US economic growth and strong corporate results boosted US equities in the third quarter and Federal Reserve interest rate hikes continue to weigh on US bond markets. US-China trade tension and significant Chinese industrial sector weakness have impacted the growth of non-US economies and their equity markets. Europe has experienced the greatest slowdown among developed regions, leading to patchy performance for what was once a global synchronized growth story.
Equity markets in the third quarter were led by US stocks where the consistency of the corporate and economic fundamentals attracted capital from home and abroad. European and Asian developed country equity markets have disappointing so far this year and have performed below our expectations. As of September 30, the MSCI World ex. USA index was -1.5% year-to-date versus the MSCI USA Index which was up 10.2%. Emerging Markets have lost -7.7% year-to-date.
Investors ‘Picked’ US Stock Markets and ‘Panned’ Commodities in 3Q 2018:
US Equities Benefited from Repatriation and Buybacks
Our forecast at the beginning of the year was for the European, Asian and Emerging markets to appreciate broadly in-line with US stocks. We see that growth in US corporate earnings has occurred in conjunction with an estimated $1 trillion corporate share buyback program. Outsized earnings per share (EPS) gains have been driven predominantly by Trump tax cuts and the buybacks. As buyback activity and the benefits of tax cuts fade, corporate earnings growth is put at risk, and this could weigh on equity prices.
In fixed income markets, US Treasury yields rose for the third consecutive quarter. After quarter end, ten-year Treasury yields rose to their highest levels since 2011, 3.23%. This significant move can be explained by subtle increases in inflation expectations, moving real yields to the upper end of their range since mid-2011. Short-term Treasury rates yielding close to 3% are now a viable alternative to longer-dated bonds and provide a safe haven from higher equity market risk. Credit and structured markets risk premiums tightened during the quarter. High yield and structured-credit markets are worth keeping an eye on since they have traditionally started to weaken before equity markets.
Outlook and Portfolio Positioning
The expansion remains solid in the US, but many major economies have progressed toward more advanced stages of the business cycle. With the unemployment rate below 4% in the US and moving lower in Europe, consumer spending globally has received a boost. In September, the Fed raised rates for the eighth time this cycle, responded to falling unemployment and rising wages.
US recession risk remains extremely low and the US economy has kept to a very gradual growth progression through this business cycle. But late-cycle trends are emerging after years of tightening labor markets and gradually firming wage growth. Manufacturing trends offer evidence of slowing momentum in global growth and, along with elevated trade risks, remain a headwind for export-oriented economies.
Trade disputes are an indication that the global economy may have reached a secular peak in globalization. Economic growth can continue but changes to trade rules and relationships will introduce uncertainty and market risks Fading globalization and rising populism could mean lower productivity, lower profit margins, and potentially higher inflation. Slowing global trade combined with the impact of normalized monetary policy and less US fiscal stimulus might contribute to a slowdown in 2019 and a potential end to the US expansion in 2020 or soon after.
Mid-cycle investing has tended to favor riskier asset classes and ample market liquidity. The late cycle often has featured limited overall upside and less confidence in equity performance. With expected equity returns falling and inflation potentially picking up, Inflation-resistant assets—e.g., commodities, energy stocks, and Treasury Inflation Protected Securities (TIPS)—have performed relatively well.
Disruptions have not derailed global growth just yet. We continue to favor global equity and fixed income strategies with an active and global approach. Active management will be beneficial as countries adapt to the breakdown of globalization and we see greater dispersion in the performance of companies and economies.
• In equities, we favor a neutral position by reducing the overweight to Large Cap Growth. Small Cap equities should be trimmed as the risk of lower economic growth and increased financing costs are a concern. Global diversification into Europe and Asia should be maintained as we look for them to recover value relative to US equities.
• In fixed income, we are investing to achieve lower price sensitivity to rising rates while carrying overweight to credit markets. We don’t expect a sudden, large increase in rates but the threat of higher rates will persist.. Portfolios are overweight short-term spread markets such as 1-3 year Credit and floating rate notes. Core-plus mutual funds are also being used for broader credit market and yield curve diversity.
Summary of our three main Market Themes and the corresponding Investment Views:
John Kirby is a Principal and co-founder of Laurentide Advisory
This information is not personalized investment advice or an investment recommendation from Laurentide Advisory. There is no guarantee that any investment strategy illustrated will be successful or achieve any particular level of results. The performance quoted represents past performance and does not guarantee future results. Investing involves risk, including possible loss of principal. Asset allocation and diversification may not protect against market risk, loss of principal or volatility of returns.
Global Stocks is the MSCI World Index. A market capitalization weighted index that is designed to measure the equity market performance of developed markets. US Stocks is the MSCI USA index. Non-US Stocks is the MSCI World ex USA Index.. Emerging Market Stocks is the MSCI Emerging Markets Index. US Bond Market is the Bloomberg Barclays US Aggregate Bond Index. A rules-based index measuring the total return of the investment grade, US dollar, fixed-rate taxable bond market. U.S. Treasuries is the Bloomberg Barclays US Treasury Intermediate Index. Measures the total return of USD denominated, fixed rate 1-10-year nominal debt. High Yield Bonds is the Banc of America/Merrill US Master HY Index total return of high yield US corporate bonds. Commodities are the Bloomberg Commodity Index. Representing a diversified commodities benchmark of energy, metals, and agriculture.
Please visit our website www:LaurentideAdvisory.com for important disclosures.