Travelers to the London Underground Metro system are likely familiar with the title of this commentary, which serves as a repeated reminder for tube travelers to pay attention to the space between the train and the arrival platform. Similarly, a “gap” exists today between asset price performance, which has been strong since a dramatic intraday reversal on December 26, 2018, and global economic performance, which has been challenged across most major regions and countries. Global policymakers seem to recognize a soft patch in the economy’s expansion, including central bankers who have almost uniformly vowed to keep borrowing costs low or, in some of the more troubled regions, continue to promote pro-growth policies. This gap can be filled in one of two ways — strong prices presage a shallow economic dip that quickly resolves and the economy catches up to asset prices that have already moved and could catapult higher, or the economy weakens further and asset prices fall in sync with a deteriorating reality.
Our analysis suggests that the economy will continue to show some softness, but that softness will not give way to sustainably lower prices. Several policy events are yet to be resolved at the time of publishing this commentary, including United States/China tariffs, Brexit resolution and debt ceiling considerations, but neither the economy’s trajectory nor asset price momentum will be dominated by any of those events.
The content that follows reflects our assessment of global and domestic economies, several asset categories and other considerations as we exit the first quarter of 2019. As always, we will keep you posted on developments and changes to our views and welcome any of your feedback.
Global economic views
Strong U.S. finish in 2018 appears to be giving way to a re-synchronized global economic slowdown, although recession prospects remain low.
U.S. economic data generally softened in the first quarter. The month-long U.S. government shutdown likely contributed to the weakness, along with trade uncertainties with China and the downgrade of corporate earnings growth prospects. The shift in the Federal Reserve (Fed) to “patient” regarding further interest rate hikes should help create a floor for U.S. growth over the course of 2019. Average growth for 2019 is likely to be slower than 2018, which finished at just over 3 percent, reflecting the abating tailwind from tax cuts and continued policy uncertainty around government budget funding and trade with China. Despite risk of slower growth, we believe a recession is unlikely. Debt growth has been high but is not excessive and we see evidence of few imbalances emerging given the very modest trend in economic growth since the great financial crisis.
- We would normally expect the improving wage growth and inflation to allow the Fed to raise rates later this year. However, recent Fed communication indicates this may be unlikely and that they prefer to allow inflation to run slightly higher.
- The shift by the Fed to a patient stance on interest rate increases should ease financial conditions for the United States, thereby supporting economic growth. Ultimately improving wage growth and inflation should allow the Fed to raise rates later this year.
- Fiscal policy in the United States has been modestly accommodative so far this year, but uncertainty around trade policy and the government budget is likely to weigh on investor and business sentiment.
Growth in 2019 for Europe and Japan is likely to be a lot like 2018 — disappointing, with recession risks on the rise.
Trend growth for Europe and Japan, the other major developed global economies, has been quite disappointing over the past year or so. Political risks, tighter fiscal policies and softening global trade have slowed growth, although both economies have avoided recession. Trends in the first quarter of 2019 have stabilized and the level of activity remains low. The strong U.S. dollar trend from 2018 could ultimately help export prospects for this region, if trade disputes are resolved. The shift by the European Central Bank (ECB) to a more dovish stance, with the return of quantitative easing (via targeted longer-term refinancing operations, aka TLTROs II) should help stabilize economic growth later this year.
China stimulus doing little so far to rekindle growth. A resolution to trade uncertainties could improve economic growth prospects.
Emerging market economies have remained weak to start 2019 and trade uncertainties between the United States and China are doing little to help growth prospects. The dovish shifts by the Fed and ECB should aid stabilization. A trade deal, combined with recent stimulus in China, could also help growth prospects as 2019 unfolds.
U.S. equities seem poised to trend higher in 2019 following superb first quarter performance, albeit at a more subdued pace. Stocks should be bolstered by moderate earnings growth, tame inflation and a Fed that is on hold for now.
The bull market in U.S. equities turned 10 years old on March 9, dating back to the financial crisis in 2009. While this current rally is among the longest in history, lack of excesses or “bubbles” in inflation, valuation or investor euphoria point toward still more upside.
- Earnings for the S&P 500 continue to trend higher, albeit at a moderating pace. To a degree, the earnings landscape presents conflicting trends. Fourth quarter sales and earnings results, released mostly in February and March, trended above expectations year over year, according to Bloomberg, advancing roughly 6 percent and 12 percent, respectively. Conversely, expectations for first quarter and overall 2019 results are less sanguine. Consensus expectations are generally for 2019 S&P 500 earnings within the $165 to $170 range, advancing roughly 6 percent over 2018 levels. Of near-term concern, equity prices have continued to inch higher as the rate of earnings growth in 2019 has slowed, which is a longer-term disconnect.
- Subdued inflation and relatively low interest rates, consistent with periods of slow-to-moderate economic growth, are among indicators suggesting that it is premature to conclude that a recession is imminent and the long-running bull market in equities is soon to be over.
Sentiment has improved in early 2019, evidenced by strong performance and compelling broad market valuations. Rising sentiment, short of extremes, presents a favorable backdrop for rising stock prices.
Improvement has come on the heels of dovish Fed comments and optimism over prospects for a U.S.- China trade agreement. Broad-based performance, with growth/cyclical companies and sectors generally outperforming defensives, reflects a risk-on bias.
- The S&P 500 continues to trend above expectations, with overall year-to-date performance being superb. As of March 27, all 11 S&P 500 sectors were posting gains, with eight sectors (Communication Services, Consumer Discretionary, Consumer Staples, Energy, Industrials, Information Technology, REITs and Utilities) advancing 10 percent or greater, consistent with a favorable fundamental backdrop. Financials, Healthcare and Materials, while posting positive returns, were lagging the other sectors.
- Broad market valuation is favorable, with the S&P 500 being neither at high nor low extremes. The S&P 500 trades at approximately 18.5 times trailing 12-month estimates, modestly below the 28-year average multiple of 19.3 times, dating back to 1990. However, downward-trending earnings estimates weaken the valuation argument. Hence, broad-market valuations are attractive as long as earnings hold, elevating the importance of first quarter results and forward guidance.
We retain a neutral outlook for foreign developed equities through 2019 as risks and opportunities look reasonably balanced.
Following a rough fourth quarter that saw foreign developed equity markets, as measured by the MSCI EAFE Index, fall more than 12 percent, foreign equities have recovered some of last year’s losses so far in 2019, posting a year-to-date gain of more than 9 percent. Positive equity returns have been broad based across the eurozone, United Kingdom and Japan. Australia experienced double-digit growth and remains strongly tied to the fortunes of China.
Despite the strong year-to-date performance, valuation of foreign developed equities remains modestly below to well below long-term historical averages, depending on the measure used. Meanwhile, corporate profits for the full calendar year are estimated to grow by more than 12 percent over 2018 levels, a notable improvement on the 5 percent growth in 2018. In our view, strong profit growth, combined with the current dividend yield of 3.6 percent, and modest valuation continues to provide a solid base for foreign developed equity prices to move higher in 2019. Regarding policy, the ECB and Bank of Japan remain firmly committed to providing monetary stimulus throughout 2019, which is supportive for equity prices. Finally, China remains a significant trade partner for Europe, Japan and Australia. A potential stabilization in China’s economy, due to efforts by authorities to stimulate growth there, would benefit the economies of foreign developed markets.
Tempering our positive outlook, economic momentum in Europe has clearly decelerated, based on our analysis of a broad range of macroeconomic indicators. The Italian economy is hovering near recession, and the ECB recently slashed its 2019 forecast for full-year economic growth across the euro-area from 1.6 percent to 1.1 percent. A large portion of the 12 percent growth expectation for corporate profits in 2019 is concentrated in the fourth quarter and, given the “wedge” between those optimistic estimates and continued weakness in economic data, we view those estimates with some caution. Additionally, while the price performance of the MSCI EAFE Index has been positive in 2019 and some technical indicators have improved, the index has not broken decisively through and held above the 200-day moving average, which for us represents a key technical resistance line. Finally, valuation of foreign developed equities relative to the S&P 500 remains extremely low, reflecting stronger investor confidence in the U.S. economic and corporate profit outlook.
Balancing a strong profit growth outlook, supportive dividend yield and modest valuation against continued softening macroeconomic data, worsening economic outlook and technical resistance, we maintain a neutral outlook on foreign developed equities in 2019.
Similarly, we continue to view opportunities and risks in emerging markets as also fairly balanced as we look to 2019 and retain our neutral stance.
Emerging market equities as measured by the MSCI Emerging Market Index have also recovered somewhat from last year’s decline, with prices rising nearly 9 percent so far in 2019. A primary catalyst for the recovery in emerging market stock prices was the pivot in Fed interest rate policy in late 2018 to a more patient outlook for potential U.S. interest rate increases in 2019.
An environment of rising U.S. interest rates, combined with an appreciating U.S. dollar relative to other currencies, creates one of the most challenging macro environments for emerging market countries.
Borrowing costs for emerging market countries and companies increase, and rising U.S. interest rates increase the competitiveness of U.S. Treasury yields to other, riskier investments, such as emerging markets equities. Thus, the Fed pivot to a more patient forward interest rate outlook provides relief from the rising U.S. interest rate environment of 2018, while the dividend yield on emerging market equities once again offers a competitive yield relative to 2-year U.S. Treasury yields.
Regarding fundamentals, expectations for corporate profit growth in emerging markets have been revised downward to a modest 3 percent for the full calendar year in 2019. Similar to other foreign equities, a large portion of the earnings growth in 2019 remains concentrated in the fourth quarter of the year, which again we view with some caution given uncertainty in the global economy and key policy outcomes. Price technicals have improved from last year, with the emerging market index trading above key moving averages and forming a pattern of higher lows and higher highs. The combination of rising equity prices and downward revisions to expected profit growth have resulted in the forward-looking valuation of emerging market equities returning to levels above long-term historical averages, indicative of a renewed investor optimism, and on a rising trend.
China’s policymakers continue to enact a variety of measures to stimulate the economy, including monetary easing, middle-class tax cuts and regulatory reforms, which provide some fundamental support for emerging markets. However, the key policy outcome for emerging markets in 2019 remains the ongoing trade negotiations between the United States and China, the world’s two largest economies. There remains little clarity regarding ongoing negotiations, and we view headline related market volatility as “noise” with little informational content, what we refer to as an “edgeless phenomenon.”
Thus, we view increased investor optimism in the form of higher-than-average equity valuation with some caution, given the uncertainty in trade negotiation outcomes.
Taking into consideration improved price momentum, near-term relief from U.S. interest rate increases, Chinese policy stimulus and renewed investor optimism with uncertainty regarding China/U.S. trade outcomes, muted corporate profit growth expectations, and above average valuation, we view risks and opportunities as balanced and maintain our neutral outlook for emerging market equities for the remainder of 2019.
Fixed income markets
We continue to anticipate modestly higher bond yields as the Fed remains patient and financial conditions recover, though a slowing U.S. economy remains a risk.
Bond market returns have been strong in early 2019 after much volatility in 2018. Yields remain low by historical standards, despite four rate hikes by the Fed last year. Economic uncertainty prompted the Fed to pause rate hikes and communicate patience. It is increasingly difficult to envision a rate hike this year given recent Fed communication, weakness in Europe and China, and the relatively flat yield curve. Catalysts for higher longer-term rates include stable to rising core inflation, increased U.S. Treasury debt issuance due to a rising fiscal deficit, and weak demand for U.S. Treasuries by foreign investors. We advocate for shorter than normal bond portfolio maturities due to the minimal compensation for extending maturities, along with our expectation for higher rates (bond prices move inversely to yields). We continue to emphasize that high quality bonds should form the primary share of fixed income allocations to provide adequate diversification.
Credit valuations have recovered, and now appear reasonable to slightly expensive.
Investment-grade credit valuations are near long-term normal levels after being expensive for most of 2018. High yield valuations are bordering on expensive after recent volatility and remain susceptible to repricing should the economic outlook darken. Trailing corporate fundamental metrics remain mixed too strong and domestic economic indicators have only moderated slightly. Corporate indebtedness remains high but is falling gradually as many companies prioritize debt reduction. We believe normal allocations to investment grade credit investments are appropriate and recommend a balanced approach relative to U.S. Treasuries. We remain neutral on high yield bonds, with a downside bias. Overall allocations to riskier fixed income sectors, such as high yield corporate and emerging market bonds, should be modest, with active management a critical factor. Deteriorating issuance quality in the bank loan segment of the high yield market warrants caution.
Global central bank policy is likely on hold for now, with a chance (albeit falling) the United States could tighten further before the end of the cycle.
There is increasing uncertainty around the direction of the next Fed rate move. While markets underappreciate the likelihood of a hike, there is rising downside risk as the yield curve nears inversion and after a string of weak economic data from the United States and abroad. The Fed has communicated clearly that they are on hold for now. They will likely err on the side of dovishness in the second quarter. Markets price a reasonable chance of a rate cut this year and more than one cut by the end of next year. This pessimism implies a weaker domestic economy than we foresee, although we continue to closely monitor trends in the data and maintain meaningful high-quality bond exposure to act as a portfolio diversifier.
Municipal debt valuations are elevated, though limited supply and robust demand should remain as tailwinds.
Municipal bond (muni) valuations are expensive by historical comparisons, particularly at shorter maturities. Longer maturities appear more reasonable, particularly when considering the persistently strong demand from investors seeking scarce tax havens. Limited supply continues to support prices and munis continue to provide value for taxable investors in higher tax brackets. Longer term, legacy liabilities (such as underfunded pensions, increased healthcare spending and deferred maintenance on infrastructure) may pose risks to certain segments of the municipal bond market.
Emerging market debt has become somewhat expensive and economic data has deteriorated.
Emerging market debt has rebounded in early 2019 after a tumultuous 2018. Spreads are now expensive once again and economic data in emerging economies continues to weaken. The Fed’s pause in rate hikes is constructive for emerging market economies, which rely heavily on U.S. dollar-denominated funding. However, it is unclear if domestic policy rates are already high enough to restrict growth in more vulnerable emerging economies. We remain neutral on emerging market debt, with a negative bias based on the expensive valuations and weakening economic momentum, which is being balanced by a more patient Fed. We continue to recommend active management. 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 assets markets
Interest rate decline provides breathing room for real estate investments, though income growth is slowing.
Prices for centrally located, Class A properties have been relatively flat for two years now. Although vacancies have declined close to record lows, net operating income (NOI) growth has been slowing. We expect the deceleration in NOI growth to continue due to supply growth and the late stage of the business cycle. Additionally, NOI relative to property values is near all-time low levels. This is another way of saying that the price-to-earnings ratio on real estate is near an all-time high. However, the decline in interest rates has created some breathing room between commercial mortgage interest rates and the earnings yield on Class A property. This eases pressure on prices. If interest rates remain in check, property can generate attractive returns.
While many of our property market indicators are urging caution, we believe investors can still earn the dividend yield of real estate investments. Furthermore, property investments do offer a compelling risk/reward tradeoff relative to other asset classes. Therefore, we remain tactically cautious acknowledging that interest rate movements will play an outsized role in determining the direction of property prices from here.
Fed dovishness, lower interest rates helping commodities.
Commodity markets from industrial metals to oil have rallied back strongly to start 2019 as Fed dovishness and lower interest rates have brought a bid to the commodities market. A more conciliatory tone between the United States and China on trade has also helped. However, better economic growth will ultimately need to present itself if prices are to move higher. The reason being that commodities are fairly well supplied across all complexes and so growth is necessary to prevent supply gluts. On the supply side of the oil market, U.S. shale production has broken out to new record highs since it appears some bottlenecks to production, especially in the Permian basin, have been resolved. Domestic inventories are growing and are now above five-year averages. For prices to hold up, the OPEC agreement to curtail supply may need to be extended if economic growth fails to increase.
The midstream infrastructure space has been a huge beneficiary of Fed dovishness and the increase in oil prices. From a fundamental perspective, the midstream industry is improving. Earnings (before certain expenses) are growing at a high rate and conversion of master limited partnership legal structures to C-type corporations have greatly improved corporate governance. With valuation metrics lower than 95 percent of historical ratios relative to itself and relative to the broader market, we believe the midstream space looks cheap. Based on our analysis, expected annualized forward returns are likely in the high single-digits over the next business cycle.
Within hedged equity, we continue to favor merger arbitrage strategies.
2018 was a banner year for mergers and acquisitions (M&A). It was characterized by large successful transactions across many sectors as companies sought cost savings and earnings growth. Many were cross-border deals and the number of transactions larger than $10 billion were the second highest over the past 15 years. We expect M&A to continue as companies prefer to “buy overbuild,” which drives strategic transactions to increase top line and bottom line growth. In addition to increasing M&A activity, increased market volatility adds to the attractiveness due to wider merger arbitrage deal spreads. This generally provides funds and the potential for higher returns.
Private equity is in demand more than any other alternative investment.
Fundraising for private market funds in 2018 was $432 billion and the amount of uncommitted capital rose to an all-time high of $1.6 trillion. Demand is expected to continue because private markets have consistently outperformed the respective public market indices since the global financial crisis. When investors’ demand to deploy capital exceeds the supply of available funds, there is higher risk of disappointing results. The chart below illustrates the views of both investors and fund managers regarding portfolio company/asset valuations. The takeaway from this graph is investors need to invest in funds disciplined in deploying capital, considering current valuations. Investing in a fund lacking investment discipline can result in the fund paying above fair market value, which will lower expected returns.
How investors and fund managers feel about portfolio company/asset valuations:
|Undervalued, considerable room for further price raises:
|Undervalued, some room for further price raises:
|Overvalued, correction more than 12 months away:
|Overvalued, correction likely within next 12 months:
|Overvalued, correction imminent:
|Source: Preqin Fund Manager and Investor Surveys. Date: November 2018.
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 March 2019 and represent 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, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio.
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. The MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 countries in Europe, Australasia and the Far East (EAFE). The MSCI Emerging Markets Index is designed to measure equity market performance in global emerging markets. The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities. The Bloomberg Barclays U.S. Treasury Bond Index measures U.S. dollar denominated, fixed-rate, nominal debt issued by the U.S. Treasury. The Bloomberg Barclays U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market and includes U.S. dollar denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers. The Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the U.S. dollar denominated, high yield, fixed-rate corporate bond market. The Bloomberg Barclays Emerging Markets Bond Index tracks total returns for external currency-denominated debt instruments of the emerging markets, including Brady bonds, loans, Eurobonds and U.S. dollar denominated local market instruments. The Bloomberg Barclays Global Aggregate ex-U.S. Dollar (USD) Index is a measure of global investment grade debt from 24 local currency markets. This multi- currency benchmark includes Treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. The Bloomberg Barclays Emerging Markets U.S. Dollar (USD) Aggregate Index is a flagship hard currency emerging markets debt benchmark that includes fixed and floating-rate U.S. dollar denominated debt issued from sovereign, quasi-sovereign and corporate EM issuers.