February 2019

The World as We See It

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The World as We See It provides a high-level overview of developments in the global economy and financial markets that helps inform our view of the investment landscape.

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Throughout the economic cycle, we expect returns to vary across asset classes. These returns not only measure the health of financial markets, but can also provide valuable signals on the trajectory of particular industries, regions and the broader global economy.

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1. 2018 Global Market Total Returns
2. 2017 vs. 2018

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World Markets in 2018: Global Market Total Returns

The pressure felt by international stocks for much of 2018 caught up with U.S. equities during the autumn as concerns about global growth seeped into domestic economic and market sentiment.

Compounding the pressures on stocks was the gradual rise in U.S. interest rates over much of the year. This not only weighed on returns of U.S. Treasuries and investment‐grade credits, but the associated increase in borrowing costs also represented an additional expense that had to be factored into stocks.

While the late‐year rally in Treasuries stanched losses in government bonds and investment‐grade credits, the source of the flight to safety – slower growth – magnified losses in stocks and high‐yield corporates.

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World Markets in 2018: 2017 vs. 2018

Some of the highest‐flying segments of the market in 2017 delivered the steepest losses in 2018. Among them were emerging markets and Asian stocks, given global growth concerns, and European equities for a combination of acute economic and political developments.

Strong earnings pushed U.S. stock indices higher through September, before worries about the Federal Reserve’s (Fed) interest‐rate path in light of slowing global growth expectations turned the tide.

The U.S. dollar’s gain for much of the year versus most other currencies illustrated a bifurcated global economic trajectory, with the U.S. on one side and much of the rest of the world on the other.

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Gauging the underlying economic landscape is an important step in an investment process, even for those focused on fundamental company analysis. Understanding growth, inflation and production and consumption trends is crucial in assessing which companies are well positioned to navigate the next stage of the economic cycle.

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1. Global Growth Outlook
2. Global Consumer Price Inflation Forecasts
3. U.S. Employment Outlook
4. Global Purchasing Managers’ Indices
5. Europe’s Measured Recovery Continues

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Global Growth Outlook

At an annualized rate of 3.4%, U.S. real GDP growth in the third quarter outpaced most other developed markets. And while fourth‐quarter growth is forecast to be lower, data still indicate a healthy domestic economy.

Headwinds are gathering for 2019. Brexit hangs over the UK and political risk in the eurozone adds to the concerns about whether the economy is resilient enough to withstand the eventual removal of highly accommodative monetary policy.

Despite the potential benefits of U.S. tax reform, rising trade barriers and geopolitical tensions may also be factors that could torpedo what had been a story of converging global growth.

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Global Consumer Price Inflation Forecasts

Slowing growth may be behind falling U.S. inflation expectations, as seen in the average rate of inflation over the next five years implied in TIPS market falling from 2.17% to 1.64%.

Europe’s attempt to catalyze its economy by having ample liquidity fuel inflation – thus bringing forward purchases – is now facing a less favorable backdrop given slowing growth on the continent.

While inflation is set to slip globally in 2019, investors must be wary of any potential shocks that could lead to rising prices. While tariffs may dampen global growth prospects, the associated higher import costs could lead to inflationary pressure in some markets.

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U.S. Employment Outlook

A robust U.S. jobs market has pulled some previously sidelined workers back into the labor force, resulting in a mild uptick in the unemployment rate to a still low 3.9%.

Importantly, competition for workers appears to be pushing wages up as evidenced by annual average hourly earnings rising by over 3% for each of the final three months of 2018.

Larger paychecks would put more dollars in consumers’ wallets, yet also could be a source of higher input costs for companies as wages are a material source of inflation in a service‐based economy.

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Global Purchasing Managers’ Indices

2018’s strong run of U.S. PMI data ended during the autumn as the manufacturing survey slid to 54, which still indicates expansion. Both the new orders and production components recorded acute weakening.

While stronger than the manufacturing survey, the U.S. services PMI, which covers roughly 80% of the economy, also cooled considerably during the autumn.

Matters appear worse in the eurozone as some member countries’ PMIs have entered contraction territory, among them France and Italy.

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Europe’s Measured Recovery Continues

Rising household consumption had been a relative bright spot for the eurozone, but that tailwind dissipated over 2018.

Sounding the alarm was eurozone heavyweight Germany registering negative GDP growth in the third quarter, with continued weakness expected.

A potentially rough Brexit could weigh on the eurozone’s growth prospects, as does possibly lower export demand to key foreign markets for European manufactured goods.

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In recent years, accommodative monetary policy has been a factor all investors must consider. As certain countries take steps to normalize policy while others move more cautiously, it is arguably even more important to monitor developments emanating from global central banks.

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1. Monetary Policy: Tapering Has Begun
2. Expected Fed Balance Sheet Taper

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Monetary Policy: Tapering Has Begun

The U.S. has commenced balance sheet tapering, with the Fed expected to allow up to
$50 billion per month in Treasuries and mortgages to mature without reinvesting.

The European Central Bank ceased buying new assets in December, although it plans to keep rates on hold at least through the summer of 2019.

Only the Bank of Japan remains an active buyer. However, its pace of balance sheet expansion has slowed.

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Expected Fed Balance Sheet Taper

Even if the Fed follows through on its plans to reduce its balance sheet by $50 billion per month, total assets will remain well above its pre‐crisis level of just under $1 trillion.

The Fed’s balance sheet reduction represents a form of monetary tightening, which could act as an additional headwind to economic growth, especially if it continues to raise interest rates.

While the market is presently focusing on slowing inflation, we must stay vigilant to an upside surprise in prices. Given the amount of cash in the system, only a small increase in monetary velocity, presently at a low 1.46%, could result in a snapback in inflationary pressure.

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The breadth of styles available to stock investors is extensive. Observing market-based metrics such as volatility and correlations is an integral part of managing the risks inherent in equities markets.

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1. U.S. Corporate Earnings Growth
2. U.S. Stock Volatility Year to Date
3. Stock Correlations
4. Forward P/E Ratios by Sector – U.S. Stocks
5. Forward P/E Ratios of Major Indices
6. Growth vs. Value
7. Returns by Market Cap

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U.S. Corporate Earnings Growth

Earnings growth enjoyed a pronounced upward push in 2018. And while we may be past peak earnings acceleration, we believe that earnings growth by U.S. corporations should continue.

This expectation is largely being borne out in the early days of fourth‐quarter earnings season as companies that have reported so far have delivered both sales and earnings results slightly ahead of expectations.

While many have remarked that an inversion along the front‐end of the U.S. Treasuries yield curve potentially signals recession, we would find it difficult to imagine a recession occurring with company performance remaining strong.

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U.S. Stock Volatility Year to Date

2018 reminded investors that stock returns can be volatile and that paying close attention to potential losses will take on heightened importance as the economic cycle grows older.

Along with a wider range of potential economic outcomes, due in part to tit‐for‐tat tariffs, higher volatility is the consequence of higher real interest rates as investors are less incentivized to sell volatility – which can suppress market swings – as investors can once again generate income in safer short‐term debt and money markets.

Higher volatility can lead to attractive entry points for companies with secular tailwinds that are well positioned to grow across the entire economic cycle.

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Stock Correlations

Stock correlations in the U.S. ticked up slightly during the autumn sell‐off, but have more recently resumed their trend of greater dispersion among equity returns.

Going forward, so‐called overarching beta trades may prove less effective as stocks will need more than broad bullish sentiment to push levels higher. Instead, companies will increasingly rely upon their own prospects for earnings growth.

The ability to identify companies with the most attractive business models and avoid those that are structurally challenged will possibly prove crucial in generating excess returns.

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Forward P/E Ratios by Sector – U.S. Stocks

Valuation multiples have decreased across nearly all U.S. large‐cap stock sectors. Only the historically defensive telecommunications sector has seen its favorability among investors increase.

It is important to note that earnings data remain strong. Lower multiples largely infer that investors may not be as willing to pay as much for earnings in light of an uptick in uncertainty and acute events roiling markets.

When focusing on company fundamentals, volatility and accompanying falling valuations can present attractive entry points for advantaged companies that may not have been as compelling an investment only a few months ago.

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Forward P/E Ratios of Major Indices

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Growth vs. Value

For much of the post‐crisis era, growth has outperformed value as investors were willing to pay a premium for growth in a tepid economic environment.

The concentration of gains in growth stocks, however, left this segment of the market vulnerable to a shift in sentiment, which occurred last autumn, resulting in growth underperforming value during the sell-off.

Should the economy slow, investors may once again be willing to pay a premium for companies capable of growing in a weak environment. But with valuation multiples of value stocks below their 10‐year average – in contrast to growth – opportunities may exist to access companies primed for a rerating by the market.

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Returns by Market Cap

A small number of mega‐cap stocks led markets higher through the first nine months of 2018.

This trend reversed during the autumn, with some of the previously highest flying technology and consumer discretionary names falling the farthest.

While many of the heretofore market leaders have what we view as attractive business models, we believe that advantaged companies exist throughout the economy and a sign of a healthier market is a greater dispersion of flows and returns.

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We live in a global economy, and investors should approach their portfolios accordingly. Corporate earnings are increasingly generated across a range of geographies, and regions are often at different stages of the economic cycle, which can lead to a dispersion of potential returns available to investors.

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1. International Stock Performance
2. European & U.S. Price/Earnings Ratios
3. Emerging Market Equity Performance
4. MSCI World EPS Growth Forecast (YoY%)

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International Stock Performance

Since emerging from the Global Financial Crisis, U.S. stocks have outpaced their developed market peers.

This run, however, has made U.S. stocks expensive relative to other countries.

Compared to its long‐term, cyclically adjusted P/E ratio, U.S. stocks also appear expensive by historical standards, while other markets are trading below their long-term averages.

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European & U.S. Price/Earnings Ratios

The autumn sell‐off brought valuations in both the U.S. and Europe below their long-term average.

While lower valuations may reflect slower growth, geopolitical risks or other factors that may widen the range of economic outcomes, the sell‐off’s indiscriminate nature may also present attractive entry points.

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Emerging Market Equity Performance

Emerging market stocks underperformed developed markets for most of 2018, although that beaten‐down status meant they slipped less than their advanced economy counterparts during the autumn sell‐off.

While emerging markets face real challenges, including slowing end markets for their manufactured goods and raw materials as well as headwinds caused by tariffs, these regions are home to several secular themes that are primed to deliver attractive earnings growth for years to come.

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MSCI World EPS Growth Forecast (YoY%)

Driven by improving global growth, 2017 and 2018 saw upward revisions to earnings estimates, a marked contrast to what proved to be overly optimistic early forecasts in the preceding years.

It remains to be seen which direction 2019 forecasts go. Company fundamentals, especially in the U.S., remain sound but slowing global growth may present a more challenging environment, especially if the hurdles placed in the way of global trade become more entrenched.

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Dividends can be an attractive source of income for investors. They can also show the commitment of corporate boards to return value to shareholders.

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