Tempering our positive outlook, economic momentum in Europe has clearly decelerated, based on our analysis of a broad range of macroeconomic indicators. The Italian economy is hovering near recession, and the ECB recently slashed its 2019 forecast for full-year economic growth across the euro-area from 1.6 percent to 1.1 percent. A large portion of the 12 percent growth expectation for corporate profits in 2019 is concentrated in the fourth quarter and, given the “wedge” between those optimistic estimates and continued weakness in economic data, we view those estimates with some caution. Additionally, while the price performance of the MSCI EAFE Index has been positive in 2019 and some technical indicators have improved, the index has not broken decisively through and held above the 200-day moving average, which for us represents a key technical resistance line. Finally, valuation of foreign developed equities relative to the S&P 500 remains extremely low, reflecting stronger investor confidence in the U.S. economic and corporate profit outlook.
Balancing a strong profit growth outlook, supportive dividend yield and modest valuation against continued softening macroeconomic data, worsening economic outlook and technical resistance, we maintain a neutral outlook on foreign developed equities in 2019.
Similarly, we continue to view opportunities and risks in emerging markets as also fairly balanced as we look to 2019 and retain our neutral stance.
Emerging market equities as measured by the MSCI Emerging Market Index have also recovered somewhat from last year’s decline, with prices rising nearly 9 percent so far in 2019. A primary catalyst for the recovery in emerging market stock prices was the pivot in Fed interest rate policy in late 2018 to a more patient outlook for potential U.S. interest rate increases in 2019.
An environment of rising U.S. interest rates, combined with an appreciating U.S. dollar relative to other currencies, creates one of the most challenging macro environments for emerging market countries.
Borrowing costs for emerging market countries and companies increase, and rising U.S. interest rates increase the competitiveness of U.S. Treasury yields to other, riskier investments, such as emerging markets equities. Thus, the Fed pivot to a more patient forward interest rate outlook provides relief from the rising U.S. interest rate environment of 2018, while the dividend yield on emerging market equities once again offers a competitive yield relative to 2-year U.S. Treasury yields.
Regarding fundamentals, expectations for corporate profit growth in emerging markets have been revised downward to a modest 3 percent for the full calendar year in 2019. Similar to other foreign equities, a large portion of the earnings growth in 2019 remains concentrated in the fourth quarter of the year, which again we view with some caution given uncertainty in the global economy and key policy outcomes. Price technicals have improved from last year, with the emerging market index trading above key moving averages and forming a pattern of higher lows and higher highs. The combination of rising equity prices and downward revisions to expected profit growth have resulted in the forward-looking valuation of emerging market equities returning to levels above long-term historical averages, indicative of a renewed investor optimism, and on a rising trend.
China’s policymakers continue to enact a variety of measures to stimulate the economy, including monetary easing, middle-class tax cuts and regulatory reforms, which provide some fundamental support for emerging markets. However, the key policy outcome for emerging markets in 2019 remains the ongoing trade negotiations between the United States and China, the world’s two largest economies. There remains little clarity regarding ongoing negotiations, and we view headline related market volatility as “noise” with little informational content, what we refer to as an “edgeless phenomenon.”
Thus, we view increased investor optimism in the form of higher-than-average equity valuation with some caution, given the uncertainty in trade negotiation outcomes.
Taking into consideration improved price momentum, near-term relief from U.S. interest rate increases, Chinese policy stimulus and renewed investor optimism with uncertainty regarding China/U.S. trade outcomes, muted corporate profit growth expectations, and above average valuation, we view risks and opportunities as balanced and maintain our neutral outlook for emerging market equities for the remainder of 2019.
Fixed income markets
We continue to anticipate modestly higher bond yields as the Fed remains patient and financial conditions recover, though a slowing U.S. economy remains a risk.
Bond market returns have been strong in early 2019 after much volatility in 2018. Yields remain low by historical standards, despite four rate hikes by the Fed last year. Economic uncertainty prompted the Fed to pause rate hikes and communicate patience. It is increasingly difficult to envision a rate hike this year given recent Fed communication, weakness in Europe and China, and the relatively flat yield curve. Catalysts for higher longer-term rates include stable to rising core inflation, increased U.S. Treasury debt issuance due to a rising fiscal deficit, and weak demand for U.S. Treasuries by foreign investors. We advocate for shorter than normal bond portfolio maturities due to the minimal compensation for extending maturities, along with our expectation for higher rates (bond prices move inversely to yields). We continue to emphasize that high quality bonds should form the primary share of fixed income allocations to provide adequate diversification.
Credit valuations have recovered, and now appear reasonable to slightly expensive.
Investment-grade credit valuations are near long-term normal levels after being expensive for most of 2018. High yield valuations are bordering on expensive after recent volatility and remain susceptible to repricing should the economic outlook darken. Trailing corporate fundamental metrics remain mixed too strong and domestic economic indicators have only moderated slightly. Corporate indebtedness remains high but is falling gradually as many companies prioritize debt reduction. We believe normal allocations to investment grade credit investments are appropriate and recommend a balanced approach relative to U.S. Treasuries. We remain neutral on high yield bonds, with a downside bias. Overall allocations to riskier fixed income sectors, such as high yield corporate and emerging market bonds, should be modest, with active management a critical factor. Deteriorating issuance quality in the bank loan segment of the high yield market warrants caution.
Global central bank policy is likely on hold for now, with a chance (albeit falling) the United States could tighten further before the end of the cycle.
There is increasing uncertainty around the direction of the next Fed rate move. While markets underappreciate the likelihood of a hike, there is rising downside risk as the yield curve nears inversion and after a string of weak economic data from the United States and abroad. The Fed has communicated clearly that they are on hold for now. They will likely err on the side of dovishness in the second quarter. Markets price a reasonable chance of a rate cut this year and more than one cut by the end of next year. This pessimism implies a weaker domestic economy than we foresee, although we continue to closely monitor trends in the data and maintain meaningful high-quality bond exposure to act as a portfolio diversifier.
Municipal debt valuations are elevated, though limited supply and robust demand should remain as tailwinds.
Municipal bond (muni) valuations are expensive by historical comparisons, particularly at shorter maturities. Longer maturities appear more reasonable, particularly when considering the persistently strong demand from investors seeking scarce tax havens. Limited supply continues to support prices and munis continue to provide value for taxable investors in higher tax brackets. Longer term, legacy liabilities (such as underfunded pensions, increased healthcare spending and deferred maintenance on infrastructure) may pose risks to certain segments of the municipal bond market.
Emerging market debt has become somewhat expensive and economic data has deteriorated.
Emerging market debt has rebounded in early 2019 after a tumultuous 2018. Spreads are now expensive once again and economic data in emerging economies continues to weaken. The Fed’s pause in rate hikes is constructive for emerging market economies, which rely heavily on U.S. dollar-denominated funding. However, it is unclear if domestic policy rates are already high enough to restrict growth in more vulnerable emerging economies. We remain neutral on emerging market debt, with a negative bias based on the expensive valuations and weakening economic momentum, which is being balanced by a more patient Fed. We continue to recommend active management. Incurring emerging market foreign currency risk has often resulted in uncompensated price volatility. As such, we advocate for U.S. dollar-denominated bonds within the emerging market bond category.
Real assets markets
Interest rate decline provides breathing room for real estate investments, though income growth is slowing.
Prices for centrally located, Class A properties have been relatively flat for two years now. Although vacancies have declined close to record lows, net operating income (NOI) growth has been slowing. We expect the deceleration in NOI growth to continue due to supply growth and the late stage of the business cycle. Additionally, NOI relative to property values is near all-time low levels. This is another way of saying that the price-to-earnings ratio on real estate is near an all-time high. However, the decline in interest rates has created some breathing room between commercial mortgage interest rates and the earnings yield on Class A property. This eases pressure on prices. If interest rates remain in check, property can generate attractive returns.
While many of our property market indicators are urging caution, we believe investors can still earn the dividend yield of real estate investments. Furthermore, property investments do offer a compelling risk/reward tradeoff relative to other asset classes. Therefore, we remain tactically cautious acknowledging that interest rate movements will play an outsized role in determining the direction of property prices from here.
Fed dovishness, lower interest rates helping commodities.
Commodity markets from industrial metals to oil have rallied back strongly to start 2019 as Fed dovishness and lower interest rates have brought a bid to the commodities market. A more conciliatory tone between the United States and China on trade has also helped. However, better economic growth will ultimately need to present itself if prices are to move higher. The reason being that commodities are fairly well supplied across all complexes and so growth is necessary to prevent supply gluts. On the supply side of the oil market, U.S. shale production has broken out to new record highs since it appears some bottlenecks to production, especially in the Permian basin, have been resolved. Domestic inventories are growing and are now above five-year averages. For prices to hold up, the OPEC agreement to curtail supply may need to be extended if economic growth fails to increase.
The midstream infrastructure space has been a huge beneficiary of Fed dovishness and the increase in oil prices. From a fundamental perspective, the midstream industry is improving. Earnings (before certain expenses) are growing at a high rate and conversion of master limited partnership legal structures to C-type corporations have greatly improved corporate governance. With valuation metrics lower than 95 percent of historical ratios relative to itself and relative to the broader market, we believe the midstream space looks cheap. Based on our analysis, expected annualized forward returns are likely in the high single-digits over the next business cycle.