Gaining trust newsletter Spring 2017 Global economic outlook The International Monetary Fund is projecting global economic growth to be 3.4% and 3.6% in 2017 and 2018, respectively. Emerging market economies are estimated to grow at a faster pace. Dennis A. Johnson, CFA, Chief Investment Officer TIAA-CREF Trust Company, FSB The National Association of Business Economics (NABE) is estimating the U.S. economy will grow 2.4% in 2017, up from 2.2% in 2016. Similar to the last few years, economic growth for the year is projected to be driven by economic activity during the middle of the year and part of the back half of 2017. Therefore, we should generally not become concerned by uneven economic data reports that might surface during the first half of this year. NABE s 2017 forecast for U.S. economic growth does not include any impact of fiscal policies under consideration by the current Administration. At the earliest, the economic impact from the implementation of an infrastructure bill will be 2018. Under such a scenario, the current view is that approximately $100 billion would be spent on infrastructure programs in 2018. Given suggestions from the Administration that an infrastructure plan could total $1 trillion, the annual and cumulative economic effect of such a plan could be gradual over the next 5-10 years. Outside the U.S., major economies around the world are standing on relatively firmer ground. The European Union is expected to grow in 2017 by 1.6%, up from previous economists estimates of 1.5%. Inflation in the European Union is picking up causing investors to question how much longer the European Central Bank will maintain its Quantitative Easing monetary policy. Also, Japan s economy seems to have stabilized at a growth rate of 1% per year after experiencing a few years of growth and recession resulting from a low interest rate policy by The Bank of Japan offset by tightening fiscal policies like tax increases. China s economy is projected to grow by 6.5% in 2017, according to the National People s Congress. The government reaffirmed its commitment to policies that should result in 15 million people entering the job market this year. This level of annual job growth should allow China to not only remain as one of the fastest growing economies in the world, but also support the previously referenced global economic growth projections.
Global monetary policy outlook Investors may be approaching a turning point in navigating through the coordination of global monetary policy. To help the global financial markets and global economy get out of the malaise associated with the financial crisis, central bank leaders around the world conducted a coordinated effort to lower interest rates and increase available financial liquidity credit. Several years later, the U.S. Federal Reserve (Fed) took the first step to prepare investors for an eventual end to its Quantitative Easing policies. The communication of these intentions by then Fed Chairman Ben Bernanke resulted in the taper tantrum which weakened and increased volatility for the financial markets. Fast forward to 2017, the Fed is well into executing its policy to normalize interest rates in the U.S. Exhibit 1 shows the current thinking by the Fed in terms of the potential direction and magnitude of interest rates in the U.S. It illustrates the Fed s compass for interest rates is pointing upward now after pointing downward for more than 30 years. Exhibit 1: Fed officials median interest rate projections (%) While it may be a coincidence, two other major central banks around the world are signaling that their era of accommodative monetary policies may also be coming to an end. For example, European Central Bank-ECB President Mario Draghi suggested that fresh economic stimulus measures were unlikely given recent data on inflation and economic growth in the Eurozone. In addition, the People s Bank of China has suggested that it may tighten monetary conditions to prevent the local real estate market from overheating and slow down the growth in the amount of debt in the economy. With a starting point of very low interest rates, tightening monetary policies by the central banks of the largest economies around the world should not present any unusual risks to the global financial markets or global economy. History suggests that future returns for Gaining trust newsletter 2
stocks and bonds are more tempered during periods of rising interest rates and tightening monetary policies. We think history may continue to be a guide and that return expectations going forward should be more measured as investors adjust their thinking about how to value stocks and bonds as interest rates rise. The other key point about this potential turning point in global monetary policies is the impact on the foreign currency markets. For the last several years, the U.S. dollar has increased in value versus most other currencies. This strength in the dollar was primarily the result of investors anticipating an increase in interest rates in the U.S. during a period when interest rates were lower and declining in many developed markets around the word. To invest in the U.S. assets with higher yields, international investors needed to sell the local currency and buy U.S. dollars for use to complete the transaction. With the possibility of the European Central Bank moving to end its quantitative easing policy and other currency markets stabilizing, it is possible that the U.S. dollar will no longer strengthen but fluctuate in a relatively narrow range versus other currencies over the intermediate term. A relatively stable U.S. dollar could be a positive for the U.S. economy and U.S. multinational companies that conduct business outside the U.S. Exhibit 2 shows the revenue mix for U.S. companies. Taking what has historically been a negative growth rate for 30% of revenues (international) for most U.S. companies and recognizing the possibility of it changing to a positive growth rate, supports our contention of a potential positive effect on U.S. companies and their profits if indeed we do enter a period a relative stability in the value of the U.S. dollar. Exhibit 2: Geographic revenue exposure S&P 500: Aggregate Geographic Revenue Exposure (%) Asset allocation The strategic or long-term asset allocation decision has been shown to be one of the most important investment decisions that can be made. This decision explains a significant percentage of the investment performance and risk for client accounts. Gaining trust newsletter 3
Continuing with the theme that investors may be nearing a turning point in the direction of global monetary policy and interest rates more specifically, it s important to revisit asset allocation to make sure portfolio diversification is appropriate and the portfolio is constructed in a manner to perform well over the intermediate term. 1 Exhibit 3 shows how different classes of investments performed during the last period of tightening monetary policy carried out by the Fed. In general, equities, international investments and those specifically associated with emerging markets, performed well. Our current asset allocation targets are inclusive of allocations to U.S. and international equities as well as emerging market stocks and bonds. Exhibit 3: Returns during last Fed tightening cycle (June 2004-June 2006, %) Source: Capital Economics * Past performance is no guarantee of future results. Global equity market outlook The equity markets are expected to potentially trend higher in 2017. One of the critical variables that influence the direction of the stock market is the path of corporate profits. Exhibit 4 shows the long-term relationship between the direction of the U.S. stock market and corporate profits. Corporate profits are projected to increase further in 2017 supported by economic growth and a potential reversal in the negative impact of the strengthening U.S. dollar. Particularly for the U.S. stock market, we note via Exhibit 5, that companies across a majority of the economic sectors are projected to report positive, although likely low earnings growth in 2017. The expected earnings growth rate for energy companies is expected to be abnormally high driven primarily by the comparison to depressed profits and in many cases, losses reported during much of 2016. Gaining trust newsletter 4
Exhibit 4: S&P 500 change in forward 12-month earnings per share (EPS) vs. change in prices: 10 years Exhibit 5: S&P 500 earnings growth: CY 2017 Exhibit 6 shows the trend and current valuation level for the U.S. stock market. Low interest rates, rising corporate profits and rising investor confidence all contributed to the advance in the equity markets and rising stock valuations. While above the long-term average, current Gaining trust newsletter 5
stock market valuations should not prevent the stock market from trending higher. However, we note that current stock market valuations and the likelihood of interest rates trending higher may produce modest positive returns in the future. Exhibit 6: S&P 500 forward 12-month P/E ratio: 20-year Earnings growth prospects for companies domiciled outside of the U.S. are more promising in 2017, and could support good absolute and relative performance. Earnings growth for international companies is projected to increase at a low double-digit rate this year, more than twice that for U.S. companies. One reason for this expected level of growth is the improvement in global economic growth and the potential early benefits of significant restructurings that are occurring at the company level and in some cases, across entire industries. Combine these sources of potential earnings growth for international companies, valuations below those for U.S. stock and the possibility of emerging-market stocks continuing their historical pattern of performing well during periods of rising interest rates, and you have a constructive backdrop for the future performance of international stocks. Bond market outlook Treasuries Ten-year Treasury yields have largely been confined to a range of 2.30% to 2.63% in advance of and following the March rate increase. While interest rates may trend higher in anticipation of additional rate hikes later this year, it would probably take an uptick in the strength of economic data and a rising inflation trajectory that is viewed as sustainable to reset the range higher for Treasury yields in the near term (i.e., a fairly high hurdle). While the safe haven aspect of Treasuries has not underpinned yields as much as in the past couple of years, geopolitical anxieties such as North Korea and election uncertainty abroad could alter the situation. Gaining trust newsletter 6
Credit After reaching the tighter end of the historical levels in the first couple months of the year, spreads on investment grade and high yield have widened slightly yet remain near multiyear lows as shown in Exhibit 7. On a relative basis, high-yield spreads had tightened more meaningfully than those of investment-grade corporate bonds. High yield as a sector is influenced by the outlook for oil prices, and the recent weakness in oil prices contributed to the move wider in high-yield spreads. Additionally, the fund flows into investment-grade mutual funds continue to be sizable and positive, whereas flows among high-yield funds and ETFs have been more erratic. 2 Exhibit 7: Corporate bond credit spreads Source: Morningstar, Inc. BofA Merrill Lynch Global Indexes Data as of 02/10/2017 The differences in the investor base for investment-grade and high-yield bonds drive the behavior in fund flows and imply that investment-grade credit should have a less volatile profile in the coming months. With an improving economic landscape, lower-rated issues may potentially continue to outperform higher-rated corporates, absent continued weakness in oil prices and/or periodic bouts of market volatility. Conclusion 2017 is expected to be a year of positive global economic growth and likely low positive returns for the financial markets. As always, investors will have several risks to navigate including geopolitical risk, gradual tightening of global monetary conditions, tight corporate bond spreads and equity market valuations that are above the historical average. However, critical variables that influence the performance of stocks and emerging-market investments in particular continue to point in the right direction. The direction in which these variables are trending, still low interest rates around the world by historical standards and maintenance of the appropriate asset allocation target, could possibly support decent portfolio performance this year. Gaining trust newsletter 7
1. While diversification is a technique to help reduce risk, it cannot guarantee against loss. 2. Wells Fargo Securities High Yield Publications. Investment products are not insured by the FDIC; are not deposits or other obligations of TIAA-CREF Trust Company, FSB; are not guaranteed by TIAA-CREF Trust Company, FSB; and are subject to investment risks, including possible loss of principal invested. The information provided here is for informational purposes only. It does not constitute an offer or recommendation to buy or sell any security. The views expressed in this newsletter may change in response to changing economic and market conditions. Past performance is not indicative of future returns. TIAA-CREF Trust Company, FSB, provides investment management and trust services. Advisory services are provided by Advice & Planning Services, a division of TIAA-CREF Individual & Institutional Services, LLC, a registered investment adviser. 2017 Teachers Insurance and Annuity Association of America-College Retirement Equities Fund, 730 Third Avenue, New York, NY 10017 133860 141022959 (05/17)