July, 2017

BBT-perspectives-market-monthly-july-2017-feature

“Go fast enough to get there, but slow enough to see, moderation seems to be the key.”

Jimmy Buffett, Barometer Soup

If only financial markets had a scientific instrument that forecasted their path with the precision a barometer forecasts the weather. Imagine planning your summer vacation around a weather forecast that depended on global economic and political events and the human behavior that shaped them. In this month’s Market Monthly, we take a brief snapshot of the market’s quick start to the year and offer our thoughts about what may lie ahead. There are pressures on some fronts but we continue to believe conditions warrant remaining invested while being thoughtful about implementing sideline cash. On balance, moderation is the key.

Summary:

First Half Recap: Global markets started quickly in 2017 with global economic growth and corporate earnings serving as primary drivers. Growth stocks and international stocks offered outsized gains through June, but we expect that to moderate as we head into the second half of the year with new leadership emerging.

Global Economic Growth: Global manufacturing data reflects broad based strength and growth trends led by Europe. History suggests that we may be marking the mid-point of this economic cycle, which could support markets for the next 12 months before risks begin to rise. Growth rates are low but seem sustainable.

Fed Update: The Fed remains on track for a measured pace of tightening. The odds of additional rate hikes in 2017 have diminished due to stubbornly low inflation readings, but the Fed knows it must reload its toolbox at this late stage of the cycle. Recent strong financial conditions have put stock markets, low volatility and financial stability back on the Fed’s radar.

Outlook: We remain cautiously optimistic into mid 2018 but late cycle market pressures could interrupt currently low volatility levels. Broad based global growth could continue to extend the recovery that began in 2009 and support risk assets for the next 12 months. A short-term summer drawdown would not be a surprise after such a long period of low volatility and could provide an entry point for sideline cash.

First Half Recap:

Global Rally: Broad-based global economic growth and robust global earnings growth propelled equities for the first half of 2017. In our February edition we said, “U.S. stocks are no longer rising and falling on the Fed’s tide. Instead, anticipated tax reforms and de-regulation are causing sectors and stocks to behave more independently based on their own fundamental merits. This bodes well for skilled active managers for the first time in several years.”

Through June 30, over 50 percent of large cap U.S. active managers are outpacing their respective benchmark for the first time since 2009. Broad-based growth and low correlations among stocks have supported stock pickers. Active managers and passive index funds often go through cycles of relative outperformance versus one another so this bears watching over coming quarters. Stay tuned for an edition of Market Spotlight in the coming weeks that discusses the active versus passive debate in more detail.

The orange bars in the chart below reveal that international markets lead the way so far in 2017. Developed and emerging markets generated double digit returns of 13.81 percent and 18.43 percent respectively. Growth stocks, led by the technology sector, earned 13.33 percent easily outpacing value stocks as the Trump trade fizzled from its Q4 2016 pace. The excess returns from value stocks in Q4 were reversed by excess returns from growth stocks so far in 2017. The table has been set for more balanced performance between the growth and value styles for the remainder of the year.

BBT-perspectives-market-monthly-july-2017-Stock-Index

International Returns Boosted by Currency: In our February edition we said, “A flat or declining dollars helps international stock returns for U.S. investors.” This is exactly what has occurred so far in 2017. The chart below illustrates YTD and three-year returns for the MSCI EAFE benchmark index for developed international stocks in Europe and Asia.

BBT-perspectives-market-monthly-july-2017-MSCI Index Returns

The red bars illustrate returns on the MSCI EAFE index measured in U.S. dollar. The orange bars illustrate returns on the MSCI EAFE index without any currency impact. Almost half of the YTD returns for the MSCI EAFE index have come from the decline in the dollar. This is the opposite of the last three years when the dollar was strengthening. During this time, U.S. investors saw most of their market gains in foreign markets neutralized by the strong dollar.

Currency fluctuations have a muted impact on international equity returns over the long term but the short-term impact can be noticeable. Over the next 12 months, we expect the dollar to recoup some of its recent losses.

Record Low Volatility: Low volatility is another key theme so far in 2017. Goldman Sachs recently did a study of low volatility periods in the stock market since 1928 and found 15 low volatility periods which lasted, on average, 18 months. Ironically, conditions were often similar to our current conditions with low inflation, low unemployment and stable economic growth.

Two of the biggest downside risks of a low volatility environment include:

  • Rising asset correlations are masked like we saw in 2008 when all financial asset prices rose and fell in unison.
  • Investors become complacent and engaged in excessive risk taking.

This last point is like setting the cruise control of your car at 85 miles per hour and thinking it’s not dangerous.

Low volatility can also cause upside risk when investors don’t invest for fear of a market correction. For example, since July 2009 the S&P 500 has jumped roughly 175 percent. Yet, if an investor missed the best 10 trading days for each of the last eight years, their returns would have shrunk to an abysmal 26 percent. It clearly paid to remain invested even though it may have felt painful to do so.

We are in the midst of the fourth longest stretch on record (450 days) without a doubling of the VIX volatility index. The recent low levels of volatility have not been seen since 1966. Extended periods of low volatility are not uncommon and on average last roughly 21 months. We began this current stretch of low volatility in July of 2016 immediately following the Brexit vote so there may be more low volatility to come. Stay alert!

Bond Update: The decline in bond yields we saw in mid-June reflected an overly pessimistic outlook anchored by fears of low inflation. In last month’s edition, we discussed a “disconnect” between bond markets and the Fed. Since that time, we’ve seen bond yields slowly grind higher as a result of continued global economic growth, robust manufacturing trends, strong jobs data and a resolute Fed. All signs continue to point to a higher rate path that could lead us to 2.75 percent to 3 percent on the 10-Year Treasury Note by year end. To put that in context however, remember that since last June, immediately following the Brexit vote, interest rates on the 10 year U.S. Treasury have already climbed almost 1 percent from their low of 1.37 percent. In other words, some of this risk has already been priced into bond markets leaving investors in a position to “keep their coupon” as a potential best case scenario for bond returns over the next 6-12 months.

Corporate credit and municipal bonds remain more appealing choices than Treasury Notes and Mortgage Backed Securities as the Fed contemplates shrinking its balance sheet holdings as early as September. Year to date returns are shown below.

BBT-perspectives-market-monthly-july-2017-Bond-Index

Global Economic Growth:

Recent Purchasing Manager Index (PMI) data reveal continued broad based global growth among the 34 countries representing the Organization for Economic Co-operation and Development (OECD). Currently, 90 percent of the member countries are in expansion territory and over 60 percent are up month over month. Developed markets are outperforming emerging market economies and Europe is overwhelmingly leading the way. The Eurozone PMI rose for the tenth straight month in June and every EU member is in expansion territory. This is one reason we’ve highlighted European equity markets as an opportunity as we entered 2017. French elections surpassed markets’ greatest fears of euro-skepticism with Macron’s election and, despite U.K. Prime Minister May’s “snap election” disappointment, the Brexit negotiations are proceeding. We suspect this fall’s German elections will fall in line with expectations for Angela Merkel and that next year’s Italian elections will be the next potentially destabilizing Euro event.

That leaves the United States. As Washington and the Fed have passed the baton of leadership back and forth, U.S. corporations have emerged as a stronger healthier economic presence since any time in the last several years. Corporate earnings have been the comeback story of the year and are expected to continue to please shareholders. We will learn more in the weeks ahead and are off to a good start in Q2 earnings season.

We expect continued economic growth for the balance of 2017 and into 2018 with risks increasing as 2018 progresses. By then, we will have clarity on the shape and scale of tax reform and the Fed’s path with a high likelihood of a new Fed chairperson. Inflation expectations have come down since the beginning of the year but growth remains on track as does the Fed.

Fed Update:

Extraordinary monetary policies such as Zero Interest Rate Policy (ZIRP) and Quantitative Easing (QE) did not generate meaningful economic growth. When Quantitative Tightening (QT) occurs later this year as the Fed unwinds its balance sheet, it is unlikely to send the U.S. economy into a tailspin. One unintended consequence of QE that is gaining the attention of Fed members is the inflation of financial asset prices. The wealth effect created by unconventional monetary policy has been powerful. So the question becomes, what happens when QT ensues?

Having achieved full employment, the recent inflation debate has focused on future wage growth inflation. However, recent Fed official comments indicate the Fed is increasingly focused on financial asset price inflation such as stock and home prices. We include excerpts of recent Fed commentary here not to distort by telling just “part” of the story but simply to illustrate what the Fed has on its mind.

Who said it When they said it What they said
Robert Kaplan
Dallas Fed CEO
May 30, 2017 “..but I do think that if there were some correction also in the markets that would be a healthy thing.”
Stanley Fischer
Fed Vice Chair
June 20, 2017 “House prices are now high and rising in several countries, perhaps as a result of extended periods of low interest rates.”
John Williams
San Francisco Fed CEO
June 27, 2017 “The stock market seems to be pretty much running on fumes…so something that clearly is a risk to the U.S. economy, some correction there, is something that we have to be prepared for.”
Janet Yellen
Fed Chairperson
June 27, 2017 “Asset valuations are somewhat risky if you use some traditional metrics like price earnings ratios…”
Fed Minutes July 5, 2017 “..a few market participants expressed concern that subdued market volatility…could lead to a build up of risks of financial stability.”

Current financial conditions are positive and anchor the Fed’s base case for continued natural economic growth and further tightening. Continued economic strengthening, record high stock prices, a weaker dollar and low volatility are on the Fed’s radar as new data points to watch for signs of financial instability. Improving financial conditions have largely neutralized the Fed rate hikes we’ve had to date. It may not be a zero sum game but it is close.

Outlook:

We are in the late stages of a prolonged economic cycle made possible by extraordinary and unconventional monetary policies.

For some historical perspective, see the table below:

BBT-perspectives-market-monthly-july-2017-S&P

  • The S&P 500 earned a positive return for each of the first six months of 2017
  • This has only happened seven times in 89 years
  • The average second half return the previous six times was 8.4 percent
  • The S&P 500 has had 16 occasions when it did not have a 5 percent drawdown in the first six months of the year
  • The average second half gain for the other occurrences was 8.1 percent
  • The average second half maximum drawdown for the other occurrences was -6.6 percent
  • 2017 experienced the second smallest first half drawdown in the S&P 500’s history at just -2.8 percent

OECD business cycle data going back to 1960 has identified eight global expansionary cycles ranging from 11 months in 1963 to 60 months ending in 2008. The duration of these global cycles has averaged roughly two years. Our current cycle began in July 2016, which places us at approximately halfway through the typical cycle. This has historically been a good spot for global economies and global equities. Of the seven prior global expansions, median global equity returns as measured by the MSCI All Country World Index for the following six and nine month time periods were 10.4 percent and 9.0 percent respectively and have never been negative.

Above we’ve offered some market history when conditions have been similar to what they are today but we all know that no two time periods are identical.

Bottom Line:

  • We expect that stock returns will outpace bond returns into 2018 as the global economic expansion moves past its mid-point.
  • Volatility will remain muted but will have increasing spasms as the cycle advances. Use it as a warning signal to re-evaluate and shift portfolio strategy if needed.
  • International stock returns should remain attractive on their own merits but additional gains from a weak dollar are unlikely.
  • Bond risks are overstated but returns may be uninspiring until later in this cycle.
  • The Fed will continue to redefine “normalization” while it balances its 2 percent transitory inflation target against rising financial asset inflation and the potential for financial instability.

We will continue to seek the right “barometers” to identify pressure points that reveal value or reduce portfolio risk. In the end, “Moderation seems to be the key!”

July, 2017

BBT-perspectives-market-monthly-july-2017-feature

“Go fast enough to get there, but slow enough to see, moderation seems to be the key.”

Jimmy Buffett, Barometer Soup

If only financial markets had a scientific instrument that forecasted their path with the precision a barometer forecasts the weather. Imagine planning your summer vacation around a weather forecast that depended on global economic and political events and the human behavior that shaped them. In this month’s Market Monthly, we take a brief snapshot of the market’s quick start to the year and offer our thoughts about what may lie ahead. There are pressures on some fronts but we continue to believe conditions warrant remaining invested while being thoughtful about implementing sideline cash. On balance, moderation is the key.

Summary:

First Half Recap: Global markets started quickly in 2017 with global economic growth and corporate earnings serving as primary drivers. Growth stocks and international stocks offered outsized gains through June, but we expect that to moderate as we head into the second half of the year with new leadership emerging.

Global Economic Growth: Global manufacturing data reflects broad based strength and growth trends led by Europe. History suggests that we may be marking the mid-point of this economic cycle, which could support markets for the next 12 months before risks begin to rise. Growth rates are low but seem sustainable.

Fed Update: The Fed remains on track for a measured pace of tightening. The odds of additional rate hikes in 2017 have diminished due to stubbornly low inflation readings, but the Fed knows it must reload its toolbox at this late stage of the cycle. Recent strong financial conditions have put stock markets, low volatility and financial stability back on the Fed’s radar.

Outlook: We remain cautiously optimistic into mid 2018 but late cycle market pressures could interrupt currently low volatility levels. Broad based global growth could continue to extend the recovery that began in 2009 and support risk assets for the next 12 months. A short-term summer drawdown would not be a surprise after such a long period of low volatility and could provide an entry point for sideline cash.

First Half Recap:

Global Rally: Broad-based global economic growth and robust global earnings growth propelled equities for the first half of 2017. In our February edition we said, “U.S. stocks are no longer rising and falling on the Fed’s tide. Instead, anticipated tax reforms and de-regulation are causing sectors and stocks to behave more independently based on their own fundamental merits. This bodes well for skilled active managers for the first time in several years.”

Through June 30, over 50 percent of large cap U.S. active managers are outpacing their respective benchmark for the first time since 2009. Broad-based growth and low correlations among stocks have supported stock pickers. Active managers and passive index funds often go through cycles of relative outperformance versus one another so this bears watching over coming quarters. Stay tuned for an edition of Market Spotlight in the coming weeks that discusses the active versus passive debate in more detail.

The orange bars in the chart below reveal that international markets lead the way so far in 2017. Developed and emerging markets generated double digit returns of 13.81 percent and 18.43 percent respectively. Growth stocks, led by the technology sector, earned 13.33 percent easily outpacing value stocks as the Trump trade fizzled from its Q4 2016 pace. The excess returns from value stocks in Q4 were reversed by excess returns from growth stocks so far in 2017. The table has been set for more balanced performance between the growth and value styles for the remainder of the year.

BBT-perspectives-market-monthly-july-2017-Stock-Index

International Returns Boosted by Currency: In our February edition we said, “A flat or declining dollars helps international stock returns for U.S. investors.” This is exactly what has occurred so far in 2017. The chart below illustrates YTD and three-year returns for the MSCI EAFE benchmark index for developed international stocks in Europe and Asia.

BBT-perspectives-market-monthly-july-2017-MSCI Index Returns

The red bars illustrate returns on the MSCI EAFE index measured in U.S. dollar. The orange bars illustrate returns on the MSCI EAFE index without any currency impact. Almost half of the YTD returns for the MSCI EAFE index have come from the decline in the dollar. This is the opposite of the last three years when the dollar was strengthening. During this time, U.S. investors saw most of their market gains in foreign markets neutralized by the strong dollar.

Currency fluctuations have a muted impact on international equity returns over the long term but the short-term impact can be noticeable. Over the next 12 months, we expect the dollar to recoup some of its recent losses.

Record Low Volatility: Low volatility is another key theme so far in 2017. Goldman Sachs recently did a study of low volatility periods in the stock market since 1928 and found 15 low volatility periods which lasted, on average, 18 months. Ironically, conditions were often similar to our current conditions with low inflation, low unemployment and stable economic growth.

Two of the biggest downside risks of a low volatility environment include:

  • Rising asset correlations are masked like we saw in 2008 when all financial asset prices rose and fell in unison.
  • Investors become complacent and engaged in excessive risk taking.

This last point is like setting the cruise control of your car at 85 miles per hour and thinking it’s not dangerous.

Low volatility can also cause upside risk when investors don’t invest for fear of a market correction. For example, since July 2009 the S&P 500 has jumped roughly 175 percent. Yet, if an investor missed the best 10 trading days for each of the last eight years, their returns would have shrunk to an abysmal 26 percent. It clearly paid to remain invested even though it may have felt painful to do so.

We are in the midst of the fourth longest stretch on record (450 days) without a doubling of the VIX volatility index. The recent low levels of volatility have not been seen since 1966. Extended periods of low volatility are not uncommon and on average last roughly 21 months. We began this current stretch of low volatility in July of 2016 immediately following the Brexit vote so there may be more low volatility to come. Stay alert!

Bond Update: The decline in bond yields we saw in mid-June reflected an overly pessimistic outlook anchored by fears of low inflation. In last month’s edition, we discussed a “disconnect” between bond markets and the Fed. Since that time, we’ve seen bond yields slowly grind higher as a result of continued global economic growth, robust manufacturing trends, strong jobs data and a resolute Fed. All signs continue to point to a higher rate path that could lead us to 2.75 percent to 3 percent on the 10-Year Treasury Note by year end. To put that in context however, remember that since last June, immediately following the Brexit vote, interest rates on the 10 year U.S. Treasury have already climbed almost 1 percent from their low of 1.37 percent. In other words, some of this risk has already been priced into bond markets leaving investors in a position to “keep their coupon” as a potential best case scenario for bond returns over the next 6-12 months.

Corporate credit and municipal bonds remain more appealing choices than Treasury Notes and Mortgage Backed Securities as the Fed contemplates shrinking its balance sheet holdings as early as September. Year to date returns are shown below.

BBT-perspectives-market-monthly-july-2017-Bond-Index

Global Economic Growth:

Recent Purchasing Manager Index (PMI) data reveal continued broad based global growth among the 34 countries representing the Organization for Economic Co-operation and Development (OECD). Currently, 90 percent of the member countries are in expansion territory and over 60 percent are up month over month. Developed markets are outperforming emerging market economies and Europe is overwhelmingly leading the way. The Eurozone PMI rose for the tenth straight month in June and every EU member is in expansion territory. This is one reason we’ve highlighted European equity markets as an opportunity as we entered 2017. French elections surpassed markets’ greatest fears of euro-skepticism with Macron’s election and, despite U.K. Prime Minister May’s “snap election” disappointment, the Brexit negotiations are proceeding. We suspect this fall’s German elections will fall in line with expectations for Angela Merkel and that next year’s Italian elections will be the next potentially destabilizing Euro event.

That leaves the United States. As Washington and the Fed have passed the baton of leadership back and forth, U.S. corporations have emerged as a stronger healthier economic presence since any time in the last several years. Corporate earnings have been the comeback story of the year and are expected to continue to please shareholders. We will learn more in the weeks ahead and are off to a good start in Q2 earnings season.

We expect continued economic growth for the balance of 2017 and into 2018 with risks increasing as 2018 progresses. By then, we will have clarity on the shape and scale of tax reform and the Fed’s path with a high likelihood of a new Fed chairperson. Inflation expectations have come down since the beginning of the year but growth remains on track as does the Fed.

Fed Update:

Extraordinary monetary policies such as Zero Interest Rate Policy (ZIRP) and Quantitative Easing (QE) did not generate meaningful economic growth. When Quantitative Tightening (QT) occurs later this year as the Fed unwinds its balance sheet, it is unlikely to send the U.S. economy into a tailspin. One unintended consequence of QE that is gaining the attention of Fed members is the inflation of financial asset prices. The wealth effect created by unconventional monetary policy has been powerful. So the question becomes, what happens when QT ensues?

Having achieved full employment, the recent inflation debate has focused on future wage growth inflation. However, recent Fed official comments indicate the Fed is increasingly focused on financial asset price inflation such as stock and home prices. We include excerpts of recent Fed commentary here not to distort by telling just “part” of the story but simply to illustrate what the Fed has on its mind.

Who said it When they said it What they said
Robert Kaplan
Dallas Fed CEO
May 30, 2017 “..but I do think that if there were some correction also in the markets that would be a healthy thing.”
Stanley Fischer
Fed Vice Chair
June 20, 2017 “House prices are now high and rising in several countries, perhaps as a result of extended periods of low interest rates.”
John Williams
San Francisco Fed CEO
June 27, 2017 “The stock market seems to be pretty much running on fumes…so something that clearly is a risk to the U.S. economy, some correction there, is something that we have to be prepared for.”
Janet Yellen
Fed Chairperson
June 27, 2017 “Asset valuations are somewhat risky if you use some traditional metrics like price earnings ratios…”
Fed Minutes July 5, 2017 “..a few market participants expressed concern that subdued market volatility…could lead to a build up of risks of financial stability.”

Current financial conditions are positive and anchor the Fed’s base case for continued natural economic growth and further tightening. Continued economic strengthening, record high stock prices, a weaker dollar and low volatility are on the Fed’s radar as new data points to watch for signs of financial instability. Improving financial conditions have largely neutralized the Fed rate hikes we’ve had to date. It may not be a zero sum game but it is close.

Outlook:

We are in the late stages of a prolonged economic cycle made possible by extraordinary and unconventional monetary policies.

For some historical perspective, see the table below:

BBT-perspectives-market-monthly-july-2017-S&P

  • The S&P 500 earned a positive return for each of the first six months of 2017
  • This has only happened seven times in 89 years
  • The average second half return the previous six times was 8.4 percent
  • The S&P 500 has had 16 occasions when it did not have a 5 percent drawdown in the first six months of the year
  • The average second half gain for the other occurrences was 8.1 percent
  • The average second half maximum drawdown for the other occurrences was -6.6 percent
  • 2017 experienced the second smallest first half drawdown in the S&P 500’s history at just -2.8 percent

OECD business cycle data going back to 1960 has identified eight global expansionary cycles ranging from 11 months in 1963 to 60 months ending in 2008. The duration of these global cycles has averaged roughly two years. Our current cycle began in July 2016, which places us at approximately halfway through the typical cycle. This has historically been a good spot for global economies and global equities. Of the seven prior global expansions, median global equity returns as measured by the MSCI All Country World Index for the following six and nine month time periods were 10.4 percent and 9.0 percent respectively and have never been negative.

Above we’ve offered some market history when conditions have been similar to what they are today but we all know that no two time periods are identical.

Bottom Line:
  • We expect that stock returns will outpace bond returns into 2018 as the global economic expansion moves past its mid-point.
  • Volatility will remain muted but will have increasing spasms as the cycle advances. Use it as a warning signal to re-evaluate and shift portfolio strategy if needed.
  • International stock returns should remain attractive on their own merits but additional gains from a weak dollar are unlikely.
  • Bond risks are overstated but returns may be uninspiring until later in this cycle.
  • The Fed will continue to redefine “normalization” while it balances its 2 percent transitory inflation target against rising financial asset inflation and the potential for financial instability.

We will continue to seek the right “barometers” to identify pressure points that reveal value or reduce portfolio risk. In the end, “Moderation seems to be the key!”

Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, Ned Davis Research, BCA Research Inc., Morningstar

This piece is produced by BB&T’s Wealth Portfolio Management Team.

The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.