This summary is provided by BMT Wealth Management.
Earlier this year, the BMT Investment Team provided its expectations for the global economy, as well as the equity and fixed income markets for 2019. Our comments followed a dismal fourth quarter in 2018 where risk aversion was widespread across various asset classes. Today, the economic and financial market environment has changed given the strong performance of risk assets in the first half of the year coinciding with a meaningful drop in bond yields across the yield curve.
We want to take this opportunity to share our current thinking and expectations for the remainder of 2019, broken down between the U.S. and global economy, and the equity and fixed income markets. Overall, we believe slow but positive economic growth will lead to modest equity returns in the second half of the year while bond yields will stabilize and modestly adjust higher from current levels.
The following provides a more detailed look into our thinking as well as the fundamental drivers behind our outlook. We hope you enjoy the content that follows and appreciate the opportunity to keep you abreast of our current views on the global economy and the equity and fixed income markets.
Global Economy: Positive but Decelerating Growth Will Continue
The U.S. economy is well positioned to maintain positive economic growth for the remainder of the year and into 2020 driven by consumer spending and accommodative monetary policy. We anticipate the U.S. economic growth will resort back toward the long-term growth rate of 2.0%. Any significant downside deviations from 2.0%, we believe, will be addressed with appropriate levels of U.S. monetary policy action. The biggest risk to our growth expectations is global trade disruptions.
Ongoing trade discussions have been occurring over the past year. Positive/negative headlines have led to increased volatility in the financial markets and have altered both consumer and business sentiment. We believe the risks to deterring global growth will increase so long as trade negotiations remain ongoing and unresolved.
Consumer spending should continue to benefit from a strong labor market, increased household wealth, and healthy consumer balance sheets. Business spending, however, has been more influenced by trade uncertainty that has led to a decrease in business confidence levels. Overall, we expect consumer spending to provide a boost to economic growth while business spending will remain volatile for the remainder of the year.
We expect the current decline in global manufacturing to stabilize on the heels of continued but slow progress regarding trade discussions as well as proactive central bank policies to ensure economic growth remains positive. During the current economic expansion, that commenced over a decade ago, there were three other instances (2011, 2012, 2016) when Global Manufacturing PMI dipped below 50 (indicative of contraction) and a recession did not ensue. In each of these instances, central banks provided further monetary accommodation.
JPMorgan Global Manufacturing PMI SA
(July 31, 2016 – June 30, 2019)
Source: Bloomberg Finance, L.P.
The U.S. labor market will remain healthy as company hiring exceeds working-age population growth. We believe there is additional slack remaining in the labor force that is contributing to modest, although positive wage gains. This is evident given the mostly stable labor participation rate over the past year. We acknowledge the pace of hiring will most likely trend lower but remain above the level we believe is supportive of healthy economic growth.
We expect core consumer prices to increase but at a subdued pace below 2.0%. Globalization, technology, and the current composition of the U.S. labor force will likely act as an ongoing to significantly higher prices. Wage inflation, although trending higher, is not at a worrisome level for corporations and their operating margins. We do not believe economic growth, although positive, will be robust enough to lead to a spike in wage inflation this year.
The housing market is probably the beneficiary of the steep drop in mortgage rates, although extensive improvement has yet to materialize. Low mortgage rates and healthy consumer spending should be supportive of robust housing activity. However, many interested home buyers are challenged with rising home prices as well as limited housing supply. We believe these issues will continue, limiting any significant housing market activity and any robust improvement.
In the Eurozone and Japan, we believe that economic growth will continue to lag behind the U.S. Regarding the former, the European Central Bank and the Bank of Japan have already indicated openly that more easing is currently being discussed. Low inflation continues to be the primary focus within both economies as neither of the central banks has been able to successfully reach their respective inflationary objectives.
Improvements in the labor market, most notably in the Eurozone, have boosted consumer spending and confidence levels to more acceptable levels over the years. We are sensitive, however, to the amount and duration of this policy stimulus that has led to modest growth and we question how much ammunition remains to provide further economic stability.
Eurozone Unemployment Rate
(July 31, 2006 – May 31, 2019)
Source: Bloomberg Finance, L.P.
Keeping this in mind, we believe the Eurozone and Japan are more susceptible to slowing global growth and trade uncertainty that ultimately may lead to more economic volatility within their homelands. It is also worth noting that Brexit remains an ongoing concern and will most likely lead to some level of economic instability if not resolved in the months ahead.
In emerging markets, global growth and growth expectations have tilted lower on the heels of slowing global manufacturing as well as slowing Chinese economic growth. The latter was partly expected given the country’s economic reformation geared toward relying more on the domestic consumer and less on manufacturing and exports for economic growth.
However, the ongoing trade issues have only quickened the pace of ongoing deceleration.
We believe long-term fundamentals for emerging markets look good given the trend of lower inflation over the years as well as more diversification among economic resources. We do, however, acknowledge that the emerging markets may bear the brunt to the extent trade disagreements continue.
Equities: U.S. Value Companies Look Appealing as well as Emerging Markets
Price momentum is a powerful force in terms of the effect it can have on asset prices. Momentum-based investment strategies have clearly worked despite the fourth quarter 2018 market selloff. Such an approach often leads to continuous capital flows into a narrow segment of the equity markets. In this case, it clearly has been large-cap growth stocks. While there are some clear differences in terms of the economic and investing environments from the late 1990s relative to today, one thing that has been consistent is the significant outperformance of large-cap growth stocks. The following charts juxtapose a two-and-a-half-year period from the late 1990s compared to today. As you can see, large-cap growth stocks clearly diverged from the broad market over both periods.
Russell 1000 Growth Index and S&P 500 Index Returns
(September 30, 1997 – March 31, 2000 (Indexed to 100))
Source: Factset, Inc.
Russell 1000 Growth Index and S&P 500 Index Returns
(December 31, 2016 – June 30, 2019 (Indexed to 100))
Source: Factset, Inc.
We understand that equity market forecasting using a building block approach, or dividend yield (%) + EPS Growth (%) + Δ in Multiple + Δ in FX (international only), can have significant limitations over the short-run. The reason the markets have moved considerably higher over the last six months has less to do with earnings growth, which has been quite modest, but mainly a function of a rise in the equity multiple, or the price an investor is willing to pay for a dollar of earnings.
For the second half of 2019, we would not be surprised if price momentum persists, favoring large-cap growth stocks. However, the risk-to-reward ratio is not favorable in our opinion, especially for higher beta (riskier) securities and we continue to think it makes sense in this environment to look for relative value opportunities. We continue to favor international stocks, especially emerging markets, and we are maintaining our modest overweight position to domestic value stocks. These areas held up better during the more volatile fourth quarter period and we think the cheaper valuations of these segments of the equity market will outperform if the environment gets more turbulent for the rest of the year.
Late economic cycle periods usually favor large-cap domestic stocks over mid and small cap securities. This cycle has been no different. The Russell 2000 Index suffered a more pronounced decline in the fourth quarter of 2018 (-20.20%) and has lagged thus far over the first half of 2019. Over the past 12 months, ending June 30, 2019, the Russell 2000 Index has trailed the S&P 500 Index by approximately 1,400 basis points (14%). This trend may persist but we may look to increase small-cap exposure if large-cap dominance gets to extreme levels.
From a style perspective, value is moderately more attractive than growth. This view has clearly been a headwind for us so far this year but we continue to believe relative valuations are slightly more attractive for value-oriented sectors of the market. The large-cap growth universe is littered with dominant franchises with strong competitive positions. However, operating margins are considerably high relative to history. If profit margins fall even modestly, it can have a materially negative impact on the equity multiple investors are willing to pay.
Overall, we think the risk/reward ratio is not great for equities, but in this extremely low interest rate environment in conjunction with a high probability of Federal Reserve (Fed) rate cuts, we don’t see a reason why investors should dramatically cut their equity exposure in favor of fixed income securities. For balanced portfolios, a neutral to slight overweight to equities in our opinion is a reasonable allocation as we proceed through the second half of 2019.
Fixed Income: Federal Reserve Remains Accommodative
We expect that the Fed will be proactive with their monetary policy tools to stimulate and maintain economic growth at or near 2.0%, given an environment of low inflation and a labor market with excess capacity. We believe the Fed will act accordingly to ensure the ongoing U.S. economic expansion continues and will err on the side of being too accommodative as opposed to less.
Also, there is limited room for potential rate cuts given the small gap between the current federal funds upper bound of 2.50% and zero which is important to recognize since the Fed will have less room to maneuver interest rates lower if U.S. economic growth declines. The Fed has acknowledged as such while leaving the door open for potential “insurance cuts” to act as a buffer for unexpected economic deterioration.
Federal Funds Target Rate – Upper Bound
(January 2, 2007 – June 30, 2019)
Source: Bloomberg Finance, L.P.
Overall, we believe the underlying fundamentals of the U.S. economy remain strong, but we expect the Fed to take advantage of the stubbornly low inflationary environment to support the duration of the current economic expansion. We believe the Fed will cut interest rates by 50 basis points in 2019 to provide additional stimulus to the U.S. economy while looking to further support the labor market and add a boost to inflation.
Currently, investors are pricing in a more aggressive rate cutting agenda from the Fed relative to our forecasts. This is evident when looking at the steep drop in bond yields thus far in 2019 and the current level of U.S. Treasury yields. Although we believe rate cuts are justified, we do not share, in our opinion, the overly pessimistic economic outlook that investors have incorporated in the low yielding environment.
With that said, we believe it is acceptable to lengthen duration nearer to that of the benchmark given the low inflationary environment and potential risks to U.S. economic growth. However, we believe a modestly short duration relative to the benchmark is currently appropriate given how quickly yields have dropped.
We believe a modest overweight position to investment grade credit is consistent with our views of positive economic growth. Investment grade bonds have performed very well thus far in 2019 as credit spreads have tightened throughout the year. Although further tightening may be limited, we expect investor demand and search for yield will continue while the underlying fundamentals of corporate issuers benefit from lower borrowing costs.
We also expect high yield and bank loans to perform well for the remainder of the year but believe these sectors are more susceptible to the current aging of the business cycle. A more cautious positioning is acceptable considering the good performance high yield and bank loans have already earned this year. It is also worth noting that as the underlying fundamentals within high yield issuers remain strong and have possibly peaked, bank loan issuers have shown signs of weakening.
Emerging market debt has been a top performer across all fixed income sectors in 2019. Consistent with our views on high yield and bank loans, we believe this sector is positioned to perform well for the remainder of the year given the underlying fundamentals of emerging markets. Offsetting our positive thinking, however, is that emerging markets are more exposed to global trade concerns. With this in mind, and given the uncertainty around trade discussions and global economic growth, we believe it is prudent to take a more conservative position, especially when considering emerging market debt’s very favorable performance this year.
The BMT Investment Team’s global economic outlook is generally positive driven by strong underlying fundamentals of the U.S. economy. The biggest risk, from our point of view, is the ongoing trade discussions/negotiations. It is difficult to predict where discussions go from here although we are hopeful for positive developments as negotiations continue.
Equity performance has been a big positive this year, but probably at the expense of future returns. We believe equities, with a tilt toward international and emerging markets, will continue to perform well but not to the same extent as the first six months of the year. In fixed income, lower yields will make riskier sectors look more appealing; however, investors need to be cognizant of the aging of the business cycle and its potential impact on credit spreads.
We appreciate the opportunity to share our thoughts and expectations regarding the current state of the economic and financial market and look forward to providing more updates as the year progresses.