MARKET COMMENTARY

Synchronized Growth Broadens the Market

03.23.2017 - Ronald J. Sanchez, CFA

When we released our outlook for the global economy and financial markets in December, we identified a number of fundamental shifts that we believed would make 2017 a year of transition.

KEY TAKEAWAYS
  • Global economies are realigning, improving the prospects for sustained and durable growth.
  • Equity market returns could broaden out, with participation from a wider variety of asset classes, geographic markets and market capitalizations.
  • Corporate fundamentals will drive the market, making selectivity more important. In a reflationary environment, trends that have persisted since the financial crisis are shifting.

Well before the November elections, near-full employment levels were already putting upward pressure on wages and raising inflationary expectations. Those expectations were strengthened by President Trump’s pro-growth proposals, which include the repatriation of cash held in offshore accounts by US corporations, tax reform and significant regulatory relief. The Fed’s rate hike in December offered further evidence that the US was indeed moving away from deflationary fears and into a reflationary environment.

As we expected, the US economy continued to strengthen during the first two months of 2017, with improvements seen in manufacturing activity, personal consumption figures and employment data. More encouraging, perhaps, was the acceleration of economic expansion overseas. In Europe, GDP growth outpaced the US for the first time since 2008, while stronger manufacturing numbers in both Germany and Japan inspired policymakers to revise their annual GDP forecasts upward (CHART 1). Likewise, emerging markets stabilized after a period of heightened risks.



It appears that 2017 is shaping up to become a year of moderate economic growth not only for the US but also for the world.

In our view, these improvements in economic indicators are not temporary blips or anomalies. Rather, they appear to be bona fide trends that have been gathering momentum, sometimes sporadically, for years. While we do not believe these incremental improvements in GDP mean the world is on the verge of an economic resurgence, the fact that global economies are moving in the same direction for the first time in years has profound implications for global economic stability and financial markets.

A Reflationary World

Most importantly, this global synchronization means that trends that have been in place since the early years of the global economic recovery are unlikely to persist.

With growth branching out to countries other than the US, indicators of inflation began moving higher in late 2016 as well. Conviction in the durability of US and global growth, as well as sustainability of inflationary trends, has led to the beginning of normalization of Federal Reserve monetary accommodation. This would be a major shift from the post-recession world where unprecedented monetary accommodation has been the norm. Like the resynchronization of growth, the gradual tightening of monetary policy will have important implications for financial markets. In our view, fixed income markets are beginning to digest this dynamic by way of higher interest rates.

The big question among US investors is: What happens to economic growth and the financial markets if President Trump is unable to deliver on his campaign promises? While his pro-growth policies may be an accelerant for economic growth and have lifted market sentiment, we do not view them as a primary catalyst for the economy. Economic fundamentals have been strengthening since mid-2016. So if tax reform or deregulation initiatives fall short of expectations the markets are likely to adjust, but we would not expect to see a dramatic market reversal or the derailment of a global economic recovery.

Since the financial crisis, investors have found sanctuary in US markets. Muted but positive economic growth, extraordinary monetary support and the lack of investment opportunities elsewhere around the globe led investors to favor US large-cap stocks and US bonds (CHART 2).



In fact, returns from US stocks and bonds aligned more closely than they had in over a decade late last year. But in our view, the recoupling of low but positive economic growth around the world will encourage investors to search for return opportunities in international and emerging markets as well as small- and mid-cap stocks.

In a similar vein, financial repression by way of central bank accommodation and deflationary pressures led investors over the last several years to treat fixed income assets more like instruments with price appreciation potential than income-producing assets. But as central banks become less accommodative, we expect bonds to resume their normal role as income producers. 

In the US equity market, the Fed’s policies suppressed volatility and overshadowed fundamentals, consistently lifting valuations in the S&P 500 despite flat corporate earnings. As long as the Fed maintained rates at record-low levels, limiting market volatility and providing corporations with a cheap source of capital to buy back stocks, investors seemed comfortable owning the market. In this era of financial repression, investing indiscriminately across the market rather than specifically among individual stocks was relatively effective.

Without a doubt, the post-financial crisis era has been a challenging one for active portfolio management as higher correlations, lower dispersion and muted volatility narrowed the opportunity to generate above-benchmark returns. But this environment is transitioning. In fact, we have already seen correlations within the S&P fall to multi-year lows (CHART 3).

 

Implications for Investors

What does all this mean for investors? As monetary conditions tighten for the first time in almost a decade, we expect the market’s steady upward trajectory to become less predictable. As that happens, corporate fundamentals will influence the market more than Fed policy.

In this new landscape, the opportunity for investment returns could broaden out significantly, resulting in participation from a broader variety of asset classes, geographic regions and market capitalizations. Additionally, alternative investments like hedge funds could regain the broad appeal they held with investors before the financial crisis.

In short, based on our reflationary outlook, we see opportunities for global equity market returns broadening out, a more challenging fixed income environment and a more favorable landscape for active management.


This communication is intended solely to provide general information. The information and opinions stated are as of March 24, 2017, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. 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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