4Q investment outlook: Holding on to portfolio gains with both hands
Investors enter the year’s final quarter witnessing strong gains across asset classes; domestic and international equities, real estate, bonds and other areas have all seen sharp moves higher thus far in 2019. Ironically, these gains have occurred despite a global economic deceleration. Investors may recall 2018’s fourth quarter with disdain, when we experienced widespread volatility due to central bank policy indecision amid a weaker economic trajectory. Fast forward one year and central banks around the world are enacting more pro-growth measures to offset economic weakness, so that policy set appears to be clearer than this time last year. However, trade policy remains a central issue, and uncertainty on the Chinese/U.S. negotiations could spill into the fourth quarter and the new year.
We maintain a positive view of a diversified portfolio’s return prospects as we close out 2019. While economic growth has stagnated, we expect a gradual recovery to emerge and, if we are wrong, we do not forecast future weakness to be cycle-ending in nature. Domestic consumers are enjoying low unemployment, improved personal balance sheets and lower borrowing costs. Even though we are now in the longest post-World War II recovery period in history, slack in the rest of the world’s economies offer an opportunity for further growth prospects, but we are watching for potential cracks in the global economic foundation. The sections that follow reflect our most current thinking across economics and capital markets. As always, please do not hesitate if we can answer any questions.
Global economic views
United States/China tariffs and trade news are the primary uncertainties for businesses and investors with no clear path to resolution. The Fed appears on a path to provide further rate cuts this year, but other global central banks have also provided rate cuts that provide support to the global market and the economy. In our view, recession odds remain low, despite still sluggish economic data around the world.
The backdrop for domestic equities remains positive: non-problematic inflation, low interest rates, moderate earnings growth and uninspiring alternatives. Excesses that typically accompany the end of a market cycle do not appear prevalent, suggesting that the current long-running bull market still has room to run. However, despite a favorable environment for U.S. equities, the path forward is likely to be more volatile and returns more subdued.
We retain a neutral outlook for foreign developed equities through the end of 2019; risks and opportunities continuing to look reasonably balanced, but sector composition remains a headwind. Compared to the S&P 500, the MSCI EAFE Index, a proxy for foreign developed markets, has a far lower weighting in growth sectors such as technology. Meanwhile, heavier weights to sectors such as Industrials and Materials have been a headwind for the MSCI EAFE Index due to slower growth in global activity. Finally, valuation of foreign developed equities relative to the S&P 500 remains extremely low, reflecting continued investor preference for U.S. securities, given higher confidence in U.S. economic and corporate profit outlook.
Similarly, we continue to view opportunities and risks in emerging markets as also fairly balanced and retain our neutral stance. Clouding the outlook for emerging market equities, analysts have slashed expectations for corporate sales and profit growth in emerging markets in 2019. Valuation indications are mixed, with backward-looking measures lower than historical averages while forward-looking measures on expected earnings well above average.
Fixed income markets
Markets anticipate aggressive central bank rate cuts, likely keeping returns low for bond investors. Central banks outside the United States have also begun rate cutting campaigns and expect continued monetary policy easing to combat slowing global growth and anemic inflation. Return expectations for core bonds should be muted due to the low level of interest rates, although we continue to emphasize the importance of high-quality bonds to provide adequate portfolio diversification.
Somewhat rich valuations and eroding fundamentals limit the attractiveness of “reaching for yield.” We believe normal allocations to investment-grade credit investments are appropriate and suggest a balanced approach relative to U.S. Treasuries. The outlook for select structured credit opportunities such as non-agency mortgage-backed securities continues to be supported by strong consumer fundamentals and compelling incremental yield. Overall allocations to riskier fixed income sectors should remain modest for now, with active management a critical factor.
Real estate and commodity markets
Lower interest rates help by making the earnings yield of commercial real estate look more attractive compared to alternatives. Additionally, since investors purchase most commercial real estate using some loans, lower rates mean investors should net more income relative to their loan costs, increasing their returns. We do expect property market fundamentals to deteriorate slightly from current levels. We believe investors should maintain normal real estate exposures for now, since we believe these softening fundamentals are not yet a meaningful threat to investors.
Hedge fund returns are up but outflows continue. Private capital remains the alternative investment of choice. Investors’ enthusiasm for private capital remains strong and it’s easy to understand why. First, private capital investors have been cash flow positive for the past eight years, according to a Bain & Company Global Private Equity Report, meaning distributions have outstripped contributions each year. Second, private capital funds have outperformed their respective public market indices. Therefore, we continue to be judicious in assessing funds to ensure we work with those we believe have a unique skillset and competitive advantage.
For more information
A detailed version of our fourth quarter 2019 investment outlook commentary is available. To access a copy, please visit our website at www.usbank.com/wealth-management/financial-perspectives or contact your financial professional if you have questions.
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This commentary was prepared September 2019 and represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are not intended to be a forecast of future events or guarantee of future results and is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this commentary are not affiliated or associated with U.S. Bank or U.S. Bancorp Investments in any way.
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Diversification and asset allocation do not guarantee returns or protect against losses. Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio.
Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general. The MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 countries in Europe, Australasia and the Far East (EAFE).
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in mortgage-backed securities include additional risks that investors should be aware of, such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. There are special risks associated with investments in real assets such as commodities and real estate securities. For commodities, risks may include market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults). Hedge funds are speculative and involve a high degree of risk. An investment in a hedge fund involves a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage and short sales, which can magnify potential losses or gains. Restrictions exist on the ability to redeem or transfer interests in a fund. Private equity investments provide investors and funds the potential to invest directly into private companies or participate in buyouts of public companies that result in a delisting of the public equity. Investors considering an investment in private equity must be fully aware that these investments are illiquid by nature, typically represent a long-term binding commitment and are not readily marketable. The valuation procedures for these holdings are often subjective in nature.
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