Editor’s Note: The following information was originally published on October 15, 2018.
We see ongoing investment opportunities in the U.S., tied to its economic leadership. We also see new opportunities in Asia, where equity underperformance has shifted the region’s risk and return outlook. While markets always face uncertainties,economic and market fundamentals appear stable.
Q3 2018 Review
The U.S. has demonstrated its relative economic strength this year. The positive economic picture in the U.S. and a reset of growth expectations for overseas economies contributed to significant outperformance in the first three quarters of the year for U.S. equities compared to international markets.
Even with favorable data, U.S. economic readings still point to moderate growth. The 4.2% GDP growth in Q2, for example, was driven, in part, by an unusual boost from exports, as illustrated in Figure 1. U.S. GDP growth on a year-over-year basis, which helps smooth out quarter-to-quarter volatility, remains below 3%. Figure 1 also shows we have seen a number of quarters with annualized GDP growth in excess of 4%, even within the moderate growth trend of the current expansion.
Overseas, developed economies continue to deliver modest economic growth. The fundamentals in emerging markets, however, have been more mixed. For example, political and economic instability in countries like Turkey and in regions like Latin America contrast sharply with the relative stability in Asian emerging market countries.
Global equity market returns varied broadly across countries and regions in Q3, but regional equity market winners largely mirrored the fundamental backdrop, which is often not the case in the short run. For example, U.S. equities posted strong performance, with the S&P 500 returning 7.7%, its highest quarterly return in eight years. It is also not surprising to see stocks pull back in early Q4 on the heels of strong Q3 returns.
Within the U.S., equity sectors that are benefitting from secular trends generally outperformed, including Health Care and Information Technology. In contrast, sectors with the most economic and interest rate sensitivity generally lagged, including Energy, Materials, Real Estate and Utilities. Industrials were an outlier among economically-sensitive U.S. sectors in Q3, outperforming as investors’ concerns about trade tensions seemed to ease. Despite this bounce, Industrials continued to underperform year-to-date.
Outside the U.S., a deterioration in investor sentiment with respect to international equities, especially for emerging markets, led to their underperformance in Q3. Developed international markets posted modest gains overall, but signs of slowing growth in Europe, for instance, belied elevated investor expectations and weighed on returns. The MSCI Emerging Markets Index actually declined 1.1% in Q3, driven by a combination of continued concern over international trade tensions, signs of slower global growth, and U.S. dollar strength.
U.S. interest rates continued to rise in Q3, albeit at a slower pace than in the first half of the year. This presented a continued headwind for fixed-income returns in the quarter. Treasury bonds were particularly impacted due, in part, to their higher duration (interest rate sensitivity) relative to corporate bonds of similar maturity, and also due to shrinking credit spreads. Longer-term interest rates have moved up further in the first few weeks of Q4.
Outlook
U.S. Outlook: Our overall global economic outlook remains positive. The U.S. continues on a trend of moderate economic growth. The 4.2% annualized GDP growth for Q2 was a deviation from the multiple-year trend of 2% to 3% readings. However, other broad based measures of the U.S. economy, like the Chicago Fed National Activity Index (CFNAI), continue to point to moderate growth in Q2 and Q3, consistent with the 2.3% average annualized growth rate during the current expansion.
The U.S. economy has made significant progress since the cyclical trough in 2009, including a rebound in auto sales, growth in construction spending, and a tightening of the labor market. However, while auto sales (Figure 2) and construction spending remain at high levels, their growth has stalled, and unemployment has dipped well below levels economists have historically considered to represent “full employment.” This suggests there is limited economic fuel to drive sustained dynamic growth going forward. However, at this point, these constraints appear to be acting more as a governor on the economic throttle rather than an outright brake for the economy.
Data in Q3, meanwhile, reaffirmed our view that the consumer remains healthy and a key driver of the economy. Core retail sales growth has been trending higher, and hit 5.2% year-over-year as of August. The spending increases are supported by income growth, which is increasingly coming from gains in hourly wages, rather than additional hiring and hours worked. In fact, growth in average hourly wages reached 2.9% in August, the highest rate since mid-2009.
This shift among over sources of personal income is expected as the economic cycle matures. Personal income growth, which incorporates job growth as well as wage gains, was 4.7% year-over-year in August. This should support continued consumer spending
There remain risks to growth in the U.S., however, even as the consumer picture is positive. For example, the flip-side of wage growth is rising costs to employers, which, in addition to dampening profitability, could eventually translate into general inflationary pressure. This, in turn, could put additional upward pressure on interest rates. As shown in Figure 3, the U.S. Employment Cost Index, which accounts for wages and other forms of employee compensation, is nearing 3% growth on a year-over-year basis.
We expect interest rates to move higher with continued modest inflation increases and potential normalization of real (inflation-adjusted) interest rates. For example, while real interest rates have remained low throughout this expansion, they have moved up recently, driving the rise in nominal long-term rates in September and early Q4. Meanwhile, the Federal Reserve continues to tighten monetary policy, which is pushing up short-term interest rates.
International trade policy also presents risk. We anticipate, however, that a sustained escalation in the trade dispute with China is unlikely, as deals reached with the European Union and with NAFTA trade partners suggest the Trump Administration is willing to compromise rather than suffer too great a negative economic impact. Short of a prolonged escalation of the trade dispute with China, material impacts on the U.S. economy should be limited to specific segments, such as manufacturing and agriculture, given the positive U.S. fundamentals.
Another source of uncertainty is the upcoming midterm elections. While we are not making a prediction on whether Republicans lose control of one or both houses of Congress, the specific degree of the outcome is less important than directional shift in power. Democrats are likely to gain seats in the House. A pickup of seats in the Senate is less likely, however, given the number of Democratic incumbents running for reelection in states President Trump won in 2016. With a Republican President and less-than-overwhelming Republican majorities in Congress, any Democratic gains would reduce the government’s already-limited ability to pass major legislation. Thus, absent surprise strength by Republicans, the net result of the elections should increase gridlock and have limited impact on our broad outlook.
International Outlook: Outside the U.S., European economies remain constrained by structural challenges, such as Italy’s debt load, and have recently shown signs of cyclical headwinds. Euro Area GDP growth has slowed notably so far this year compared to 2017. In contrast, in Asia, the long-suffering Japanese economy is showing some signs of improvement, including improved personal income growth (Figure 4) and a pickup in business capital expenditures on the back of increased corporate profitability.
Economic growth in some key emerging economies, like China, has been slowing for some time. Still, economic growth rates are notably higher in emerging markets, on average, than in developed markets. Asian economies, in particular, should continue to benefit from positive secular drivers. There has been a fundamental shift over the last decade in the composition of economic activity in these markets, and Information Technology is now the largest equity sector within Asian emerging markets. This gives emerging Asia a fundamentally different profile than emerging markets in other regions, such as Latin America, where commodity-related industries are key drivers. Thus, Asian emerging markets should receive a tailwind from many of the same long-term trends that are benefitting the Information Technology sector in the U.S.
While the global economic picture has not shifted dramatically this year, a deterioration in investor sentiment toward international equities, and especially emerging markets, has led to a significant valuation discount of certain international equities compared to U.S. stocks. Asian equity markets, in particular, are at essentially all-time low P/E valuations compared to U.S. stocks.
In our view, some of the concerns that have weighed on emerging markets are overdone. Trade tensions, for example, are likely to ease. If they do, Asian stocks should benefit, and the U.S. dollar is likely to weaken, which would provide an additional tailwind for emerging markets. If, on the other hand, trade tensions continue or intensify, they should pose less of an economic headwind than is widely anticipated. China, for example, is the primary target of U.S. tariffs, but only about 19% of Chinese exports go to the U.S. The Chinese government is also likely to take measures that can mitigate some of the negative economic impact of tariffs, while other emerging markets in Asia are likely to benefit if trade shifts away from China. We recognize there are material risks associated with shifting U.S. trade policy, but we currently believe equity markets have substantially discounted those risks, which makes the risk/reward profile of emerging Asian stocks much more attractive today than at the beginning of the year.
Conclusion
We expect moderate economic growth will continue in the U.S. and abroad into 2019. Our portfolios are positioned in U.S. sectors that benefit from certain cyclical trends, such as U.S. consumer strength, as well as secular trends, like the shift to digital media. We continue to manage portfolio risk, in part, through avoidance of the most economically-sensitive U.S. sectors and, in balanced portfolios, by limiting exposure to longer-duration fixed-income securities. We have also made minor allocation adjustments in our global strategies to take advantage of expected improvement in sentiment toward Asia, where we now view valuations as misaligned with fundamentals.
We remain vigilant in our analysis of global macroeconomic and market conditions. As we write this, an uptick in market volatility is highlighting a range of investor uncertainties, but does not change our fundamental outlook. Please feel free to contact us with any questions on our outlook or portfolios, and thank you for your continued interest in WestEnd Advisors.
Disclosures:
This report should not be relied upon as investment advice or recommendations, and is not intended to predict the performance of any investment. These opinions may change at any time without prior notice. All investments carry a certain degree of risk including the possible loss of principal, and an investment should be made with an understanding of the risks involved with owning a particular security or asset class. Portfolio characteristics and/or allocations are generally averages and are for illustrative purposes only and do not reflect the investments of an actual portfolio unless otherwise noted. Portfolios that are concentrated in a specific sector or industry may be subject to a higher degree of market risk than a portfolio whose investments are more diversified. While every effort has been made to verify the information contained herein, we make no representation as to its accuracy. We invite you to view additional information about our strategies, including a full set of disclosures, on our website at www.westendadvisors.com. Additional information may also be obtained by phone at 888-500-9025, or by email at info@westendadvisors.com.
The MSCI ACWI consists of 47 country indexes comprising 23 developed and 24 emerging market country indexes. The total return of the MSCI ACWI (Net) Index is calculated using net dividends. Net total return reflects the reinvestment of dividends after the deduction of withholding taxes, using (for international indices) a tax rate applicable to non-resident institutional investors who do not benefit from double taxation treaties. The MSCI Emerging Markets Index represents a subset of the MSCI ACWI, comprising 24 emerging market country indexes. The Standard and Poor’s 500 Stock Index includes approximately 500 stocks and is a common measure of the performance of the overall U.S. stock market. An index is unmanaged and is not available for direct investment.
Holdings, Sector Weightings, and Portfolio Characteristics were current as of the date specified in this presentation. The listing of particular securities should not be considered a recommendation to purchase or sell these securities. While these securities were among WestEnd Advisors’ holdings at the time this material was assembled, holdings will change over time. There can be no assurance that the securities remain in the portfolio or that other securities have not been purchased. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities presently in the portfolio. Individual clients’ portfolios may vary. Upon request, WestEnd Advisors will provide a list of all recommendations for the prior year.