In This Issue: An Economic & Market Commentary from Trust Point. Economic And Market Update Equity Market Update Fixed Income Market Update

Transcription

1 Issue No. 21 In This Issue: Economic And Market Update Equity Market Update Fixed Income Market Update An Economic & Market Commentary from Trust Point

2 An Economic and Market Update from Trust Point From general euphoria in January to panic selling in February, it certainly has been a roller-coaster ride for investors over the past three months. For the first quarter of 2018, global equity markets were down 1.3%, while global bonds (hedged) were down 0.1%. The good news is that the macroeconomic backdrop remains solid. However, Washington is looking to make some noise ahead of the mid-term elections in November. Dollar Index Level March US Economic Activity KEY ECONOMIC DATA As of Actual 3 Mos. Ago 1 Year Ago ISM Manufacturing (>50 = Expansion) March ISM Non-Manufacturing (>50 = Expansion) March Non-Farm Payrolls March 103K 175K 73K Unemployment Rate March 4.1% 4.1% 4.6% CPI Ex-Food & Energy (yoy) Feb 1.8% 1.7% 2.2% Global Economic Activity JP Morgan Global Manufacturing Index (>50 = Expansion) March JP Morgan Global Services Index (>50 = Expansion) March Trade War? Not so Fast In early March the Trump administration announced tariffs on imported steel and aluminum. A few weeks later, the administration announced a package of $50-$60 billion in tariffs on goods from China. Markets sold off in the days following both announcements, while volatility spiked up. At this point, we view the announcements as a negotiation tactic; we doubt we are seeing the end of years of lower trade barriers and greater global integration. Washington is looking for concessions from China, and we suspect there will be some. At the time of this writing, it has already been reported that Chinese policymakers are preparing market-opening measures in the financial sector and have shown an appetite for increased purchases of U.S. goods to help narrow the trade deficit (Chart 1). A full-blown trade war (tariffs followed by retaliatory tariffs) would be a lose-lose situation for all parties as it would reduce trade flows and depress economic growth, while leading to higher inflation as well. Negotiations are underway behind the scenes, and we suspect that a negotiated outcome before the full implementation of the tariffs (which could still be a few months away) is ultimately what the Trump administration is looking for ahead of the mid-term election. Source: Bloomberg Chart 1: U.S. Ran a $375B Merchandise Trade Deficit with China in Current Account (US$ bn) Goods Total Goods, Feeds & Beverages Capital Goods Ex-Autos Consumer Goods Ex-Food & Autos Source: MRB Partners, U.S. Bureau of Economic Analysis U.S. Exports to China U.S. Imports From China Net Balance

3 Economic Growth: Still Very Healthy Chart 2: Earnings Benefiting from Tax Reform and Deregulation Heading into the mid-terms, both the U.S. and the world economies continue to enjoy a broad and synchronized expansion. Although the expansion has continued for several years, it remains relatively mild in strength, with few signs of bubbles developing. For the rest of 2018, we are quite confident that economic growth will remain strong, though we recognize that the pace of growth could be moderating slightly. At this time, absent a significant deterioration in trade relations between the U.S. and China, we see no near-term economic threat that would lead to a significant deterioration in global or domestic economic activity. In the U.S., the tax reform and deregulation efforts of the Trump administration should continue to be supportive for equities, as earnings (Chart 2), buybacks, and dividends will be lifted. In the Eurozone and China (the other two most important pillars of the global economy), growth remains relatively strong as well. Now that a 21-month transition agreement for Brexit has been approved by E.U. leaders, U.K. businesses have a little more breathing room, knowing that the free movement of goods, services, and people will now be extended to December This is a positive development for the U.K. economy following months of uncertainty. Source: BCA Research, IBES Data What If? Growing our clients assets is important, but preserving capital during bad times is equally important. Our weight of evidence approach focuses on the hard data and not the headline news. Our investment process and philosophy requires us to gain a thorough understanding of economic and market cycles. We recognize that both equities and bonds have provided solid returns in recent years. However, pricier equity valuations and low bond yields are headwinds to future expected returns. As much as we would like future returns to match recent ones, we find it increasingly difficult to spot true longterm investment opportunities in the marketplace today. As we slowly approach the end of this economic cycle (which is already the third-longest since World War II) (Chart 3), we are spending more and more time asking ourselves: What If?. What if inflation surprises on the upside? What if the U.S and China can t reach a trade agreement? What if interest rates make a significant move higher? With those and other questions in mind, we monitor a number of indicators and models to provide us with insightful signals that a change in strategy is warranted. At this time, we are maintaining the status quo. But, we are alert for signals that changes to portfolios may be necessary in the latter part of Chart 3: U.S. Economic Expansion: Getting Long in the Tooth Source: Ned Davis Research

4 An Equity Market Update from Trust Point The first quarter of 2018 was a volatile one for equity markets. The S&P 500 declined 0.8% while the MSCI EAFE index fell 1.5%. Trust Point continues to believe that an overweight allocation to equities is appropriate, given synchronized global growth along with bond yields that remain below fair value levels. Additionally, although U.S. equity valuations are comfortably off their recent highs, international equities are earlier in their economic cycles, with still lower valuations combined with solid expectations for earnings growth. Thus, we continue to overweight international equities relative to our base case. Equity Volatility Returns, Finally US Economic Activity S&P 500 2,641 2,674 2,363 2,068 1,569 Dow Jones Industrial Average 24,103 24,719 20,663 17,776 14,579 NASDAQ 7,063 6,903 5,912 4,901 3,268 Equity Returns (%) Source: Bloomberg, Morningstar Chart 4: Intra-Year Drop of 10% in Q1 EQUITY BENCHMARK TABLE Quarter-End 3 Mos. Ago 1 Year Ago 3 years Ago 5 Years Ago 3 Year 5 Year 3 Month YTD 1 Year (Ann) (Ann) US Large Cap Growth 1.4% 1.4% 21.3% 12.9% 15.5% US Large Cap Value -2.8% -2.8% 6.9% 7.9% 10.8% US Mid Cap Growth 2.2% 2.2% 19.7% 9.2% 13.3% US Mid Cap Value -2.5% -2.5% 6.5% 7.2% 11.1% US Small Cap Growth 2.3% 2.3% 18.6% 8.8% 12.9% US Small Cap Value -2.6% -2.6% 5.1% 7.9% 10.0% International Large Cap Developed (US Dollar) -1.5% -1.5% 14.8% 5.6% 6.5% International Small/Mid Cap Developed (US Dollar) 0.2% 0.2% 23.5% 12.3% 11.1% Emerging Market (US Dollar) 1.4% 1.4% 24.9% 8.8% 5.0% After a year in which equity price volatility was the second lowest since 1928, global equity markets have already experienced strong upward and downward swings in the first quarter of From late January through early February, the S&P 500 formally entered correction territory, defined as a market index down by 10% or more from a recent high (Chart 4). Then the S&P turned around and rebounded by 8% by early March. The Dow Jones index followed by entering correction territory in late March. Investors can point to several reasons why volatility has returned: potential trade wars, economic data suggesting growth is moderating, rising U.S. interest rates amid an uncertain inflation outlook, and a sell-off of high-flying tech stocks. While investors generally don t want asset prices to decline, enough time had passed since the last correction to raise concerns that the next correction might also bring on a bear market. However, given a broad, strong global economic backdrop and healthy corporate earnings growth, we do not feel a recession is imminent in the nearterm. Market corrections are healthy and normal, with 10%+ corrections occurring once per year on average. They can reset expectations for longterm appreciation and they give buyers opportunities to purchase equities at discounts to enhance future returns. Source: J.P. Morgan Asset Management

5 Global Earnings Revisions Are Off to a Good Start Chart 5: Global Earnings Revisions Are Off to a Good Start As global corporations released their Q revenue and earnings results, analysts and investors were presented with outcomes generally stronger than expected. Building off their year-end optimism, corporate executives provided forward guidance and expectations that were higher than what was already expected. In turn, analysts assigned to forecast future corporate financial results took those strong Q4 figures and increased their own earnings forecasts. In fact, over 75% of companies in the MSCI All Country World Index (~2,500 constituents) had their 2018 earnings expectations revised upward, a 4.9% increase from a year ago (Chart 5). The positive revisions primarily came from U.S. companies (which make up just over 50% of the index s market value), as they benefited from strong organic growth expectations and the Trump tax cuts announced in December. As earnings growth is the fundamental driver of stock prices, an increase in positive revisions should be viewed as good news for global equities. Despite a Breakout in Bond Yields, Growth Stocks Continue to Outpace Value Stocks Bond yields have declined over several years due to aggressive central bank actions, despite an improving economy. Finally, in Q1 yields spiked, but value stocks did not take the bait. In the past year, growth sectors such as technology and consumer discretionary outperformed value sectors such as financials and energy. Historically, improving economic growth and rising bond yields are positive catalysts for value stocks (Chart 6). Tech stocks, a significant growth-sector constituent, are now more cash-rich than in the past, making them more resistant to a rise in bond yields. Techs today don t have the extreme valuations of the past, as robust earnings growth has kept them more attractively priced; that has taken investor attention away from traditional value stocks. Despite growth s outperformance, we continue to position for inflation expectations to move higher, pushing bond yields and interest rates up, which will bode well for financials and other more value-oriented sectors, like energy. Copyright 2018 Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at com/copyright.html. For data vendor disclaimers refer to Source: Ned Davis Research, Inc. Chart 6: Value Stocks are not Following the Lead from Interest Rates Source: MRB Partners

6 A Fixed Income Market Update from Trust Point Tax reform and strong growth helped apply upward pressure on bond yields into Rising yields remain a headwind for high-quality bonds, but the risk/reward outlook is starting to shift as investors are finally getting paid higher interest rates on their bonds. Yields Should Keep on Rising US Yields (%) 3 Month T-Bill 1.7% 1.4% 0.8% 0.0% 0.1% 2 Yr US Treasury 2.3% 1.9% 1.3% 0.6% 0.2% 10 Yr US Treasury 2.7% 2.4% 2.4% 1.9% 1.9% Global Economic Activity FIXED INCOME BENCHMARK TABLE Quarter-End 3 Mos. Ago 1 Year Ago 3 Years Ago 5 Years Ago 3 Year 5 Year 3 Month YTD 1 Year (Ann) (Ann) US Intermediate Treasuries -1.5% -1.5% -0.3% 0.5% 1.0% US Treasury Inflation Protected Sec. -0.8% -0.8% 0.9% 1.3% 0.0% US Mortgages -1.2% -1.2% 0.8% 1.1% 1.8% US Short-Intermediate T/E Munis -0.6% -0.6% 0.6% 1.2% 1.5% US Investment Grade Corporates -2.3% -2.3% 2.7% 2.3% 3.0% US Senior Bank Loans 1.4% 1.4% 4.4% 4.2% 3.9% US High Yield -0.9% -0.9% 3.7% 5.2% 5.0% US Convertibles 2.4% 2.4% 10.6% 6.6% 9.7% Int l Bonds Ex-US (Hedged) 1.5% 1.5% 3.9% 2.8% 4.1% Int l Bonds (Unhedged) 1.4% 1.4% 7.0% 2.0% 1.5% Emerging Market Debt (US Dollar) -1.8% -1.8% 3.3% 6.8% 3.9% Last quarter we mentioned that a key to the direction of U.S. interest rates would be the materialization of inflation. Our view was that rising inflation expectations would force longer-term interest rates higher to compensate investors for the risk of losing future purchasing power. This scenario started to materialize in the first quarter, as economic data began to reveal higher wages and business surveys showed increases in prices paid. Surveys also showed a greater willingness for businesses to pass these higher wages and production costs on to consumers via higher selling prices. As a result, underlying inflation picked up, causing interest rates to move higher. The 10-year Treasury yield, which was closer to 2% for most of 2017, rose to nearly 3% in the first quarter and settled in March at the highest levels since Typical of an economic cycle, inflation is lagging the strong economic growth we have experienced since the middle of We expect higher inflation and interest rates through the rest of the year (Chart 7). Our portfolios have been positioned for this development by favoring inflation protection while keeping interest-rate sensitivity at below-benchmark levels. Our portfolios remain positioned to do well relative to our benchmarks in an environment of rising inflation and interest rates. Source: Bloomberg, Morningstar Chart 7: Core Inflation Has Started to Turn Higher Source: MRB Partners

7 Federal Reserve Delivers Another Rate Hike While rising inflation expectations were one of the catalysts for higher yields in the first quarter, the Federal Reserve has also been a major contributor. March saw the sixth Federal Funds interest-rate hike of the current cycle, which began in December 2015 (when the Fed ended seven years of near-zero rates). With the unemployment rate continuing to fall and inflation starting to pick up, the Fed has projected a total of three interest-rate hikes for 2018, which could easily be revised to four if inflation and economic growth are maintained. Higher Federal Funds interest rates have caused market interest rates to rise, especially on the front end of the curve, where short-term interest rates are most sensitive to Fed policy. Short-term rates have risen to the highest levels in a decade alongside the Federal Funds rate (Chart 8). Although rising short-term rates could result in slightly higher payments for some borrowers with variable-rate loans such as credit cards, lines of credit, or adjustable rate mortgages, higher rates have also brought a welcome reprieve to investors who for years have accepted near-zero percent interest rates on everything from money-market savings accounts to certificates of deposit. We have been able to capitalize on this trend of rising short-term interest rates to enhance yields in our fixed-income allocations. Chart 8: Short-Term Treasuries Have Risen With Fed Funds Rate Hikes - 10 Year Highs Source: Bloomberg Taking a Closer Look at Corporates With the latest Fed Funds rate hike and the gradual shift away from historically accommodative monetary policy, we have been focusing more attention on corporate credit markets. When the Fed is hiking rates, they are considered to be tightening policy and restricting financial conditions. This process has weighed on credit markets in recent weeks and will likely contribute to volatility going forward. However, corporate profits continue to rise and, as mentioned above, corporations have been able to raise prices to compensate for higher labor and production costs (Chart 9). In addition, corporations have received a major benefit to the bottom line through a significant tax cut which is just beginning to show through in earnings. As long as profit growth is sustained, corporate health should remain stable even as debt levels and production costs are increasing. The outlook for future returns from price appreciation in the corporate credit markets remains modest, given the strong performance in 2017, but the yield offered by corporate bonds remains attractive relative to government bonds. We continue to monitor markets closely for developing signs of deterioration in corporate health or stress in credit markets. Chart 9: Higher Selling Prices Will Support Profitability - For Now... Source: MRB Partners

8 is a quarterly market commentary designed to provide you with an overview of economic conditions, as well as equity and fixed income market summaries for the quarter. This commentary is offered by the Investment management team. The individuals contributing to are Randy Van Rooyen, CFA, Yan Arsenault, CFA, CAIA, Brandon Hellenbrand, CFA, Steve Brudos, Ryan Bergan and Evan Schnetzer. Please feel free to contact any team member with questions. Pictured left to right: Ryan Bergan, Yan Arsenault, Randy Van Rooyen, Evan Schnetzer, Steve Brudos and Brandon Hellenbrand. The opinions herein are those of Trust Point Inc, are made as of the date of this material, and are subject to change without notice. Trust Point uses its best efforts to compile its data from reliable sources, however, it does not warrant the accuracy, completeness or timeliness of any of the information provided. This publication is prepared for general information only. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. All investing involves the risk of loss, including principal, a reduction in earnings, and the loss of future earnings. Past performance is no guarantee of future results. Individual client portfolio performance and transactions therein can vary greatly based on factors including investment strategy, objective, limitations, risk tolerance, time horizon, asset composition, asset allocation and tax implications. Trust Point Inc. Headquarters La Crosse, WI P: Minneapolis, MN P: Eau Claire, WI P: Copyright Trust Point Inc. La Crosse, WI All Rights Reserved 230 FRONT STREET NORTH I PO BOX 489 LA CROSSE, WI Standard U.S. Postage PAID Mailed from Zip Code Permit No. 125