Key Private Bank s Market Outlook. Executive Summary. Contents. April We expect interest rates to rise modestly over the remainder of 2018

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1 Key Private Bank s Market Outlook April 2018 Key Private Bank s Investment Management Team follows a rigorous and disciplined process as we evaluate markets and manage client portfolios. Our quarterly newsletter highlights our research and strategy teams current thinking on the most important trends likely to shape the market behavior and serves as a foundation for constructing client portfolios. Inside you ll find greater detail on our market, equity, and fixed-income outlook. Executive Summary We expect interest rates to rise modestly over the remainder of Contents We expect two additional Federal Reserve rate hikes this year. Aging economic cycle Although the economic cycle is clearly aging, economic growth remains strong and should continue for much of the next year. Market Outlook...2 Equity Outlook...4 Fixed-Income Outlook...6 Tax Cuts and Jobs Act (TCJA) dramatically improved profitability The newly passed tax act has dramatically improved profitability for many U.S. companies. While the change will not necessarily alter long-term earnings growth, there will be a surge of earnings growth this year. Trade war heats up We expect volatility in the markets to remain elevated as the U.S. and China publicly negotiate trade. However, we believe the strong macro and fundamentals will eventually prevail The markets appear to be overreacting. The positives that continue to underpin the bullish thesis include solid global growth, positive domestic activity driving corporate earnings growth, capital spending improvement, and real household median incomes jumping with strong employment. Key Private Bank s Market Outlook April

2 Market Outlook, April 2018 Equity outlook Investors rediscovered the risks of the economic cycle this year, as fears of rising wages and higher inflation caused the worst equity selloff since early in More recently, trade tensions have added to investor anxieties, as the public worries trade wars could derail global economies. The U.S. economic cycle is clearly aging. However, economic growth remains strong and should continue for much of the next year unless something extraordinary happens. Economic cycles rarely end quickly. Instead, interest rates rise slowly as authorities gradually tighten monetary policy. It usually takes a number of significant rate hikes before the economy slows. Rate hikes also have a lagged effect on the economy, so it typically takes nine months to a year for rate hikes to have their full effect. In a similar way, it is rare for financial markets to hit a new high and then drop immediately into a bear market. Those who watch market prices expect to see rounded tops before equities drop into major declines. Beyond the recent price decline, there has been little deterioration in the major leading indicators. We need to monitor conditions closely, but there should still be some time left on the clock. That means investors should be able to hold off significantly underweighting equity exposure. Since lower tax rates will generate strong earnings growth this year, extra equity exposure could make a meaningful contribution to portfolio returns. U.S. large-cap equities The Tax Cuts and Jobs Act (TCJA) dramatically improved the profitability of many U.S. companies. Companies that were paying close to the highest rate will see a windfall surge of profits. While the change will not necessarily alter long-term earnings growth, there will be a surge of earnings growth this year. Added tax incentives for capital spending should also strengthen U.S. economic growth this year. Already, increased capital spending has prompted more manufacturing jobs and higher wages on that side of the economy. Earnings for domestic large-caps are projected to rise about 18% for 2018, while the 2019 projections run closer to 10%. The 8% difference gives us an indication of how much effect the legislative changes will have on corporate earnings. However, investors may not pay quite as much for onetime earnings gains as they would for ongoing growth. Particularly as interest rates rise in the late stages of the economic cycle, the multiple paid for U.S. earnings may compress. On balance, domestic equities should have a stronger year in 2018 as a result of the tax changes, but beyond that the longer-term trends should reassert themselves. While there may be shorter-term opportunities to benefit from the changes, the longer-term outlook has not changed as significantly. U.S. small-cap and mid-cap equities Smaller-cap stocks should have benefitted heavily from the corporate tax decrease, since smaller companies have generally had fewer opportunities to shield themselves from taxes through overseas operations. Yet forecasts of earnings growth do not show a large growth differential for the small-cap indices. Without a strong growth advantage, we would retain a neutral exposure to smaller stocks within the domestic portion of the equity allocation. Developed international equities International markets clearly outperformed in 2017, as the Vanguard FTSE/Russell Developed Index rose 22.8%. The S&P 500 rose 19.5%. Over the first quarter of 2018, the two indices lost roughly the same amount. The dollar gave the overseas markets a major tailwind in The dollar index fell almost 10%, which translates overseas earnings and share price gains into higher dollar-based returns. The outlook for stronger U.S. growth, however, suggests currency trends could be less favorable to international investments in Key Private Bank s Market Outlook April

3 Europe Europe was the leading performer within the developed international region in 2017, rising 25.4% for the year. Europe is down a little less than the rest of the developed world this year. The Markit Manufacturing Purchasing Managers Indices (PMIs) showed extraordinary strength in Europe through In 2018 many of the PMIs remain high, but indicate a moderating outlook. The Eurozone PMI declined 4 points to That still implies a solid outlook, but the current reading is now more on par with the 55.6 reading for the United States. With GDP (gross domestic product) growth of 2.8% over the last year, the Eurozone grew slightly faster than the United States (2.6%). This year, however, tax reform and fiscal spending give the U.S. a somewhat better outlook for improved growth than Europe and other areas of the world. The strong European growth in 2017 occurred despite a very strong currency. The euro gained 14.4% against the U.S. dollar last year and gained another 2.5% through March of this year. If U.S. growth strengthens this year, the euro should not remain as strong. Other developed regions The United Kingdom (U.K.) exchange-traded fund (ETF) returned only 16.7% for 2017 and fell another 3.4% through March. The U.K. s economy grew 1.4% over the last year. Although the U.K. Manufacturing PMI has declined modestly, the current reading of 55.1 remains solid. While the uncertainties surrounding Brexit are undoubtedly dampening growth in the U.K., the outlook remains reasonably favorable. Japan s economic cycle is in the late stages, yet authorities there continue to provide economic stimulus. They want to ensure that a healthy level of inflation ends Japan s long period of economic stagnation. Raising the inflation rate, however, may do little to increase real economic growth (i.e., net of inflation). Japan s 2.1% year over year (real) GDP growth was modestly weaker than in Europe and the U.S. And Japan s Manufacturing PMI reading of 53.1 lags a little behind the equivalent survey in other countries. The Japanese ETF gained 22.7% in 2017, and has added 1.3% through the end of March. The weak dollar bolstered that return. Rising Japanese inflation, however, along with stronger U.S. growth, should lessen the translation effects in The Pacific ex-japan, which includes Australia, Hong Kong, and Singapore, returned 20.8% last year. The region dropped almost 3% in the first quarter. Australia, the largest part of that region, gained only 14.5% last year, while it dropped 5.0% through March 29. Still, Australia s GDP grew 2.4% over the last year, and Manufacturing PMI of 54.3 suggests a good outlook. Canada s ETF gained only 13.3% last year, and also lost 7% in the first quarter. The Canadian economy grew 2.9% over the last year, but it tends to be more leveraged than most economies to commodities trends. The Manufacturing PMI for Canada stands at Emerging markets equities Emerging market equities led the rest of the world last year. The Vanguard FTSE/Russell Emerging Markets Index rose 28.3%, and added another 2.3% in the first quarter. China s large-cap ETF rose 30% in 2018, and it is off only fractionally this year. Despite the strong market performance, fundamental growth was not inordinately strong. China s Manufacturing PMI has remained just over the breakeven level of 50 for most of the last year (currently 51.0). A number of the other major emerging economies also have PMIs in the low 50s. China s GDP growth was listed at 6.8%, but economists believe growth was closer to the mid-4% range. Like other parts of the international world, forecasters expect growth to continue in the emerging world but do not expect that growth to accelerate. Fixed income The 10-year Treasury yield has come to life in 2018, rising from around 2.4% at the end of the year to close to 2.7% at the end of the first quarter. The fears of higher inflation that drove the first sizeable equity correction in two years, obviously also had an impact on bonds. Inflation trends will be key this year. With expectations of somewhat more inflation pressure, we think rates will continue to move higher. Key Private Bank s Market Outlook April

4 Equity Outlook, April 2018 Perspectives from Key Private Bank s Equity Research Team Quite a ride After getting off to a stellar start during the month of January rising over 6%, global equity markets provided investors with a volatile ride. As measured by the FTSE Global All Cap which includes U.S. global equity markets, both developed and emerging market equities ended the quarter with a modest loss, falling -0.9%. The quarter marked the end of a remarkable period that saw global stocks rise 15 consecutive calendar months stretching back to October The U.S. large cap benchmark was ahead of its global developed market brethren, declining -0.8% to their -1.2%, respectively. Both emerging market and U.S. small-cap equities bucked the weakening trend, rising +1.3% and +0.6% on the quarter, respectively ISM Manufacturing & S&P 500 Total Return (Y/Y%): Will Strong Fundamentals Lead the Way Higher? ISM Manufacturing (LHS) S&P 500 Total Return Y/Y% (RHS) 60% 40% 20% 0% -20% -40% -60% Higher volatility or merely a return to more normal volatility? That is the question Plausible excuses The S&P 500 is now down approximately 10% from the heights seen in late January and is trading at pre-tax reform levels despite stronger fundamentals (higher organic growth and margin expansion) and favorable flows (with corporations accelerating buyback programs ahead of upcoming earnings season blackout period). In our view, the correction that began January 26 has very little to do with labor inflation, short volatility exchange-traded notes, Federal Reserve (Fed) uncertainty or potential trade wars. While these all make for very plausible excuses, we believe the weakness and ensuing volatility has been more about human nature than anything else. The market rallied 7.5% to begin 2018 following a 20% gain in An investor pulling up a chart of the S&P 500 over this time period would see a move straight up and to the right, with no meaningful pullbacks, complete with a parabolic acceleration of the upward move post the passage of tax reform. This extended low-volatility move resulted in historic levels of optimism and complacency, both of which were bound to be worked off. The only thing needed was a call to action. Proximate cause The wage gains in the January jobs report offered proximate cause to begin a more significant sell-off, as interest rate and Fed policy uncertainty shocked investors. Poof! Just like that, there was a 12% SPX decline in little over a week. In our annual outlook, we discussed the fact history tells us that equity market corrections of more than 5% happen on average three times per year, that high levels of optimism were present, and that we would not be surprised to see an opportunity this year to buy the S&P 500 5% to 10% off of its highs. Of course, we did not think this opportunity would come so quickly. Key Private Bank s Market Outlook April

5 Key Takeaways In our view, the correction that began January 26 has very little to do with labor inflation, short volatility exchange-traded notes, Fed uncertainty or potential trade wars. The constantly changing narratives suggest to us that the price action is more about relieving historic levels of both market and economic optimism, than it is about a fundamental change that warrants a more defensive posture. We believe the strong macro and fundamentals will eventually prevail over the wall of worry as we head into the summer. Changing narratives So, is this a normal market correction or something more sinister the beginning of a bear market? We believe the answer lies in clues gleaned from the changing narratives. According to the talking heads, the plunge in early February began with stronger economic data and accelerating labor inflation that was going to drive interest rates past 3%, propelling them into a new secular uptrend. Now, the same cast of characters is saying that market is retesting the early February low on slowing global economic data, fears of a trade war, and a meaningful drop in 10-year U.S. Treasury yields. The key thing to notice here is that the reason for the correction changed. This changing of the narrative suggests to us the price action is more about relieving historic levels of both market and economic optimism, than it is about a fundamental change that warrants a more defensive posture. Strong fundamentals Fundamentals remain strong with greater than 30% earnings per share (EPS) growth projected over the next two years. Since November, the S&P 500 consensus earnings growth has been revised up sharply to 32% (versus 22%) as a result of tax reform and stronger sales growth. There is still room for estimates to move higher given indirect benefits of tax reform such as rising disposable income and increased capital expenditures are difficult for analysts to model. We also expect a record year for buybacks and believe the consensus is underestimating the potential EPS benefit there, as well. Based on consensus EPS estimates for the next twelve months, the S&P 500 now trades at roughly 16x, below the 30-year median. Checking the boxes Stepping back and looking at things from the macro level, the positives that continue to underpin the bullish thesis include: Solid global growth Positive domestic activity driving corporate earnings growth Capital spending improvement Real household median incomes jumping with strong employment Demographic-driven push to higher home ownership In our view, the market appears to be overreacting to the aforementioned sequential negative narratives (inflation scare, rising yields, hawkish Fed, rising deficits, trade war, etc.), and we believe strong macro and fundamentals will eventually prevail over the wall of worry as we head into the summer. Pivot? What would make us pivot away from our bullish thesis? There has been much talk of inflation lately, and we are sympathetic to the old Wall Street axiom that inflation kills bull markets. However, when one looks at the state of play, there is not yet cause for concern. We monitor a combination of consumer and producer prices, Key Private Bank s Market Outlook April

6 purchasing manager surveys, and raw commodity prices in order to objectively gauge the inflation regime. Currently, this set of indicators is presenting a mixed message, suggesting that we are in an inflationary regime that is relatively benign. If and when we see a coordinated move higher across a variety of inflation indicators along with deterioration in the macro picture, then we would become more cautious. All clear? How to know that the all clear signal has been given? Bull markets tend to rejuvenate themselves by changing leadership as they progress. We will be watching closely to see if new leadership that benefits from loose, reflationary fiscal policy and increasing capital expenditures asserts itself. If this occurs, it will suggest that the correction is over. Key sectors to watch for positive relative performance clues will be financials, industrials, and information technology. Fixed-Income Outlook, April 2018 Market overview The first quarter of 2018 proved to be a difficult one for the fixed-income markets. Volatility finally picked up as politics and tension over a possible trade war rose. Fears of rising inflation initially sent interest rates higher but began to subside as the quarter came to a close. The Federal Open Market Committee (FOMC) raised short-term interest rates by 25 basis points (BPS) to a target rate of between 1.50% and 1.75% at its March 21 meeting. The FOMC expressed confidence in U.S. economic growth by increasing its median GDP forecast from 2.5% to 2.7% for 2018 and from 2.1% to 2.4% in Inflation is expected to reach 2% in 2019 and 2020, allowing the Fed to continue its path of normalizing interest rates. Key Concerns Unexpected inflation Inflation concerns spiked after the January wage data was released but have subsided a bit as February data calmed the markets. Trade war heats up We expect volatility in the markets to remain elevated as the U.S. and China publicly negotiate trade. Probability of Rate Hike 120.0% 100.0% 80.0% 60.0% 40.0% 20.0% FOMC Rate Hike Probability 0.0% 5/2/18 6/13/18 8/1/18 FOMC Meeting Date 11/30/17 12/31/17 8/1/ Fed becomes too aggressive Should the Federal Reserve start to increase rates at a quicker pace than the markets expect, this could lead to a spike in interest rates. Rush for the exit Should investors become concerned about rates or credit risk and rush for the exits at the same time, this would lead to decreased liquidity pushing interest rates higher and credit spreads wider. Key Private Bank s Market Outlook April

7 U.S. Treasury yields were higher across the board during the quarter with the 2-year note yield rising 35 BPS to 2.27% and the 10-year yield rising 27 BPS to 2.74%. An abundance of supply of Treasuries is expected to be issued over the next several years as the federal government continues to run a deficit. Expectations are for U.S. Treasury net issuance to surpass $1 trillion in each of the next five years. This supply could lead to higher interest rates as investors will demand more yield to take on additional bonds. For the remainder of 2018, we expect two additional rates hikes by the FOMC and for interest rates to continue to gradually rise with the 10-year Treasury yield ending the year in the range of %. We expect volatility to remain elevated across the bond market as political risks and fears of inflation weigh on the markets. We expect returns across the fixed-income asset class to remain muted for the remainder of We remain underweight duration for fixed-income portfolios 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 30Y 12/31/16 12/31/17 2/2/18 2/29/18 3/30/18 12/31/18E U.S. Treasury Curve and continue to remain overweight Investment Grade Corporate Credit. Within corporate credit, we believe the front-end of the curve (maturities of three years and shorter) are attractive versus longer maturities. We remain cautious on U.S. Treasuries and High Yield. Contributors Bruce McCain, CFA, PhD Chief Investment Strategist Paul Toft, CFA Director of Municipal Investments Kevin Gale Head of Taxable Fixed-Income Stephen Hoedt Head of Equity Research To learn more, please consult with your Key Private Bank Advisor. Any opinions, projections or recommendations contained herein are subject to change without notice and are not intended as individual investment advice. Investment products are: NOT FDIC INSURED NOT BANK GUARANTEED MAY LOSE VALUE NOT A DEPOSIT NOT INSURED BY ANY FEDERAL OR STATE GOVERNMENT AGENCY 2018 KeyCorp Key Private Bank s Market Outlook April