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A Justifiable Rally

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A Justifiable Rally VIEWPOINTS November 2017 A JUSTIFIABLE RALLY While investor sentiment has been improving, many remain 2014 and 2015, and has led the rebound since. Most skeptical about the current market rally and the resulting recently, September import and export data showed outlook. We have analyzed returns across the major equity meaningful acceleration from last month, and surveys of markets this year, and earnings growth has been the companies doing business in China are setting new highs. biggest contributor by far. Earnings growth has contributed European growth, including in the important industrial 53% of the gains in emerging market stocks, 81% of the sector, has been remarkably durable, shaking off political gains in U.S. equities, and virtually all of the gains in difficulties and euro currency strength. Finally, U.S. growth developed markets outside the United States. Currency has shown little evidence of wide-spread disruption from moves have been a big issue this year, significantly the hurricane season. boosting returns in non-U.S. developed markets (adding Inflation is one of the great variables in the outlook; central 9% to total return), but they have only been a minor bankers and investors have been waiting for its re- contributor to emerging market gains. Finally, emerging emergence for years (while our Stuckflation theme has markets also have benefitted from increasing valuations predicted continued torpor). We formally learned of the U.S. this year, while falling valuations in developed markets Federal Reserve’s plan to begin shrinking its balance sheet outside the United States have been a headwind to their in September, but we expect the pace to be slow and the returns. U.S. valuations have increased modestly this year, overall impact to be manageable. This will help pave the contributing just 1% of the 14% total return. way for tapering of the European Central Bank’s (ECB’s) While earnings growth over the next year is likely to purchases, but actual increases in rates by either the ECB decelerate, momentum in the global economy is supportive or Bank of Japan are likely far in the distance. Inertia in the of continued solid growth. Global economic growth looks inflation metrics across most developed economies has set to accelerate a full 0.5% in 2017 over 2016, a central bankers questioning their models, which we think meaningful move upward. Importantly, corporate spending will lead them to choose deliberation over action when it has finally picked up and tracked at an annualized 7.5% comes to hard choices in monetary policy. rate last quarter. China led the downturn in global growth in EARNINGS HAVE DRIVEN STOCK RETURNS Only emerging markets have seen a real boost to returns from valuations. 32 24 16 8 Percent (%) 0 -8 -16 U.S. Developed ex-U.S. Emerging markets Earnings Currency Valuations Dividend Total return Source: Northern Trust Investment Strategy, Bloomberg. 111 N. Washington Street • Green Bay, WI 54305-3900 • 800.369.0226 • www.nicoletbank.com INTEREST RATES FINDING A NEW LEVEL The Fed has formally announced the start of its balance sheet The Fed’s balance sheet reduction has its limits. reduction plan. It plans to reduce holdings slowly and mechanically, 4.5 initially allowing $10 billion worth of bonds to mature each month, with an eventual upper limit of $50 billion per month. We believe the 4.0 Fed prefers to slowly tighten policy despite recent data showing continued modest growth and limited inflation. As a result, we 3.5 believe interest rates will slowly rise across the curve and we look to 3.0 position portfolios neutral relative to their benchmark duration. Euro- ($) Trillions area economic conditions remain solid and appear supportive for 2.5 the ECB to announce the start of policy renormalization later this month. However, ECB rhetoric has remained cautious, and political 2.0 2010 2013 2016 2019 2022 2025 developments are once again dominating the headlines. Elections Balance sheet assets Forecasted across Europe have shown that voters remain fragmented, and the Source: Northern Trust Fixed Income; Federal Reserve Bank renewed push from Catalonian separatists provides an unwelcome of New York. distraction at a time when German elections have weakened the x Fed balance sheet reduction to finally commence. hand of pro-European policy makers. European bond markets have been fairly well behaved, and a flight to quality bid has not x We expect the pace of normalization to be very materialized in the wake of political headlines. Even the Bank of gradual. England appears ready to deliver a rate hike in spite of Brexit x We are neutral U.S. duration, underweight uncertainties. We maintain an underweight bias to short-dated European short-dated government bonds. European government bonds because they look most vulnerable as they remain below official policy rates. CREDIT MARKETS ENERGY BOOST The high yield market posted a 2.0% return in the third quarter and Energy sectors showed third quarter outperformance. is now up 7.0% on the year. While its return pales in comparison to 10 the 18% return from global equities, we remain attracted to the lower risk profile of high yield vs. the higher risk profile of other 8 asset classes (e.g., global equities) found in the risk asset portfolio. 6 Digging deeper into high yield’s third-quarter returns, we find they were boosted by strong returns in the energy sector. Oil prices rose 4 Return (%) over 12% to close the quarter at $52 per barrel – and drove the 2 8.4% return in the refining sector, a 6.5% return in the oil field 2.0 8.4 6.5 5.0 services sector and a 5.0% return from exploration and production 0 companies. These three sectors comprise only 10% of the high HY index Refining Oil field E&P yield market, but they accounted for more than 25% of the market’s services Source: Northern Trust Investment Strategy, Bloomberg return for the quarter. Now that oil prices appear to have more stability (at around $50) x Third-quarter high yield returns were boosted by the energy sector as oil prices stabilized. and the energy sectors have become more fairly valued, outlying sectors are less likely to drive returns. High yield portfolio managers x Looking ahead, returns likely will be more likely will look to exploit issuer-level opportunities for dependent on individual contributions vs. sector outperformance for the remainder of the year. Because of our performance. constructive outlook for global economic growth, we expect those x We remain overweight high yield, with a focus on portfolio managers to also receive a tailwind from steady returns in corporate issuers (over emerging market debt). aggregate. We retained our 3% overweight to high yield in our global policy model, with our 5% overweight to high yield corporate issuers offsetting our continued 2% underweight to emerging market debt, a region where we prefer to get our exposure through equities. 2 VIEWPOINTS EQUITIES As equities have marched steadily higher in 2017, markets have MOVING TO THEIR OWN BEAT Correlations between stocks are falling. departed from recent history by exhibiting low levels of volatility and 1.0 lower correlations. As the chart shows, correlations between stocks rose dramatically during the financial crisis sell-off, which is to be 0.8 expected as stocks are more indiscriminately sold during periods of significant weakness. But correlations remained relatively elevated 0.6 for several years post-crisis. Most attribute the higher post-crisis 0.4 correlation to the “macro-driven market,” where central bank policy Correlation was viewed to be the driver of equity returns. With central banks on 0.2 the path toward normalization, particularly in the United States, 0.0 while global growth expectations have firmed, markets have shifted 1987 1993 1999 2005 2011 2017 their focus to company-level fundamentals. Low volatility is Avg. correlation coefficient between stock returns generally supportive of equity returns, and lower correlations Source: Northern Trust Investment Strategy, Bloomberg. Data from 12/31/1986 through 9/30/2017. provide opportunities to capture more alpha than when the market is macro-driven. While there’s a tendency to equate low volatility to x Stocks have started trading more on their own complacency, given the economic backdrop and gradual central fundamentals. bank movement, we are less concerned that the muted volatility x This could improve the opportunity for stock conditions spell trouble for equities over the intermediate-term. A pickers. small correction is inevitable, but we could have said the same thing x We remain constructive on equities globally. at the beginning of the year and missed a gain 15% trying to avoid a 5% pullback. REAL ASSETS ONLY A PROBLEM WHEN IT’S A PROBLEM Investors worldwide have been anticipating a “global reflation trade” Wage growth has more impact when above 4%. – global growth acceleration that would push inflation higher, 15 bringing interest rates along with it. Recently investors have been teased with higher commodity prices, upward-trending Chinese 12 inflation and increased central banker rhetoric about the need to 9 unwind accommodative monetary policy. Then the September U.S. jobs report hit, showing that unemployment had fallen to 4.2% and 6 wage growth continued to strengthen, now at 2.9% year-over-year. 3 Core inflation(y/y%) However, the wait for the global reflation trade is likely to continue. 0 While wage growth is correlated to inflationary pressures overall, 0246810 low levels of wage growth show a much weaker relationship. As the Wage growth chart shows, wage growth above 4% has a 0.7 correlation with core Wage growth <= 4% Wage growth > 4% inflation but wage growth at 4% or less has a correlation of only 0.3.
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