David Joy: Early signs of improvement in emerging markets

Stocks rose last week for the third straight week, during which the S&P 500 added 5.0%, to bring its return on the year to 14.5%. Notably, however, the leadership has recently shifted to more economically-sensitive sectors. So far in the month of May, industrial stocks have produced the best returns at 4.0%, whereas they lag behind for the year to-date, with a return of 13.5%. Consumer discretionary ranks second for the month, as it has for the year so far. But, in third place is the information technology group, with a return of 3.0%, despite rising just 8.2% for the year so far, ahead of only the materials sector. Even materials have beaten the broader index this month. Conversely, the dividend darling defensive groups of utilities and telecom are actually lower for the month so far. And barely positive are consumer staples and healthcare, both among the leaders on the year. The primary exception to this more cyclical rotation has been energy, which although positive for the month, has not exhibited the same degree of buoyancy.

Emerging market equities have also shown recent signs of life, after having lagged developed market returns badly throughout the year. Since April 5, the MSCI Emerging Markets (EM) index has climbed 4.2%, still trailing the 5.2% climb in the S&P 500 during the same interim, but generally tracking the same trajectory. Prior to that, for the year through April 5, the MSCI EM index had fallen 4.5%, in stark contrast to the 8.9% gain in the S&P. Through April 5, the MSCI Europe, Australasia and Far East (EAFE) index rose 3.5% in dollar terms, and since has climbed an additional 5.9%. At the regional level, this relative improvement in emerging market equities since early April has occurred primarily in Asia, where stocks have climbed 6.0%. In contrast, the more commodity-sensitive Latin America region is fractionally lower.

This recent shift in sentiment has been reflected in the bond market as well. The yield on the ten-year U.S. Treasury note closed on Friday at 1.90%, after having fallen to a low for the year of 1.63% on May 2. The Barclays Intermediate U.S. Treasury index total return has declined 0.43 this month, while the long index has fallen 3.1%. Investment grade corporate bonds have fallen as well, with the Barclays Intermediate Corporate index falling 0.4% and the long index falling 2.1%. It has been a different story, however, in the high yield sector, where prices continue to rise. For the month to-date, the Barclays Intermediate High Yield index is up 0.8%, and the long index is up 1.4%, as the reach for yield shows no signs of abating. In fact, the lowest quality bonds within the sector have delivered the strongest returns. As a result of these divergences, the yield on the Merrill Lynch High Yield Master II index has fallen to its lowest rate ever at 5.98%, and its spread versus Treasuries has contracted to its lowest level since August 2007, just four months before the Great Recession began.

What at least partly accounts for this relative improvement in cyclical exposure is the aggressive stance of central banks, in some cases increasingly so, and a general belief that global economic performance is expected to improve in the second half of the year. In the U.S., the cumulative impact from higher taxes and spending cuts will begin to dissipate beyond the second quarter. In Europe, the headwinds from austerity will also begin to lessen. And in Japan, Abenomics appears to be aggressive enough to result in at least some relative improvement. China remains a wildcard, and its relative strength is especially important for commodity producing countries. Uncertainty here is reflected in the weakness in Latin America. Commodity price weakness is also a result of dollar strength, itself influenced by anticipation of the beginning of a reduction in the pace of quantitative easing by the Fed, perhaps as early as the second half of this year, and the increasing relative aggressiveness of foreign central banks.

Whereas this past week was largely devoid of economic reports as a source of direction, that is not so for this week. Starting with retail sales on Monday, the calendar includes reports on industrial production, producer and consumer prices, consumer confidence, leading indicators, and regional manufacturing indices. Importantly, the latest data on the housing sector will be released, including the National Association of Home Builders index, housing starts, and building permits. While the prevailing view is that the generally soft economic data from late in the first quarter was mostly attributable to a combination of bad weather and the temporary drag from changes in fiscal policy, more evidence of firming conditions is necessary to confirm that view. The April employment report was a step in that direction. But we will need to see more if the recent turn toward cyclical assets, and away from defensives, is justified and sustainable.

Disclosures
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

Morgan Stanley Capital International EAFE Index (MSCI EAFE), an unmanaged index, is compiled from a composite of securities markets of Europe, Australasia and the Far East.
 
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.

The Barclays Intermediate U.S. Treasury Index includes all publicly issued, U.S. Treasury securities that have a remaining maturity of greater than or equal to 1 year and less than 10 years, are rated investment grade, and have $250 million or more of outstanding face value.

The Barclays Intermediate U.S. Corporate Index is designed to measure the performance of U.S. corporate bonds that have a maturity of greater than or equal to 1 year and less than 10 years. The Index is a component of the Barclays U.S. Corporate Index and includes investment grade, fixed-rate, taxable, U.S. dollar-denominated debt with $250 million or more par amount outstanding, issued by U.S. and non-U.S. industrial, utility, and financial institutions.

The Barclays High Yield Index covers the universe of fixed rate, non-investment grade debt. Pay-in-kind (PIK) bonds, Eurobonds, and debt issues from countries designated as emerging markets (e.g., Argentina, Brazil, Venezuela, etc.) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, and 144-As are also included.

The Merrill Lynch High Yield Master II is a broad based index consisting of all U.S. dollar-denominated high-yield bonds with a minimum outstanding amount of $100 million and maturing over one year.

Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution and involve investment risks including possible loss of principal and fluctuation in value.

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