After a year when markets did nothing but go up steadily, 2018 got off to a rough start. Interest rates and the fear of inflation were on everybody’s mind, and as the quarter progressed, we saw both the S&P and rates roll over a little bit. This is against a backdrop of economic growth around the world that’s holding its own.
2Q:2018 Capital Markets Outlook Presentation
Chris Marx—Senior Portfolio Manager
Well, that was certainly different: After a year in 2017 when markets did nothing but go up in a smooth manner, we were greeted in 2018 with a bit of a rude awakening. We saw markets sell off and volatility return, and indeed the VIX spiked quite sharply during the course of the quarter. Interest rates and the fear of inflation were on everybody’s mind, and as the quarter progressed, we saw both the S&P and rates roll over a little bit.
This is against a backdrop, however, of economic growth around the world that’s pretty strong. PMIs are still well into expansionary territory. And there are some signs of cracking there, we need to be a little bit careful. But generally the economic outlook is pretty good. So the central bankers and the fed are faced with the task this year of raising rates to start to normalize that picture, and we expect rates to go up three times during the course of the year.
The market however, has not quite caught up to this, and we think there might be a little bit of volatility on the way as they start to adjust to that. The real conundrum they and other central bankers face, however, is to keep us in the territory of expansionary growth, without too much inflation, and not tip us over into a range where inflation starts to spark up and they’re forced to act more aggressively, and start to bring rates up more quickly.
The equity markets were a great place to be over the last few years with extremely attractive returns. However, most of this came on the back of PE expansion and margin expansion. Going forward, we expect we’re going to need more in the revenue growth space in order to drive returns going forward. And you have to be selective in looking for that. Actually, if you just look at the S&P 500, only about a third of companies are able to grow at 10% or more, and you need to be selective picking those companies and not just blanket buying the index.
Also, within sectors you need to be thoughtful. Conditions are improving for active stock pickers. Dispersion is coming up. Correlations are coming down. But you’ve got to go out there and find those parts of the market that are most attractive. The defensive areas like utilities and REITs, even after recent underperformance remain pretty expensive, areas like consumer discretionary more attractive. And even in an area like tech, which on average is pretty expensive, there are pockets that are quite attractive that our portfolio managers are finding.
In the fixed income markets, rising rates is the order of the day. But we don’t need to be worried about this too much. The chances of a very sharp rise in rates are quite low historically. And even if rates go up in a normal manner, that’s general pretty good for bond markets as well. We do see an initial sell-off in the first six months, but over time, that actually gets reflected in good performance. And in the credit markets it’s even better because those higher rates are typically associated with better economic conditions.
Within credit, we’re finding opportunities for the first time in a while in energy, where a combination of higher oil prices and better balance sheets are improving the credit conditions there. And also in European financials, where a lot of hard work to reduce leverage on the balance sheets and improve those core tier one ratios is creating some attractive opportunities for our bond portfolio managers.
Around the world outside the developed markets, we do see good opportunity in Latin America in select economies that are showing signs of fundamental improvement, and in Asia you need to be a little bit careful around some markets where the rates are not really high enough to compensate you for some of the risk that’s out there.
So in aggregate, our advice remains fairly stable here: You want to be balanced, have those assets that are in your portfolio to grow your wealth over time. But balance them off against those that will protect you in the inevitable downturns that will come along the way. Be global in your outlook to find the best opportunities and be selective. Look for those companies and credits that give you the best risk adjusted return going forward. Thanks very much, and we look forward to speaking with you again next quarter.