
Reflecting this view, we continue to invest in Chinese and
Hong Kong companies with growing franchises that are
selling at reasonable valuations. While there are pockets of
overvaluation in segments of the market (particularly those
traded primarily by local investors), the multiples of other
Chinese stocks are far more palatable—even attractive—
when compared to our long-term earnings growth and
sales estimates. Valuations are quite compelling for a
number of stocks in which non-local investors participate,
such as shares traded on the Hong Kong exchange and
other select larger-cap issues.
Fragile Five. We are closely monitoring our exposure to
the “fragile five” economies (Brazil, India, South Africa,
Turkey, Indonesia). All are highly dependent on capital flows
given their fiscal and current account deficits, but there
are important fundamental differences that influence our
country-specific outlooks and positioning.
We continue to favor India given its ongoing progress in
economic reforms and its improved monetary flexibility.
The market correction in India this spring can be attributed
to a combination of factors: market expectations that got
ahead of fundamentals, a pause in policy momentum,
and growing concerns regarding the monsoon season and
other technical factors. Looking forward, we see a number of positives. The monsoon season does not appear to be as
bad as feared, we see the reform agenda getting back on
track during the second half of 2015, and we are hopeful
about a ramp up in government investment spending.
The Philippines. We remain positive on the Philippines
as the strong business process outsourcing industry, U.S.
dollar remittances and lower commodity prices should
continue to support domestic liquidity. We also expect the
election cycle to drive a more meaningful ramp up in progrowth