It is difficult to believe we are already at the midpoint of 2018. The year’s first half has been news filled, although global capital market performance suggests a less eventful start to the year. Global equities have delivered listless performance, bonds are slightly weaker, and real estate and commodity markets have been mostly flat. The global economic environment is largely positive, anchored by a strong U.S. economy benefiting from corporate profit growth, but we are seeing evidence of a slowdown in Europe and emerging market economies that bears monitoring and could impact asset returns in the coming quarters.
As we head into the year’s second half, U.S. midterm elections, trade policy and central bank activity are key focal points that may shape financial assets. As a general statement, markets have not demonstrated meaningful volatility outside what occurred in late January and early February, but should late economic cycle inflation pick up, central banks may become more aggressive than markets currently anticipate and meaningful policy surprises could cause market jitters. However, we retain a “glass half full” perspective on asset returns and look forward to updating you with any changes to our viewpoints.
Global economic views
U.S. economy remains strong and shrugs off trade skirmish
Despite headline fear of a trade war, the U.S. economy continues to see accelerating growth and inflation. Fiscal stimulus, via the Tax Cuts and Jobs Act, continues to provide support to the current nine-year economic expansion, the second-longest in the post World War II era. The benefits to the economy from tax cuts remain much larger than potential drag from tariffs and a trade war and the planned normalization of monetary policy by the Federal Reserve (Fed). We believe economic growth is likely to remain solid well into next year. Price shocks, perhaps from a sudden drop in oil supply or a rapid expansion in trade disagreements giving rise to a global trade war, are primary risks to our outlook.
- U.S. economic momentum remains quite positive, in our view, with continued growth in jobs. The reported unemployment rate in May of 3.8 percent is the lowest since April 2000. Consumer confidence remains robust, consumer spending continues its modest positive growth and consumer debt service costs remain well contained. The one concern has been modest wage growth, but we have seen signs of improvement to start this year.
- Inflation is a goldilocks economic indicator — it needs to be "just right." Too little inflation is typically bad, with consumers seeing little wage growth and dampening future economic expectations and investment. Too much inflation is painful, with consumers struggling to maintain their current standard of living. Inflation indicators have been moving from “too little” into the “just right” category, with most measures of inflation at or near Fed target levels. Risks of “too much” inflation appear limited for now, with the Fed raising interest rates, the U.S. dollar strengthening and global commodity markets, especially oil, still well supplied.
Europe and Japan economies are slowing despite monetary stimulus
The major developed economies of Europe and Japan have experienced significant deceleration in growth over the first half of 2018. Economic data on growth and inflation has generally been disappointing relative to expectations. Business and investor surveys have "rolled over," with negative future expectations replacing previously positive outlooks. Monetary policy remains a meaningful support to both economies. The European Central Bank (ECB) and the Bank of Japan (BoJ) are holding interest rates at or below zero and are continuing quantitative easing, or asset purchases, through this year. This may be enough to stave off recession, but growth trends in both Europe and Japan appear to be slowing. Elections over the past year have had little impact on market results, but continued uncertainty around political leadership in Europe and now Japan may contribute further to the slowing economies.
Emerging market growth continues to slow
U.S. dollar strength has become a challenge for emerging market growth. The surge of dollars back to the United States is starting to strain most emerging market economies, especially those with negative trade balances. Economic momentum is likely to continue slowing across this segment, especially relative to the United States. While some economies are poised on the precipice of crisis, such as Turkey, most are likely to avoid recession for a while. Major economies, such as China and India, continue to post very solid overall growth, though at somewhat slower recent levels. Despite stronger oil prices, we have seen softness across commodity producing economies, such as Brazil, Russia and Mexico, with U.S. dollar strength a meaningful headwind. An expansion of the current trade skirmish into a more robust “war” would have meaningful negative consequences for many emerging market economies. For now, we believe this economic slowdown is not yet poised to turn into a global recession.
We expect U.S. equities to trend higher in the second half of 2018, albeit at a more subdued pace
Rising earnings continue to provide valuation support and the basis for stocks to trend higher. Conversely, valuations are elevated, inflation is creeping into the marketplace and interest rates in the United States are trending higher, all which tend to weigh on valuation levels and the pace of future returns. Our year-end 2018 price target for the S&P 500 is 2,900, roughly five percent above the June 30 close of 2,718.
Performance of U.S. equities in the first half of 2018 was varied, with growth outperforming defensive sectors and small-cap stocks outpacing large companies.
Year-to-date performance leadership as of June 30 is narrow, with only four of 11 S&P 500 sectors posting gains, led by the respective 10.2 percent and 10.8 percent gains of Information Technology and Consumer Discretionary. Additionally, the small cap-oriented Russell 2000 Index outperformed the large cap-oriented S&P 500 by nearly a three-to-one margin, up respective 7 percent and 1.7 percent. The relatively high growth profiles of many Information Technology and select Consumer Discretionary companies, and U.S.-centric nature of smaller companies are among reasons for this outperformance.
Earnings continue to trend higher, a primary driver of still higher equity prices
Consensus earnings estimates for 2018 and 2019 are approximately $160 and $175 as of midyear, according to Bloomberg, FactSet and S&P Global, reflecting year- over-year earnings growth of roughly 20 percent and 10 percent, respectively. While higher earnings typically equate to higher stock prices, of looming concern is sentiment once investor focus shifts to 2019 and the consensus prediction of a slower rate of growth becomes a reality.
Valuations are elevated, suggesting that future returns are likely to lag historical averages
The S&P 500 ended June 30 trading at approximately 21.5 times trailing 12-month earnings and 17 times 2018 earnings estimates, respectively, roughly two times above historical levels. While these levels remain short of extremes, unlike the past 10 years, valuations tend to contract in rising inflation and interest rate environments thus leaving earnings growth as the primary driver of higher stock prices. This is a potential headwind for equities, with the rate of earnings growth projected to slow in 2019.
Volatility seems poised to increase in the second half of 2018
On balance, the "degree of investing difficulty" is on the rise. Interest rates are on the cusp of change, inflationary pressures are more prevalent, tariff-related tensions could damage business confidence and delay pro-growth strategies, a rising dollar could weigh on earnings, the midterm elections add to political uncertainty, and so on. In aggregate, uncertainty begets volatility.
The technical outlook for U.S. equities remains inconclusive, suggesting more time is needed before concluding that a near-term market bottom has been reached
A series of price trend higher-highs and higher-lows provides support and instills confidence that a near- term market bottom has been reached and stocks are poised to trend higher. The S&P 500 ended the quarter approximately 2 percent above its 200-day moving average, an overall positive trend. Of technical concern, the popular index has remained in a muddle along zone, trading below the 200-day moving average six times since early-February, A move higher above the 2,800 level would be a positive outcome, providing technical support for further upside.
Neutral view on foreign developed equities as softening data offsets healthy earnings growth
We view opportunities for foreign developed market equities as fairly balanced for the remainder of 2018. Current economic conditions in Europe and Japan provide a generally positive backdrop for equities. Corporate profits across foreign developed markets are estimated to grow at a healthy 11 percent over the full year in 2018. Valuation has moderated and is closer to historical averages. Finally, monetary policy is expected to remain supportive for risk assets. While the ECB is looking to end its asset purchase program after 2018, they have indicated that interest rates in the region would likely remain at current low levels well into 2019. The BOJ remains committed to both asset purchases and low interest rates as inflation and growth in that country remain below the central bank’s targets.
Tempering our positive outlook, business surveys in Europe indicate that while current economic conditions in the region remain quite positive, upward momentum appears to be stalling based on a broad range of macroeconomic indicators. The Japanese economy also slowed noticeably in the first quarter. Despite notable improvements in corporate profitability of "Japan, Inc.," foreign investors remain skeptical toward Japanese equities, as evidenced by net outflows of investor funds in 2018. Finally, price momentum, or the trend in stock price movements, for foreign developed equities is weak and is in sharp contrast compared to positive U.S. equity price trends.
Neutral view on emerging market equities as healthy earnings growth offset by challenging macro environment
Opportunities and risks in emerging market equities appear fairly balanced for the remainder of 2018. The current environment of rising U.S. interest rates, a rising U.S. dollar relative to other currencies and rising oil prices combine to create one of the most challenging environments for emerging market countries. In particular, rising U.S. interest rates increases the competitiveness of U.S. Treasury yields to other, riskier investments, such as emerging markets equities. The interest rate on the two-year U.S. Treasury note is now equivalent to the dividend yield on the emerging market equity index.
Over the past few months, the confluence of these factors has led to recent underperformance of emerging market equities relative to U.S. equities. In addition, countries such as Mexico and Brazil have also been impacted due to uncertainty around general elections and future trade policies with the United States.
Despite the challenging environment and negative price momentum, the global economy remains healthy. Corporate earnings in emerging market equities are estimated to rise an estimated 19 percent in 2018. Valuation of emerging market equities has moderated and is closer to historical averages. And within emerging market equities, we continue to have a positive view of “thematic” approaches that focus on China’s maturing economy (areas such as healthcare, the environment and infrastructure that connects China to the world) and the growing ranks of middle class consumers in emerging markets.
Cautious on corporate credit, reflecting balanced risk/reward versus U.S. Treasuries
Relatively tight investment grade corporate bond spreads, or incremental yield offered above U.S. Treasuries, are likely to be offset by modest spread widening. Despite a constructive economic backdrop, high corporate credit valuations may be increasingly challenged by questions around the sustainability of global growth trends and more compelling compensation from higher U.S. Treasury yields.
High yield bonds offer incremental yield relative to investment grade corporates and U.S. Treasuries, but high valuations leave little room for error. The resilience of high yield bonds, despite first half 2018 volatility, is partially due to limited net new supply. Bank loans should offer a lower risk, lower return alternative in the near term. However, credit losses may be higher than expected when the credit cycle eventually ends due to eroding investor protections in the loan market. We strongly advocate for active management within the high yield space, reflecting the higher risk and diverse nature of the market.
Constructive on municipal debt, elevated valuations offset by limited supply
Longer term, legacy liabilities (underfunded pensions and the like), increased health care spending and deferred maintenance on infrastructure may pose risks to certain segments of the municipal bond market. As a result, we recommend active management in the municipal space. For crossover investors, municipals with longer maturity profiles may offer more compelling value relative to longer maturity Treasury and investment grade corporate bonds.
Mixed view on non-U.S. bonds leads us to prefer currency hedged or U.S. dollar-denominated investments
Yields in developed markets remain quite low, with some countries still experiencing negative yields for many bonds. Coupled with risks from currency volatility, we believe exposure in foreign developed market bonds is unattractive, especially if you own bonds denominated in foreign currencies. On a currency-hedged basis, the investment picture is more mixed, but with higher rates and lower central bank liquidity likely ahead, we prefer U.S. markets. The heavy influence of European and Japanese central banks’ extreme monetary policy makes fundamental analysis of fair value difficult, decreasing our confidence in the space.
For investors with higher-than-average risk tolerance, emerging market debt remains an opportunity for diversification
Emerging market assets have been under intense pressure, driven largely by the ripple effects of weak currencies. Economic fundamentals are mixed across the segment. Continued volatility is a clear risk and we recommend active management. Like non-U.S. developed markets, incurring emerging market foreign currency risk has often resulted in uncompensated price volatility. As such, we advocate for U.S. dollar- denominated bonds within the emerging market bond category.
Real estate markets
Real estate providing solid income, but warning lights are flashing
Centrally located, Class A property prices have been flat for the better part of two years now. Vacancies appear to have bottomed and property income growth (net of certain expenses) has come under pressure. We expect the deceleration in income growth to continue as building projects are completed in certain property types and in certain locations of the market. Valuations, defined as the income of a property divided by property price, remain at all-time lows. Rising yields on competing assets, such as bonds, and further Fed rate increases are likely reducing the relative attractiveness of real estate.
Trade wars creating uncertainty in the commodity markets
Commodities have performed well as an asset class for the past year, but have recently come under pressure. Oil prices have declined 10 percent since the Saudi oil minister said OPEC would offset any supply disruptions from Iranian sanctions. More recently, the grain markets have declined because China has proposed retaliatory tariffs on U.S. agricultural products. In general, most global commodity markets are well supplied. Spare capacity was built when prices were at all-time highs five years ago. This spare capacity was being worked off. However, increased tariffs reduce global trade and potentially global gross domestic product (GDP). This lessens the risk of unanticipated supply shocks and makes commodity markets more supplied.
In the short term, we expect commodity prices to be volatile and to trade with headlines pertaining to changes in the global trade war. As spare capacity is reduced and markets approach equilibrium, we believe prices will need to rise to create a supply response. Over time, we believe that rising costs and emerging supply constraints will put upward pressure on most commodities.
Alternative investment strategies
Third quarter is not expected to be easy for investors if second quarter market volatility is the indicator. Going forward, it will be important to understand the risks in a portfolio compared to the past several years when investors were able to focus on returns. This requires a different mindset. The good news is that we believe the current market environment can be favorable for alternative investments, especially hedge funds. Political brinkmanship regarding trade tariffs provides a good example. Aggressive negotiations between the United States and China, and the potential for collateral damage to other countries, helps to keep market participants off balance. Market uncertainty may be able to work to the benefit of hedge fund managers who might be able to potentially reduce risk during these periods of uncertainty and then react quickly as events unfold.
Investors continue to show interest in private capital funds, though relative to the past few years, overall fund raising appears to be leveling off in 2018. Deal activity is also slowing down, a development we attribute to the rich valuations companies are currently commanding. Many private capital firms appear hesitant to deploy capital early in an expected three-year to five-year investment period, reflecting a belief that we are in the later stages of an economic cycle.
We reiterate our view that exposure to alternative strategies, as appropriate, remains important for both taxable and tax-exempt investors in helping to achieve targeted returns. Expected returns in public markets are lower than what stocks and bonds have generated over the past 10 years. Lower expected returns are attributable to the end of historical low interest rates, which provided a strong tailwind for both stocks and bonds over an extended period.
Below are a few unique investment opportunities that can be exploited by hedge funds and private capital funds with a unique skillset and competitive advantage relative to their peers:
From a strategy perspective, here are our views on some of the major subsectors:
- Hedged equity: A theme we have highlighted over the past several quarters is the favorable investment environment for event-driven managers. This is punctuated by the recent $85 billon AT&T/Time Warner merger that was approved by the courts. The court decision is viewed by the markets that antitrust hurdles are not as difficult to overcome as in the past. Comcast acted immediately on the court’s ruling by making an all-cash bid of $65 billion for 21st Century Fox, which was already in discussions with Disney. As of mid-June, $2.1 trillion of global merger and acquisition (M&A) activity has taken place. We expect that M&A will continue due to the court’s ruling and because rates are still low and global corporations are confident about the health of the global economy, which is necessary to support these large acquisitions through both stock and bond issuance.
- Hedged fixed income: With the Fed expecting to raise rates through 2018 and into 2019, and global growth expected to continue (albeit maybe slower), we continue to like the opportunities in U.S. and European high-yield credits. These credits are less interest rate sensitive because credit quality is more important to valuation. The work required to invest successfully in this space is difficult and time consuming. The adage “it’s not what you know but who you know” holds true when it comes to sourcing these bonds. The size of the issuance is small by most standards, usually a few hundred million dollars or euros, which is perfect for the smaller, nimbler high-yield hedge funds accustomed to navigating the less efficient areas of this section of the market. The rewards for the efforts are coupons paying between 8 percent to 15 percent and bonds selling at a substantial discount to par, or their redemption value. The discount may not necessarily be due to the perceived risk of default, but have more to do with the bonds not being well understood and/or not rated by the rating agencies.
- Private equity: We are finding some interesting opportunities in the healthcare space. One unique opportunity is big pharmaceutical companies that are working with private capital firms to assist them in developing/facilitating drug research in order to reduce the amount of research and development (R&D) spent on early stage drugs that often results in no viable product. To reduce costs and increase the hit rate of viable drugs and medical devices, global pharmaceutical companies are engaging private capital firms to invest in fledging biotech/ medical device companies in various stages of research and FDA trials. This approach allows the pharmaceutical companies to identify prospective drugs/devices further along in the development and testing processes, which serve to reduce some of the risk and potential losses associated with early stage R&D. This approach provides the pharmaceutical companies with a “first-look” at the drug or devices and can either buy the drug, the company or enter into a royalty or distribution revenue sharing arrangement.
Investment products and services are:
NOT A DEPOSIT • NOT FDIC INSURED • MAY LOSE VALUE • NOT BANK GUARANTEED • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY
This commentary was prepared June 2018 and represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are not intended to be a forecast of future events or guarantee of future results and is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this commentary are not affiliated or associated with U.S. Bank in any way.
U.S. Bank and its representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/ or legal advisor for advice and information concerning your particular situation.
Diversification and asset allocation do not guarantee returns or protect against losses. Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals.
Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general.
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. The value of large-capitalization stocks will rise and fall in response to the activities of the company that issued them, general market conditions and/or economic conditions. Stocks of small-capitalization companies involve substantial risk. These stocks historically have experienced greater price volatility than stocks of larger companies and may be expected to do so in the future. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer’s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes, and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risks related to renting properties (such as rental defaults). Hedge funds are speculative and involve a high degree of risk. An investment in a hedge fund involves a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage and short sales, which can magnify potential losses or gains. Restrictions exist on the ability to redeem or transfer interests in a fund. Private equity investments provide investors and funds the potential to invest directly into private companies or participate in buyouts of public companies that result in a delisting of the public equity. Investors considering an investment in private equity must be fully aware that these investments are illiquid by nature, typically represent a long-term binding commitment and are not readily marketable. The valuation procedures for these holdings are often subjective in nature.
©2018 U.S. Bank (6/18)