- Fixed Income Outlook
- Equity Market Outlook
- Alternative Investment Outlook
- Outlook Summary
- U.S. Macroeconomic Trends and Policies
- Global Macroeconomic Trends and Policies
- The Fine Print
Our Perspectives on the Markets, Interest Rates, and the Economy
Despite a slow start in 2015, the U.S. economy should see continued expansion through the rest of the year. This view is buoyed by a steadily improving labor market and the fact that inflation remains in check. As the Federal Reserve (Fed) approaches its first rate hike in nine years, market volatility is likely, although a pull-back could be temporary, as has been the case in recent years.
- Dramatic bond volatility in early June surprised investors accustomed to stable bond markets. As a precaution, investors can check the duration of their bond portfolios to guard against interest rate increases, which are widely expected.
- With U.S. equity valuations exceeding long-term fair values by most measures, the rate hike could potentially trigger a 10 percent to 20 percent downward correction. Investors can review their cash reserve balance needs as well as their portfolio allocations, and reduce equity positions that may have grown higher than asset allocation targets.
- Hedge funds should continue to outperform traditional investments, a trend which began earlier in 2015. Alternative investments tend to benefit from capital market volatility, and add value through trading and hedging strategies, including fundamental, quantitative, trend and counter-trend models.
- Eurozone economies are stabilizing, and international equities remain more attractively valued than U.S. varieties. This suggests there may be more to be gained from investing in international equities.
- The impact of the global financial crisis remains. More than six years after the crisis, and despite unprecedented monetary stimulus by central banks, global economic growth remains 10 percent below levels that the International Monetary Fund (IMF) predicted before the financial crisis.
The current investment environment is challenging for investors, and volatility is expected from both stocks and bonds as markets adjust to unprecedented monetary policy actions.
The long-run linkages between valuations and returns clearly indicate that future real returns from bonds and stocks will be low compared to cycles which start with more attractive valuations.
In the past, stocks were typically cheap when bonds were expensive, and bonds were cheap when stocks were expensive. Today, both markets are overextended—U.S. stocks by nearly one standard deviation, and U.S. Treasuries by more than 1.5 standard deviations. For example, the U.S. Shiller PE ratio hit record highs through the 1990s, but did not peak until January 2000.
Fixed Income Outlook
The dramatic increase in bond market volatility in early June surprised investors who may have been lulled into thinking that bonds are stable investments by the sanguine bond bull market of the last 30 years. In the current low interest-rate environment, volatility is exacerbated because any change in rates has a larger impact on bond prices than when rates are high. Municipal bonds continue to offer an after-tax yield advantage over Treasuries for investors in high tax brackets. They also are effective anchors for equity portfolios, and provide sources of liquidity should unexpected cash needs arise.
Investors are advised to check the risk exposure of their bond portfolios to guard against changes in interest rates. The sensitivity of a bond's price in response to a change in interest rates is measured by modified duration. As a guide, for every year of modified duration, a 1 percent change in interest rates will cause an equal change in price. For example, if a bond has a modified duration of five years, then a 1 percent increase in interest rates will translate to a 5 percent drop in the value of the bond. In the low interest rate environment of today, low bond coupon yields do not provide much protection against falling bond prices.
The recent rise in bond yields gives investors an opportunity to deploy cash into bond portfolios. Investing in individual bonds in a diversified portfolio offers some advantages over bond funds. The latter are subject to greater price volatility due to fund flows and interest rate changes. Balancing coupon income and duration risk is a challenging problem for even seasoned investors, but generally long duration bonds are not advisable in this low-rate environment.
Equity Market Outlook
In the short run, U.S. equities remain vulnerable as anticipation builds for the first Federal Reserve (Fed) rate hike in many years. Historically, stock prices have corrected after the second or third rate hike. Initially, the first rise in interest rates is viewed as evidence of a continuing strong economic cycle that will support the growth of profits. However, this time, the anticipated initial rate hike is six years into the economic recovery. Such a late move is unprecedented. This deep into the recovery, stocks have had ample time to reach rich valuations and profit margins are under pressure. We believe that stocks in this environment will react negatively to the Fed's initial hike.
Volatility is predicted in the short term for U.S. equity markets, although pull-backs could be temporary, as has been the case in recent years. Over the long term, stocks offer better prospects than bonds. Over the next decade, stock returns subdued by a slow global economy will likely be lower than long-term stock market averages.
Investors are counseled to review cash reserve balance needs as well as their portfolio allocations, and reduce equity positions that may have grown higher than asset allocation targets. Conservative investors who wish to deploy cash into long-term portfolios are advised to take advantage of market pull-backs and gradually move into target allocations.
Developed International Equities
As of mid-June, international stocks were handily surpassing U.S. equities in terms of total returns. Eurozone economies are stabilizing, benefiting from the tailwinds of lower energy prices, a recovery in bank lending and a weaker euro. International equities remain more attractively valued than U.S. equities, and are earlier in the profit margin recovery cycle. This suggests there may be more to be gained from investing in international equities.
Increasing allocations to international stocks relative to U.S. stocks has become a popular stance of wealth advisors, and is becoming a crowded trade. Investors seeking to increase exposure to developed international equities should consider allocating to active managers with strong stock-picking skills.
Emerging Market Equities
The outlook for emerging market equities remains weak. China's economy is responding very slowly to monetary easing, which is stalling exports for other countries in the region. Russian and Brazilian economies, which rely heavily on oil revenues, are experiencing recessions. Argentina's economy, which is heavily dependent on Brazilian consumers, has been hit hard by the depreciating Brazilian currency, and a scarcity of dollars is making it difficult for firms to import Brazilian goods. In addition, the currencies of most emerging market countries have been depreciating relative to the dollar. While this may boost exports, it may also increase inflation and the burden of dollar-denominated debt.
In general, investors should expect continued volatility in EM capital markets and a wide variation of the performances delivered by individual emerging market countries. Modest exposure to emerging market equities is advised for long-term investors, but we believe it is too early to overweight this asset class.
Investors who wish to establish long-term positions in emerging market equities could benefit from strategies with lower risk profiles than the overall market segment.
Alternative Investment Outlook
Hedge funds should continue to outperform traditional investments, a trend which began earlier in 2015. Alternative investments tend to benefit from capital market volatility and add value through trading and hedging strategies, including fundamental, quantitative, trend and counter-trend models. These investments are designed to capture mispricing opportunities as market performance shifts from beta-driven factors to more complex, asymmetric macroeconomic conditions.
Unprecedented monetary stimulus by central bankers worldwide has kept interest rates well below historical levels for many years. As the Fed approaches its first rate hike in nine years, market volatility is likely. With U.S. equity valuations exceeding long-term fair values by most measures, the rate hike could potentially trigger a 10 percent to 20 percent downward correction. While painful for investors in the short run, recent market corrections of this magnitude have been followed by quick recoveries. Such consolidations typically give the markets an opportunity to extend their growth paths.
In fixed income markets, global yields likely will stabilize at lower levels as investors realize that the European Central Bank is likely years away from increasing interest rates. Meanwhile, higher U.S. rates are giving investors an opportunity to add to bond portfolios at favorable prices. Outlook risks include the possibility that enhanced volatility in equity and bond markets will unsettle investors and cause a major correction. In addition, should global bond yields remain high, the fragile European economic recovery might stall. With the European Central Bank facing zero bond interest rates, traditional monetary policy actions available to support the recovery are limited.
U.S. Macroeconomic Trends and Policies
Despite a slow start in 2015, the U.S. economy should see continued expansion. This view is buoyed by a steadily improving labor market and the fact that inflation remains in check. However, economic growth is underperforming historical trends. In early June, the International Monetary Fund's annual report on the U.S. economy lowered its 2015 forecast for U.S. GDP from 3.1 percent to 2.5 percent.
On a positive note, consumer spending should get a boost from the improving labor market. Initiatives to raise the minimum wage are being implemented by numerous local governments, and wage increases have been announced by several major employers—including Walmart and McDonald's. Several states have announced increases in minimum wages.
Inflation and Interest Rates
Following solid economic news in May, U.S. Treasury yields increased dramatically in early June, with 10-year Treasuries increasing from 2.1 percent to 2.4 percent in one week. With interest rates so low, any change in rates will have a big impact on bond prices; this increase in rates pushed total returns earned year-to-date on taxable bonds into negative territory. Municipal bonds followed the trend, but experienced a more moderate impact. The volatility and price impact was an unwelcome surprise to investors who expected bonds to remain stable investments.
As the Fed carefully prepares for its first rate hike in nearly nine years, the exact timing continues to be enthusiastically debated. The consensus view is that a Fed Funds rate increase could happen as early as September. In the meantime, the International Monetary Fund (IMF) in early June warned the Fed that higher interest rates could cause "abrupt rebalancing of international portfolios with market volatility," and recommended the Fed delay any increase until 2016. However, with economic growth serving as a tailwind and the Fed increasing its medium term inflation objective to 2 percent, the IMF likely will be disappointed.
May's U.S. employment report showed solid job gains, improving wages and a healthier employment mix. Payrolls added 280,000 jobs that month and another 32,000 as a result of revisions to March and April jobs reports. Hours worked and labor force participation measures also improved. Hourly earnings were up 2.3 percent over 2014, the biggest gain since 2009. These factors should lead to moderate increases in consumer spending, although, as noted below, we believe growth will be slower than seen in past recoveries.
Strong job growth, low interest rates, and higher average hourly earnings are expected to support additional consumer spending through 2015; however, lower oil prices have not boosted consumer spending as expected. A variety of factors are likely responsible, including higher winter utility bills and health care spending combined with an increased propensity to save.
With the job market improving, consumers might increase spending beyond autos and health care. Headwinds remain significant however, and are likely to keep spending below pre-crisis levels. Household debt levels remain high, making consumers vulnerable to Fed monetary tightening. In addition, investment gains have led to improvements in household balance sheets (not including housing). But those gains typically benefit higher wage earners more than consumers in general.
Since its trough in June 2009, real consumer spending has risen at an average annual rate of 1.7 percent. In the 15 years or so leading up to the financial crisis, the annual growth in consumer spending averaged 3.5 percent. This latter period is now considered one fueled by excess credit which essentially allowed consumers to increase current spending with the result of sacrificing future spending.
Employment growth, low interest rates, and high rental housing costs have helped fuel home buying. New home sales rebounded in April, a sign of rising demand. However, the constrained supply of existing homes combined with slow housing starts and rising prices could squeeze first-time buyers out of the market. In April, there was a modest 4.8-month supply of new homes, sharply below the average of six months' inventory, the level that indicates a market with a healthy balance of demand and supply. Economists estimate that 1.5 million new homes are needed to keep pace with housing demand.
But in 2015, housing starts have been averaging just over 1 million. U.S. home ownership is estimated to be 63.7 percent, a level below where it stood more than two decades ago. The majority of new households are being formed by minorities who typically have lower incomes, less accumulated wealth, and thus lower home ownership rates compared to the U.S. average. As a result, the boost to GDP from housing construction that has historically followed economic recoveries could be muted this time.
Global Macroeconomic Trends and Policies
Global Macroeconomic Trends
In the Eurozone, economic growth is on track for a 1.6 percent increase in 2015, a welcome result of quantitative easing, albeit well below the 2.2 percent pace logged prior to the financial crisis. Concerns about Europe triggering a crisis are receding as periphery countries, for the most part, are experiencing growth trends similar to stronger countries like Germany.
The impact of the global financial crisis remains. More than six years after the crisis, and despite unprecedented monetary stimulus by central banks, global economic growth remains 10 percent below levels that the IMF predicted pre-financial crisis. The crisis reduced the level of potential output and continues to impact growth rate. The IMF has repeatedly lowered its five-year estimate of potential real GDP growth. Its latest forecast for developed countries predicts that growth will average 1.6 percent annually over the next five years, which would be a slight improvement over the 1.3 percent average annual growth achieved between 2008 and 2014. For comparison, the average annual rate hit 2.3 percent from 2001 to 2007.
In emerging economies, the IMF now expects annual economic growth to average 5.2 percent from 2015 to 2020, down from an annual average rate of 6.7 percent from 2008 to 2014.
Consistent with the IMF's projections, the Organisation for Economic Co-operation and Development (OECD) has moved its global economic growth forecasts down, from 3.6 percent in 2015 and 3.9 percent in 2016 to 3.1 percent and 3.8 percent, respectively.
One note of caution: Measuring potential growth is problematic because of the uncertainties associated with estimating potential vs. actual output (known as the output gap) which guides fiscal and monetary policy. Central bankers tend to err on the side of doing less rather than more, since there is no empirical policy solution for addressing deflation as there is for tackling inflation. In deflation, interest rates are close to zero, thus limiting policy action while there is theoretically no limit on increasing rates
Global Monetary Policy
Globally, central bankers have kept the pedal to the metal hoping to accelerate economies.
An unexpected challenge to economic recovery has been the careless communication style on the part of Mario Draghi, the head of the European Central Bank, in contrast with the cautious messaging from Fed governors. Draghi's comment, in early June, that investors should expect more volatility in bond markets, caused yields to surge.
German bunds increased from a few basis points to 90 bps in a matter of weeks, triggering a general rise in global bond yields. If these higher yields are sustained, the fragile economic recovery could be threatened. However, it seems likely that yields will retreat from these elevated levels as the European Central Bank is not in a position to raise rates for several years. Core inflation in the Eurozone is showing signs of stability (CPI is now up 0.3 percent year over year), but that is still a long way from the ECB's target inflation rate of 2 percent.
Greece remains a wild card, but the risk of Greece's departure from the Eurozone, causing a widespread crisis, has receded. Greece continues to resist structural reforms, spending cuts and sales tax increases, all of which have been mentioned as requirements for the Euro group (the ECB, European Commission and IMF) to release the final tranche of funds in Greece's second bailout package. Without the funds, Greece will default on its interest payments. This event would not necessarily lead to an exit from the Eurozone, but it would increase the odds.
Over the last several years, banks and private investors substantially reduced exposure to Greek debt, and the yields of peripheral Eurozone countries are no longer highly correlated with Greek yields. Nonetheless, the uncertainty around a potential Greece exit could spook investors, and with equity markets so highly valued, such a scenario could trigger a correction.
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