An Update on our 2018 Outlook
At the end of 2017, we argued change was on the way for markets. Stocks and bonds had potential to grind higher thanks to a strong global economy, but rising interest rates could trigger the return of market volatility. Additionally, we said innovation would continue to disrupt a range of industries, while sound fundamentals in emerging markets looked set to drive investor demand for those regions’ assets.
So far, much of our outlook has proven true – with a few surprises. For one, we did not foresee that data privacy concerns would leap to a sharp pullback in technology stocks. Geopolitical events, including this year’s threat of a global trade war, were impossible to predict. Global equities, in turn, have struggled to deliver positive returns. But the major themes from our 2018 Market GPS are playing out: The Federal Reserve (Fed) continues to unwind accommodative monetary policy and the European Central Bank and the Bank of Japan seem primed to follow suit. Market volatility has inched toward historical norms, emerging markets have outperformed developed market peers and innovation continues to disrupt.
Recently, we spoke with a number of our portfolio managers from across different asset classes to learn whether these trends might persist for the rest of 2018, as well as what new themes have emerged. In short, they argue the global economy is on sound footing, but more change could be on the way and investors need to be selective. Continue reading below for their comments.
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What is driving the return of market volatility?
Rising Treasury rates. Higher yields lure investors seeking income away from selling volatility, a strategy that has muted price swings in stocks in recent years.
What risks are investors potentially overlooking?
A bond sell-off led by real rates. Inflation is getting all the attention despite bonds already pricing in near-normalized levels. Real rates are still very low, with much of the developed world yielding less than 0%. Inflation was the first step on the path to normalization; real rates are the second – potentially more painful – step as they impact all asset classes.
Where is the options market signaling opportunities?
Emerging market stocks appear attractive despite a potentially stronger U.S. dollar, as many countries have shifted to funding debt in local currencies. A stronger dollar stands to lift exporters’ competitiveness, especially if U.S. consumption remains healthy.
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How would you assess global central banks’ path toward policy normalization?
We believe that most central banks are reactive, rather than proactive. This patient approach is merited as the global economy is more fragile than it seems and we consider inflation concerns exaggerated.
Where might markets and central banks diverge on their views of the economy?
In growth environments, investors tend to jump on the bandwagon of expecting rate hikes and favoring risk assets. We, however, believe the Fed won’t meet its rate target for this year or next. The jury is out on the benefits of tax reform, and trade is another threat. Central banks won’t risk policy error by hiking too quickly.
How can bond investors position themselves in a less-accommodative environment?
Investors would be well served to pursue attractive opportunities – with respect to geography and duration – regardless of benchmarks. Today’s environment appears favorable for an absolute-return mindset as different countries operate in different economic cycles.
Inflation Unlikely to Trend Higher
Yields have risen this year, but Jenna Barnard and John Pattullo argue the trend may not continue as core inflation in developed markets is likely to be contained. They also believe synchronized global growth may be nearing its end, creating new opportunities for bond investors.
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Could we see a breakout in inflation later in 2018?
While inflation can go higher, a breakout is unlikely. Technological advances, especially, should help keep inflation in check as they help companies navigate labor shortages and higher employee costs. Other factors that could support higher inflation – like strengthening crude oil or wages – are unlikely to have outsized impacts.
Where do you see opportunities amid rising rates?
Our first question is if a security can deliver a reasonably positive return as rates go higher, so investors should consider avoiding excessive duration risk. We think investors should focus on companies with strong asset bases, management teams and balance sheets.
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How have rising rates impacted dividend-paying stocks?
Higher interest rates have caused some dividend stocks to underperform, but in the longer term we expect company fundamentals to be the main driver of returns. Also, many financial services firms’ earnings benefit from rate increases, and commodity sectors can be positively correlated to rising rates.
What factors could drive dividend growth in 2018?
Dividends tend to lag earnings growth because management teams like to see improving profits before committing to dividend increases. If today’s benign macroeconomic environment continues, 2018 should see good dividend growth. U.S. tax reform and rising commodity prices could also provide a boost.
Where are you finding dividend opportunities now?
We think the market underappreciates the energy sector’s improved cash generation. European stocks may also be attractive: Firms in the region are undertaking positive restructuring activities, increasing share buybacks and maintaining low debt levels.
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What has been the impact of economic reform in China?
We still see limited opportunities in China due to the presence of state-controlled enterprises, which raises concerns about alignment with investor interests. Also, Beijing’s focus on debt reduction could force cash-rich private companies to perform “national service,” rather than focus on sustainable growth and the return of profits to shareholders.
What are your expectations for emerging markets broadly?
Lately, we’ve seen enthusiasm for risky assets such as emerging markets, and think investors could be overly optimistic. But we are positive about the long-term investment opportunities based on rising living standards in parts of the developing world.
Where are you finding exciting opportunities?
Significant changes are underway in South Africa: A rising middle class is demanding less corruption and improved living standards. Corporate confidence has also lifted after Cyril Ramaphosa’s election as president, and we expect to see private investment pick up. As a result, we think South Africa offers fertile ground for long-term investors.
An improving European economy should benefit the region’s equities over the long term. At the same time, an end to accommodative monetary policy could help value stocks – prevalent in Europe’s market – outperform. The outlook for Japanese stocks also is positive, as companies there have delivered strong corporate earnings and management teams give greater consideration to shareholder interests.
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The European economy has been strengthening. What has been the effect on European equities?
After years of anemic growth, we have seen a pickup in demand and business confidence in Europe, supporting European equities over the past year. More recently, economic data have been dull, which, in dollar terms, has weighed slightly on the region’s stocks. But we believe this is more of a soft patch, rather than the end of the European recovery, and that this extended economic cycle will become more of the norm.
How could changing monetary policy impact equity markets?
“Tighter” monetary policy is still some way off in Europe and Japan, but there is a light at the end of the quantitative easing tunnel. With the era of central bank domination slowly coming to a close, we believe a change in style leadership is in the offing in equity markets. Looser conditions have, in our view, helped sustain an extraordinary period of growth outperformance relative to value globally, but with conditions changing at the macroeconomic level, we believe a rotation in market leadership is possible.
Which regions do you think currently offer the best risk-reward opportunities?
Should we see a market rotation in style, Europe could be well positioned to outperform, given its greater exposure to value sectors relative to Asia and the U.S. Within Europe, we have been finding greater opportunities in the UK, as depressed valuations there are creating select opportunities for the contrarian stock investor.
Looking further afield, Japanese equities could be well positioned to reverse their long-term underperformance. The corporate earnings picture appears strong, while Japanese stocks, on average, trade at a discount to developed markets. In addition, we feel changes to the way Japanese companies are managed – with shareholders now being given more consideration – could herald a period when returns from Japanese corporates start to narrow the gap relative to their American and European counterparts.
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What could help push U.S. equities higher this year?
I expect that sustained economic growth, along with continued strength in corporate earnings, will continue to boost stocks. Corporate tax reform should also aid cash flow, which could allow companies to enact aggressive capital return plans.
How is disruption creating investment opportunities?
The disintermediation of traditional industries is creating many opportunities. For example, the shift from traditional retail to e-commerce may allow us to capitalize on consumers’ changing habits. Similarly, continued adoption of cloud technology, which helps companies run more efficiently, offers attractive opportunities.
A number of factors in today’s market environment signal that we are undergoing a shift. Rising interest rates and the slow unwind of accommodative monetary policy, along with accelerating inflationary pressures, will likely benefit value stocks. Specific sectors also stand to benefit from these trends, including financials. However, now more than ever, investors should remember that it’s important to protect their hard-earned gains.
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Why did value stocks underperform growth during the market correction earlier this year?
The composition of indices played a large role in growth’s relative outperformance. The technology and consumer discretionary sectors – two of the sectors that helped lead markets higher during the first part of the year – are larger constituents in growth indices than they are in value indices. These higher allocations helped boost growth indices. Moreover, value indices were weighed down by larger exposure to sectors that can be considered bond proxies, like utilities and real estate, which underperformed the broader market during the sell-off in February.
What is your outlook for value stocks, given the segment’s recent underperformance and shifting monetary and fiscal policies?
While there has been a long period of outperformance by growth, we are now seeing signs that value is poised to outperform. The shift to tighter monetary policy and higher interest rates should bode well for value in general, especially the financial sector. Accelerating inflationary pressures – thanks to stronger economic growth, tighter labor markets and wage increases – should also bolster value, especially given the prevalence of commodity-related names in the value segment.
What sectors or companies are particularly primed to outperform in this type of environment?
Banks stand to benefit from higher, and still rising, interest rates. They have also benefited from tailwinds after the 2016 election, primarily in the form of expectations for easing regulations and tax reform – both of which have since come to pass. More generally, we believe a focus on less mainstream holdings – which we think of as "off the beaten path" – may limit investors' exposure to market bullishness and, crucially, a reversal in the level of bullishness. For example, investors should consider stocks with minimal Wall Street or sell-side coverage, management teams that are not overly promotional and are good stewards of shareholder capital, and niche businesses with secular business drivers.
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What has driven earnings growth so far in 2018?
Generally, earnings have exceeded expectations, and I think the combination of a healthy global economy and U.S. tax reform is the reason. Also, we continue to see strength in China, which benefits markets closely aligned with China’s economy.
Do you think this growth can continue in the near term?
It depends. The earnings potential of small- and mid-cap U.S. companies is powerful, thanks to tax reform. Globally, Europe ex-UK appears to be in the middle of its business cycle and, therefore, could have more upside. But I’m negative on consumer stocks. Many of these firms face higher input costs and have zero pricing power due to competition.
Has market volatility made some sectors more attractive?
We’ve had a pretty big pullback in a number of natural resources stocks and commodity prices, and these could rebound along with economic growth. Also, the flat yield curve has weighed on bank stocks. But bank earnings still tend to be strong during such periods, creating potential upside.
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What’s behind the volatility in technology stocks this year?
One driver has been concerns about potential regulation in the wake of the Facebook user data breach. President Trump also railed against Amazon on Twitter for several days. And new privacy rules are taking effect in the European Union (EU), which could impact firms that use customer data for targeted advertising.
Will regulation become a significant headwind for tech?
I don’t think so. In the EU, companies could find ways to work around new regulations. In the U.S., I think it will be difficult to define large tech companies as monopolies, per antitrust law, because their products are free to consumers. Meanwhile, revenues for many of the tech sector’s leaders continue to grow at double-digit rates.
What innovations are you most excited about for 2018?
I think artificial intelligence (AI) is coming into its own now, but not the cyborg-idea of AI. I’m talking about machine learning: companies using AI to gain customer insights and to drive productivity. These tools are helping businesses today.
Intech’s equity market stress metrics continue to exhibit extreme levels when compared to historical values. The greater the deviation versus long-term mean, and the longer it persists, the more likely it is that the return to the norm will be abrupt and accompanied by substantial volatility. There is, therefore, likely an increased risk that the market will continue to suffer drawdowns as equity market volatility increases in the future.
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Despite a short-term spike in February, volatility has been unusually subdued. Why has that been the case?
Volatility was at unusually low levels from August 2016 through January 2018, coinciding with very strong market returns. Global economies are growing, and monetary policies have furnished additional support while investors shrugged off the negative tail risk of geopolitical instability. In Intech’s Equity Market Stress MonitorTM, we observe that the dispersion of returns of stocks across equity markets remains near historically low levels, which is indicative of excessive group think and consistent with the low volatility environment. This tends to increase the risk that the market will suffer drawdowns as volatility increases in the future.
Market-based risk metrics have been at extremes. Which, if any, signals a reversion to the mean? What does that mean for investors?
When market-based risk metrics move far from their norms there tends to be an increased risk that investors will overreact to bad news, leading to market drawdowns. Sometimes, as in the aftermath of Brexit in 2016, the drawdown was quickly corrected. In other cases, such as the Global Financial Crisis, the recovery took years. Intech’s equity market stress metrics – applied to various indices – continue to exhibit extreme levels when compared to historical values. The greater the deviation versus the long-term mean, and the longer it persists, the more likely it is that the return to the norm will be abrupt and accompanied by substantial volatility. Given that extreme readings persist across indices, investors should continue to prepare for a less likely but more significant move downward in global equity markets.
Which segments of the global equity market currently have the most attractive risk-adjusted return opportunities?
The Intech Equity Market Stress MonitorTM currently exhibits extreme levels in three out of five metrics for all broad markets. In addition, European equities are showing even greater strain. As such, investors in equities, regardless of market segment, should prepare for a potential drawdown as volatility increases. Even so, equity markets still offer a high level of reward and liquidity, so risk-managed strategies in any segment of the global equity market may offer the most attractive risk-adjusted return opportunities.