The Road Ahead | Third Quarter 2018

October 22, 2018 by Peter Sorrentino

Equity Market Review
The third quarter marked a change in the underlying leadership of the market advance. After furtive attempts at rotation towards value in the large and small cap space in the market overall, over the summer, we experienced a reassertion of large cap growth leadership. The difference being that, rather than companies in technology and consumer discretion, this most recent leg of the advance was led by shares of healthcare and consumer staples. These changes reflect what we are experiencing in the domestic economy, as it not only continued to expand, but accelerate, during the third quarter. This acceleration is accompanied by a slight uptick in the overall rate of inflation. Though not a major resurgence by any measure, it is enough to benefit healthcare and consumer staples whose pricing power relies heavily upon inflation. As illustrated in Exhibit 1, this has hardly been a homogenous rally for stocks, and these performance differentials have reached inflection points sparked not only by the extreme nature, but by an evolving economy. Because of this rotation, large cap stocks were once more the performance leaders in the third quarter, due in large measure to their inherent liquidity, which facilitates realignment. While, on a year-to-date basis, small cap stocks retain the top return slot, shares in the large cap segment closed the gap.

The results for global equities during the quarter reflect many of the same dynamics with the large developed markets posting roughly the same gain as that of the domestic market. The smaller emerging markets, though positive, trailed considerably for the quarter, and there was a distinct geographic bias. Asian emerging markets posted declines, while those in Europe were positive. Some of this is attributable to the impact of the strength in the value of the dollar, but a considerably larger influence on the Asian emerging markets was the impact of China’s efforts to offset the impact of trade tariffs on exports by weakening its currency.

Exhibit 1 (Source: Crandall, Pierce & Company)

Fixed Income Market Review

The interest rate climate during the third quarter was favorable for bond holders, as the term structure continued to flatten from the short end with the Federal Reserve still on track to lift short-term interest rates, and longer-dated obligations continued to enjoy strong demand. The lingering influence of the Italian market scare from the second quarter held U.S. rates in check, at below 3%, for much of the third quarter, as foreign investors hesitate to leave the perceived safety of U.S. Treasury obligations. Even with this flow of funds, you can see in Exhibit 2 that rates finished the quarter at the upper end of their twelve-month band. Bond investors also have the strength of the equity market to thank for the continued demand for longer-dated obligations. Many institutional investors have been forced to rebalance their portfolios (because of the continued rise in equities) and add to their bond holdings, thus adding to the demand. This last part has largely masked what has been a noticeable trend of falling demand for U.S. Treasury debt among foreign central banks. The volume of buying from the central banks of several developed countries has been falling recently, most notably China and Russia, but Europe and Japan have throttled back as well. The most recent Treasury auction had the lowest bid-to-cover ratio since 2008. How much longer the current rate dynamic will hold in the face of rising deficits remains to be seen, but it appears clear the interest rates will continue to gradually rise. In Exhibit 2, you can see the compressed nature of the term structure of interest rates with the yield on thirty-year Treasury bonds offering only 1% more than available on three-month Treasury Bills. This compression represents a duration risk to holders of long-dated debt obligations, one we recommend addressing by moving to shorter maturity obligations. Paramount among our concerns currently is the corporate bond market and its declining credit quality. This type of debt, particularly high yield corporates, has enjoyed strong demand as investors search for yield. Now that rates overall are rising, the growing concern is the demand that supports this market will evaporate at a time when these obligations will need to be rolled over or restructured.

Exhibit 2 (Source: Crandall, Pierce & Company)

Other Asset Classes

The impact of China’s currency operations was also evident in the pricing activity for commodities during the quarter, as most experienced modest price declines in U.S. dollar terms but rose when priced in other currencies due to the impact of the Chinese currency intervention. Securitized real estate (REITs) posted gains during the quarter, as property values continue to rise, while yields offered elsewhere have yet to reach a level that would offer an attractive alternative to income-producing real estate. Precious metal prices fell during the quarter, thanks to benign inflation measures and a dearth of compelling crises – the two general catalysts for investor migration to these traditional safe-haven assets. The derivative markets, options and futures primarily, have gotten a boost from rising short-term interest rates, but continue to suffer from a dearth of volatility. There was a brief period in February where it did spike, and unlike last year, it has remained at a slightly elevated level, but as you can see in Exhibit 3, it is still at a level indicative of complacency.

Exhibit 3 (Source: Bloomberg)

Outlook

The strength of the economy and the improving trend in corporate profit margins serve as powerful backstops to the equity market. Our bias continues to be shaped by a gradually-rising interest rate environment and a late-cycle economy where business spending on productivity enhancement rather than financial engineering takes center stage. We hold that the changes in the tax code, coupled with continued uncertainties regarding global trade, favor smaller, principally domestically-focused companies over larger multinationals. Our forecast calls for slightly slower growth in 2019, and that, along with rising rates, leads us to favor stocks with stronger value traits over those whose growth expectations will come under pressure in the immediate future. Our fixed income outlook continues to be one of reducing risk wherever possible, from shortening average maturities to reducing exposure to credit risk. Conditions in the global debt market show signs of unsustainable compression, and like any spring that has been wound too tightly, abrupt catastrophic failure is a very real threat.

For a PDF version of this publication, click here: TheRoadAhead_3Q2018


NOTE: IMPORTANT INFORMATION
Source: Unless otherwise noted, all statistics herein obtained from Bloomberg.

This is not a complete analysis of every material fact regarding any company, industry or security. The information and materials herein has been obtained from sources we consider to be reliable but Comerica Wealth Management does not warrant, or guarantee, its completeness or accuracy. Materials prepared by Comerica Wealth Management personnel are based on public information. Facts and views presented in this material have not been reviewed by, and may not reflect information known to, professionals in other business areas of Comerica Wealth Management, including investment banking personnel.

The views expressed are those of the author at the time of writing and are subject to change without notice. We do not assume any liability for losses that may result from the reliance by any person upon any such information or opinions. This material has been distributed for general educational/informational purposes only and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product, or as personalized investment advice.

Past performance is not indicative of future results. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The investments and strategies discussed herein may not be suitable for all clients. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations.

Comerica Wealth Management consists of various divisions and affiliates of Comerica Bank, including Comerica Bank & Trust, National Association; World Asset Management, Inc.; Comerica Securities, Inc.; and Comerica Insurance Services, Inc. and its affiliated insurance agencies. World Asset Management, Inc. and Comerica Securities, Inc. are federally registered investment advisors. Registrations do not imply a certain level of skill or training. Non-deposit Investment products offered by Comerica and its affiliates are not insured by the FDIC, are not deposits or other obligations of or guaranteed by Comerica Bank or any of its affiliates, and are subject to investment risks, including possible loss of the principal invested. Comerica Bank and its affiliates do not provide tax or legal advice. Please consult with your tax and legal advisors regarding your specific situation.

The S&P 500®Index is a product of S&P Dow Jones Indices LLC or its affiliates (“SPDJI”) and Standard & Poor’s Financial Services LLC, and has been licensed for use by Comerica Bank, on behalf of itself and its Affiliates. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); and these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Comerica Bank, on behalf of itself and its Affiliates. S&P Trademarks are trademarks of S&P and have been licensed for use by SPDJI and Comerica Bank, on behalf of itself and its Affiliates.
“Russell 2000® Index” is a trademark of Russell Investments, licensed for use by Comerica Bank and World Asset Management, Inc. The source of all returns is Russell Investments. Further redistribution of information is strictly prohibited.
MSCI EAFE® is a trade mark of Morgan Stanley Capital International, Inc. (“MSCI”).

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The Road Ahead | Second Quarter 2018

July 23, 2018 by Peter Sorrentino

Second Quarter 2018 Recap
If the hallmark for the first quarter of 2018 was rising interest rates, the second quarter can claim global politics as its theme. For as much of a concern as the course of interest rates was, it faded quickly, thanks to the escalating war of words on trade that took center stage. A closer look at the complexion of the stock market leadership coming out of the 2016 trough explains the threat. The narrow group of market leaders share a common characteristic – they enjoy about a 2% faster growth rate than the balance of the market, the bulk of that coming from offshore. Threats to that, real or simply perceived, are quickly being telegraphed back through to share prices. So, for those leading companies in the technology and consumer groups that managed to escape the self-inflicted wounds of the first quarter, covert data collection and privacy breaches, the prospect of diminished foreign opportunity is adversely impacting share prices. The dispersion of performance in the second quarter also stood in stark contrast to the homogeneity of the market in 2017. While the once laggard energy sector posted the strongest gains for the quarter, up 13.5%, both the industrial and finance sectors lost slightly over 3%. The revival of price volatility was again evident, not only in stock prices, but in commodity prices and interest rates as well. Copper fell 8%, while in the agricultural sector, corn and soybeans fell 14% and 19%, respectively. As expressed in Exhibit 1, interest rates in the U.S. did rise over the quarter, but ended the quarter off the May 17 highs, as political uncertainty in Europe following elections in Italy and continued Brexit confusion combined with trade anxieties to spark a migration to the comparative safety of U.S. Treasuries.

Exhibit 1 (Source: Bloomberg)

This easing back of interest rates took place across the term spectrum. The result for stock prices was a dramatic turnaround of investors’ appetite for bond surrogates, such as REIT’s and utilities, which after having suffered declines in the first quarter, posted gains of 6.13% and 3.74%, respectively, in the closing weeks of the second quarter. The move in interest rates had broad implications for the overall market, as it reversed the value bias witnessed in the first quarter firmly back in favor of growth, as the Russell 1000 Growth Index gained 5.8%, versus the Russell 1000 Value Index gain of only 1.2%. What the rise in rates did not affect is the performance advantage small capitalization stocks have been enjoying. Both the S&P 600 Index (+8.8%) and the Russell 2000® Index (+7.8%) bested the large cap S&P 500® Index (+3.4%) and Russell 1000 Index (+3.6%). This rotation is typically seen late in an economic cycle, as spending shifts from consumers to businesses, setting off a period of accelerating revenue and profit growth for smaller companies. Adding fuel to this episode are the recently-passed tax reform and the concerns over foreign trade and currency fluctuations – issues smaller companies are typically less exposed to relative to multinationals. Among the casualties of the second quarter were the foreign markets, particularly the emerging markets with both currency and investor sentiment quickly turning against them. In Exhibit 2, you can see that the developed markets of the MSCI EAFE® Index fell roughly in line with the change in currency valuation. The shares of the MSCI Emerging Market Index experienced absolute price declines as capital flight drove those markets downward.

Exhibit 2 (Source: Bloomberg)


Third Quarter 2018 Outlook
Threats to U.S. equities are rising input cost for labor and commodities (the impact of gasoline prices on consumer spending), an abrupt leadership rotation sending the overall market into a correction. But as was the case in 1987, solid economic fundaments should prevail. The wild card for the back half of 2018 will be how the market responds to the growing size of U.S. Treasury auctions, now slated to increase at a 15% rate in the back half of 2018. A ‘Buyers Strike’ by global central bankers, or simply a loss of appetite, could serve to push rates higher. Threats to U.S. corporate bonds are a cascade of defaults within the corporate bond market (think retailers and private equity refinancing).

Our outlook for both the economy and the market remains unchanged. We view this as a late cycle expansion characterized by increased business spending to improve efficiency and enhance profitability. The principal beneficiaries are smaller, domestically-focused enterprises with limited exposure to the global uncertainties of trade tariffs and currency fluctuations. The duration of this economic recovery has reached the point where it is likely to be reinforced by a modest replacement cycle for passenger and commercial vehicles of all types. Infrastructure replacement, beyond just bridges and roads, will experience increased spending for example as pipelines replace rail tankers for moving fuel and autonomous vehicles rescue us from a national driver shortage.

Topline revenue growth for the S&P 500® Index is 7.2% for 2018, and 3.1% for 2019, driven by accelerating growth abroad and increased domestic CAPEX. Profit margins should improve approximately 12% by the end of 2018, resulting in about $163.23 ep and about 174.70 for 2019 for the S&P 500 Index, a 7% year-over-year gain. The S&P 600 index is forecast to earn roughly $52.50 in eps for 2018, and roughly $58.90 for 2019, a 12% year-over-year gain. We anticipate mid-single digit returns for the large cap segment of the market, with the small cap segment generating mid-teen returns for the year. The bond market, and municipal bonds in particular, have been resilient in the face of shifting interest rate trends and rising concerns regarding demand in the face of rising supply. It bears pointing out that the municipal bond market not only absorbed a record new issuance, it has also navigated the Puerto Rico defaults without incident. And while clearly not out of the woods by any means, most state budgets have been approved, and the post-retirement funding gaps, while not closed, are at least now acknowledged. In our first quarter commentary, we pointed out the interest rate compression across the credit quality spectrum, warning that investors were not being adequately compensated for the inherent risk of lesser credits. We continue to recommend investors gravitate towards higher quality credits, as those interest rate differentials have begun the process of return to their historic levels. As evidenced in Exhibit 3, while the yield on U.S. Treasury debt did climb slightly during the quarter, the rise in rates at the bottom of the investment grade debt was notably larger.

Exhibit 3 (Source: Bloomberg)

Our inward emphasis is not to imply that we eschew investment opportunities elsewhere around the globe, but quite the contrary. In the developed markets of Western Europe and Asia, we see accelerating economic growth as an opportunity for enhancing investment returns. Emerging markets, too, offer attractive risk and reward propositions for investors with valuations well below those found in the U.S. and those of the developed foreign markets. But as the past quarter has demonstrated, investing in this asset class is not without the perils of currency, capital flows and politics that serve to amplify volatility.

For a PDF version of this publication, click here: TheRoadAhead_2Q2018.

 

NOTE: IMPORTANT INFORMATION
Source: Unless otherwise noted, all statistics herein obtained from Bloomberg.

This is not a complete analysis of every material fact regarding any company, industry or security. The information and materials herein has been obtained from sources we consider to be reliable but Comerica Wealth Management does not warrant, or guarantee, its completeness or accuracy. Materials prepared by Comerica Wealth Management personnel are based on public information. Facts and views presented in this material have not been reviewed by, and may not reflect information known to, professionals in other business areas of Comerica Wealth Management, including investment banking personnel.

The views expressed are those of the author at the time of writing and are subject to change without notice. We do not assume any liability for losses that may result from the reliance by any person upon any such information or opinions. This material has been distributed for general educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product, or as personalized investment advice.

Past performance is not indicative of future results. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The investments and strategies discussed herein may not be suitable for all clients. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations.

Comerica Wealth Management consists of various divisions and affiliates of Comerica Bank, including Comerica Bank & Trust, National Association; World Asset Management, Inc.; Comerica Securities, Inc.; and Comerica Insurance Services, Inc. and its affiliated insurance agencies. World Asset Management, Inc. and Comerica Securities, Inc. are federally registered investment advisors. Registrations do not imply a certain level of skill or training. Non-deposit Investment products offered by Comerica and its affiliates are not insured by the FDIC, are not deposits or other obligations of or guaranteed by Comerica Bank or any of its affiliates, and are subject to investment risks, including possible loss of the principal invested. Comerica Bank and its affiliates do not provide tax or legal advice. Please consult with your tax and legal advisors regarding your specific situation.

The S&P 500®Index is a product of S&P Dow Jones Indices LLC or its affiliates (“SPDJI”) and Standard & Poor’s Financial Services LLC, and has been licensed for use by Comerica Bank, on behalf of itself and its Affiliates. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); and these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Comerica Bank, on behalf of itself and its Affiliates. S&P Trademarks are trademarks of S&P and have been licensed for use by SPDJI and Comerica Bank, on behalf of itself and its Affiliates.

“Russell 2000® Index” is a trademark of Russell Investments, licensed for use by Comerica Bank and World Asset Management, Inc. The source of all returns is Russell Investments. Further redistribution of information is strictly prohibited.

MSCI EAFE® is a trade mark of Morgan Stanley Capital International, Inc. (“MSCI”).
 

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The Road Ahead | First Quarter 2018

April 13, 2018 by Peter Sorrentino

First Quarter 2018 Recap
The first quarter of 2018 witnessed a return to normalcy, as the major indices posted the first decline in ten quarters and the lingering effects of monetary intervention faded. Investors were forced to cope with the uncertainties of trade tariffs and confusing economic data without the backdrop of inflation-adjusted negative short-term interest rates. The modest declines posted by the major indices is deceiving, for underneath the surface, returns were radically different – not merely among economic sectors, but by size and location as well. In a major change, technology shares were not collectively the best performers, as that distinction belongs to shares within the consumer discretion sector, which generated a positive 2.6% return. That stands in stark contrast to the largest decline of the quarter among shares of the consumer staples, which collectively surrendered 7.5%. The former is enjoying the prospect of better sales owing to strong wage and employment growth, while the latter is suffering the prospect of limited pricing power and relentless competitive pressures as automation rolls into the industry.

During the post-crisis recovery, investors have exhibited a habit of buying any dips in the market with the backdrop of easy monetary policy. It made sense as a means of escaping the financial repression being imposed on what investors typically view as safe assets, money market and passbook accounts, along with Treasury Bills and certificates of deposit. All of which had offered what were negative returns on investment when adjusted for inflation. As the central banks have wound down their extraordinary measures, short-term interest rates have responded as evidenced in Exhibit 1. Since the Federal Reserve began raising short-term interest rates just over a year ago, the change in rates has been most dramatic for shorter maturity obligations – now triple what they were 12 months earlier. Therefore, investors are no longer compelled to buy the dips, as there are now legitimate investment alternatives to risk assets.

(Exhibit 1) Source: Bloomberg

The bond market struggled as well, where the continued rise in short-term interest rates had little impact on longer maturity interest rates. Inflation, despite rising wage and commodity prices, continues to be offset by the deflationary impact of technological innovation increasing efficiency and, thereby, creating downward price pressure. In the end, markets loathe uncertainty, and in the opening months of 2018, uncertainty was the order of the day with new leadership at the Federal Reserve Bank, the prospect of trade tariffs, and a political impasse. But this is how the world is supposed to be – not the numbed and coddled environment that was the hallmark of the post-crisis period. On a positive note however, it must be noted that following the passage of the tax legislation, investors stepped up and absorbed one of the largest new-issue calendars the municipal bond market has ever experienced. Even after the recent changes to individual income tax rate, municipals (Exhibit 2) may offer a meaningful return advantage to retail investors.

(Exhibit 2) Source: Bloomberg

 

2018 Outlook
Our outlook for both the economy and the market remains unchanged. We view this as a late cycle expansion characterized by increased business spending to improve efficiency and enhance profitability. The principal beneficiaries are smaller, domestically-focused enterprises with limited exposure to the global uncertainties of trade tariffs and currency fluctuations. We experienced the investors embracing this viewpoint during the first quarter, in what looked like a tug-of-war in the performance of the shares of large versus small company stocks. That interplay can easily be seen in the price graph below for the S&P 100 Index, the largest of the large, and the S&P 600® Index, the smallest of the 1500 S&P stock universe.

(Exhibit 3) Source: Bloomberg

The duration of this economic recovery has reached the point where it is likely to be reinforced by a modest replacement cycle for passenger and commercial vehicles of all types. Infrastructure replacement, beyond just bridges and roads, is expected to experience increased spending, for example, as pipelines replace rail tankers for moving fuel, and autonomous vehicles rescue us from a national driver shortage.

Our inward emphasis is not to imply that we eschew investment opportunities elsewhere around the globe, but quite the contrary. In the developed markets of Western Europe and Asia, we see accelerating economic growth as an opportunity for enhancing investment returns. Emerging markets, too, offer attractive risk and reward propositions for investors with valuations that have only just broken levels achieved prior to the global financial crisis. As illustrated below, the U.S. equity market capitalization is currently well beyond the U.S. portion of global GDP. This does not portend collapse of U.S. equity prices, but rather that other markets are likely undervalued and, as such, present attractive return opportunities.

(Exhibit 4) Source: Crandall, Pierce & Company

 

(Exhibit 5) Source: Crandall, Pierce & Company

Commodity prices have enjoyed a significant advance in recent months, and considering uncertainties regarding trade will likely experience significant volatility for the immediate future. In light of considerable idle capacity among industrial metals and miners, any sustained price advance will be countered by a return of production to the marketplace. As such, we see limited upside potential in this category. The trend towards higher interest rates will be a gradual, halting one as the countervailing inflationary and deflationary forces ebb and flow. Demand for income assets has not gone away and, with an aging population, will likely persist well into the future. The magnitude of that demand will be tested later in the second half of this year as the U.S. Treasury comes to market with a record volume of new issuance.

The return of price volatility enables us to put idle funds to work at more attractive valuations – an opportunity ten quarters in the making. While painful by any measure, the ongoing correction is very healthy for the market. Corrections, like recessions, are a way of dealing with excess and imbalances that have been building. Were this not to have occurred, the market would continue to build up distortions that, as we witnessed in 1987 and 1999, end in what can best be termed as unfavorable events.

 

For a PDF version of this publication, click here: TheRoadAhead_1Q2018

 

Peter Sorrentino, Chief Investment Officer, Comerica Asset Management Group
1717 Main Street, 3rd Floor, Dallas, Texas 75201 / 214-462-6690


NOTE: IMPORTANT INFORMATION
Source: Unless otherwise noted, all statistics herein obtained from Bloomberg.

This is not a complete analysis of every material fact regarding any company, industry or security. The information and materials herein has been obtained from sources we consider to be reliable but Comerica Wealth Management does not warrant, or guarantee, its completeness or accuracy. Materials prepared by Comerica Wealth Management personnel are based on public information. Facts and views presented in this material have not been reviewed by, and may not reflect information known to, professionals in other business areas of Comerica Wealth Management, including investment banking personnel.

The views expressed are those of the author at the time of writing and are subject to change without notice. We do not assume any liability for losses that may result from the reliance by any person upon any such information or opinions. This material has been distributed for general educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product, or as personalized investment advice.

Past performance is not indicative of future results. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The investments and strategies discussed herein may not be suitable for all clients. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations.

Comerica Wealth Management consists of various divisions and affiliates of Comerica Bank, including Comerica Bank & Trust, National Association; World Asset Management, Inc.; Comerica Securities, Inc.; and Comerica Insurance Services, Inc. and its affiliated insurance agencies. World Asset Management, Inc. and Comerica Securities, Inc. are federally registered investment advisors. Registrations do not imply a certain level of skill or training. Non-deposit Investment products offered by Comerica and its affiliates are not insured by the FDIC, are not deposits or other obligations of or guaranteed by Comerica Bank or any of its affiliates, and are subject to investment risks, including possible loss of the principal invested. Comerica Bank and its affiliates do not provide tax or legal advice. Please consult with your tax and legal advisors regarding your specific situation.

The S&P 500®Index is a product of S&P Dow Jones Indices LLC or its affiliates (“SPDJI”) and Standard & Poor’s Financial Services LLC, and has been licensed for use by Comerica Bank, on behalf of itself and its Affiliates. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); and these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Comerica Bank, on behalf of itself and its Affiliates. S&P Trademarks are trademarks of S&P and have been licensed for use by SPDJI and Comerica Bank, on behalf of itself and its Affiliates.

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The Road Ahead | Fourth Quarter 2017

January 12, 2018 by Peter Sorrentino

2017 Wrap-Up
By any definition, 2017 was a good year for investors. Whether in fixed income or equities, there were rewards for all. The impact of global quantitative easing (QE) made itself known in the U.S. last year, as the Federal Reserve discovered it could push interest rates higher for shorter maturities, but not those on longer-dated obligations. The fluid nature of global capital won out, at least in 2017, as the lure of comparatively higher U.S. interest rates overwhelmed the three rate increases. The outcome for taxable bond holders was benign, as the need for coupon income kept sellers at bay. Municipal bond investors labored under a cloud of uncertainty for most of the year as the debate drama surrounding the tax legislation played out. Once that uncertainty passed, issuers queued up a large new issuance calendar, offering investors generous selection and yield. Evidence of potential valuation bubbles became increasingly apparent as the search for coupon income produced situations for which there is little economic defense. In the European bond market, negative interest rates, which have been a reality on sovereign debt for some time, emerged in the corporate market where we witnessed a three-year BBB-rated offering with a negative 0.026% yield. Interest rates in emerging and frontier markets slipped into mid-single digits, despite prevailing solvency, inflation and political risks.

For equity investors, this was not a bad outcome, as having the ten-year yield stubbornly moored just below 2.4% for most of the year allowed rising earnings to be telegraphed directly into stock prices. Last year was atypical for the path of earnings expectations as well. Generally, earnings expectations enter the year on the optimistic side only to be revised downward as the year progresses. In 2017, we experienced the reverse. Domestic optimism following the 2016 general election fed improvement in the labor market and consumer spending. External economic growth accelerated, adding to domestic activity with it as well. The combination of these factors resulted in upward earnings estimate revisions as solid economic data confirmed the increase in output. At the sector level, we experienced a range of drivers for price performance. In information technology, the knowns garnered much of the attention, such as Apple (+48%) and Microsoft (+41%), but behind the scenes, the lesser knowns, such as NVDA (+82%) and Micron (+88%), posted far larger gains and gave us an indication that the realm of artificial intelligence is attracting not only headlines, but investment. 

By and large, the balance of the U.S. market generated roughly a 21% return, but again, beneath the surface it was anything but homogeneous. In the consumer discretionary sector, shares of Amazon (+56%) and Netflix (+55%) led the pace with even traditional consumer names like Home Depot and McDonald’s adding 44%, but for former industry leaders Disney (+4.7%) and Starbucks (+5.4%), it was a disappointing year. Oddly enough, the one sector that exhibited pricing power last year posted the sole decline, as the energy stocks slipped a collective 4%. This despite the price of crude oil and coal climbing $4.48 per barrel and $5.25 per ton, respectively, in 2017.

2018 Outlook
Looking ahead to 2018, we anticipate topline revenue growth for the S&P 500® Index of around 6.5%, driven by accelerating growth abroad and a lingering storm-induced bump in domestic results. Profit margins, which troughed in the second quarter of 2017 at 10%, should improve to roughly 11.5% by the end of 2018, still well short of the cycle peak 12.5% margin in 2015, but a definite improvement.

The result should be a near 11% increase in earnings, putting the 2018 earnings per share (eps) for the S&P 500® Index at about $145.97, up from the 2017 forecast of $131.59. The wild card for 2018 will be the actual flow through from the change in the corporate tax rate. Estimates of the actual cash impact range from $4.25 to $5.00 in incremental eps for the Standard & Poor’s 500® Index. Using the mid-point of that range yields an adjusted eps of roughly $150 per share. This places the implied forward P/E ratio at just under 18 times, still considerably above the five- and ten-year average P/E ratio of 14. Our economic outlook calls for the U.S. economy to continue its transition to a late cycle environment marked by increase business spending on productivity and capital stock replacement. The result should be a general shift in market leadership to the more cyclical companies.

Among the features of the recently-passed tax legislation are the bias towards domestic versus multinational companies and the treatment of capital spending; these are characteristics most often found in smaller companies. These factors, and the extended valuation of the current market leadership, create conditions favorable for a domestic leadership rotation to small and mid-cap stocks. A late cycle economy also has historically favored industrials over consumers, financials over REIT’s and utilities, and lastly, value over growth. Typically, the catalyst for the rotation has been rising interest rates, which failed to materialize in 2017 due to continued global QE, the impact of which should fade in 2018 as the European Union (EU) winds down its program. Internationally, growth in Western Europe and selected emerging markets is forecast to outpace U.S. domestic growth in 2018. Even with their higher 2017 return, these markets generally are still trading at valuation levels below that of domestic equities and remain attractive alternatives.

As a cautionary, we are monitoring the markets for signs of growing excess as the duration of monetary stimulus has led to asset valuation bubbles in numerous hard asset categories, from coastal real estate and fine art to last year’s most egregious example – Bitcoin. For fixed income investors, the flat yield curve and compressed state of credit spreads presents the ability to shorten maturities and upgrade quality at a very nominal cost in coupon. In equities, trading down in valuation means trading up in asset quality and cash flow. Being defensive does not imply settling for less at this point in the economic cycle. At some point, volatility will return to the equity market, and in such periods, the value methodology has historically outperformed the growth approach.

 

Source: Bloomberg

 

Source: All statistics herein obtained from Bloomberg.  

NOTE: IMPORTANT INFORMATION
This is not a complete analysis of every material fact regarding any company, industry or security. The information and materials herein has been obtained from sources we consider to be reliable but Comerica Wealth Management does not warrant, or guarantee, its completeness or accuracy. Materials prepared by Comerica Wealth Management personnel are based on public information. Facts and views presented in this material have not been reviewed by, and may not reflect information known to, professionals in other business areas of Comerica Wealth Management, including investment banking personnel.

The views expressed are those of the author at the time of writing and are subject to change without notice. We do not assume any liability for losses that may result from the reliance by any person upon any such information or opinions. This material has been distributed for general educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product, or as personalized investment advice.

Past performance is not indicative of future results. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The investments and strategies discussed herein may not be suitable for all clients. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations.

Comerica Wealth Management consists of various divisions and affiliates of Comerica Bank, including Comerica Bank & Trust, National Association; World Asset Management, Inc.; Comerica Securities, Inc.; and Comerica Insurance Services, Inc. and its affiliated insurance agencies. World Asset Management, Inc. and Comerica Securities, Inc. are federally registered investment advisors. Registrations do not imply a certain level of skill or training. Comerica Bank and its affiliates do not provide tax or legal advice. Please consult with your tax and legal advisors regarding your specific situation.

The S&P 500®Index is a product of S&P Dow Jones Indices LLC or its affiliates (“SPDJI”) and Standard & Poor’s Financial Services LLC, and has been licensed for use by Comerica Bank, on behalf of itself and its Affiliates. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); and these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Comerica Bank, on behalf of itself and its Affiliates. S&P Trademarks are trademarks of S&P and have been licensed for use by SPDJI and Comerica Bank, on behalf of itself and its Affiliates.

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