Quarterly Reflections & Outlook
Second quarter 2018 investment views: Still positive, but an increasing degree of difficulty
We have recently shifted our perspective on the capital market environment from a more pro-growth viewpoint to one that embraces a more balanced return opportunity. While the global economic backdrop remains positive and our analysis reveals broad-based momentum, we believe investors will have to digest two major developments throughout 2018 that could cause some challenges as the year unfolds.
- First, global central banks, that had promoted economic growth during and since the 2008-2009 recession, are shifting to a less accommodative stance, raising interest rates and slowing asset purchase programs. Central banks had aggressively cut interest rates and bought bonds and other assets in an attempt to stimulate consumer and business activity. Following recoveries in major economies, central bankers do not want to stoke inflationary pressures.
- Second, the geopolitical environment could prove challenging because major economic powers appear to be taking a more inward focus. Concerns about trade negotiations, currency volatility and the potential spillover into borrowing costs could lead to increased volatility following two relatively placid years for investors.
While we respect the potential risks that could develop, we still see opportunities across asset classes, and the underlying economic momentum should not be ignored. Should central banks pursue a more gradual path in changing policies and geopolitical tensions ease, asset prices could continue to rise, albeit at a likely slower pace than the last few years. As always, we will keep you updated to our most recent thinking and appreciate your trust.
Global economic views
The U.S. growth outlook remains positive, but unknown policy outcomes may add to uncertainty in 2018.
With the passage of the Tax Cuts and Jobs Act, we believe fiscal stimulus is likely to support continued economic growth in the United States. Our positive outlook is moderated somewhat by our expectation for continued, gradual removal of monetary stimulus by the Federal Reserve (Fed). We expect three, or possibly four, increases in interest rates in 2018. In addition, we expect the Fed to continue to reduce the size of assets on its balance sheet, which also serves to reduce monetary stimulus in the economy.
Uncertainty over trade negotiations, including proposed tariffs and potential retaliation from global trade partners, may prove to be a headwind to the U.S. economy if businesses postpone hiring or investment as a result. In addition, midterm Congressional elections in November carry the potential for a change in party leadership.
In summary, our base view is that growth remains positive in 2018 and that a positive growth trend remains intact well into next year, but policy uncertainty has increased. We see inflation continuing to rise modestly, reflecting wage growth, fiscal stimulus and continued lift from easy monetary policy.
The developed economies of Europe and Japan appear to be well supported in 2018 by easy monetary policy.
Europe has entered 2018 at the fastest pace of economic growth since 2011. Yet, core consumer price inflation (CPI) remains well below the European Central Bank’s (ECB) target level. This indicates that monetary policy should continue to be supportive for economic growth through continuation of low interest rate policy and the asset purchase program. Political risks appear to have eased in Europe, with Angela Merkel elected to her fourth term as Prime Minister of Germany. After setbacks in the Netherlands and France early in 2017, populist parties gained ground in recent German and Italian national elections but still lack sufficient popularity to form a ruling majority.
Japan is also entering 2018 amid accelerating economic growth. Core inflation has turned positive but remains well below the Bank of Japan’s target level. As with Europe, this suggests a continuation of accommodative monetary policies, such as low interest rates and asset purchases, well into 2018 and possibly beyond. Meanwhile, the political environment in Japan is mixed. Prime Minister Shinzo Abe’s party won a supermajority in October, which increases the chances of enacting growth-oriented reforms. However, a recent scandal surrounding Abe and his wife Akie creates greater uncertainty in Japan’s future political leadership following party elections slated for September.
Concentration of power with China President Xi Jinping likely does not change prospects for modest growth.
China’s legislature, the National People’s Congress, voted overwhelmingly to abolish the decades-old, two- term limit on the presidency. This paves the way for a potentially much longer leadership tenure for current President Xi Jinping, who is in his second five-year term. We expect domestic policy to focus on the environment, healthcare, military modernization and financial sector reform. For the next couple of years, we still believe growth in China will continue to decelerate since the focus is on quality, rather than quantity of growth. Tighter financial conditions, intended to reign in credit growth outside of the formal banking system, and a crackdown on corruption are both headwinds to growth. However, we believe the risk of a banking crisis and spillover into the global economy are limited given ample deposits, available foreign currency reserves and tighter government oversight.
On average, growth trends across emerging market nations remains varied. Russia and Brazil continue to recover from recent recessions and should continue to see improving prospects as long as oil prices remain flat to higher. Countries such as India and Korea, on the other hand, have seen somewhat softer growth in the face of somewhat tighter monetary and fiscal policies. Our view is that trends remain mixed into year-end but see little risk of a negative impact to global growth.
U.S. stocks are likely to trend higher this year, supported by increasing earnings, generally restrained inflation and low interest rates relative to historical norms, although returns may be more subdued than in recent years.
With inflationary indications creeping into the marketplace and interest rates inching higher, volatility among U.S. stocks is apt to remain elevated throughout the year. Earnings are increasing, bolstered by synchronized global growth, tax reform and ramping expectations for capital expenditure spending. As of the end of the first quarter, consensus earnings estimates for the S&P 500 in 2018 and 2019 are approximately $156 and $170, respectively, based on Bloomberg and FactSet data. This represents year-over-year earnings growth of roughly 17 percent and 9 percent, and higher earnings typically equate to higher stock prices.
Valuations are elevated yet short of extremes. Of debate is the degree to which price-earnings multiples may reset lower when investor focus shifts to a slower rate of year-over-year earnings growth in 2019. At a minimum, given the current stage in the business cycle, it seems unlikely that price-earnings multiple expansion will be a significant driver of higher equity prices. In fact, from current levels, valuation is likely to be more of a headwind than tailwind.
Growth and cyclical-oriented sectors typically outpace defensives in an expanding global economy amid upward-trending interest rates. We continue to favor sectors and companies growing faster than peers, operating in segments of the market growing faster than the broad economy. On balance, select companies within the Consumer Discretionary, Information Technology, Industrials, Materials and Financials sectors have attractive growth prospects.
Our 2018 year-end price target for the S&P 500 is 3,000 based on a multiple of 19 times to 20 times our earnings estimate of $155. Upside to our price target is likely to be a function of higher-than-expected earnings growth. Any downside is likely to be a result of price-earnings multiple compression in response to ramping inflation and an accelerating pace of interest rates hikes.
Positive outlook for foreign developed equities tempers as economic momentum stalls.
Our outlook for foreign developed equity markets has shifted from a “glass half full” to a more balanced perspective on risk and return. On the positive side, economic and corporate fundamentals continue to provide a solid backdrop. Strong year-over-year growth in corporate profits reflects an underlying economic recovery that has transitioned into expansion in both continental Europe and Japan. Inflation is positive but remains well below central bank target levels. Therefore, we expect monetary policy in both regions to remain supportive for risk assets by maintaining low interest rate policies and asset purchase programs well into 2018 and possibly beyond.
Tempering our positive outlook, recent business surveys in Europe indicate that while economic conditions remain quite positive, upward momentum appears to be stalling. Valuation, particularly for European equities, remains elevated relative to historical averages. This suggests that some of the positive economic and corporate fundamentals may already be “priced in” to current stock prices. Price momentum, or the trend in stock price movements, for foreign developed equities is weak, with Europe the weakest among major global equity markets. Meanwhile, despite notable improvements in corporate profitability of “Japan, Inc.,” foreign investors remain skeptical toward Japanese equities, as evidenced by outflows of investor funds. Finally, weakness in the U.S. dollar, which provided a meaningful lift to investments in foreign equities in 2017, has abated in early 2018.
Neutral view on emerging market equities shaped by valuation and policy risk.
We view opportunities and risks in emerging market equities as fairly balanced for the remainder 2018 and retain our neutral outlook. The overall economic environment for emerging markets remains positive. Brazil has emerged from a deep recession and manufacturing surveys there are reflecting robust
domestic sentiment. Overall, corporate profit growth in emerging markets remains strong, with estimates for earnings in 2018 continuing to be revised higher. Rising levels of foreign exchange reserves in emerging market countries are reflective of a continued robust global economy. Also, measures of risk in emerging markets, such as the difference in the average government bond yield versus equivalent U.S. Treasuries, remain benign.
Our neutral view on emerging market equities is shaped primarily by valuation and policy risks. Measures of valuation are well above historical averages and reflect heightened levels of investor confidence. Policy risks center around U.S. trade policy and the greater susceptibility of emerging market economies to disruption in global trade. Finally, monetary policies across emerging markets appear to be less coordinated, ranging from very loose (Brazil) to very tight (Mexico). While we have a constructive view of the global economy in 2018, diverging policies will likely lead to less synchronized, diverging outcomes in emerging markets in the years ahead.
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.
Fixed income markets
Bond yields are still low by historical standards despite the recent rise, indicating likely subdued future returns. We anticipate gradually higher yields driven primarily by higher inflation, central bank actions, increased U.S. Treasury debt issuance and stable global growth. As a result of our expectation for higher yields, we advocate for shortening maturity profiles within bond portfolios. Treasury bonds offer increased competition and a more balanced risk/reward versus riskier income-producing assets, as a result of recently higher bond yields and high valuations across other asset classes. The primary risk to our view is that rates could remain low if inflation remains stable or falls.
Inflation, central bank policy and higher U.S. Treasury issuance should push bond yields higher.
Higher inflation appears likely, in part due to robust job growth and low unemployment. Inflation also tends to follow growth and the recent rise in domestic and global growth should soon flow through to higher inflation. Rising inflation and inflation expectations should apply modest upward pressure on bond yields.
We expect the Fed will increase their target funds rate three times in 2018, though odds of four times are rising. We also expect the Fed to continue unwinding their balance sheet, albeit at a modest and deliberate pace. The ECB is likely to conclude their asset purchase program by year-end while the Bank of Japan is likely to remain an active buyer at least into next year. While on a net basis, central banks are still injecting liquidity into markets via asset purchases, declining net purchases are expected as we approach 2019.
Ongoing deficit spending is probable, necessitating elevated U.S. Treasury issuance. This, in turn, should place upward pressure on bond yields as investors digest increasing supply.
We are cautious of using corporate credit to enhance income because the risk/reward of corporate credit now appears balanced versus U.S. Treasuries.
Relatively tight investment grade corporate bond spread, or incremental yield offered above U.S. Treasuries, is likely to be offset by modest spread widening. Despite a constructive economic backdrop, high corporate credit valuations may be increasingly challenged by increased market volatility and compensation from higher U.S. Treasury yields.
While the degree of value offered by municipal bonds for taxable investors is compressed, prices should be supported by limited supply. Municipals with a longer maturity profile offer more value than shorter maturities, relative to Treasury and investment grade corporate bonds.
High yield bonds offer incremental yield relative to investment grade corporates and U.S. Treasuries, but high valuations leave little room for error. Investors should be wary of repricing risk and volatile investment flows are creating additional uncertainty. 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 protection in the corporate balance sheet. We strongly advocate for active management within the high yield space, reflecting the higher risks and diverse nature of the market.
The outlook for non-U.S. bonds remains mixed and we recommend any international exposure remain currency hedged.
Unhedged exposure in developed markets is unattractive due to low yields and often uncompensated currency volatility. On a currency-hedged basis, the investment picture remains mixed, but with higher rates and lower central bank liquidity likely ahead, we prefer U.S. markets.
For investors with higher-than-average risk tolerance, emerging market debt remains an opportunity for diversification. Economic fundamentals in many areas are improving, though like U.S. high yield bonds, repricing risk remains a consideration, and we recommend active management. Like non-U.S.
developed markets, incurring emerging market foreign currency risk has resulted in materially higher (and often uncompensated) price volatility. As such, we advocate for U.S. dollar-denominated bonds within the emerging market bond category.
Real estate markets
After a 110 percent recovery from the depths of the financial crisis, the best of times in the real estate cycle are clearly behind us now.
Centrally located, Class A properties are experiencing slight year-over-year price declines and real estate investment trusts (REITs) have fallen 9 percent from the recent peak in December 2017. Income growth of real estate (net of expenses for operations) has come under pressure. We expect the deceleration in income growth to continue as more properties are offered for sale. Valuations for properties, typically measured as net income relative to price, are expensive relative to long–term averages. Any pressure on income or rising U.S. Treasury yields may further harm real estate prices. Even though real estate looks attractive versus other similar investment strategies on a long-term basis, we remain tactically cautious as a more active Fed and an increase in interest rates could dislodge relative expensive valuations, causing larger price declines in commercial real estate.
While longer-term supply and demand fundamentals may be improving for several commodities, we remain cautious in the current market environment.
In the short term, we expect commodity prices to be volatile and to trade in line with production costs as the remaining excesses of the previous cycle are worked down and spare capacity is reduced. As markets approach equilibrium, we believe prices will need to rise in order to create a supply response. Over time, we believe that rising costs and emerging supply constraints will put upward pressure on most commodities. However, investor sentiment is positive and investors are positioned bullishly across most commodity sectors, which could act as a headwind to any significant upside price move.
Energy market supply and demand fundamentals have improved. OPEC production cuts have helped bring global inventories back toward more average levels.
However, further price gains will require further surprises in demand growth and some limitation in growing U.S. oil production.
Alternative investment strategies
Three months into 2018 and we continue to believe the environment for alternative investments remains favorable. Why? First, dispersion among securities, asset classes, countries and regions will continue as the Fed’s tightening of U.S. monetary policy diverges from those of Europe and Japan through 2018. This bodes well for trading- oriented hedge fund strategies that can quickly react to an ever-changing investment environment. Second, we are expecting lower-than-historical returns from public market securities. This can benefit private debt and private equity, which are generally expected to generate higher returns than traditional bonds and traditional equities, respectively, over the next full market cycle.
Continuing through 2018, we expect the demand for less liquid strategies to increase as both taxable and tax-exempt investors strive to achieve their targeted returns. Private debt funds should continue to attract capital due to the low yields offered by investment grade and high yield bonds available in the public markets. However, caution is warranted since the quality of loans and borrowers is deteriorating due to increased competition among direct lending funds needing to put capital to work.
Private equity investors invested in industries such as biotechnology, medical devices, robotics, etc. have the opportunity to profit as technology innovations/discoveries are quickly making way into their respective markets. Biotech is a good example where recent discoveries for treatments for serious diseases are being fast-tracked through the FDA’s accelerated approval process. From a global perspective, private capital investing in Asia and Europe is attractive due to:
1) improving economies throughout the regions,
2) fewer private capital funds vying to deploy capital, and 3) higher expected returns due to investing in opportunities with lower valuations.
From a strategy perspective, here are our views on some of the major subsectors:
Hedged equity: We believe that event-driven managers are positioned to profit from the global mergers and acquisitions (M&A) activity taking place as companies embrace the “cheaper to buy than to build” mantra. These multi-billion dollar M&A deals require financing through the public markets. This is a “vote of confidence” by global corporations on the health of the global economy needed to support these large acquisitions.
In both the United States and Asia, investment opportunities in the Healthcare and Technology sectors are attractive due to the high velocity of change that disrupts the status quo, which leads to disparity between winners and losers. Both regions understand the impact of technology in social media, machine learning applications and automation used in production. An investment theme we embrace is how healthcare companies are positioned to prosper in both developed and developing countries. Medical costs increase as populations grow older, which is a defining characteristic of both the United States and Japan. At the same time, members of the growing middle class in emerging countries are consuming more healthcare services as their level of discretionary income increases.
Hedged fixed income: As the Fed continues to raise interest rates in the United States, we target investment opportunities that are less interest rate sensitive and more driven by credit quality. The most attractive opportunities are below investment grade (high yield) bonds issued by domestic and European companies. Credit quality catalysts, such as a rating upgrade or a debt restructuring drive price change. The securities are less liquid, less researched and often issued by companies in “old economy” industries. Therefore, it is important to focus on trading-oriented strategies that combine the “technical” knowledge of how these securities trade, with a thorough credit analysis.
Private equity: We see value in funds that focus on niche strategies in growth sectors that can take advantage of the “buy versus build” corporate mindset. Value can be added via purchasing companies and incorporating operational initiatives with the end goal of selling it to another firm to assist in its strategic business plans. From a regional perspective, the uncertainty in Europe due to Brexit should provide opportunities for private equity. In Asia, most countries’ economies are becoming less tied to China’s economy and more by their local economies and the growth in domestic consumption.
Below are the type of investment opportunities and/or investment characteristics we favor when looking for private equity funds:
- Strategies focused on acquisitions and/or improving growth through operational initiatives that result in increasing cash flow by either generating growth or reducing costs.
- Funds that recognize how technology is disrupting the way business is conducted. This is most visible in the healthcare, consumer and business/financial services sectors.
- Understanding that investing in Asia requires both capital and being a solution provider. Companies are wanting to work with partners that can assist them with sharing knowledge on how to grow market share domestically or build a global business.
- Experienced managers that are well positioned to capture the opportunity in Europe given the dislocation caused by Brexit negotiations.
Private debt: Funds with a unique access or knowledge of specialized industries, such as healthcare, have a competitive advantage due to high barriers to entry, pricing power and premium products or services. The type of loan is important. Club-style first lien loans provide a sense of comfort by investing alongside other “smart money” but the yield is lower. Higher yields can be found investing in riskier loans, such as a middle- market debt issued from a company that operates in an industry subject to technology innovation.
This commentary was prepared March 2018, and the views are subject to change at any time based on market or other conditions. This information represents the opinion of U.S. Bank Wealth Management and is not intended to be a forecast of future events or guarantee of future results. It 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.
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.
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. 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). Alternative investments very often use speculative investment and trading strategies. There is no guarantee that the investment program will be successful. Alternative investments are designed only for investors who are able to tolerate the full loss of an investment. These products are not suitable for every investor even if the investor does meet the financial requirements. It is important to consult with your investment professional to determine how these investments might fit your asset allocation, risk profile and tax situation. 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 debt investments may be either direct or indirect and are subject to significant risks, including the possibility of default, limited liquidity and the infrequent availability of independent credit ratings for private companies. 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 (3/18)