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. 19 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 It was another good quarter for our modeled portfolios, with September being a particularly strong month. Alpha (excess returns over benchmarks) came from various sources during the quarter. Our overweight exposure to Eurozone stocks (equities) and credit strategies (fixed income) contributed most significantly to our results. We continue to see a lot of opportunities in both equity and fixed income markets for relative outperformance in the months and quarters to come. Dollar Index Level Sept US Economic Activity Source: Bloomberg KEY ECONOMIC DATA As of Actual 3 Mos. Ago 1 Year Ago ISM Manufacturing (>50 = Expansion) Sept ISM Non-Manufacturing (>50 = Expansion) Sept Non-Farm Payrolls Sept -33K 210K 249K Unemployment Rate Sept 4.2% 4.4% 4.9% CPI Ex-Food & Energy (yoy) Aug 1.7% 1.7% 2.3% Global Economic Activity JP Morgan Global Manufacturing Index (>50 = Expansion) Sept JP Morgan Global Services Index (>50 = Expansion) Sept Global Economy: Healthy As Can Be The current macroeconomic environment is quite healthy. In fact, for the first time in 10 years, all major countries are growing, while none are contracting (Chart 1). Among those economies, the Big 3 (U.S., Eurozone and China) are performing quite well, with China and the Eurozone clearly outperforming economic expectations year-to-date. Globally, corporate profits are strong, inflation remains low, and monetary conditions are still accommodative. In addition, fiscal support in the U.S., in the form of tax cuts, is increasingly likely. At this point in the cycle, we think that these conditions continue to favor equities over bonds, and we have positioned portfolios accordingly. We are also maintaining a strong bias towards international equity markets, which has served us very well YTD. We do not see signs of bubbles or reckless speculation within traditional asset classes like equities and bonds. We fully recognize, however, that valuations are getting fuller. In the context of a healthy global economy, fuller valuations shouldn t prevent asset prices from appreciating further; but they are certainly a reminder that the best returns for this cycle are probably behind us. Chart 1: Global Economy is Performing Well Source: Organization for Economic Cooperation and Development, Wall Street Journal

3 Worrying About What Could Go Wrong Chart 2: Equity Volatility Represented by the VIX index As portfolio managers and analysts, we spend a lot more time discussing what could go wrong rather than what could go right. We never worry too much about short-term market volatility and shallow corrections, since those can happen at any time, for any reason, and without warning. Short-term declines in markets are an unavoidable aspect of investing and will always be part of the journey. We cannot predict those, and neither can anyone else. Having said that, our responsibility is to grow our clients assets in good times (accumulation) while protecting them in bad times (preservation). While it is too early to speculate about when and how the next financial crisis will occur, we intend to be fully prepared for it. Each cycle has its own characteristics, which makes end-of-market cycles difficult to pinpoint accurately. However, our models and indicators will provide useful clues to help identify trouble areas in advance. At this time, few warning signs are visible. We believe that we remain in a good environment for asset prices to appreciate. But, fuller valuations of financial assets and low volatility in financial markets (Chart 2) have certainly narrowed the margin for error. Source: Bloomberg Chart 3: North Korea - Sandwiched between China and South Korea North Korea: The Luxury of Time and Distance is Gone For years, the proximity of North Korea to South Korea s capital, Seoul, has prevented South Korea and its main ally, the U.S., from solving the North Korean problem militarily. The fear of retaliation has been too great. Today, rapid improvements in North Korea s nuclear and missile capabilities are starting to put U.S. territory at risk. North Korea s motives remain unclear, although many have speculated that diplomatic recognition and blackmailing countries for economic aid may be the objectives driving its young (33) leader Kim Jong-un. In our opinion, North Korea has only two gears: provocation and nuclear Armageddon. The inferiority of its military and the desire of its leader to stay in power make it unlikely that North Korea will attack America or one of its allies. Continued sanctions, followed by some diplomatic negotiations, are the most likely moves at this point for the U.S. and the international community. In that effort, China will play a very important role. China is North Korea s only global ally and its only important trading partner. China has economic leverage over North Korea, but it also has an interest in keeping a geographic buffer between its homeland and South Korea, where the U.S. maintains a large military presence (Chart 3). Source: Teacher.scholastic.com

4 EQUITY BENCHMARK TABLE An Equity Market Update from Trust Point The third quarter was another solid quarter for global equities. The MSCI EAFE index (international developed markets) increased 5.4% in Q3, while the S&P 500 returned 4.5%. Trust Point continues to believe that an overweight allocation to international equities presents the best opportunity to benefit from improved global growth and lower valuations, when compared to U.S. equities. US Economic Activity S&P 500 2,519 2,423 2,168 1,972 1,441 Dow Jones Industrial Average 22,405 21,350 18,308 17,043 13,437 NASDAQ 6,496 6,140 5,312 4,493 3,116 Global Economic Activity Source: Bloomberg, Morningstar 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 5.9% 20.7% 21.9% 12.7% 15.3% US Large Cap Value 3.1% 7.9% 15.1% 8.5% 13.2% US Mid Cap Growth 5.3% 17.3% 17.8% 10.0% 14.2% US Mid Cap Value 2.1% 7.4% 13.4% 9.2% 14.3% Us Small Cap Growth 6.2% 16.8% 21.0% 12.2% 14.3% US Small Cap Value 5.1% 5.7% 20.5% 12.1% 13.3% International Large Cap Developed (US Dollar) 5.4% 20.0% 19.1% 5.0% 8.4% International Small/Mid Cap Developed (US Dollar) 7.5% 25.4% 21.8% 11.1% 12.8% Emerging Market (US Dollar) 7.9% 27.8% 22.5% 4.9% 4.0% International Equity Investing Trust Point s use of international equities cial to portfolios over the last 12 months, in portfolios is not just about providing and we continue to favor the Eurozone diversification to help smooth out volatility. It also is about owning a potential gion s economic recovery from recession over the next six to 12 months. The re- source of greater returns in periods of is closely mirroring the United States recovery, but with a three- to four-year lag solid global economic growth. As of April 2017, the International Monetary Fund (Chart 4). Should this trend continue, the forecasted the global economy to grow at next several years could be quite good for a 3.5% rate in 2017, ahead of its 2.3% forecast for the U.S. economy. The Eurozone the Eurozone s economy and its equities. is a region that Trust Point began to overweight in portfolios in That allocation change has been extremely benefi- Chart 4: Euro Area Recovery: Lagging the U.S. By 3-4 Years Source: MRB Partners

5 Valuations: Most Attractive Outside the U.S. Valuations have become a concern for investors recently, as the global equity market has been strong over the last 18 months and, frankly, since Global equity valuations are largely above historical averages, which is not unusual after long periods of appreciating asset prices and strong global economic growth. As of the end of August, the MSCI World Index (a proxy for the global equity market) was trading at a valuation of 16x the aggregate earnings of the companies in the index, above its historical average of approximately 14x. The S&P 500 Index (a proxy for the U.S. equity- market) was trading at 17.7x earnings, above its historical average of 14.1x. Isolating the U.S. equities included in the MSCI World Index, one can see that international equities have U.S. Equity Style Rotation? As Q3 came to an end, the months of outperformance by growth stocks appeared to be coming to an end also. Technology stocks, usually the most significant contributor in growth funds, have not been favorites of late. High-flying stocks like Apple and Facebook have given up some gains, and investors have chosen to invest those dollars in less expensive value sectors. In fact, stocks in the financial and energy sectors (large value sectors) saw a turnaround in their prices, pushing value funds higher after their performance had languished in the last few months (Chart 6). In the case of financials, low bond yields were the culprits that kept this sector down. Inflation has been depressed this year, causing investors to believe that the Fed would slow down the interest rate hikes it had previously outlined. That lower valuations than U.S. equities (Chart 5). While valuation levels themselves don t signal a correction, bear market or recession, they can signal how much risk/ reward exists; they also can reflect how much downside risk exists. At Trust Point we believe in building well-diversified portfolios. Within equities, that includes allocation to large/mid/small cap U.S. equities, emerging markets, international developed, and international small cap. At the current time, we are maintaining an overweight allocation to international equities, which means a lower allocation to the more expensive U.S. equities, thereby improving the risk/reward outlook of client portfolios. meant financials, including banks, would continue to see a cap on their profitability (since higher interest rates are a benefit for banks). In recent weeks however, investors have become a little more concerned about inflation. This has led to speculation that the Fed will raise interest rates in December after all, which would benefit banks and other financials. The energy sector s newfound attractiveness, on the other hand, is due to an improvement in oil prices, now above $50 a barrel. In May, inside of our asset modeled portfolios, Trust Point lowered the allocation to large -cap growth, locking in profits, and moved those allocations into less expensive large cap value and small cap value funds. Chart 5: International Equity Valuations Lower Than U.S. Equity Valuations Source: J.P. Morgan Chart 6: Rotation Towards Value Stocks in September Source: Morningstar

6 A Fixed Income Market Update from Trust Point It was another solid quarter for the bond market as well. All sectors in which we invest generated positive returns. We continue to find attractive opportunities in the bond market, as the global economic outlook is above trend, with central banks shifting toward tighter monetary policy. US Yields (%) 3 Month T-Bill 1.0% 1.0% 0.3% 0.0% 0.1% 2 Yr US Treasury 1.5% 1.4% 0.8% 0.6% 0.2% 10 Yr US Treasury 2.3% 2.3% 1.6% 2.5% 1.6% Global Economic Activity Source: Bloomberg, Morningstar 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 0.5% 2.6% -2.1% -2.6% 1.4% US Treasury Inflation Protected Sec. 0.9% 1.7% -0.7% 1.6% 0.0% US Mortgages 1.0% 2.3% 0.3% 2.4% 2.0% US Short-Intermediate T/E Munis 0.7% 3.7% 1.0% 1.9% 1.9% US Investment Grade Corporates 1.3% 5.2% 2.2% 4.1% 3.5% US Senior Bank Loans 1.0% 3.0% 5.3% 3.9% 4.1% US High Yield 2.0% 7.0% 9.1% 5.9% 6.4% US Convertibles 3.8% 12.0% 14.3% 6.8% 11.0% Int l Bonds Ex-US (Hedged) 0.6% 0.8% -1.4% 3.7% 4.0% Int l Bonds (Unhedged) 1.8% 6.3% -1.3% 1.3% 0.5% Emerging Market Debt (US Dollar) 2.4% 8.7% 4.2% 6.1% 4.3% End of an Era The bond market has always taken an interest in Federal Reserve meetings and the Fed s projections for the future path of interest rates. The latest September meeting was no exception, as the Fed kept the door open for another rate hike this year, while also indicating its intent to begin reducing its balance sheet in October. The Fed s balance sheet has grown since the great recession as they purchased bonds in the open market. The Fed is sending a message that the ultra-accommodative policies initiated after the great recession are no longer warranted. The reduction of these bonds bought by the Fed will start a reversal of nine years of various bond buying programs, called quantitative easing (QE), which attempted to stimulate the economy (Chart 7). Implications for the bond market are difficult to gauge, as this type of exit has not been attempted before. Some think the increase in supply from the Fed s lack of buying could shock the market, driving down bond prices. Others argue that the excess supply will be efficiently absorbed by the banking sector, which is an active buyer due to tighter regulations, such as liquidity coverage ratios. We are in the latter camp. Internationally, other central banks, such as the Bank of Canada and Bank of England, also have begun removing accommodative measures. The European Central Bank is likely to follow suit. Chart 7: The Fed s Balance Sheet Has Grown to $4.5 Trillion Source: JP Morgan Asset Management

7 So Why Haven t Longer-Term Rates Moved Higher? Short-term rates, which the Fed has more taken stubbornly low levels of inflation as control over, have reached the highest an indication that the Fed will keep rates level in nine years following the Fed announcements in September. However, only two rate hikes by the end of 2018, lower for longer. The market is forecasting other factors have kept longer-term rates while the Fed has called for four. In other lower year-to-date. There is little doubt words, the difference between the Fed s that ongoing tensions with North Korea forecast and market expectations for the and political uncertainty in the U.S. have pace of rate hikes has become quite extreme (Chart 8). We think this is a mistake contributed to lower longer-term yields. More significant, however, has been the by the market, since underlying inflation market s reluctance to accept the Fed s pressures are starting to build from rising path of future interest rate hikes. There is import prices, manufacturing prices, and a strong connection between longer-term wages. Any boost in inflation could lead to treasury yields and the number of rate a rerating in the bond market. As we saw hikes expected over the next 24 months. last November, an adjustment in market The Fed is targeting 2% core personal consumption expenditures (PCE) inflation, yet can lead to sharply rising yields. We think expectations for the path of interest rates core PCE has fallen sharply to 1.3%, well off this is a risk to be carefully monitored. that target. Contrary to what Fed members have communicated, investors have Diversified Sources of Alpha Chart 8: Market Failing to Price in Federal Reserve Rate Hike Projections Source: Bloomberg Chart 9: Credit Spreads Approach Post Crisis Lows Most investors know that diversification in portfolios helps to reduce risk. Often overlooked, however, is how diversification can target different sources of potential return more sources than are available in a broad, high-quality bond index. We are still outperforming our benchmark year to date as we invest across multiple sectors of the global fixed income market. Credit spreads continue to tighten (Chart 9), and our allocations to emerging market debt and corporate bonds, in particular, have outpaced bonds that have benefited from lower rates. Another source of return is our allocation to investments with a substantial yield advantage over that of the U.S. Aggregate Index, which is a common benchmark for fixed income portfolios. High yield corporate, mortgage-backed securities and senior bank loans help to increase our portfolio yield while simultaneously reducing interest rate risk. Combining high quality investments with off-benchmark allocations can lead to higher expected yields and additional sources of return, while diversifying the risk profile of the portfolio. Tactical flexibility to manage these risks and exposures is important as we continue to seek opportunities for return amid continually shifting market conditions. 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. Pictured left to right: Randy Van Rooyen, Yan Arsenault, Brandon Hellenbrand, Steve Brudos, Ryan Bergan and Evan Schnetzer 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. 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 Office 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