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 heading into 2019.
The fundamental backdrop, while less constructive than mid-year, still appears to be supportive of a low-default environment, and thus a positive for credit. S&P 500® index earnings, while slower than the 24% growth rate of 2018, are still expected to grow 8%–10% in 2019. Inflation continues to hover within acceptable ranges, which should not force the Federal Reserve (Fed) to tighten at a more rapid pace, and fiscal policy remains supportive for corporate earnings. With defaults expected to remain below historic norms and in light of the more recent volatility, we now consider valuations to be a slight tailwind as yields and spreads have moved higher.
Beginning in early October, friction regarding rising U.S. Treasury yields and global trade concerns were met with increased Brexit uncertainty and slowing corporate earnings. As volatility increased, risk sentiment shifted quickly, resulting in a negative technical dynamic. Collectively, this has translated into a repricing of risk premiums across most markets. Entering 2019, corporate earnings are expected to grow at a slower rate and seems to be priced in. Brexit concerns will most likely remain through first quarter of 2019 and will certainly affect global risk sentiment. Regarding the U.S. economy, uncertainty about the number of Fed rate hikes and tariffs appears to be reducing risk appetite. As short-term rates increase, compensation for additional risk typically increases. As tariffs persist, input costs and potential supply-chain disruptions could negatively impact earnings and capital expenditures. We would expect positive clarity is needed around these two elements for risk sentiment to improve.
POTENTIAL INVESTMENT IMPLICATIONS
Since mid-2018, the fundamental picture is less positive given slowing corporate earnings and rising interest rates. The largest change has been the technical picture as sentiment altered dramatically, resulting in large selling pressure and squeezing certain markets. Due to this dynamic, we believe the relative value picture is now more attractive. In the short term, market technicals and sentiment warrant a slightly defensive posture within credit. However, as clarity emerges on tariffs, the Fed, and Brexit, coupled with a steady U.S. economy and more attractive valuations, the risk/return profile of certain credit markets could be very attractive in 2019.
Equity markets shook off volatility to push higher in November. Large-cap stocks (as measured by the S&P 500® index) climbed 2.0%, and small-cap stocks (as measured by the Russell 2000® Index) rose 1.6%. Investors rotated out of Technology stocks in favor of defensive stocks in Health Care, Transportation, and Real Estate sectors. Accordingly, the Russell 1000® Defensive Index® was up 4.1%, and the Russell 1000® Dynamic Index® declined 0.1%.
After a volatile start to the month, investors’ faith in equities was boosted by comments from Federal Reserve (Fed) Chairman Jerome Powell that indicated a less-hawkish stance on interest rates. The personal-consumption-expenditures price index—the Fed’s preferred inflation measure—rose 1.8% year-over-year in October, which may give the Fed latitude to take a more dovish approach.
The tale-of-two-halves for the month of November also may have reflected the passage of midterm elections. Contrary to popular belief, markets tend to rally regardless of partisan tilt to the outcome, simply as a relief-rally following an end to the uncertainty. Election results spurred Democrats’ gains in the House, likely leading to a stay of execution for the Affordable Care Act and further boosting stocks in the Health Care sector.
Evidence that the current rate cycle may have tempered some economic activity came from the housing market. Sales of new homes fell 8.9% to a seasonally adjusted annual rate of 544,000 in October.1
While third quarter 2018 gross domestic product (GDP) grew at an annualized rate of 3.5%, this represented a 0.7% decline quarter-over-quarter, as protectionist measures caused exports to decline.2 Moreover, the synchronized global expansion investors had cheered on earlier in the year seems to have faded, as China continues to exhibit signs of slowing growth.
The labor picture was somewhat weak, with U.S. employers adding just 155,000 workers to their payrolls in November. Although these results came in below expectations, the unemployment rate held steady at 3.7%.3 Modest job growth could possibly provide a silver lining should the Fed decide to dial back its efforts to apply the brakes in the absence of overheating.
West Texas Intermediate crude oil priced dropped below $50 a barrel due to increased production in the U.S., Saudi Arabia, and Russia, along with greater-than-expected waivers of sanctions against Iran. The rising dollar, which tends to move in the opposite direction, may have also contributed to falling oil prices. The decline could have mixed effects, acting as a tax-cut for consumers of oil, but depressing earnings for the energy sector.
POTENTIAL INVESTMENT IMPLICATIONS
Markets initially rallied following a constructive meeting at the Group of 20 Summit in Argentina between President Trump and China’s President Xi. The immediate benefit will be to cancel a planned increase in tariffs on $200 billion in Chinese goods from 10% to 25%, although the two sides set an ambitious timeline of three months to hammer out a long-term proposal.
Despite our expectation that increased market volatility will persist, we see robust economic data and less hawkish Fed commentary reducing near-term risk of recession. Rather than making any top-down calls, we will continue to take a bottom-up approach, seeking stocks with attractive valuations relative to peers and the potential to exceed expectations.
1U.S. Department of Commerce, November 28, 2018.
3“Employment Situation Summary – November 2018.” U.S. Bureau of Labor Statistics, U.S. Department of Labor, December 7, 2018.
The overall economic backdrop remains sound, with low unemployment and stable inflation. This should provide a solid foundation for risk assets, especially as the Federal Reserve (Fed) has become modestly more dovish with a shallower rate-hiking path. A potential resolution on trade between the U.S. and China also would serve as a significant tailwind, particularly for emerging-market assets. Markets like to discount uncertainty, and so clarity about issues in Europe such as Britain's exit from the European Union (EU), Italy's budget, and reforms in France also may serve as a tailwind once resolved. More narrowly, as the more transitory effects of fiscal stimulus, such as tax reform, fade in the U.S., a slower expected U.S. growth rate would make overseas assets more attractive as growth rates converge.
Central bank policies for the Fed, European Central Bank (ECB), and Bank of Japan create the strongest headwinds as central banks end quantitative easing and look toward higher rates and quantitative tightening. In Europe, the ECB has ended its easing program while somewhat paradoxically acknowledging that risks were moving to the downside, and October 2019 marks the end of current ECB President Mario Draghi's term. While the Fed has become more dovish on its projected rate hikes, the reduction in its balance sheet is creating a challenging environment for firms that will need to raise new debt as current issues mature. Issues coming due over each of the next three years are roughly triple those from 2018, while leverage in investment-grade credit is close to all-time highs and available cash has decreased to levels last seen in 2006. Slower expected growth in the U.S. is also a potential headwind for U.S. assets as stimulus fades and capital becomes more expensive. Finally, the chance for misstep in trade negotiations, particularly between China and the U.S., could become the defining headwind should talks sour and tariffs increase substantially. U.S. companies that use Chinese intermediate and final goods will have a very hard time adjusting their supply chains and will face falling margins and/or lower demand from having to pass on costs to consumers, which would likely break the strong consumer sentiment that has supported the current bull market.
potential INVESTMENT IMPLICATIONS
With the image of a tightrope walker, we view the environment as supporting a modest overweight to risk assets with a close eye on issues that might nudge the delicate balance toward the downside. In the U.S., we favor the more defensive sectors of the market over the more cyclically sensitive. Caution toward some value sectors and greater concern over some of the more richly valued growth sectors would lean toward a preference for more core holdings within the U.S. Given valuations that are attractive by almost any measure and the prospect of greater clarity as trade talks reach a resolution, we favor emerging-market equities, especially as China provides stimulus to battle a deepening economic slowdown with ample ability to provide more stimulus. The potential for a Fed pause or shallower rate-hike path also favors shorter duration fixed-income assets as yields have become attractive, and yet they remain insulated from broader concerns around credit.
The U.S. dollar has been in a secular bear market since 2017, interrupted by a short cyclical bull cycle in 2018, and therefore represents a potential tailwind for overseas assets such as emerging-market equities and debt. Factors in 2018 – such as fiscal stimulus in the form of lower taxes in the U.S., trade conflict, and interest-rate hikes that led to a higher U.S. dollar – are set to shift in 2019 as Federal Reserve (Fed) rate hikes slow down, the Fed balance sheet continues to shrink, and U.S. budget deficits increase. These factors all point to a lower dollar in 2019. Also, as the Fed is closer to its neutral policy rate and the interest on 10-year U.S. Treasuries is not expected to increase substantially, higher-yielding asset classes like real estate investment trusts (REITs) may benefit by providing more yield as rents and occupancy trends are expected to remain supportive.
The current environment is challenging for managers due to the significant role that geopolitical events are likely to play in driving asset returns. Expectations based on fundamentals have not been met, and – instead – returns have been driven by idiosyncratic risks. One way to measure these risks is by how investors treat different asset classes and the degree to which they rise and fall together. Intra-asset correlations have risen, indicating a heightened sensitivity to specific events and less concern over developments in the fundamentals of individual securities. On the margin, higher returns to cash also create pressure for alternative asset classes, particularly if they have struggled during periods of volatility.
potential INVESTMENT IMPLICATIONS
Return expectations have shifted into a lower-return world for risk assets, while volatility expectations have moved higher. The reduction in global liquidity from central banks and increases in interest rates likely have shifted the return-and-risk dynamic as we move into the later part of the economic cycle. Strategies that can provide lower correlation and generate similar expected return are potentially even more valuable in constructing portfolios moving forward. At the same time, traditional diversifiers such as Treasuries and credit have felt the brunt of higher rates and quantitative tightening, shifting the opportunity set to favor diversifying through liquid alternatives.
Why Pacific Funds
Pacific FundsSM 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.
Core personal consumption expenditures (PCE) price index measures the prices consumers pay for goods and services without the volatility caused by energy and food prices.
Headwind: A condition or situation that will make growth more difficult.
The National Association of Home Builders Index gauges builder opinion on the relative level of current and future single-family home sales. It is a diffusion index, which means that a reading above 50 indicates a favorable outlook on home sales; below 50 indicates a negative outlook.
The Russell 1000® Defensive Index® measures the performance of companies that have relatively stable business conditions which are less sensitive to economic cycles, credit cycles, and market volatility based on their stability indicators.
The Russell 1000® Dynamic Index® measures the performance of companies that have relatively less stable business conditions and are more sensitive to those market cycles.
The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-value ratios and higher forecasted growth values.
The Russell 1000® Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.
The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
The S&P 500® index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market.
Tailwind: A condition or situation that will help move growth higher.
Rothschild & Co Asset Management US Inc. is unaffiliated with Pacific Life Insurance Company.
This commentary reflects the views of the portfolio managers at Pacific Asset Management, Rothschild & Co Asset Management US Inc., and Pacific Life Fund Advisors LLC, as of December 21, 2018, are based on current market conditions, and are subject to change without notice. These views represent the opinions of the portfolio managers 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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