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Midyear Outlook: The Journey from the "Unnatural" State

Investor analyzing data

Investors are on a long journey from an “unnatural” market environment to a more normal one. There are concerns that steps taken to normalize financial conditions could lead to instability if they’re not managed properly. We believe the journey will continue for the rest of the year and beyond.

The journey from the “unnatural” state may suggest a space odyssey, an episode of Land of the Lost or some sort of science fiction adventure. However, we believe this term aptly describes the path from the early phase of this business cycle to its latter stages.

Low-cost funding is not new but its reach, duration, and overall impact have been much greater than in the past. This is why we believe its stabilizing effects could become destabilizing if they persist too long. This normalization “journey” is uncharted territory for investors.

Christopher Hyzy Chief Investment Officer

We believe the journey from the unnatural state, and policy normalization, can last longer and be less destabilizing than some of the bears believe. We see 10 main features of it evolving: more normal asset price volatility; a grind higher in rates, but to levels still below historical neutral rates; structural disinflation; patient central banks; a stable dollar; a continued search for yield; fair-to-premium equity valuations; tighter-than-normal credit spreads; continued disruptions from technological innovation, and higher deficits and global debt levels.

We are still equity bulls, but expect lower returns as the cycle matures. We would maintain a high-quality bias across all assets. Diversification across and within asset classes at this stage in the cycle is important as is a balanced mix of passive and active management, in our view.

Macro Environment

  • Despite rising rates in the U.S., the domestic economy is   still getting stronger while the rest of the world, particularly the Eurozone, is starting to fade.
  • One reason the U.S. economy is not showing signs of slowing despite seven quarter-point hikes in the fed funds rate is the expansive fiscal and regulatory policies that   have been implemented to counteract rising rates. This is a major difference between Europe and the U.S.
  • The captains of the Eurozone economy remain adamant in resisting the populist pressure for more pro-growth economic policies. As a result, they are left without any offset to the unwinding of massive monetary accommodation that the U.S. has begun.
  • The U.S. cycle has room to run. While this expansion is old by historical standards and the low unemployment rate is at levels usually only seen at the end of expansions, the overall use of leverage in this cycle remains closer to mid-cycle   than late-cycle levels.
  • U.S. businesses are in part using their bolstered cash flows to repay debt and strengthen balance sheets, but also to invest in equipment. The capital spending (capex) revival will need to boost productivity to keep higher wages from causing inflation and ending the profits expansion and equity bull market. Fortunately, more capital spending is exactly what’s needed to boost productivity.
  • In the absence of signs of inflation overheating, the Federal Reserve (Fed) should be content to let the economy continue growing with low unemployment and inflation near or slightly above the target.
  • In short, the next global recession is more likely to come from abroad than the U.S., unlike the Global Financial Crisis which clearly originated in the U.S. financial system.
  • The sharp change in the relative attractiveness of the U.S. economy has caused the dollar to strengthen. On balance, we have a neutral view of the dollar over the rest of the year.
  • Macro financial conditions are neutral and support our view that equities will grind higher. This is consistent with our view that Fed policy is also near neutral.
  • Rising frictions between the U.S. and its trading partners have been a periodic source of market volatility during the first half of 2018. And following the discord at the June G7 meetings, we fully expect trade tensions to persist into the second half of the year. But we see the tariff measures and counter-measures introduced so far as insufficient to have a major impact on the fundamental outlook for global growth in aggregate.

Equity Markets

  • On balance, the surprise dollar and U.S. economic strength in 2018 has made the U.S. equity market relatively attractive compared to foreign markets.
  • We have recently lowered our tactical allocation to international developed market stocks in favor of U.S. stocks. In terms of real gross domestic product (GDP) growth, the U.S. economy has opened up a considerable lead over its developed market counterparts, such as Europe and Japan, and this growth gap is likely to persist.1 International developed market equities demonstrate some relative value at current levels, however the bullish undertones that supported the group heading into the year have been tempered by a series of disappointing economic reports.
  • We see more positives for U.S. stocks, such as improving corporate profits along with management guidance, better economic growth and business spending, than negatives, such as geopolitical concerns and rising interest rates in the months ahead. We are maintaining our view that stocks will grind higher towards the upper end of our year-end S&P 500 target range of 2800 to 3000.
  • Our expectations for an increase in capex, a gradual rise   in interest rates, the effects of propitious policy and the longer-term transition to the Digital Era keep us favorable on the Information Technology and Financials sectors.
  • The recent volatility in emerging markets (EM) has borne some of the hallmarks of past periods of major stress for  EM assets. Most important in the current environment of rising rates and dollar appreciation is that the fundamentals for most emerging economies have improved significantly from past periods of crisis. Absent a full blown trade war, we expect continued leadership to come from the Asia region, with particular support from its high exposure to consumer-linked sectors.
  • As experienced so far in 2018, past U.S. Congressional mid- term election years have tended to feature policy-related market volatility and large market corrections. Every cycle is of course different, but these historical patterns will be worth keeping in mind ahead of this November’s elections and into 2019.

Fixed Income

  • There are two large risks to fixed income markets for the rest of the year. The first is increasing non-U.S. volatility while the Fed is reducing monetary policy accommodation. The second is a breakdown in the typically inverse correlation between bond and equity prices as rates continue to rise.
  • We note that, thankfully, the Fed has a number of tools to deal with these risks. It has a significantly larger balance sheet than it did pre-crisis, so it could sell Treasurys directly to the market if it wanted to impact the supply / demand balance to assert more effective control over long-term rates.
  • From a strategy perspective, within fixed income we continue to prefer credit over Treasurys, with an emphasis on investment grade corporates—particularly banks—and municipals, although we are neutral on both.
  • We expect yields to remain around current levels and we expect the 10-year Treasury to limit its rise above 3% through year-end. The European yield anchor on the U.S. has continued.
  • Municipal valuations are not too rich right now, in our view. Ten-year muni-to-Treasury ratios are certainly at the low end of the post-crisis range, but compared to pre-crisis  ratio levels they do not appear to be out of line.
  • We expect the strong technical environment for munis to extend at least through the summer, and the strong fundamental environment to extend through this phase of the business cycle. However, we remain cautious on state and local governments with large and growing unfunded pension liabilities and/or structurally unbalanced budgets (such as Illinois, New Jersey and Connecticut), and certain high-yield sectors like tobacco bonds that could underperform when the credit cycle finally does turn. Therefore we do not recommend that conservative investors venture down the credit spectrum in search of higher yield.

Alternative Investments (AI)

  • Periods of heightened volatility have historically coincided with strong AI performance when compared to traditional investments (see the February and March equity drawdowns). With markets normalizing after an extraordinary nine years for both stocks and bonds, we expect that alternative investments will become increasingly important to multi-asset portfolios and recommend  investors look to the asset class as a way of managing risk and return going forward.
  • For qualified investors, we see opportunities in exploring additional allocations to equity long/short, equity market neutral and merger arbitrage strategies as part of a    broader diversified hedge fund portfolio. As we have written previously, the current environment has continued to reward both passive and active  strategies.
  • For qualified investors looking to build out their strategic allocation to private equity, we see compelling opportunity in strategies that can complement traditional buyout and venture allocations, such as private credit and special situations.


  • We are still equity bulls, but expect lower returns as the cycle matures.
  • Continued tariff and trade disputes plus concerns over Italy’s debt “dance” and emerging market pressures are dimming the positive views of the broader global economy and profits.
  • The U.S. is, to date, breaking free from the rest of the world in terms of growth, financial conditions and portfolio   flows.
  • Capital expenditures and a strong U.S. consumer are the engines powering the U.S. economy relative to Europe.
  • We believe the mid-to-late-cycle environment has further room to run, but we will need earnings to do the heavy lifting between now and year-end for equities to break out above their trading ranges.
  • A slow rise in interest rates, limited inflationary pressures, stability in the U.S. dollar and economic growth momentum should continue into 2019. Our upper-end equilibrium target on the S&P 500 remains at   3000.
  • Yields should remain around current levels and we expect the 10-year Treasury to limit its rise above 3% through year end. The European yield anchor on U.S. rates continues.
  • Maintain a positive view on equities and a negative view on fixed income, with an emphasis on the U.S. relative to international developed markets.
  • Maintain a high-quality bias across all assets. Diversification across and within asset classes at this stage in the cycle is important, as is a balanced mix of passive and active management.

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