Key Private Bank s Economic and Market Outlook October 2017 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 Interest rates to rise modestly over the remainder of 2017 We expect one additional Federal Reserve rate hike this year. Investors very optimistic Earnings growth has been very positive for equities this year, as earnings bounced back from last year s weak levels. With solid economic growth and strong earnings growth, investors have become extremely optimistic. FOMC begins the balance sheet reduction The balance sheet reduction will begin in October and will consist of $6 billion in Treasuries and $4 billion of mortgage backed securities per month, rising every three months until the amount reaches $30 billion and $20 billion per month, respectively. Second longest period of consecutive gains for global equities This now ranks as the second longest period of consecutive gains for global equity markets since the inception of broad-based indices in 1969. Such a long period of gains, coupled with exceptionally low volatility, inevitably builds up risk in the financial system. Multiples and markets are likely to march higher Absent a change in liquidity conditions, which we do not foresee, both multiples and markets are likely to rise even higher. Key Private Bank s Market Outlook October 2017 1
Contents Market Outlook...3 Equity Outlook...6 Fixed-Income Outlook...8 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 Key Private Bank s Market Outlook October 2017 2
Market Outlook, October 2017 Investors continue to push equity prices higher, as market averages repeatedly hit new highs. Fundamental improvement justifies much of the move. Economies around the world have accelerated, with minimal signs of any slowdown. That makes a bear market or other major equity declines very unlikely. Yet economic growth remains slow by historical standards, with 2.1% first half GDP growth in the United States compared with a 3.1% historic average. Faster growth is not impossible, but will not be easy at this stage of what is already a very long economic cycle. Many hoped Washington would cut taxes or otherwise stimulate growth, but the prospects for a major stimulus have dimmed. In addition, rapid acceleration could prompt much tighter monetary policy. Earnings growth has been very positive for equities this year, as earnings bounced back from last year s weak levels. With solid economic growth and strong earnings growth, investors have become extremely optimistic. Some investment strategists worry investors have become too complacent about potential market risks. That may increase the chances of a correction, but should not increase the probability of a more-serious decline. High valuations are a greater threat to long-term returns. Relative to operating earnings, the S&P 500 is more than one standard deviation above its historic trend. Yet bonds and other investment options seem even more expensive. Once the fundamentals fail, high valuations should pose a larger risk. That may not occur for several years, however. We therefore have retained a relatively strong equity exposure. Equities should provide solid returns over the coming year, although investors should keep a careful eye on the fundamental and market trends. U.S. Large-Cap Equities Over the last several years, Large-Cap U.S. equities achieved strong relative gains as the United States economy grew faster than other economies around the world. Comparative investment performance was even better because the dollar rose against overseas currencies. That has all changed. Part of the faster U.S. growth came from energy exploration and development, which has Key Takeaways Emphasize With minimal risks of recession and valuations still attractive relative to bonds, a modestly aggressive equity position still makes sense. Within equities, improving growth overseas and a weaker dollar make international equities more attractive than domestic equities. Neutral Within domestic equities, Large-Cap stocks have an advantage with improving international growth but smaller-cap stocks should do better with increased consumer spending. A balanced exposure to large and small stocks provides a more-diversified exposure for potential positives in the coming months. Overseas, too, broader diversification makes sense. In has become a synchronized global expansion, we recommend a balanced exposure to the developed and emerging international markets. De-emphasize Bond prices may be more stable than many expect, but the likely returns make them less attractive than equities. slowed. Moreover, in an aging cycle, labor shortages and other constraints should begin to limit growth. Overseas economies have started growing at competitive rates. Since those economies are not as far along in their cycles, they should continue to grow for a longer time. Key Private Bank s Market Outlook October 2017 3
With improving overseas growth, the dollar has weakened against other currencies. The prospect of stronger overseas growth coupled with currency gains makes international equities more attractive now than domestic equities. U.S. Small-Cap and Mid-Cap Equities Traditionally, smaller-cap stocks benefit less from international exposure. But smaller stocks also have more leverage to U.S. consumer spending. If the international exposure dominates, smaller stocks may not do as well. If consumer spending improves sharply, smaller cap stocks should benefit. The potential for spending gains make the exposure smaller stocks provide attractive at this point. While we recommend emphasizing overseas exposure, we recommend a balanced exposure of large and small U.S. equities. Developed International Equities International developed markets have done better than the U.S. equity markets when translated into U.S. dollars. YTD through September, the S&P 500 returned 14.0%, while the All Country World Index achieved 17.6% and the S&P World ex-us returned 20.8%. Much of that outperformance stemmed from accelerating fundamentals overseas, as those economies came back from the brink of recession. Currently, it seems likely that overseas investments will outperform. If the acceleration is largely over, however, the relative performance of overseas investments may not be as strong as it has been this year. Europe Europe powered the largest share of the outperformance in the developed international markets this year. Through September, the Eurozone had a total return of 27.2%. Interestingly, however, the major countries of Europe were not the strongest. The German exchange-trade fund (ETF) returned 24.9%, while France returned 27.4% and Switzerland returned only 21.5%. Conversely, Austria returned 43.8%, Denmark 34.9%, Italy 31.9%, the Netherlands 31.6%, Poland 46.9% and Portugal 34.6%. Fundamental improvement in Europe clearly justified much of the gain. Markit Manufacturing PMI scores have rose sharply this year. The Eurozone s PMI jumped 5.6 points. Germany s PMI has increased 6.3 points, France s rose 6.4, Austria s 5.9, Italy s 5.3, the Netherlands 6.6, Poland s 1.5, Sweden s 8.8, Spain s 1.9 and Switzerland s 7.3. While much of the price gain reflected improving growth, the peripheral countries in Europe had an advantage. Germany and Switzerland, two of the stronger economies in the region, showed larger gains in their PMI scores than most other countries. Yet they returned less than the Eurozone average. The improvement in Europe likely took many investors by surprise. When that happens, higher risk investments tend to outperform. In Europe, that would explain why the peripheral countries would have outperformed their fundamental gains. Going forward, however, investors are less likely to be taken by surprise in Europe and performance should be more in line with the fundamental performance. Other Developed Regions The United Kingdom has performed poorly this year, returning only 16.1%. The U.K. Manufacturing PMI stagnated, increasing only 0.4 points. Bear in mind, too, that the weak pound should have benefited manufacturing more than other areas of the economy. A weakened government majority is struggling to address the critical Brexit negotiations. The uncertainty businesses face in the U.K. give a poorer outlook than in other parts of the developed world. Japan has fared somewhat better, but it has underperformed the broad ACWI index, returning just 14.8% YTD. Japan s PMI improved 2.5 points, which should have justified stronger gains. Much of the improvement in Japan, however, has been fairly recent. If Japan can sustain the recent acceleration, it may perform much better in the coming months. The Pacific ex-japan, which includes Australia, Hong Kong and Singapore, returned 18.8% YTD. Australia returned only 13.4%, as the Manufacturing PMI there fell 1.2 points. The Hong Kong ETF, on the other hand, returned 28.9% while Singapore returned 23.9%. Hong Kong reflected the surprisingly good performance in the Chinese economy (discussed below). Although Singapore s economy improved, with its PMI rising 1.9 points, the performance there was somewhat stronger than the PMI suggested. Canada s PMI rose 4.7 points, which implies investments there should have outperformed. Yet the ishares fund returned only 11.6% through September. Canadian authorities took steps to slow that economy, and the markets may have discounted slowing that will occur. Key Private Bank s Market Outlook October 2017 4
Emerging Markets Equities The emerging markets performed extremely well through September, providing a total return of 27.1%. Manufacturing improvement helped, but the returns for China, in particular, appear to have exceeded the fundamental improvement. While China s Manufacturing PMI rose a modest 0.9 points, the Large-Cap China ETF rose a strong 27.4%. China s authorities took steps to slow the economy this year, but they stopped short of what had been expected. Positive surprise typically leads to better performance. The emerging markets also benefited from strong performance in South Korea, up 29.8%, despite a modest 3.0 point increase in their PMI. Fundamentals did not improve markedly, but they have been better than expected. Like the peripheral European markets, emerging markets may have been buoyed by the positive surprise. With investor sentiment now extremely positive, however, future returns should depend more heavily on fundamental improvement. The combination of solid fundamental growth and currency translation gains should continue to favor the international markets. We recommend maintaining a proportional exposure to the emerging markets segment within the emphasis on the international markets. Fixed Income The 10-year Treasury yield has been relatively stable in 2017. The year started with a yield of roughly 2.5% and ended the third quarter with a yield of about 2.3%. This is the stage where rising inflation often forces the Federal Reserve to raise short-term interest rates. When that happens, longer-term bond yields typically rise to provide an offset for higher inflation. This time, however, extremely low inflation and sluggish growth have made the Fed cautious about raising short-term interest rates. The low level of inflation has also allowed long-term rates to remain low. The sluggish economy and ample supply in many industries has avoided putting pressure on prices. If slower growth extends this cycle by several years, bond rates may remain low far longer than many think. Stable prices in and of themselves, however, do not make bonds a good investment. Current bond yields offer lower prospective returns than equities. Given the comparative prospects, we recommend emphasizing equities and deemphasizing bonds. Key Private Bank s Market Outlook October 2017 5
Equity Outlook, October 2017 Perspectives from Key Private Bank s Equity Research Team Extended strength Global equity markets turned in a strong third quarter, extending their gains for the year. Emerging Market equities were the clear leader, rising 8.7% for the quarter. The spotlight of investors on positive growth differentials came into focus in earnest over the summer, while continued weakness in the U.S. dollar provided another tailwind. Developed Market equities also outperformed U.S. stocks, albeit more modestly, while rising 5.7%. Domestically, Large-Caps rose 4.5%, outperforming Mid- Caps which gained 3.2%, but trailed Small-Caps which climbed 5.9%, amidst hopes for both fiscal action and tax relief from Washington, DC. Second best This now ranks as the second longest period of consecutive gains for global equity markets since the inception of broad-based indices in 1969, with realized volatility collapsing as a consequence. Such a long period of gains, coupled with exceptionally low volatility, inevitably builds up risk in the financial system; however, low volatility is simply high price confidence, in our view, and when confidence in asset prices is high, investors tend to do risky things. Market bulls claim that this latest rise in equity markets has been supported by surging profits, and they would not be wrong. Essentially, quantitative easing by the global central banks sustained equity markets at higher levels in anticipation of a profit recovery, and now, rather than de-rating as earnings come through, global markets are simply taking another leg higher as evidenced by expanding multiples. 30 25 20 15 10 5 1990 1991 S&P 500: Starting to look expensive based on estimated forward earnings, however... 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Loose monetary conditions remain a key driver The average total return on the S&P 500 in this cycle (14%) has been somewhat higher than the historical average (11%) since 1900. In calculating the average return over this cycle, we exclude the typical large post-recession bounce in equity prices during 2009 and calculate the average return since January 2010. While some market Key Takeaways We expect the end of the year to be dominated by the Federal Reserve beginning to unwind its massive balance sheet. However, absent a change in global liquidity, which we do not foresee, both multiples and markets are likely to march higher. We anticipate a reacceleration in wage growth and higher interest rates in the as we look ahead toward 2018, leading to a rotation back into cyclicals. Key Private Bank s Market Outlook October 2017 6
participants argue that the run-up in equities has been excessive, we would reiterate that equity valuation multiples are in line with their historical drivers in a low interest rate environment, with the growth exhibited during this recovery in line with that experienced since the 1930 s. S&P 500 market returns have been anchored over the medium term by ROEs and these have not declined. ROE The financial return on corporate equity (ROE) for the S&P 500 (currently 13.3%) is slightly above its historical average (12.6%). This is despite the well-known declines for the Financials and Energy, outside of which it has been running at very robust all-time highs (~18%) for the last four years. Like the return on physical capital, the S&P 500 ROE has historically fluctuated predictably over the business cycle, falling to lows in recessions, and then recovering. But unlike the return on physical capital, the ROE often continued to rise or remained at high levels until the next recession. At the aggregate ex-financials ex- Energy level, this very robust ROE has come primarily from higher margins, as asset turnover has declined steadily and leverage was flat at low levels for most of the cycle, although it has risen somewhat over the last two years. S&P 500: Return on equity (ROE) still has room to move higher 25 20 15 10 5 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 1998 1999 S&P 500: Return on equity (ROE) s7ll has room to move higher Hitting the accelerator 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 The acceleration in equity markets that started in mid- August has seen several previously weak areas rebound strongly. The Small-Cap stocks in particular have been buoyed by renewed Trump tax reform talk, and the stocks of those companies with the weakest balance sheets the proverbial dash to trash rallied strongly, gaining 20% from their recent lows. Small-Cap shorts were burned by Trump s election in the first place, so it remains to be seen if the latest reduction of short positions in the bad balance sheet segment is merely profit-taking until tax plans are digested or a genuine fundamental reappraisal of balance sheet risk. Disruption and liquidity Information technology disruption and central bank liquidity have been the two most important themes over the past 10 years. Central banks have caused Wall Street asset prices to boom, while technology disruption has constrained wages on Main Street. We believe that relative asset price performance next year will be highly dependent on both the speed and magnitude of liquidity withdrawal by the global central banks. Since the Bear Stearns event in the summer of 2008, an expanding Fed balance sheet has led the outperformance of risk on as measured by high yield versus Treasuries, growth versus value, of U.S. equities versus global equities, etc. Low economic growth has boosted growth stocks, such as biotechnology and information technology, while low interest rates have boosted high yielding assets such as high yield bonds and equity bond proxies. With the Fed s balance sheet about to reverse and the combined global central bank balance sheet currently projected to hold steady in 2018, time will tell if the liquidity generation baton is successfully passed once again. Our forward view is unchanged Middling economic growth, lack of tax reform, increasing geopolitical tensions, and fears over the credit situation in China have mattered little. What has mattered are global liquidity conditions, and even with the Fed in tightening mode, global central banks have continued to help markets via loose monetary conditions. Absent a change in global liquidity, which we do not foresee, both multiples and markets are likely to march higher. In fact, we anticipate a reacceleration in wage growth and higher interest rates as we look ahead toward 2018, leading to a rotation back into cyclicals. Key Private Bank s Market Outlook October 2017 7
Fixed Income Outlook, October 2017 Probability of Rate Hike Market overview The FOMC remained on hold during the third quarter, but left the door open for one additional rate hike in 2017, most likely in December. The Committee also said it will begin a slow and gradual unwinding of its $4.5 trillion balance sheet. The balance sheet reduction will begin in October and will consist of $6 billion in Treasuries and $4 billion of mortgage backed securities per month, rising every three months ($6 billion for Treasuries and $4 billion for mortgage backed securities) until the amount reaches $30 billion and $20 billion per month, respectively. The Committee does not have a specific date in mind to end the run-off. We believe that the run-off will end when the Fed s balance sheet is reduced to $2.5 - $3.0 trillion. We continue to expect interest rates to rise modestly throughout the remainder of 2017 and into 2018 with the 10-year note yield ending 2017 in the range of 2.50% - 2.75%. We remain cautious on U.S. Treasuries and maintain an underweight position. Despite the spread tightening we have seen in 2017, we remain overweight on corporate credit as we believe fundamentals will remain solid. 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% FOMC Rate Hike Probability 11/1/17 12/13/17 1/31/18 3/21/18 FOMC Meeting Date: 7/27/17 8/31/17 9/290/17 Investment Grade Corporate Bonds It was more of the same during the third quarter of 2017 for the Investment Grade credit market. Credit spreads continued to grind tighter as investors reach for yield. Investment Grade credit spreads ended the quarter 8bps tighter at 101bps. Strong demand continues to Investment Grade bonds. For 40 consecutive weeks, investors have added funds to Investment Grade bond funds. Performance of Investment Grade corporate bonds continues to outpace the broader Investment Grade bond market. Investment Grade corporate bonds returned 1.34% during the second quarter, outpacing the broader bond market which returned 0.84% during the quarter. Once again, lower rated credit continued to outperform with Baa credits returning 1.46% during the quarter. A rated credits returned 1.24% while Aa rated credits returned 0.79%. Year-to-date through September 30th, corporate credit has returned 5.19% versus the broader bond market returning 3.14%. Lower rated credits are leading the way on a year-to-date basis, with Baa rated credits returning 5.77% through September 30th. We continue to remain constructive on Investment Grade corporate credit and do not see a catalyst for significant spread widening in the near-term. We believe that continued strong demand from investors (both foreign and domestic) will keep spreads relatively tight. For investors that are overly concerned about rising rates, we believe that the front-end of the corporate credit curve (18 months and in) provides an attractive alternative to cash for those that are not liquidity constrained. Key Takeaways We expect rates to rise modestly for the remainder of 2017 with one additional rate hike by the FOMC. The biggest risks to the bond market are an unexpected spike in inflation and a sudden change in investors sentiment toward the asset class. We continue to remain underweight Treasuries and overweight Investment Grade credit despite the asset class rally over the past year. Key Private Bank s Market Outlook October 2017 8
High-Yield/Leveraged Loans As has been the case all year, risk assets continue to perform well. During the third quarter of 2017, High Yield returned 1.98%, outpacing Investment Grade credit which returned 1.34% and the broader bond market which returning 0.34% during the quarter. Year-to-date, High Yield remains one of the best performing asset classes returning 7.00%. Overall, High Yield spreads continued to grind tighter during the quarter, tightening 17bps to 347bps. Lowerrated credits outperformed during the quarter with Caa rated credits returning 2.48% while B rated credits returned 1.75% and Ba credits returned 2.04%. We expect the High Yield bond market to continue to remain highly correlated to both commodity prices and U.S. economic strength. We continue to maintain our cautious outlook on the High Yield market given its high beta to the energy and material sectors and the uncertainty around the global economy. We believe that with High Yield spreads at their tightest levels since 2014, the asset class is priced to near perfection. Within the High Yield space, we continue to prefer Leveraged Loans over High Yield bonds given their lower exposure to the energy and material sectors and the floating rate nature of Leveraged Loans to help ease the impact of any unexpected spikes in short-term interest rates. For more information, contact your Key Private Bank Portfolio Manager. 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 2017 KeyCorp. 171012-305631 Key Private Bank s Market Outlook July 2017 9