Our investment managers discuss trends across the asset classes we invest in, each with the potential to alter the outlook for global growth and stimulate financial markets. In times like these, it's important to work with investment managers who are experienced at navigating these markets.
We believe active management around the tailwinds and headwinds that affect growth will have important investment implications for the remainder of 2018.
The fundamental backdrop continues to be supportive of risk assets as the U.S. economy is now in its longest economic expansion since the Great Depression. Additionally, global growth appears to be gaining momentum. Corporate profits and liquidity are being assisted by the recent tax-law changes through lower tax rates and repatriation, while unemployment is the lowest in decades. Market sentiment, while confident, does not appear to be excessively optimistic. Central banks, in aggregate, remain accommodative. Inflation continues to hover within acceptable ranges, whereas not to force the banks to tighten at a more rapid pace. In a nutshell, the result for corporate credit is that the low-default environment is expected to continue.
While the fundamental picture appears rosy, the valuation and technical picture is more mixed. U.S. Treasury yields have been rising, most credit spreads are on the tight side, acquisition multiples are the highest in years, and volatility measures, such as Cboe Volatility Index® (VIX® Index), had reached record-low levels over the past year. This paints a picture of complacency, where investors are willing to invest for lower returns with more risk. On the technical side, although central banks are largely accommodative, the Federal Reserve is expected to raise the target range for the federal funds rate four times during 2018 after raising three times during 2017. In addition, the reduction of the balance sheet puts further pressure on bonds. Add increasing uncertainty around global trade policy, populism returning to Southern European governments, and a U.S. economy seemingly unable to move above 3% real growth as potential drags. Collectively, this could easily lead to a repricing of risk premia if sentiment were to change or economic growth slows.
POTENTIAL INVESTMENT IMPLICATIONS
At mid-year 2018, we found ourselves generally balanced in our market view and neutral as it relates to strategy risk relative to our benchmarks. We do continue to have a bias against interest-rate risk in exchange for credit risk. From a bottom-up perspective, we are constructive on corporate health, giving support to the fundamental outlook. However, valuations remain in the lower half of what we have seen this cycle despite weakness seen in some markets this year. We are also mindful that market sentiment may be too high given the outlook for the ability of fiscal and tax reforms to stimulate growth. We would welcome a modest repricing of risk as an opportunity. Through this, given current valuations, we remain focused on bottom-up security selection versus an explicit weighting to asset classes or sectors.
Equity markets rebounded in May, led by small-cap stocks (as measured by the Russell 2000® Index), which rose 6.1% for the month, outpacing large-cap stocks (as measured by the S&P 500® index), which returned 2.4%. The outperformance of small-cap stocks was fueled by two tailwinds. Generally speaking, small-cap stocks are domestically oriented, and have thus had less ability than their large-cap counterparts to structure operations in foreign tax-friendly domiciles. Accordingly, investors focused on the belief that recent tax cuts will be more impactful for smaller domestic companies. In addition, negative developments in Europe (see “Headwinds”) were felt more acutely by large-cap stocks, given their multinational orientation. Similarly, the rising U.S. dollar has made U.S. exports more expensive, causing headwinds for large-cap companies.
Unemployment fell to 3.8%, the lowest level in nearly 50 years, as nonfarm payrolls rose by 223,000 in May (seasonally adjusted). While average hourly earnings rose 2.7% year-over-year (YOY), it came in below the 2.9% advance in January that initially triggered an increase in market volatility.
Data from the Commerce Department showed that new orders for nondefense capital goods excluding aircraft, a measure considered representative of the business investment, rose 1% in April. The increase was seen as falling in the sweet spot, being neither too inflationary nor too recessionary. Similarly, the Institute for Supply Management’s Purchasing Manager Index rose to 58.7%, rebounding from the April reading of 57.2%, yet not as strong as the March 59.3% reading. Consumer confidence also rebounded in May following a modest decline in April (after a downward revision), with consumers’ assessment of their current situations reaching a 17-year high.
Geopolitical events bear continued monitoring; what seemed like a spat between two superpowers (China and the U.S.) took on a wider scope, as the Trump administration announced that it will not grant exemptions to Canadian, European, and Mexican partners on steel and aluminum tariffs. The European Union responded in kind, threatening protectionist measures to block U.S. exports and filing a complaint with the World Trade Organization. The short-term effects of these tariffs could be to increase input costs, which would either be passed on to consumers, or erode manufacturers’ profitability margins.
If synchronized global growth had fueled recent optimism at home, U.S. markets could now face headwinds coming from abroad. Real casualties from Brexit are finally coming to light, as the United Kingdom posted its weakest growth since 2012. Concerns over a similar exit from the European Union resurfaced in Italy, as the coalition government has proven unstable, weighing on business confidence.
At its June meeting, the Federal Reserve (Fed) voted to raise interest rates as expected. Data from CME Group shows that investors place about a 49% chance of two more rate increases by year-end.
POTENTIAL INVESTMENT IMPLICATIONS
A trade dispute between the world’s two largest economies may further weigh on the markets though some are holding out hope that Trump’s publicly aggressive stance is designed so as to provide wiggle room for further negotiation on trade, or to serve as leverage in defusing tensions in the Korean Peninsula. Nevertheless, the combination of strong earnings and investor anxiety aligns well with our goal of identifying stocks with relatively attractive valuations and the ability to exceed expectations.
Global growth conditions remain a tailwind for the continued “Goldilocks” environment as two of the three bears, namely euphoria and inflation, remain asleep or merely stirring, leaving only the bear of protectionism to contend with. While capital expenditures expanded in the first half of 2018 as we anticipated, much of the investment so far was concentrated in technology and energy firms. We expect capital expenditures to broaden to other sectors of the market through the remainder of the year. The result still should be higher wages, productivity, and consumer spending as we called for at the beginning of the year. The impacts of the tax plan continue to work their way through company earnings and represent a continued tailwind, as many firms weigh options to buy back stock and thereby bolster stock prices.
The biggest threat to the otherwise supportive environment is the bear of protectionism, which has awoken and threatens trade ties between the U.S. and many of its trading partners. As we raised concern before, North American Free Trade Agreement (NAFTA) negotiations are proving intractable, and previously empty rhetoric toward China and the European Union (EU) has transformed into actual tariffs and policy brinksmanship. We remain concerned with these developments, as trade conflict can become a self-reinforcing feedback loop with the potential to negatively impact business spending while also fueling higher inflation. Stemming from similar causes, nationalism has claimed a new victory with the Five Star movement in Italy, which may seek to challenge the euro and entire EU project. Although both the earlier stage of Europe’s economic recovery and more attractive valuations should provide more upside, the backdrop of bailouts for periphery countries by the wealthier member countries threatens to fuel resentment that may develop into further headwinds.
POTENTIAL INVESTMENT IMPLICATIONS
While risk assets provided better return in the first half of 2018 as we called for, it has come at the cost of greater volatility. The tailwinds from earlier in the year have become less prevalent, and headwinds are no longer retreating but gaining steam. However, the underlying strength of the economy is still supportive of risk assets such as equities, and firms overseas both have more attractive valuations and may share a common trading adversary (namely, the U.S.), making them relatively attractive. We also see continued pressure on bonds with a more frequent combination of rising yields during periods of elevated volatility for equities, as evidenced in February. This development may be challenging for investors who have become accustomed to the particularly effective diversification that bonds provided under the influence of unprecedented monetary easing, which is now reversing course.
We look at the opportunities for alternatives relative to return-driving risk assets, such as equities, and diversifying assets, such as bonds. With the return of volatility to equities not seen since early 2016, the potential benefits of lowering overall volatility through diversification is the biggest tailwind for alternatives. Closely related is the simultaneous challenge to bonds represented by rising interest rates, as bonds sold off during the early stages of the equity drawdown that began in late January due to a pending Federal Reserve (Fed) hike. This situation has created a clear need for diversifying assets beyond those traditionally used in portfolios to effectively reduce the increasing volatility of equities as they shift further into the later stages of the market cycle. The combination of these two challenges should remain a strong tailwind for alternatives for the remainder of 2018 and into 2019.
While volatility has returned to equities and should remain higher, the later stages of a market cycle can see the combination of higher volatility and higher returns as things move toward euphoria, which is sometimes referred to as a melt-up. Stronger potential performance of equities in spite of higher volatility may weigh against the more modest expectations of broadly diversified alternatives, though we expect them to outperform broad bonds. As we mentioned previously, the continued uptrend in interest rates is likely to continue taking its toll on real estate. Finally, the recent uptrend in the U.S. dollar may act as a headwind to alternatives with exposure outside the U.S. such as emerging-market equities and debt.
POTENTIAL INVESTMENT IMPLICATIONS
Now that expectations for extremely low volatility and outsized returns have diminished for equity investors, many find themselves reaching for diversification that does not also share the current headwinds facing bonds. Given the strength of the underlying economy, the Fed has shifted from the dynamic that sought to calm equity investors by extending monetary easing when markets became agitated. This shift likely will weaken what had become a near-certain relationship between bouts of volatility and retreating bond yields. The result is that investors should expect more periods like the volatility that began in late January in which the Fed’s plan for interest-rate hikes drives yields higher (and bond prices lower) even if equity markets throw another tantrum. The heightened volatility also should provide investors with new information to help ensure their alternative allocations are providing the
diversification they intend.
Why Pacific FundsSM
Pacific Funds is a family of mutual funds designed for growth, income generation, and diversification. Our managers seek to deliver consistent results with downside protection strategies to help shareholders meet their long-term financial goals.
We are a multi-manager investment company consisting of managers who are:
- Selective | Our managers implement strategies using highly selective, active, and process-oriented approaches that have stood the test of time.
- Nimble | Each manager is efficiently structured to be nimble when implementing investment decisions, while being supported by the resources of a large financial institution.
- Experienced | The managers have extensive institutional experience in their respective asset classes and in navigating varying financial environments.
Tailwind: A condition or situation that will help move growth higher.
Headwind: A condition or situation that will make growth more difficult.
Statistical information presented in this publication is sourced from the following:
Dunkelberg, William C. and Wade, Holly. NFIB Small Business Economic Trends. NFIB Research Center, 2018.
“The Employment Situation - May 2018.” News Release Bureau of Labor Statistics. U.S. Department of Labor, June 1, 2018.
Rothschild Asset Management Inc. is unaffiliated with Pacific Life Insurance Company.
This commentary reflects the views of the portfolio managers as of June 22, 2018, are based on current market conditions, and are subject to change without notice. These views represent the opinions of the portfolio managers at Rothschild Asset Management Inc., Pacific Asset Management, and Pacific Life Fund Advisors LLC, and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector, or index, the offer or sale of any investment, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Sector names in the commentary are provided by the portfolio managers and could be different if provided by a third party.
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