Investment Outlook Fall 2017

Vineyard Haven, MA…We believe the U.S. is positioned for continued slow and stable expansion through 2017, framed by the larger synchronized global growth story (Figure 2). While many “hard” measures of economic activity are still less strong than “soft” measures, the near-term risk of recession is slight, and the pace of expansion could increase. Unemployment, leading economic indicators, capital expenditures, and PMIs are moving in the right direction; and inflation seems well contained. Fiscal policy has encountered hurdles, but there has been more momentum on the pro-business regulatory front. Also, enacting tax reform—even to a lesser extent than originally expected—should boost corporate spending and bolster U.S. economic growth.

During the second quarter, market participants looked through global geopolitical tensions and U.S. fiscal policy challenges, focusing instead on generally improving economic survey data, strong corporate earnings, contained inflation and well-behaved long-term interest rates. Stocks marched higher and high yield participated in a healthy measure of these gains. Emerging markets set the pace to beat, with a weaker dollar providing a supportive tailwind. Globally, growth led value. Although the Fed continued to tighten and announced its intention to slow its bond-buying activities sooner than many anticipated, U.S. Treasury bonds demonstrated continued resilience.  Figure 1 below outlines the asset class returns for the 2nd Quarter of 2017.

Source: Morningstar and Bloomberg.  All data in USD unless otherwise noted.

We see broad global economic expansion underpinning the U.S. sales and profit cycle. Earnings growth is likely to accelerate through late 2017 or even further. Rising wages may pressure US corporate profit margins in the coming quarters.   Should wages accelerate in the 2H17, this could create some headwind for the US equity markets.  While US equity valuations are extending, global growth outlooks are still stable, but the fiscal policy outlook is unstable, even worrisome to some.  Risks always increase as valuations growth and return experiences are ever positive without intermediate price corrections or adjustments.  Yet, if headwinds remain contained, as I expect, we could see equity markets continue the grind higher.

It’s prudent to acknowledge risks and begin discussing risk profiles and current allocations if portfolios have grown out of alignment due to the length of current expansion.  Our practice is starting to have these conversations during reviews and it always strikes us humorously when a suggestion to sell or lighten up on a recent winner is met with such confusion or reluctance “sell it?….but it’s done so well?”.  Selling high is the second act of the simple play whose first act starts with buy low.  It’s prudent, it’s integral and it’s a built-in feature of our investment process.  Critically, I feel it’s the right thing to do if the prudent management of portfolios is what you seek.

Other risks are building.  According to Bloomberg, year to date price advances in a handful of large technology companies have disproportionately contributed to U.S. stock returns in 2017. Removing the performance of Facebook (symbol=FB), Apple (AAPL), Amazon (AMZN), Microsoft (MSFT) and Google (GOOGL, aka Alphabet) from the S&P 500 Index reveals that over one-third of the index performance so far this year is attributable to just those five stocks.[1]  Limited participation is a risk to the overall markets, in that investors perceive value in only a few companies, rendering them prone to corrections from extreme valuations.  We will be looking closely, but as of this writing, see classic rotation from these stocks mentioned, with many correcting 5-10%, while other areas of the market continues to advance slowly.

Meanwhile, outside the US… Valuations are still relatively attractive, with margins still near trough levels with considerable room for pick-up as top-line growth improves. The slowdown we experienced in late 2015 may not have been noticed by many clients, but there was a real chance of recession, which you can see in the global GDP numbers here on Figure 2:

 Source: Haver, Morgan Stanley Research 3/31/2017

Since 1Q16, global growth fundamentals have continued to improve with central bank support, though the Eurozone is several years behind the U.S in its economic recovery. Liquidity conditions are very accommodative, issues in the banking system have begun to be addressed, and loan growth has picked up. Many companies have seen steady positive revisions to earnings expectations this year.

In Japan, reasonable valuations and accommodative liquidity conditions provide a favorable landscape for our bottom-up security selection, which is used by some of the actively managed funds throughout portfolios. By not discussing reduced accommodation over the medium term, the Bank of Japan has set itself apart as an outlier among major central banks, thereby limiting potential yen appreciation.

In the emerging markets, many countries are benefiting from strengthening economic fundamentals. Liquidity conditions are improving across many economies as inflation has eased and higher interest rates have attracted capital flows. These factors, along with balance sheet improvements over recent years should help many emerging markets navigate interest rate rises in the developed markets. Again also we have seen the opportunity for actively managed portion of emerging market funds to add value through their stock picking activities.

Interesting Times for Fixed Income….As we started off this piece observing, 2017 year to date fixed income portfolios have been supported by positive returns for the US ten-year Treasury bond.  In 2013, U.S. Treasury yields rose dramatically after then-Fed Chairman Ben Bernanke suggested the central bank might begin reducing its pace of monthly asset purchases. The so-called ‘taper tantrum’ affected markets globally.  The yield on the 10-year Treasury note rose from 1.94% the day before the testimony in May 2013 to 3.04% percent at the end of December 2013 [2] (two weeks after the actual tapering program was announced after the December Fed meeting). And the sell-off was not confined to the U.S., with global bond yields rising in tandem with the Treasury market.

During economic recovery, global fixed income investors normally face more bond market volatility as central bankers raise rates, normalize balance sheets and reset market expectations for higher yields.  And recently, the Fed is openly discussing plans to begin shrinking its balance sheet in 2017 – yet Treasury yields remain stable. We see two explanations for this striking disparity in the market’s response. First, unlike in 2013, both the Fed and market participants accept a ‘new neutral’ environment for U.S. monetary policy, which see rates ultimately lower than long term averages during expansions.  I’ve referred to this scenario in reviews as ‘lower longer’.  Second, the Fed plans to continue “managing” certain technical risks -mainly through the types and maturities of securities it buys and sells in open market operations, which it conducts routinely - for at least a year after balance sheet normalization begins. 

That said, I have not recommended that clients alter or change their particular fixed income strategies as it relates to normalization, Fed action or Fed balance sheet adjustment.  I expect the Fed’s actions to be gradual as they undertake the normalization process, though ebbs and flows within the markets themselves will always produce more movement than one would like. I still prefer and recommend income investors focus on higher quality fixed income securities and relegate low quality exposure via convertible bonds and count them as part of your equity exposure.

Observations With Implications…Interestingly, as of August 1, 2017 the annualized, ten year return of the US based S&P 500 was less than half the annualized five year return: +5.43% vs +12.36%[3].  This is evidence the damage wrought by the 2008 financial crisis (now gone from the 5-year return) was dramatic, and that any recovery from a credit induced crisis is long and difficult.  With such a strong five year annualized return, however, one must consider the probabilities of continuing at the pace, which I think is quite low. 

I have read a number of recent analyses that note future expected US equity market returns over the next ten years, in their forecast, could be in the low single digits.  While I have no model to determine a forecast such as this, simply acknowledging the recent gains (very good), estimates for future profit and earnings growth, coupled with current valuations (extended and getting stretched), it’s easy to make a case for that possibility. 

Given the cyclical nature of all asset classes, this starts to make sense: that which has just performed the best may have a harder time going forward, and of course, that which has stunk recently stands a reasonable chance of doing better.  Again, we address many of these issues through periodic rebalancing; but a systemic, long-term underperformance by US equities would affect all investors’ portfolios to a degree that requires watching.

With that, I have been adopting and implementing different strategies within our larger allocations towards strategies focusing around asset that produce cash flow, dividends and income out to investors. I believe this can provide some cushion in this type of low-return environment and seems to be one most investors are comfortable implementing.

By contrast to the US situation, the annualized, ten year returns for the MSCI World (ex US) Index, which tracks equity performance outside the US, is still a negative annual (1.39%).  We still feel valuations and cycle stage of non US equities are conducive to further investment, whereas domestic asset classes are more likely to be rebalanced back to individual guidelines to avoid over weights. And non US, dividend-paying strategies-now that will be something to talk about.

Wow-Summer’s Gone ….Nights growing colder….Jonathan R Laird, CFP

This and/or the accompanying statistical information was prepared by or obtained from sources that Wells Fargo Advisors Financial Network believes to be reliable, but its accuracy is not guaranteed. The report herein is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here reflect the judgment of the author as of the date of the report and are subject to change without notice. Any market prices are only indications of market values and are subject to change. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.

Notes: All U.S. index returns in the content above were calculated on a total return basis. International index returns were calculated on a total return basis in the respective local currency.

 Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.

 Investing in foreign securities presents certain unique risks not associated with domestic investments, such as currency fluctuation and political and economic changes. This may result in greater price volatility. These risks are heightened in emerging markets. Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk, especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility.

All fixed income investments may be worth less than the original cost upon redemption or maturity. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline of the value of your investment. 

An index is unmanaged and not available for direct investment.  There are no assurances that any target price will be achieved or forecast will be attained.  Investment products and services are offered through Wells Fargo Advisors Financial Network, LLC (WFAFN), Member SIPC. Lightship Capital Management, LLC is a separate entity from WFAFN.


[1] Source: Bloomberg, Data as of June 30, 2017

[2] Source: Thompson Reuters

[3] Source: Standard and Poor’s Financial Services, LLC