A Sigh of Relief

Investors entering October on edge, given the month’s historical tendency toward volatility, can now rest easy. Market participants looked past political volatility, including Brexit drama and U.S. impeachment proceedings, and focused on better-than-expected earnings, a U.S.-China trade détente, and certain favorable economic data. As a result, the U.S. stock market hit a new all-time high.

As we enter the final months of 2019, here are five key takeaways to consider:

1

Market Pulse

Revised Expectations

Economists and market strategists alike expressed sighs of relief in October. After months of inversion in the 3-month to 10-year maturity range, the U.S. Treasury curve resumed its positive slope. The front end retreated with Federal Reserve Chairman Jerome Powell’s third “insurance” cut to interest rates, which sent the 3-month Treasury yield down 34 basis points and effectively assuaged recession concerns.

In addition to fading U.S. recession fears, global risk assets were well supported by the combination of some (relatively) positive macroeconomic data and optimism that phase one to the U.S.-China trade détente was near completion. Not surprisingly, equity markets with the highest sensitivity to global trade performed well, with developed ex-U.S. and emerging market equities outperforming U.S. counterparts.

Notably, sectors such as global real estate and global infrastructure, which benefited from the continued search-for-yield in a low yield world, posted positive returns. And we expect them to continue benefiting from this trend, given our forecast for the extraordinary global rate environment to persist.

A Good Month for Risk

Asset Class Returns

Source: Morningstar Direct. All returns shown on a U.S. dollar basis

2

Macro View

The Good Place

U.S. Fed Chairman Powell assessed the U.S. economy as being in a “good place,” and recent data have affirmed that it continues to grow, well supported by healthy consumption. Indeed, consumer spending is offsetting headwinds from weak exports and business investment, and the outlook for U.S. consumers appears bright, with low unemployment, wage growth, an above 8% savings rate, and low debt-to-income ratios supporting future spending.

On the other side of the equation, manufacturing continues to flash red, a common global theme at this point, as the trade slowdown constrains growth, particularly in emerging Asia, where exposure is high, as well as in Europe and China. As such, the news of phase one of the U.S.-China trade détente is welcome. It will likely stem negative growth momentum and could lead to stabilizing growth trends in 2020. We continue to believe that global recession will be avoided, and we may be in the midst of a bottoming process in Europe, where Germany, with a heavy reliance on exports, sits in the vortex of global supply chains.

3

Policy Front

The Tweet Goes On

U.S. President Donald Trump remains very publically displeased with Fed Chair Powell, underwhelmed by the latest and third 25 basis point cut to the Fed funds rate. The latest announcement brought the rate to a range of 1.5% to 1.75% but was perceived as hawkish by many market participants. With the suggestion that the Fed was prepared to hold rates steady for the foreseeable future, market-based expectations for future cuts fell.

Trump is not the first U.S. President to disagree with Fed policy, but he is the first to do so publically, which has raised concerns about the Fed’s independence. While we find these fears unwarranted at this point, we agree with President Trump that the Fed raised rates too quickly and has been too slow to lower the policy rate. The U.S. economy is growing, albeit slowing – but inflation expectations remain well below the 2% policy target. And although consumption remains healthy, we continue to see corporate confidence wane in the face of economic and policy uncertainty. We believe a December rate cut should be on the table and, if not, the market will soon thereafter send Powell another strong message. The market has led the Fed so far in this cycle and will continue to do so.

Where we do agree with Fed Chair Powell, however, is on his assessment of the conditions under which the Fed would consider raising rates: a sustained period of above-target inflation. We just don’t see that happening in the foreseeable future.

4

Fundamental Focus

Beating Low Expectations

We are in the midst of third quarter U.S. earnings season, with roughly 70% of S&P 500 companies having reported thus far. If the name of the game is to lower expectations and chin a low bar, companies have certainly delivered. While analysts at the beginning of the quarter were forecasting a nearly 5% decline in year-over-year earnings, results are coming in better, with companies beating bottom-line estimates by 3.8%. However, we continue to see downward pressure on profit margins, which peaked over a year ago, as companies absorb the impact of higher wages and tariff-related expenses rather than passing them on to consumers.

The combination of higher stock prices and lower earnings has driven valuations higher, with S&P 500 companies trading above the historical average at roughly 17 times next year’s earnings estimate. Outside the U.S., earnings growth remains negative, while valuations hover around historical averages.

In 2020, we expect earnings growth to resume across the globe, with a 6% expected earnings growth rate for U.S., developed ex-US and emerging markets driving mid-single-digit total returns for global equities.

5

Segment Spotlight

The China Syndrome

Investors have largely been focused on the U.S.-China trade war, drawing a reasonable cause and effect relationship between tariffs and slowing global growth – particularly in China. But it is worth remembering that both global trade and economic growth in China have been slowing for quite a while, even before the impact of tariffs. In fact, there was a growth scare in 2015-2016, when many feared an economic hard landing. What is a bit different this time, however, is the policy response to the slowdown. Back in late 2015-early 2016, Chinese authorities aggressively addressed the slowdown with a variety of monetary and fiscal tools, driving significant credit growth in the economy. The tools worked, and the economy stabilized.

Today, the policy responses have been much more measured, as China continues to aim toward rebalancing its economy as a long-term strategic initiative. Pulling pages out of the old playbook is at odds with driving a healthier growth model that is less reliant on leverage and more reliant on domestic consumption. We continue to believe that economic growth in China will slow. Given its large contribution to global growth – 30% of global GDP growth, as measured by the World Bank – this premise is a key driver of our slower global growth outlook over a five-year horizon.

China: A Long-Term Slowing Growth Trend

Growth and Inflation - YOY%

Source: Bloomberg as of September 30, 2019

Disclosures

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

The information contained herein, including any information regarding specific investment products or strategies, is provided for informational and/or illustrative purposes only, and is not intended to be and should not be construed as an offer, solicitation or recommendation with respect to any investment transaction, product or strategy. Past performance is no guarantee of future results. All material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.