westend advisors macro highlights 2018 october v7...long-term treasury etf’s yield. looking ahead,...
TRANSCRIPT
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Q4 2018
WestEnd Advisors
Macroeconomic Highlights
www.westendadvisors.com · [email protected] · (888) 500-9025
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Table of Contents
WestEnd Outlook Highlights…………………………………………………..… 2
U.S. Economic Backdrop
Quarterly GDP Variability Doesn’t Redirect the Trend…………………… 4
Consumer Remains an Area of Economic Strength……………………………… 5
Maturing Cycle and Higher Rates are Headwinds……………………………. 6
Industrials Sector Demands More Dynamic Growth……………...…………... 7
Communication Services Sector Comes Online…...……………………………… 8
Communications Services: Well Positioned for a Moderate Growth
Environment……………………………………………………..................................……… 9
Inflation and Interest Rates
Growing Wage Pressures Support Interest Rates………………………………. 11
Fed’s Policy Moves Impact Short-Term Bond Yields……………………………. 12
International Economic Backdrop
Japanese Personal Income and CapEx Pickup…………………………………….… 14
Emerging Asia Offers Secular Tailwinds and Attractive Valuations…… 15
Trade Disputes Weigh on Sentiment, Not on Data……………………………… 16
European Economic Picture Weakens in 2018………………………………...…… 17
Disclosures…………………………………………………………………………………………... 18
1
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WestEnd Outlook Highlights
The U.S. continues on a trend of moderate economic growth, even with a boost to Q2GDP from temporary factors like exports.
Data in Q3, including core retail sales and personal income growth, reaffirmed that the U.S.consumer remains healthy and a key driver of the economy.
Trade disputes, along with constraints from progress already made this cycle, appear to beacting more as a governor on the economic throttle rather than an outright brake for theeconomy.
Modest inflationary pressures and a normalization of real interest rates are supportinghigher nominal interest rates and creating a headwind for certain interest rate-sensitiveareas of the market.
European economies remain constrained by structural and cyclical issues, with datathis year pointing to softer economic activity.
Japan’s personal income and business CapEx have improved, and Asian equityvaluations have declined markedly versus the U.S.
U.S. trade policy presents uncertainty, but short of an extended escalation of Chinesetariffs, its impacts should be limited; Asian markets, in particular, stand to benefit astensions ease.
2
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U.S. Economic Backdrop
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-4.00
-3.50
-3.00
-2.50
-2.00
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
-9%-8%-7%-6%-5%-4%-3%-2%-1%0%1%2%3%4%5%6%
Chi
cago
Fed
Nat
iona
l Act
ivity
Inde
x (0
=Tr
end
Gro
wth
)
Rea
l GD
P G
row
th (S
A A
nnua
lized
Rat
e)
U.S. Quarterly Real GDP Growth vs.
Chicago Fed National Activity Index
Quarterly GDP Growth (Annualized Rate)
Chicago Fed National Activity Index
Chicago Fed National Activity Index has had a tight relationship with annual GDP growth.
-9%-8%-7%-6%-5%-4%-3%-2%-1%0%1%2%3%4%5%6%
Rea
l GD
P G
row
th (S
A A
nnua
lized
Rat
e)
U.S. Quarterly Real GDP Growth
Real GDP has grown at a 2.3% annual rate since the U.S. economy returned to growth in Q3 2009.
2.3% CAGR
4
Quarterly GDP Variability Doesn’t Redirect the Trend
Source: Bureau of Economic Analysis, WestEnd Advisors
Source: Bureau of Economic Analysis, Federal Reserve Bank of Chicago, WestEnd Advisors
The 4.2% annualized GDP growth seen in Q22018 was a deviation from the recent trend of2% to 3% readings. The top chart, however,illustrates that we have seen a number ofquarterly readings over 4% during this neardecade-long period of moderate growth.
Other broad-based measures of the U.S.economy, like the Chicago Fed National ActivityIndex (CFNAI), continue to point to moderategrowth, even as some temporary factors, like arush to export U.S. goods ahead of trade tariffs,pushed up the Q2 GDP reading. The bottomchart indicates the CFNAI readings for both Q2and Q3 continue to point to moderate U.S.growth, consistent with the near 2.5% GDPgrowth recorded during this expansion.
Portfolio Impact
Technology & Health Care Sectors:In a moderate growth environment, continueto emphasize U.S. sectors that benefit fromsustained cyclical and secular growthdrivers.
Energy & Materials Sectors:Avoid sectors that typically benefit fromdynamic economic growth.
Portfolio Impact
Technology & Health Care Sectors:In a moderate growth environment, continueto emphasize U.S. sectors that benefit fromsustained cyclical and secular growthdrivers.
Energy & Materials Sectors:Avoid sectors that typically benefit fromdynamic economic growth.
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-6%
-4%
-2%
0%
2%
4%
6%
8%
Year
-Ove
r-Ye
ar G
row
th
Core Retail Sales
5
Consumer Remains an Area of Economic Strength
Source U.S. Census Bureau, WestEnd Advisors
Source: Bureau of Economic Analysis, WestEnd Advisors
Income gains for individuals are nearcyclical highs. This income growth isincreasingly coming from gains in hourlywages, rather than growth in hires or hoursworked. As highlighted in the top chart,gains in hourly earnings today are a muchlarger component of overall personalincome gains than they were in 2011. Thisshift among sources of personal incomegrowth is not surprising given the progresswe have seen in this economic cycle.
This strong income growth, together withrecord-low layoffs, has, in turn, driven gainsin core retail sales (retail sales excludingmore volatile spending categories, includingcars, building materials, restaurants andgasoline).
Portfolio Impact
We believe continued exposure to theconsumer – a key driver of economic growth –via the Consumer Discretionary andConsumer Staples sectors is warranted,particularly as income growth and an elevatedsense of job security among workers supportsspending growth.
Portfolio Impact
We believe continued exposure to theconsumer – a key driver of economic growth –via the Consumer Discretionary andConsumer Staples sectors is warranted,particularly as income growth and an elevatedsense of job security among workers supportsspending growth.
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
Con
tribu
tion
to 1
2-M
onth
Gro
wth
Components of Personal Income Growth
Payrolls
Hourly Earnings
Weekly Hours
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6
8
10
12
14
16
18
20
Aut
o Sa
les
SA A
nnua
lized
Rat
es 3
-Mon
th M
A
Monthly Auto Sales
6
Maturing Cycle and Higher Rates are Headwinds
Source: Bureau of Economic Analysis, WestEnd Advisors
Source: Bureau of Labor Statistics, WestEnd Advisors
The economy has made significant progresssince the cyclical trough in 2009 as key areaslike auto sales and construction spendinghave improved from their lows. At the sametime, the degree of improvement in these andother measures indicates there is limitedcyclical economic fuel to drive sustaineddynamic growth going forward. For example,the top chart illustrates that auto sales remainat a high level, but have not grown in recentyears.
Interest rate-sensitive parts of the U.S.economy, like housing and autos, are likely toface challenges with the move up in interestrates. Residential construction spending, forexample, dropped to a 4% annualized rate forthe six months ended in August.
Portfolio Impact
Progress in the U.S. economic cycle warrantsavoiding certain segments of the financialmarkets, including Energy and IndustrialsSector stocks, small-cap stocks and high-yield bonds.
Portfolio Impact
Progress in the U.S. economic cycle warrantsavoiding certain segments of the financialmarkets, including Energy and IndustrialsSector stocks, small-cap stocks and high-yield bonds.
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
6-M
onth
Ann
ualiz
ed G
row
th
Residential Construction Growth
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0
5
10
15
20
25
30
35
Per
cent
Cha
nge
(YoY
)
Return on Common Equity
Machinery Consumer Staples
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
-60.0%
-40.0%
-20.0%
0.0%
20.0%
40.0%
60.0%
OE
CD
Tot
al L
eadi
ng I
ndic
ator
s (Y
oY %
)
Indu
stria
ls S
ecto
r P
erfo
rman
ce (
YoY
%)
OECD Composite Leading Indicators &
Industrials Sector Performance
Industrials Sector Performance (YoY %, lhs) OECD Total Leading Indicators (YoY %, rhs)
7
Industrials Sector Demands More Dynamic Growth
When economies are growing rapidly, we typicallysee increased investment in infrastructure,nonresidential construction, and housing, as wellas demand for machinery and related services.Multinational Industrials Sector companies canbenefit from this type of robust global demand.
Sustained and dynamic economic growth haslargely been absent across the globe since thefinancial crisis. The OECD’s Composite LeadingIndicators (CLI) are comprised of various economicdata series and are intended to signal inflectionpoints in growth. The top chart illustrates thatrecent CLI readings signal slower global growth.
Industrials companies’ earnings and return onequity have historically demonstrated a highdegree of sensitivity to turns in economic growth.The Machinery Industry (bottom chart), whichmakes up a key segment of the Industrials Sectorillustrates these characteristics.
Portfolio Impact
Global growth trends have decelerated since late2017. We continue to avoid the Industrials Sector inour U.S. equity exposures, as the Industrials Sectordepends on robust growth not only in the U.S., butalso abroad.
Portfolio Impact
Global growth trends have decelerated since late2017. We continue to avoid the Industrials Sector inour U.S. equity exposures, as the Industrials Sectordepends on robust growth not only in the U.S., butalso abroad.
Source: OECD, Bloomberg, WestEnd Advisors
Source: Bloomberg, WestEnd Advisors
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Communication Services Sector Comes Online
8
Portfolio impact:
We see the sector shifts as beneficial for sector-focused investment approaches as the changes better align investment opportunities with economic exposures.
* Sample companies were selected based on a combination of size and recognizability and are for illustrative purposes only.
Sources: MSCI, Standard & Poor’s, WestEnd Advisors. Information has been gathered from sources believed to be reliable, however data is not guaranteed.
The widely-used Global IndustryClassification Standard (GICS)was reorganized to create a new“Communication ServicesSector” at the end of Q3 2018.
The new sector combines theold Telecommunication ServicesSector with various media,internet and entertainmentcompanies from the InformationTechnology and ConsumerDiscretionary Sectors.
After the changes, the S&P 500sector weights are more evenlydistributed, as portions of twolarge sectors (Info. Tech. &Cons. Disc.) were combinedwith one of the smallest sectors(Telecom.). This change givessector-focused investors moreflexibility to overweight largersectors and underweight smallersectors.
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-20%
-10%
0%
10%
20%
30%
40%U.S. Ad Spending Annual Growth
U.S. Total Ad Spending U.S. Digital Ad Spending
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
(% o
f Tot
al U
.S. A
d Sp
end)
U.S. Digital Ad Spending Market Share
Reported Estimate
9
Communications Services: Well Positioned for a
Moderate Growth Environment
Source: MAGNA, Bloomberg, WestEnd Advisors
As the economic cycle becomes moreadvanced, businesses continue to look forways to keep earnings growth elevated.Demand creation through spending onadvertising is a typical way for businessesto boost sales and earnings.
Traditional media companies in theCommunications Services Sector arepoised to benefit from the ongoing cyclicalstrength in ad spending. At the same time,other Comm. Services companies are someof the largest beneficiaries of the strongsecular growth in digital advertising.
In addition, a healthy consumer spendingbackdrop should support sales of mediacontent and wireless phone services.
Portfolio Impact
The Communications Services Sector hasan attractive profile for the moderateeconomic growth environment we seeahead. The sector should benefit from a mixof cyclical spending gains and seculartailwinds.
Portfolio Impact
The Communications Services Sector hasan attractive profile for the moderateeconomic growth environment we seeahead. The sector should benefit from a mixof cyclical spending gains and seculartailwinds.
Source: MAGNA, Bloomberg, WestEnd Advisors
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Inflation and Interest Rates
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1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
Year
-Ove
r-Ye
ar G
row
th
Employment Cost Index
11
Source: Bloomberg, WestEnd Advisors
Growing Wage Pressures Support Interest Rates
Source: Bureau of Labor Statistics, WestEnd Advisors
Hourly wage growth had been slow to pick upduring the expansion, but hourly earningsgrowth hit 2.9% as of August, the strongest gainsince 2009. The growth in hourly earnings iscontributing to the acceleration in growth for theEmployment Cost Index (ECI), a measure ofemployment costs for companies. The top charthighlights that the ECI recorded its strongestgrowth of the cycle with its latest reading.
These labor cost pressures should keep inflationelevated and push long-term interest rateshigher. In fact, in the early part of Q4, the 10-year Treasury yield moved to the highest level inseven years. In addition, Fed Funds hikes willput upward pressure on short-term rates.
Portfolio Impact
Fixed Income: Emphasize short-durationsecurities. Exposure to investment-gradefloating rate securities and TIPS are warranted.
Equities: Financials Sector should benefit fromhigher short-term rates. Continue avoidingsectors most negatively impacted by risingrates, like Utilities and Real Estate.
Portfolio Impact
Fixed Income: Emphasize short-durationsecurities. Exposure to investment-gradefloating rate securities and TIPS are warranted.
Equities: Financials Sector should benefit fromhigher short-term rates. Continue avoidingsectors most negatively impacted by risingrates, like Utilities and Real Estate.
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%10-year Treasury Yield
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0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
Inte
rest
Rat
e
Fed Funds Rate and 2-Year Treasury Yield
2-Year TreasuryFed Funds Rate
0.00%
0.25%
0.50%
0.75%
1.00%
1.25%
1.50%
1.75%
2.00%
2.25%
2.50%
2.75%
3.00%
3.25%
Indi
cativ
e Yi
eld
Fixed Income ETF Yields
SPDR Portfolio Short Term Corp iShares Floating Rate Bond ETF
iShares 10-20 Year Treasuries iShares 20+ Year Treasuries
12
Source: Bloomberg, WestEnd Advisors
Fed’s Policy Moves Impact Short-Term Bond Yields
Source: Bloomberg, WestEnd Advisors
Improved economic conditions and higher inflationreadings have led to Fed Funds increases and, inturn, higher short-term interest rates.
Higher short-term interest rates, along with aflattening yield curve, mean that the difference inincome generation between long-term and short-term bonds has declined. For example, in early2015, the yield on the investment grade Short-TermCorporate Bond ETF was 85 basis points lower thanthe yield on the 10-to-20 Year Treasury ETF. By theend of Q3 2018, however, the short-term corporatebond ETF‘s yield was 4 basis points higher than thelong-term Treasury ETF’s yield.
Looking ahead, longer-maturity fixed-income, ingeneral, would be more negatively impacted by acontinued move up in interest rates. Today, the 10-to-20 Year Treasury ETF has a duration of 10.6years, while the Short-Term Corporate Bond ETF hasa duration of just 1.9 years.
Portfolio Impact
Short duration bonds are more attractive today asthe level of income sacrificed to insulate theportfolio from higher long-term interest rates hasfallen as short-term interest rates have moved up.
Portfolio Impact
Short duration bonds are more attractive today asthe level of income sacrificed to insulate theportfolio from higher long-term interest rates hasfallen as short-term interest rates have moved up.
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International Economic
Backdrop
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-6.0
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
Year
-Ove
r-Ye
ar G
row
th (%
)
Japanese Personal Income Growth
Total Cash Earnings (3-Month Avg.)
Ordinary Time Earnings
-30%
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
Year
-Ove
r-Ye
ar G
row
th
Japanese Capital Expenditures Growth
Capital Expenditure on Plant, Equipment excluding Software
14
Source: Ministry of Finance Japan, WestEnd Advisors
Japanese Personal Income and CapEx Pickup
Source: Ministry of Health, Labor and Welfare Statistics of Japan, WestEnd Advisors
Japanese corporate profit margins reached7% as of Q2 2018. In addition, Q2 profits as apercentage of nominal GDP were at thehighest level since 1980.
The increase in corporate earnings, along witha tight labor market, has supported gains inpersonal income. The top chart illustrates thatrecent readings for Total Cash Earnings, whichincludes volatile bonus payments, and themore steady Ordinary Time Earnings are attheir highest level of growth in over a decade.
Similarly, an improved corporate profitbackdrop has contributed to an improvedbusiness investment picture. Japanesespending growth on plant and equipment hasreached its highest level since the globalfinancial crisis.
Portfolio Impact
Additional exposure to Asian equities iswarranted as economic trends are improving,particularly in Japan, and Asian stocks tradeat a near record discount to U.S. stocks.
Portfolio Impact
Additional exposure to Asian equities iswarranted as economic trends are improving,particularly in Japan, and Asian stocks tradeat a near record discount to U.S. stocks.
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0%
5%
10%
15%
20%
25%
30%
35%
40%
Porti
on o
f MSC
I EM
Asi
a In
dex
Historical Sector Weights for Emerging Asia Index
Financials Sector
Information Technology Sector
-60%
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
Year
-Ove
r-Ye
ar P
erfo
rman
ce D
iffer
entia
l
Performance Spread: S&P 500 vs. MSCI Emerging Asia
SP 500 Less EM Asia
15
Emerging Asia Offers Secular Tailwinds and
Attractive Valuations
The significant underperformance of EmergingAsian equities over the last year has resulted inEM Asia trading at a 32% P/E discount to S&P500, which matches the largest discount since2005.
Within EM, we favor Emerging Asian stocks inpart because Asia is less commodity-orientedthan areas such as Latin America. In fact,Technology companies have grown to over 35%of the MSCI Emerging Asia Index. Global techleaders from Asia are benefiting from cyclicalconsumer and business spending as well asfrom secular trends including acceleratinginternet penetration, rapid adoption of digitalpayments, and e-commerce growth. Thisincreased exposure to secular growth driversmakes the valuation discount for EM Asia stockseven more compelling.
Portfolio Impact
The global economic picture has not shifteddramatically this year, but a deterioration ininvestor sentiment with respect to internationalequities, especially in emerging markets, has ledto a significant valuation discount of certaininternational equities compared to U.S. stocks.
Portfolio Impact
The global economic picture has not shifteddramatically this year, but a deterioration ininvestor sentiment with respect to internationalequities, especially in emerging markets, has ledto a significant valuation discount of certaininternational equities compared to U.S. stocks.
Source: Bloomberg, WestEnd Advisors
Source: Bloomberg, WestEnd Advisors
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16
Trade Disputes Weigh on Sentiment, Not on Data
Source: Bureau of Economic Analysis, WestEnd Advisors
Source: Customs General Administration PRC, WestEnd Advisors
Trade plays an important role in globaleconomic growth, although its impacts varyacross economies.
For the U.S., exports make up 12% of nominalU.S. GDP. Disruptions from additional tariffswould heighten volatility in U.S. trade data, butimmediate negative impacts to the broader U.S.economy are unlikely, in our opinion. Still, wesaw volatility in Q2 when higher exports, drivenby exporters front-running tariff implementation,caused the trade deficit to shrink substantially,and thus added to GDP growth (top chart).
For China, 19% of exports go to the U.S. Thismatches exports to Europe and is less than halfof what is sent to other Asian countries,collectively. In this context, we again see thepotential for trade volatility, but low likelihood ofa severe economic disruption for China. Thereis also a good chance that other emerging Asiaeconomies actually benefit.
Portfolio Impact
We recognize the potential for escalating tradedisputes, but we currently see the U.S. impactas limited to specific segments of the economylike manufacturing and agriculture. We are alsoclosely monitoring developments in Asia.
Portfolio Impact
We recognize the potential for escalating tradedisputes, but we currently see the U.S. impactas limited to specific segments of the economylike manufacturing and agriculture. We are alsoclosely monitoring developments in Asia.
Asia49%
United States19%
Europe19%
South America5%
Africa, 4%Oceania, 2%
North America ex-U.S.
2%
China Exports (in USD)
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
Q32013
Q42013
Q12014
Q22014
Q32014
Q42014
Q12015
Q22015
Q32015
Q42015
Q12016
Q22016
Q32016
Q42016
Q12017
Q22017
Q32017
Q42017
Q12018
Q22018
Qua
rter
ly A
nnua
lized
Gro
wth
(pp
t)
Net Trade's Impacts to U.S. GDP Volatile But Small
GDP ex-Net Exports Contribution of Net Exports Real GDP Q/Q SAAR
Source: Customs General Administration PRC, WestEnd Advisors
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S&P 500 MSCI Europe
Information Technology 20.99 5.79Health Care 15.05 12.52Financials 13.32 18.54Consumer Discretionary 10.31 9.47Communication Services 10.03 5.01Industrials 9.71 14.35Consumer Staples 6.71 12.21Energy 6.00 7.92Utilities 2.82 3.40Real Estate 2.64 2.51Materials 2.43 8.28As of 9/30/2018
Sector Weights (%)
17
European Economic Picture Weakens in 2018
Data out of Europe thus far in 2018 has pointed to softer economic activity.For example, European retail sales and export growth have decelerated inrecent quarters. Nonetheless, some investors continue to highlight thevaluation discount for European stocks compared to U.S. stocks. This 16%P/E discount on European stocks is very consistent with history, and oneexplanation for this discount is the sector makeup of each stock market.
The largest sector in Europe is Financials (≈18.5%) while the largest in theU.S. is Information Technology (≈21%). Given these weightings, it makessense that Europe consistently trades at a discount to the U.S. Those whoexpect European equities’ valuations to rise to U.S. levels are implicitlybetting on significant expansion of European Financials’ valuations, a viewthat we question.
Source: Bloomberg, WestEnd Advisors
Source: Bloomberg, WestEnd Advisors
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
Six
Mon
th A
nnua
lized
Gro
wth
(3-M
onth
Avg
)
Euro Area Retail Sales Growth
Portfolio Impact
An underweight of Europeanequities is warranted, aslower valuations do not fullyreflect the structural andcyclical economic headwindsfaced by Europe.
Portfolio Impact
An underweight of Europeanequities is warranted, aslower valuations do not fullyreflect the structural andcyclical economic headwindsfaced by Europe.
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