By Brian Herscovici, CFA
Portfolio Manager, Global Multi-Assets
Global stresses relating to trade have caused a divergence between U.S. and international equity markets. U.S. stocks have benefited from better-than-expected earnings growth, with the S&P 500 climbing into double-digit territory for the year. Trade issues and dollar strength were headwinds for overseas stocks, especially in emerging markets.
A Treasury selloff late in the quarter pushed the 10-year yield above 3% (yields move inverse to price). Credit spreads, the difference between corporate lending rates and Treasuries, tightened on solid demand for investment-grade debt. Citing economic health, the Federal Reserve raised short-term rates in late September and appears on track for one more hike before year-end.
It is hard to find much wrong with the U.S. economy these days. We are enjoying the fastest GDP growth in a decade, with unemployment near its lowest this century, manufacturing expanding for 25 straight months, scant inflation and soaring consumer confidence. Plenty of cheery news can also be found in equity markets where robust earnings have pushed share prices to new records.
With everything going so right, the inevitable question: Is this the peak?
Of course, we will not know where the top is until the economy and markets have gone past it and are heading down the back side. Still, there are signs that suggest coming quarters may offer less oomph. Current forecasts call for brisk GDP growth (4.2% annual rate in 2Q) to ease off and lower earnings growth estimates for 2019. Financial conditions are also getting tighter as U.S. interest rates climb, and the strong boost provided by the 2017 corporate tax cuts and increased government spending will soften next year.
While we are not sure about a U.S. market top, we can say with a high degree of conviction that overseas’ markets are not experiencing the same exuberance.
The threat of a global trade war has been weighing on international markets – Figure 2 shows how non-U.S. developed shares tailed off in the spring, a timing that corresponds to the first U.S. tariffs being imposed on steel and aluminum. While the market’s reaction reflects a belief that the U.S. would be a clear winner in a global trade war, history shows trade wars have adverse effects on all parties involved. For this reason, we expect markets to converge over the near term. If global growth stabilizes, the convergence can be a positive for overseas markets. But if tension escalates, the U.S. could be headed for a downturn.
There are indications that we may be past “peak protectionism,” even in light of an escalating confrontation with China. In recent weeks, the U.S. has reached deals with Mexico and Canada, the top two U.S. export markets that together account for almost a third of total trade. This follows an agreement with the European Union and talks with Japan will be starting soon.
The global economy outside the U.S. may not be booming, but it is in pretty good shape and has room to get better. As an example, Figure 3 shows the dramatic improvements in Europe since unemployment topped out at 12% in 2013, but the numbers still haven’t gotten down to their pre-Great Recession level. In the U.S., however, you have to go back to 1970 to see unemployment this low.
In addition, if you back out the one-off impact of last year’s corporate tax cuts, earnings growth forecasts for developed markets are roughly the same as the U.S. and emerging markets are greater. Manufacturing is on the rise in both EM and DM, and both are earlier in their economic cycle than the U.S., so they have more room to grow before their peak. There are risks – European banks are still rickety, for instance, and there are debt issues in EM that could worsen with higher U.S. interest rates and an appreciating dollar. Rising oil prices could also present a headwind.
Given divergent economic cycles, it’s important to reiterate the value of global diversification. U.S. equities have outperformed in 2018 due to the trade issue and stronger earnings growth, but both stand to be less of a factor going forward. If this is indeed as good as it gets, we can expect investors to rotate allocations from expensive U.S. assets to international assets that are cheap on a relative valuation basis.
In the third quarter, USAA Managed Portfolios (UMP) revised its tactical positioning by shifting an allocation from emerging markets to international developed markets. Short-term headwinds currently outweigh the long-term potential for emerging markets given trade turmoil, weakening currencies and country-specific instability. At the same time, non-U.S. developed markets are benefiting from economic growth and more confident consumers.
3Q portfolio performance was helped most by strong performance in domestic stocks (U.S. is the largest component of UMP’s equity allocation) after another strong earnings season and continued improvement in sales and profit margins. Overseas equities were mixed –developed markets contributed a small positive in the 3rd quarter, while emerging markets (a smaller allocation) detracted from performance. Fixed income finished largely flat for the period as interest-rate volatility returned in September. Our preference for credit paid off, with high yield faring well.
Our key themes:
U.S. EQUITIES: The current bull market, now in its 10th year, is the longest on record. As of the end of 3Q, consensus full-year 2018 (as compiled by FactSet) was forecast at 20% earnings growth and 7.6% revenue growth. The question of a market peak lingers, but with no significant recession fears in sight, we expect share prices to hold up. Lower corporate taxes should keep helping small caps.
INTERNATIONAL DEVELOPED: Non-U.S. developed markets appeal to us on a relative valuation basis, and we believe their earlier position in the economic cycle offers more upside potential than U.S. shares. In Europe, GDP growth is solid and the early-year constraints caused by capacity issues are getting fixed, while Japan is seeing faster profit growth than other large markets.
U.S. CORPORATE BONDS: We like short-term, investment-grade credit for both its diversification benefits and the yield pick-up compared to Treasuries with similar maturities. Short-term corporate bonds are not as safe as Treasuries, but they offer higher potential returns with only slightly more risk. Even better, they are less sensitive to rising interest rates as the Federal Reserve’s monetary tightening continues.
As always, our suggestion to members is to remain focused on the long-term investment plan that you have put so much thought into. Be diversified and have a balanced portfolio that aligns with your risk tolerance. USAA Managed Portfolio shareholders who may be uneasy about market risk in general or have concerns about current asset-class allocations should consider consulting with a USAA advisor.
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