Macro View


As of July 26, 2018

Currencies, Trade Fears Reverse the Surge in Emerging Market Equities

  • A stronger dollar, rising-rate environment and global trade tensions are weighing on the performance of emerging market equities, which was the best performing global asset class in the first quarter of 2018.
  • Central banks in emerging market countries are raising rates and taking other measures to stabilize their currencies.
  • Fragile economies like Argentina and Turkey were among the first to be affected by currency volatility, which then broadened out to Brazil, Indonesia, India and the Philippines.
  • China’s central bank took measures to encourage bank lending and promote economic growth, addressing concerns about the potential effects of a trade war with the US.

The European Economy Is Growing, but Lost Some Momentum

  • The European economy continues to expand, despite a recent pullback in economic data and a political crisis in Italy. The ECB plans to end its bond-buying program by the end of 2018.
  • Japan appears to be in the earlier stages of an economic growth cycle compared to many other international developed markets, as illustrated by its monetary policy versus other markets.
  • Earnings in Japan and Europe outpaced the US in late 2017. We continue to look for attractive buying opportunities in both markets.
  • Geopolitical risks such as populism and retaliatory trade measures could weigh on international commerce, presenting local policymakers with challenges to consider during rate deliberations.

Government Policy Is Cloudy, but Fundamentals Are Strong

  • Investor confidence has been shaken by the unpredictability of US trade policy, geopolitical risks, and concerns about rising interest rates and inflation.
  • Strong corporate earnings and supportive economic fundamentals in the US support our positive outlook for economic growth and risk assets.
  • Equity market volatility is likely to continue until trade and monetary policies become clearer, but long-term valuations are supported by a stable economic backdrop.
  • Treasury yields are rising, making dividends less attractive for some income investors.

Sector View

From the Fiduciary Trust Equity Strategy Committee
As of July 26, 2018

Financials: Overweight

Financials Benefit From Deregulation, Tax Reform, Higher Rates

We remain overweight Financials in anticipation of higher interest rates, easing regulations and the benefits of corporate tax cuts, which should make it easier for financial companies to put capital to work in productive ways. We have already seen indications that cash flow is improving for financial firms while debt remains steady.

Sector Positives

  • Balance sheets are stronger and all major banks passed the Fed’s stress test, which should allow them to return more capital to shareholders through dividend payouts and share repurchases.
  • Regulations are easing even without Congressional action.
  • A lower corporate tax rate and repatriation of offshore earnings provide a tailwind.

Sector Negatives

  • The Fed’s timeline for raising rates remains unclear.
  • Protectionist trade policies could destabilize the broader US economy.
  • Credit concerns could lead to higher loan loss provisions in the energy, auto and real estate markets.

The financials sector includes banks, thrifts, diversified financial services companies, asset managers, investment banks, insurance and reinsurance companies.

Energy: Overweight

Our Outlook For The Oil And Gas Markets Has Improved

We recently moved from marketweight to overweight in Energy, based largely on our outlook for supply and demand in the oil and gas markets. A global supply glut receded and we expect consumption to rise along with an expanding global economy. In addition, many of the largest energy companies are broadening out into sustainable energy production.

Sector Positives

  • US shale production picked up, boosting demand for oil and gas equipment and services.
  • Reinvestment has continued through recent market downturns, and free cash flow has improved in certain subsectors.

Sector Negatives

  • Low oil prices deterred drilling activity.
  • Coal-powered electricity is being phased out by the US government, individual states and other countries.
  • Narrower crude differentials weighed on profitability for oil and gas refiners.
  • The cost of capital is relatively high for energy companies.

The energy sector includes companies that produce and distribute energy. This includes the petroleum industry, containing oil companies, refiners and gas stations; the gas industry, including natural gas extraction and coal; the electrical and nuclear power industries, and the renewable energy industry.

Health Care: Overweight

Drug Prices Draw Attention, But Secular Trends Are Favorable

We are maintaining our overweight allocation to Health Care, encouraged by strong demand from an aging global population, continued innovation, the potential for industry consolidation, and the positive contributions of tax reform and repatriation.

Sector Positives

  • Valuations appear attractive for pharmaceuticals and large biotech companies.
  • Efforts to speed up the drug approval process are supported by the Trump administration.
  • Corporate restructuring continues and M&A activity is robust.
  • Strong demand is expected for innovative and effective medical treatments in areas such as cancer, diabetes, hepatitis C, and Alzheimer’s.

Sector Negatives

  • Healthcare reform proposals could resurface in Washington.
  • Drug pricing could be regulated more closely under the Trump administration.
  • Inversion deals face closer scrutiny by the IRS.
  • Medtech companies are being closely monitored by the FDA, which could impose a more rigorous review and approval process.
  • Government budget constraints could reduce spending on Medicare and Medicaid.

The health care sector covers two primary industry groups: healthcare service providers and firms that make health care equipment, and firms related to pharmaceuticals and biotechnology.

Industrials: Overweight

Stronger Earnings Could Lift Capital Improvement Spending

We continue to overweight Industrials based on improved earnings growth and expectations for more capital improvement spending. Manufacturing activity in the US and Europe is accelerating, albeit at a slower pace than previous periods, and we expect global economic growth to fuel demand for industrial products and services.

Sector Positives

  • A reduction in corporate taxes and increase in government spending on infrastructure improvements bode well for Industrials.
  • Shipping and delivery companies typically see stronger demand for their services when the US economy is growing and corporate budgets are expanding.
  • Defense spending is gaining momentum after years of government budget constraints.

Sector Negatives

  • Weakness in certain areas of the Chinese economy and protectionist trade policies in the US and abroad could constrain growth among companies with a strong international presence.
  • Profit margins could shrink if wage and commodity inflation continues.

The industrial sector encompasses transportation services and infrastructure for roads, rail, airlines and marine services. It also includes manufacturers of aerospace and defense equipment and companies providing electrical equipment, building products, and commercial services and supplies.

Telecommunications: Underweight

As the Telecom Industry Matures, More Consumers Are Cutting the Cord

We are underweight Telecommunications, a relatively mature industry with saturation levels that could limit the potential for meaningful topline growth in the future.

Sector Positives

  • Regulations could be relaxed by the new administration.
  • Costs are falling and market share is expanding for large telecom companies, driven by their massive scale.
  • Strong demand for wireless data continues to support the US consumer market.
  • Reasonable valuations and high dividend yields provide defensive characteristics for stocks issued by major carriers.
  • Bundling of services such as wireless data, internet access and media content delivery is supporting revenues and reducing subscription cancellations.

Sector Negatives

  • Carriers must modernize and reinvest heavily to support the growing demand for wireless data.
  • Broadband companies face competition from over-the-top providers like DirecTV Now, Netflix, HBO, Dish, etc., which are encouraging consumers to cut the cord.
  • Penetration rates are high, forcing major competitors to grow through acquisition.
  • Competition from abroad could pressure margins for wireless carriers in the US.

The telecommunications sector includes wireless communications, equipment, processing systems and products and carriers.

Information Technology: Overweight

Regulations Are Possible, But Developing a Framework Will Take Time

We continue to recommend an overweight position in the IT sector based on improving economic conditions and secular growth opportunities from the rise of cloud computing, Software-as-a-Service, and payment processing. While the industry could face tighter regulations, we believe market fears have been largely overblown.

Sector Positives

  • Innovation continues in areas such as artificial intelligence, manufacturing automation, and 4G systems. Strong demand for digital content and data analytics.
  • Cloud computing is gaining ground across mainstream enterprises, and legacy companies are responding by introducing new services focused specifically on the needs of end users.
  • Cybersecurity is a critical component of cloud computing and vendors are integrating new safeguards into their hardware and firmware.
  • Software defined networking (SDN) could change the market for networking gear in profound ways, similar to the way server virtualization technologies changed brand-name PCs.
  • The Internet of Things is boosting demand for semiconductors and chipsets.

Sector Negatives

  • A formal regulatory framework is possible for the tech sector, but negotiations will be complicated and time consuming.
  • We remain cautious about overpaying for IT stocks. Our approach is to identify established companies that are adapting to change and younger competitors that are agile and innovative.
  • Weak demand for PC-related products over the past several years could suppress stock prices across the supply chain.

The information technology sector includes manufacturers and providers of computer, data, and electronic equipment and services. It includes hardware, software, networking and telecommunications equipment manufacturers, IT services, providers of internet services; mobile phone producers; and semiconductor manufacturers.

Materials: Marketweight

Infrastructure Projects Could Boost Demand, but Geopolitical Risk Escalates

Our marketweight position in Materials reflects our focus on specialty chemicals and processing companies, which should benefit from an improving economy with stronger business models, as opposed to commodity-sensitive companies.

Sector Positives

  • Appreciation of the US dollar could result in lower input prices for companies that are somewhat distanced from exchange rate volatility.
  • The Chinese economy’s shift from exports to consumption is likely to benefit suppliers of chemicals used in automobiles and travel industry products.
  • Metals and mining companies have historically performed well when inflation is rising.
  • Construction materials could benefit from government spending on infrastructure improvements under the Fixing America’s Surface Transportation (FAST) Act.

Sector Negatives

  • Soft patches in the Chinese economy, uncertainty surrounding government spending and geopolitical tensions present risks for the sector.
  • Suppliers of glass and metal containers have encountered headwinds from a supply/demand imbalance in the consumer non-durables market (cosmetics, cleaning products, etc.).
  • The paper and packaging market is oversupplied, but certain manufacturers of paperboard products in the US appear well-positioned for stabilization or growth.

The materials sector contains companies engaged in the extraction and processing of raw materials such as metals, chemicals, wood and paper products, and construction materials.

Consumer Staples: Underweight

Focusing on Dividend Growth, Not High Dividend Yields

We are underweight Consumer Staples because of limited top-line growth opportunities, full valuations and other headwinds. Our primary focus is on companies with strong dividend growth (rather than high dividend yields), international scale and the ability to adapt to changing consumer preferences.

Sector Positives

  • Cost-cutting measures have improved profit margins for many companies in the sector.
  • Expansion into ecommerce and natural ingredients has become a higher priority as companies adjust their business models to keep pace with consumer tastes.

Sector Negatives

  • Sales volume is declining as major categories like grooming products and diapers have matured, and local competitors launch discounted products to capture market share.
  • Environmental awareness and health concerns among consumers are forcing mainstream brands to adjust their business models and invest more in research and development.
  • Rising rates could work against Consumer Staples, which typically show their strongest performance in a low-rate environment.

The consumer staples sector includes consumer items that are often considered household necessities. It includes personal and household products; food products; beverages and tobacco industries.

Utilities: Underweight

Expectations for Rising Rates, Inflation Make Utilities Less Appealing

We are underweight Utilities, partly due to expectations that inflation will rise. However, we continue to leverage their history of reliable dividend payouts as a defensive measure in client portfolios and we are evaluating indirect investments in renewable energy (electric vehicles, smart transportation grids, lithium ion batteries, etc.).

Sector Positives

  • Electric companies are diversifying into unregulated markets with favorable growth characteristics, such as renewable energy.
  • Utilities offer dividend income potential as well as a hedge against market volatility, with historically low correlations to the S&P 500.
  • Exposure to international markets is modest, which reduces the risks posed by protectionist trade policies and a stronger US dollar.

Sector Negatives

  • Gas utilities are trading at a premium compared to electric utilities that have similar growth characteristics.
  • Demand for electricity has weakened due to slow economic growth and higher energy efficiency.
  • Low natural gas prices are expected to continue for the foreseeable future.
  • Renewable energy is evolving rapidly, which increases the risk of new products and services quickly becoming obsolete.

The utilities sector covers a variety of industries that generate and deliver power and water. It includes nuclear facilities, electric and gas utilities, independent power producers, energy traders, and generators and distributors of renewable energy.

Consumer Discretionary: Marketweight

TAX REFORM AND WAGE GROWTH LIFT CONSUMER CONFIDENCE

We upgraded the sector to marketweight following the approval of tax reform and subsequent improvements in consumer confidence. The sector is also supported by a strong labor market and evidence that the housing market’s extended growth still has room to run.

Sector Positives

  • Tax reform could be especially helpful because retailers, restaurants and housing-related companies pay tax rates that are among the highest across all industries.
  • A strong economy and uptick in consumer spending bode well for Consumer Discretionary. When inflation is rising, companies can usually pass on price increases to consumers.
  • On-demand entertainment continues to gain traction with consumers, a trend that favors media companies with extensive content libraries and broad distribution capabilities.
  • Median home prices should continue to rise as wages improve and supply remains tight.

Sector Negatives

  • Higher retail and energy prices discourage consumers from buying discretionary items.
  • Credit concerns are mounting as the number of auto loans delinquent by more than 60 days hit a 15-year high. However, debt-to-income ratios are still below average.
  • Auto sales are slowing, forcing manufacturers to offer deep discounts, easy financing and other incentives to generate sales.
  • Ecommerce continues to threaten full-price retailers, diluting their pricing power and capturing market share.Off-price retailers appear to be more resilient.

The consumer discretionary sector includes companies that sell non-essential goods and services. It includes textiles, apparel and luxury goods; retailing; media; leisure products; hotels and restaurants; and automobiles and components.

Tactical View

From the Fiduciary Trust Asset Allocation Committee
As of July 1, 2018

Cross Asset

US Mid-Caps Offer Insulation from International Trade Tensions
Despite geopolitical concerns and global trade friction, we continue to feel confident in our overweight recommendation for global equities and underweight fixed income. However, we adjusted to current conditions by trimming our exposure to European equities and shifting the proceeds to US mid-caps.

  • Equities. We increased our allocation to US mid-caps, which tend to derive most of their revenue from the domestic market, offer a measure of insulation from geopolitical risks, and capture the benefits of US tax reform. In Europe, corporate profits continue to grow, though at a slower pace than the US, and valuations moved higher and closer to their historical average, reducing their appeal.
  • Fixed Income. Our current focus for US fixed income is on shorter durations to guard against interest rate risk. In Europe, more hawkish comments from the European Central Bank may mean rates are poised to rise. While normalization is likely to be a long-term positive for European markets, it increases the short-term risk associated with higher bond yields and currency appreciation in an economy that relies heavily on manufacturing.
  • Alternatives. We continue to recommend liquid alternatives for risk management and diversification, since non-traditional investments typically have a low performance correlation to US stocks and bonds. They also tend to outperform when rates are rising. Private equity appears particularly appealing in this environment as sponsors are raising capital and investors are receiving distributions from long-term investments.

Fixed Income

As the Fed moves cautiously toward normalization, bonds appear to offer limited total return opportunities. But we recognize their potential to generate income and mitigate portfolio risk. We continue to monitor the exodus of foreign buyers as hedging costs continue to climb, non-US central banks head toward normalization and oil prices contribute to higher inflation expectations.

  • US Government bonds. Yields on the 10-year Treasury reached a high of 3.12% before easing slightly and the market has been quite volatile as investors look for quality in an uncertain market. Markets are pricing in three rate hikes and a roughly 50% chance of four rate hikes this year. This comes at a critical time for the Treasury market as issuance is increasing to fund the US government’s tax cuts and spending-heavy budget while the Fed pares back its Treasury buying activity.
  • Municipal bonds. For highly taxable investors, we consider municipals attractive on an after-tax basis. Looking forward, market dynamics will continue to adjust to a reduction in both supply and demand in the wake of the recently passed tax reform legislation. We remain highly selective, generally favoring higher credit quality, liquidity and revenue bonds over general obligation bonds.
  • US Investment-Grade Corporate bonds. In taxable fixed income markets, we believe investment-grade corporate bonds are attractive against a backdrop of solid demand and an improving earnings outlook. Spreads could show increased volatility going forward as uncertainty regarding the impact of evolving fiscal and monetary policy pushes investors to demand more compensation for credit risk. Pre-tax yields on investment-grade corporate bonds remain attractive given fundamentals.
  • US Securitized bonds. We remain cautious about mortgage-backed securities in the face of relatively tight spreads and Fed winding down its balance sheet. Higher rates or volatility in coming months could provide a more attractive entry point.

Equities

Pro-growth fiscal policies in the US could be supportive but appear unlikely to take shape until sometime in 2018. In the US, valuations appear full and risks largely overlooked. International developed markets are more appealing.

  • US Large-Cap. Despite political distractions and trade fears, US equity markets are flat for the year (in early July). Investors appear to have priced in these risks earlier in the year and the market has been supported by corporate buying.
  • US Mid-Cap. Our asset allocation committee decided to overweight mid-cap equities in late June to buffer client portfolios if international trade is disrupted by tariffs, which would likely affect large companies with a broader international base. Mid-caps also should benefit from any fiscal thrust that has yet to come through the pipeline as the result of a lower corporate tax rate. They also tend to be less sensitive to a rising dollar than their counterparts in the large-cap category.
  • US Small-Cap. We are also overweight US small-caps, which may benefit in an environment of rising rates and an accelerating domestic economy. We are looking for opportunities to capture an upswing in small-caps as the market responds to the benefits of tax reform, financial sector deregulation, and an acceleration in the domestic economy. Within small-caps, the value space may be uniquely positioned to capture the benefits of tax reduction and easing regulatory pressure in the banking industry, since the index is nearly 30% financials.
  • International Developed Market Large-Cap. We still see the brightest prospects for equity market returns outside the US., where corporate fundamentals are strong and financial conditions remain favorable for growth. But we trimmed our overweight position in European equities as populism re-emerged and trade risks became more prominent. The ECB’s stance on monetary policy also appears less confident. We prefer Eurozone and Japan, where economic fundamentals are strong and corporate profits are gaining traction.
  • International Developed Market Small-Cap. European and Japanese companies focused on their own domestic markets rather than exports should benefit from lower borrowing costs and an acceleration in economic growth, which could cushion portfolios against a strengthening currency and global trade spats. We continue to evaluate buying opportunities for their attractiveness in this space.
  • Emerging Markets. We upgraded emerging market equities last year as we had a constructive view on the global economy and the resynchronization of global growth. While the category benefitted from weakness in the US dollar, the trend revered in 2018. A strong dollar weighed on emerging market equities, debt and foreign exchange in recent months, but the softness was driven primarily by countries that lack political and/or financial stability.

Alternatives

We are recommending liquid alternatives for risk management and diversification in client portfolios, since hedge funds and other nontraditional investments typically have a low performance correlation to traditional US stocks and bonds. They also tend to outperform when rates are rising.

  • Private equity. This asset class appears particularly appealing to us today, as sponsors are raising capital and investors are receiving distributions from long-term investments.
  • Hedge funds. In addition to their defensive qualities, hedge funds could see more attractive return opportunities as market volatility, interest rates, global currency fluctuations and economic activity pick up. Widening dispersion of equity returns across sectors and regions may also create more trading opportunities for capturing alpha.
  • Event-driven strategies. These strategies could benefit if tax reform and repatriation encourage companies to make acquisitions. Event-driven funds invest in securities of companies in the midst of bankruptcies, changes in capital structure and mergers/acquisitions.
  • Commodities. Despite recent volatility in commodity markets, sentiment surveys remain strongly positive in many parts of the world. But definite signs of an acceleration in activity have been scarcer, probably due to the structural impediments that have lingered since the global financial crisis started more than a decade ago.

This communication is intended solely to provide general information. The information and opinions stated are as of the dates specified, and may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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