In this publication, we draw on the firm’s expertise to share our current investment outlook on several key asset classes. A discussion of the key elements of the outlook follows.
- Global equities rallied during the first quarter as solid global economic data and strong earnings supported risk appetite.
- Global growth continues to trend higher. Our proprietary measure of leading economic indicators (LEI) has reached its highest level since 2010, with significant improvement since the slight growth slowdown in the first half of 2016.
- Core CPI inflation in the U.S. went up marginally since our last publication, to 2.2% year over year, mostly driven by the strong housing and shelter components. Over the next few months, we expect headline CPI readings to moderate after rolling out the base effects from the commodity price trough in early 2016.
- Earnings growth is on the upswing. U.S. earnings continued the positive trend started in the previous quarter, which had reversed a five-quarter streak of earnings declines for the S&P 500®. Outside of the U.S., earnings in the fourth quarter were even better, particularly in Europe, where earnings growth was the best in almost eight quarters.
- With an apparently synchronized recovery in economic prospects for many of the world’s major economies, investors will likely now look to first-quarter earnings results for evidence of a continued improvement in corporate profit growth.
The Global Economy
Mellon Capital’s Proprietary Expectations for Economic Growth, Leading Economic Indicators and Inflation Expectations
According to the March 30 data release, the U.S. economy grew at a 2.1% pace in the fourth quarter of 2016. The reading is a bit weaker than in the third quarter, but the underlying details were quite solid. Consumption growth accelerated, while both business fixed investment and residential housing showed signs of recovering after several weak quarters. Combined with solid Purchasing Managers Index (PMI) readings, durable goods orders, housing starts, and consumer confidence, the prospect for stronger gross domestic product (GDP) growth in 2017 has improved. Thus, we have made another upward revision to our one-year-ahead U.S. growth forecast to 2.2% from 2.0% last quarter. We currently assign a probability of about 35% to below 2% growth, a 65% probability of 2%-4% growth, and essentially zero weight on above 4% growth.
Some uncertainties remain. First, the defeat of the health care reform bill in the U.S. House of Representatives has also lowered the likelihood of pro-growth policies such as tax reform or regulatory relief passing in the future. Overall, though, we still remain cautiously optimistic about the economic impact of the new administration. Second, while consumption growth slowed in January and February of 2017, this is most likely another temporary first-quarter slowdown as we have observed multiple times during this expansion.
At the March 2017 Federal Open Market Committee (FOMC) meeting, the committee raised the policy rate by another 25 basis points and also suggested two additional hikes this year. Despite the slight acceleration in the pace of rate hikes, we deem the path of monetary tightening gradual enough to not cause any major disruption to the economic expansion, both in the U.S. and globally.
Global Leading Economic Indicators
At Mellon Capital, we generate our own proprietary measure of leading economic indicators (LEI). Our calculation is based on a number of high- and medium-frequency measures of the macro economy and financial markets that we believe are highly effective at estimating subsequent economic growth. A level slightly above 100 would indicate a significant probability of a mild economic recovery. The further the LEI measure is above 100, the faster the pace of economic growth. Conversely, a level approaching 99, and certainly below 99, would indicate a significant probability of a mild economic contraction.
The global weighted average LEI continues to rise and now stands at above 101.3, the highest level since 2010. Almost across the board, leading indicators have improved significantly since the slight growth slowdown in the first half of 2016. The strong equity performance, especially when viewed on a year-over-year basis, generally very strong PMI readings, and solid GDP growth rates certainly contributed to the increase.
Only Spain experienced a modest decline though the index level is still above 100. Italy, with its banking sector problems and the United Kingdom, with uncertainty about the cost of Brexit, are still a bit below 100 but continue to improve their LEI readings.
U.S. CPI Inflation
U.S. headline inflation rose significantly, to 2.8% on a year-over-year basis (February 2017 over February 2016), the highest reading since 2012. Most of the inflation surge was due to the energy component. The headline number would have easily breached the 3% mark without the relatively tame food inflation. Core CPI inflation went up marginally since our last publication, to 2.2% year over year, mostly driven by the strong housing and shelter components.
Over the next few months, we expect headline CPI readings to moderate after rolling out the base effects from the commodity price trough in early 2016. On a 12-month forward basis, our forecast for inflation now stands at 2.2%, which is now roughly in line with the average of other commercial forecasts. As for the distribution of likely inflation readings over the next 12 months, we predict a 5% probability of inflation below 1%, 83% probability of inflation falling into the 1%-3% range, and 12% probability of above 3% inflation over the next year.
Implications for Asset Allocation
We find that both global equities and global bonds are attractive relative to cash, with a preference for equities. In our view, global equities are attractive as earnings growth and earnings revisions are mostly positive, growth and inflation expectations have increased, while continued liquidity from central banks in the Eurozone, U.K., and Japan should continue to support risky assets.
Equity Market Allocation
Among developed global equity markets we find Japan, the U.K., and Australia to be relatively attractive as these three markets have experienced rising earnings expectations. Japanese companies reporting earnings within the Topix Index saw 12% earnings growth during the fourth quarter while Japanese stocks have underperformed so far in 2017, increasing the relative attractiveness of Japanese stocks. Improved commodity prices and positive global growth expectations have benefited Australian earnings, while U.K. earnings continue to climb due in part to the depreciation of the pound. Conversely, we dislike U.S. stocks due to relatively slower earnings growth and recent outperformance. Despite the support from Trump-induced reflation expectations, U.S. valuations remain stretched and we find U.S. equities overvalued relative to other developed markets.
Among currencies we continue to prefer the U.S. dollar relative to the euro and British pound. The Federal Reserve’s and market participants’ interest rate and growth expectations for the U.S. are higher relative to expectations in other developed markets, making the U.S. dollar an attractive long position. Negative interest rates and continued quantitative easing from the European Central Bank make the euro an attractive short position. We also dislike the British pound due to a relatively weak macro outlook. Our proprietary leading economic indicators show the U.K. with the lowest overall level and the only economy that is forecast to deteriorate over the next 12 months.
Fixed Income: Sovereigns - Among sovereign bonds, we continue to prefer U.S. and Australian bonds as we believe that they are positioned to outperform due to higher yields and wider term premiums. We continue to hold short positions in German bunds and U.K. gilts, as we expect that they will experience outflows as investors demand higher-yielding bond markets. German bonds provide relatively small term premiums in comparison to other global bonds. Gilt yields have fallen significantly. While the Bank of England’s quantitative easing program will continue to be a tailwind for U.K. bonds, recent signs of rising inflation expectations may place pressure on U.K. bonds.
Fixed Income: U.S. Treasuries - Last quarter, we opined that the 10-year Treasury bond selloff during the fourth quarter of 2016 reflected a “normalization” as interest rates moved more in line with inflation and growth fundamentals. We continue to maintain a balanced outlook for interest rates, with a bias toward higher rates. In addition to stable growth and inflation expectations, for the first time in recent memory market expectations for future Federal Reserve (“Fed”) policy rate adjustments are converging with the Fed’s own projections (the “Dot Plot”). The Dot Plot median currently projects two more quarter-point rate hikes this year, with a final resting projection at 3%, largely echoed by the current shape of the Treasury yield curve.
Term premiums continue to hover around zero. In a normal environment, we would expect term premiums to be positive and nominal rates to be higher. Uncertainty around the viability of President Trump’s economic policies and their ability to impact growth should be reflected in the form of higher (positive) term premiums. On the other hand, ongoing easy monetary policy in Europe and Japan continues to create high demand for U.S. bonds. While the defeat of the health care reform bill poses a short-term dampening effect on interest rates, in the longer run we believe that the strengthening economy, both in the U.S. as well as globally, should serve to pull U.S. rates gradually higher.
Fixed Income: Credit - We remain cautiously constructive on U.S. credit. Demand for U.S. corporate credit has been strong amid record issuance (Figures 4 and 5) and spreads have tightened to approach the recent lows of 2014. However, we do not see valuations as being overly stretched. Corporate fundamentals remain robust and the market consensus forecasts growth in earnings and sales. Defaults have begun to decline as stable oil prices leave the 2016 commodity troubles behind us. Leverage continues to be high, but not at alarming levels. With Europe and Japan still in quantitative easing mode, U.S. corporates continue to present attractive carry relative not only to other developed bond markets, but also to other asset classes.
Fixed Income: Treasury Inflation-Protected Securities (TIPS) - With low unemployment and a robust economy, inflation is expected to continue to rise, albeit gradually. Our 12-month forward inflation forecast now stands at 2.2%. With consensus estimates for long-term inflation near 2.3%, current 10-year breakeven rates at around 2.0% reflect an inflation-linked bond market that is still attractive relative to nominal bonds. As the breakeven rate in theory should represent inflation expectations plus an inflation risk premium, it is perhaps all the more surprising that breakeven rates are not wider given the uncertainty that remains around President Trump’s ability to influence growth and inflation.
U.S. Mortgage-Backed Securities - We are neutral to slightly negative on mortgage-backed securities. Spreads to Treasuries remain tight, and we continue to see strong demand from both onshore as well as offshore investors as an alternative to Treasuries. The primary market risk that gives us cause for concern would be a change in the supply/demand balance driven by unexpected developments in the Fed’s plans for reducing its balance sheet. Discussions have begun around this topic. However, the path is far from clear, and as such we believe that the market may be underpricing this risk.
We find somewhat lower relative-value opportunities among commodities. One area where we find misvaluations is in the grain sector. Wheat appears unattractive as the futures curve offers the most negative roll yield in our universe. Conversely, soybeans are relatively attractive due to better roll yields. Among softs, cotton appears attractive based on most of our signals. We are bearish on sugar due to the futures curve dynamics. Positions within the energy sector remain relatively small, with a small short position in natural gas due to spread momentum, and a small net long in the petroleum sector. Positive price momentum makes industrial and precious metals relatively attractive. Only palladium appears overvalued based on our inventory signal.
Robust flows into indexed equities during the first quarter continued the strong index asset flow momentum experienced during 2016. U.S. and international indexed assets have both seen net positive contributions during the first quarter, while actively managed U.S. assets continue to experience net outflows. International actively managed assets have been modestly negative during the quarter as outflows in January reversed in February. Assets managed in indexed U.S. mutual funds now stand at $3.2 trillion versus $3.7 trillion in actively managed U.S. equity assets, as flows into U.S. indexed assets have benefited from strong U.S. equity markets as well as continued investor interest in indexed strategies.1
The S&P 500® index has had a strong start to the year, returning over 6% during the first quarter. Robust contributions from technology stocks led returns, while negative contributions from the energy sector detracted from the index.2 Similarly strong contributions from technology stocks led U.S. large-cap growth stocks as measured by the Russell 1000® Growth Index up nearly 9% in the quarter, while U.S. large-cap value stocks as represented by the Russell 1000® Value Index lagged both growth and core exposures to return just over 3%. Energy stocks in U.S. large-cap value were the detractor to returns during the period. U.S. small-capitalization stocks as represented by the Russell 2000® Index returned nearly 2.5% for the quarter, led by strong performance from the health care sector. Negative contributions from both financials and energy stocks detracted from overall U.S. small-cap index performance during the period.3 International developed markets as represented by the MSCI EAFE Index experienced returns of over 7% during the first quarter. As in the U.S., the technology sector led performance of the index, while the energy sector detracted. The European region led performance of the index, with positive contributions from Spain, Germany and the Netherlands, among others. Emerging markets as represented by the MSCI Emerging Markets Index continued the strong momentum of 2016 with a return of more than 11% during the first quarter. In emerging markets, all sector contributions were positive, with the technology sector producing the strongest returns, while the energy sector, albeit a positive contributor, lagged the return of the benchmark. Asian emerging market countries South Korea, China and India led regional contributions to the index over the period.4
U.S. stocks continued their ascent in early 2017 as the S&P 500® rose to a new record high just below the 2,400 mark at the beginning of March. The performance of the U.S. market during much of the first quarter reflected investors’ positive expectations regarding the ability of the new administration to put policy changes into action. The potential impact of those policy changes—especially financial regulatory reform and tax reform—was reflected in the strong performance of certain sectors such as financials, information technology and industrials, in both the large-cap and small-cap space.
While equity indices took the Fed’s widely expected rate rise in stride, investors clearly became less sanguine about the prospects of success for the Trump administration’s policies as the quarter unfolded. Following the failure to replace the Affordable Care Act (better known as ‘Obamacare’), doubts surfaced about the ability of the president to work with his Republican counterparts in Congress to enact other signature reforms and the market corrected over several days. By the end of March, the S&P had retreated 30-odd points to end the quarter at 2,363, 6.1% above where it started the year.
The mild U.S. market correction in mid-March allowed global markets to catch up to the U.S. The S&P 500 Index, having posted strong returns in the immediate aftermath of the election, was ahead of the MSCI EAFE and MSCI Emerging Market indices by 5% and 7.5%, respectively, at the start of March, but ended the quarter just 1% and 2.5% ahead of those two indices. MSCI Europe, which had lagged by almost 4.5% at the beginning of March, ended the quarter slightly ahead of the S&P 500.
The overall rise in U.S. stocks during the quarter was underpinned by a stronger earnings season: fourth-quarter year-over-year earnings growth for the S&P 500 came in at 5%, with some of the strongest growth coming from utilities (+15%), real estate (+14%) and financials (+11%). The only negative change in year-over-year earnings came from telecoms (-28%), largely due to poor earnings from Level 3 Communications, and industrials (-6%), driven principally by airlines and conglomerates. The strong fourth-quarter earnings numbers continued the positive trend in earnings growth that began in the previous quarter, which had reversed a five-quarter streak of earnings declines for the S&P 500.
Outside of the U.S., economies appeared to exhibit something of a synchronous upswing that supported market fundamentals. Rising earnings, outpacing in many sectors those of the U.S., encouraged investor optimism in international markets. For example, within the DJ Stoxx 600 Index in Europe, year-over-year earnings growth for those companies reporting came in at 11% during the fourth quarter of 2016; in Japan, companies reporting earnings within the Topix Index saw 12% earnings growth. In Europe, as in the U.S., 9 out of 11 sectors delivered positive earnings growth and, overall, earnings growth in all regions was the best in almost 8 quarters.
Key Risks To Our Outlook
Key risks to our outlook remain much the same as last quarter, but many have assumed greater immediacy.
- President Trump’s failure to replace the Affordable Care Act due to divisions within the Republican Party has prompted investors to focus more sharply on other policies slated for reform or replacement. Commentators are starting to question the new administration’s ability to work with a Republican caucus that, in terms of policy positions, may be more fractured than anticipated. As Washington waits for more concrete proposals on corporate tax reform in particular—and corporate America digests the potential implications of such reforms—there are risks that the current administration loses credibility with a number of key constituencies—including markets and investors.
- With the first, widely anticipated rise in the federal funds rate for 2017 behind us following the Fed’s decision to hike by 0.25% on March 15, attention now turns to potential drivers of Fed interest-rate policy for the rest of 2017 and into 2018.
- With an apparently synchronized recovery in economic prospects for many of the world’s major economies, investors will now look to first-quarter earnings results for evidence of a continued improvement in corporate profit growth. Current forecasts indicate that the positive trend in earnings growth is set to continue, with consensus estimates of just over 9% year-over-year earnings growth for the U.S. for the first quarter. Revisions to earnings forecasts have switched to outright positive in the U.S. as well as in the Eurozone and Japan. While still negative, earnings have improved significantly in emerging markets as well.
- While the Dutch election in mid-March did not result in a populist breakthrough for right-winger Geert Wilders, the French presidential election takes place during the second quarter of 2017, with Marine Le Pen of the Front National as one of the two candidates who advanced from the first round to a runoff. An unexpected Le Pen victory in the second round of the election would likely trigger a significant upturn in market volatility.