The U.S. decouples from foreign markets

Outlook: Third quarter 2018

Economy

The rate of growth in both the U.S. and foreign economies accelerated last year and we enjoyed a synchronized global expansion. Recently, growth has been a little less robust in some foreign economies, but the U.S. continues to expand at a steady pace. Looking forward to the remainder of 2018, the expansion is expected to continue, but there are weakening trends in a few foreign countries. In the U.S., the Federal Reserve continues to move away from the crisis-based policies it has employed since the Great Recession. The Fed’s current guidance suggests it will raise interest rates two more times this year while reducing the size of its balance sheet by approximately 10%. The European Central Bank and the Bank of Japan continue to utilize aggressive stimulus policies, but if their economies continue to improve, it is likely they will take a less accommodative stance within the next six to twelve months.

Inflation

Inflation rates have increased this year moving from the 2% range in the beginning of the year to almost 3% in June. However, much of the increase is driven by rising oil prices. Inflation, excluding the volatile food and energy segments, is close to the Federal Reserve’s 2% target. We expect the price level to remain elevated this year given the acceleration in global economic growth. However, an aging population, high debt levels and the proliferation of technology will continue to work as structural headwinds that keep inflation from rising dramatically.

U.S. dollar

The U.S. dollar rallied strongly last quarter given recent interest rate hikes by the Federal Reserve, an increase in inflation, slowing growth in some foreign economies and rising trade tensions. Looking forward, we expect these trends to remain in place, keeping the U.S. dollar within its recent range, but the process of negotiating trade agreements is likely to boost the volatility of the currency.

Asset class

Cash/money market instruments

Higher interest rates are now evident in cash and money market instruments thanks to seven Federal Reserve interest rate increases over the last two and a half years. Heightened Treasury Department borrowing, to finance the growing deficit, is also generating tremendous supply in the short-end of the market and is a factor that is driving yields higher. Given its desire to stay ahead of inflation, the Federal Reserve seems committed to two more rate hikes this year and possibly three in 2019.

Intermediate government/credit bonds

Government bond yields have increased since the beginning of 2018. However, the increase in yields has not been uniform as the rise in rates has been more dramatic on shorter dated Treasury bonds, while the response on the longer dated issues has been more subdued. The result has been a flattening of the yield curve. As for corporate bonds, credit spreads have edged higher as well, resulting in increased compensation between U.S. Treasuries and corporate bonds with identical maturities. The economic backdrop remains supportive of corporate credit fundamentals, yet increased caution regarding the monetary tightening, elevated Treasury issuance, and the extended length of the business cycle have softened enthusiasm for intermediate government and corporate bonds. Looking forward, we expect corporate credit spreads to remain close to current levels and interest rates to gradually move upward.

Tax-exempt municipal bonds

The municipal market is heavily influenced by the Federal Reserve and interest rates, but currently it is being driven by supportive supply and demand dynamics. Through the summer timeframe, aggregate cashflows from maturing and called bonds will remain seasonally high, which boosts demand. At the same time, new issuance is currently down 15 to 20% relative to last year. We anticipate this will remain an important tailwind for tax-free bonds this summer, keeping yields below their traditional levels relative to Treasuries.

U.S. equity

U.S. stocks have provided solid returns through the first half of the year. However, the returns have differed significantly across the various styles of equity. Growth stocks have been the best performers driven by strong gains in the technology and consumer discretionary sectors. Stocks of small companies have also performed well as they generally have less exposure to the current trade disputes and continue to benefit from the strength of the U.S. economy. Looking forward, the ongoing economic expansion and the newly enacted tax reform bill should continue to push corporate profits to higher levels. In fact, earnings are expected to grow 20% this year, and that should drive stocks upward as we progress through the second half of the year. While stocks are expected to generate solid gains, volatility is likely to remain elevated as we work through trade negotiations and the removal of stimulus by the Federal Reserve.

International equity

In the aggregate, international equities declined in the first half of the year but returns varied within the group. Stocks in developed markets declined modestly due to some soft economic data, the trade related tensions that impacted U.S. markets and the increase in the U.S. dollar. In contrast, emerging market equities declined more significantly as the increase in the U.S. dollar and the trade tensions impact those markets to a greater degree. Many of the emerging countries have export oriented economies and changes in currency valuations, or the terms of trade, can have a meaningful impact. As the year progresses, solid earnings growth and a continuation of the economic expansion should support higher equity prices. However, in conjunction with the U.S. markets, volatility is likely to remain elevated.

Commodity

Commodity prices were mixed last quarter with declines in metals and agricultural products offset by strong gains in the energy segment. A slower pace of global growth was a primary driver of the declines in many commodities, but the pattern of returns is also consistent with each segment’s exposure to tariffs. Portions of the metals and agricultural segments are subject to tariffs and that has had a negative impact on prices. In contrast, energy is not significantly impacted by the trade dispute and it continues to benefit from the combination of both disciplined supply management and the global economic expansion. Looking forward, we expect the slower pace of global growth to act as a headwind to higher commodity prices but acknowledge that a positive resolution to the trade dispute will likely result in a rally.

Potential threats: Risks and notable items to watch

Trade disputes & rising protectionist sentiment

Trade tensions between the U.S. and several other countries have recently been escalating. While much of the rhetoric is likely a function of positioning for negotiating leverage, the newly enacted tariffs are having a meaningful impact to some companies and industries. If additional tariffs are implemented, they are likely to have a greater impact and could affect the global economic expansion.

Rising interest rates and/or inflation

A shift from the current environment of low interest rates and benign inflation is likely to be problematic if it occurs too rapidly. Structural forces such as aging populations and the proliferation of technology have kept inflation at low levels, but a marked upward shift may force the Federal Reserve to raise rates more aggressively which could bring the current expansion to an end. Increasing

Government regulation of technology companies

Several of the leading technology companies have established dominant market positions and they have few competitors. If the power of these companies continues to increase, government regulators may place them under greater scrutiny in assessing their privacy policies, acquisition plans and competitive practices.

Geopolitical risks

Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. Events in Syria continue to be important to monitor as are developments in the Middle East and the South China Sea. The recent establishment of diplomatic ties between the U.S. and North Korea is a positive development and we are watching for signs that North Korea will take steps towards denuclearization.

Debt-related issues

Sovereign debt levels continue to grow throughout much of the world, generating conditions associated with low rates of economic growth. In response to the low growth rates, there has been a meaningful shift in the willingness to use fiscal policy to stimulate these economies. However, if the initiatives are debt financed, they run the risk of exacerbating the issue and creating more significant problems in the long-term.

Policy risks

The Federal Reserve has announced its intention to continue to raise interest rates and reduce the size of its balance sheet. At the same time, central banks in other major economies are considering when to alter their policies to a more restrictive stance. If the world’s central banks reduce stimulus too quickly, there is a heightened risk of slowing economic growth.

Cybersecurity

Cybersecurity has become a significant issue as evidenced by last year’s Equifax data breach as well as persistent attacks on both the international money transfer system, SWIFT, and on systemically important financial institutions. The global cost of cybercrime was recently estimated at $600 billion annually, up 20% from 2014. The rising costs are primarily caused by the significant increase in theft of intellectual property and confidential business information. Notably, 53% of all attacks cost more than $500,000 in financial damages, according to recent reports by McAfee and Cisco Systems.