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Chief Investment Officer
American Century Investments
Global markets are jittery heading into the new year. In the second half of 2018, we saw an increase in volatility as investors fretted about economic and profit growth, rising rates and trade. These factors are still in play, so we expect the turbulence to continue in 2019.
Economic growth in key segments of the global economy is beginning to moderate. Citing the impact of tariffs, analysts have lowered their 2019 forecasts by projecting flat or slightly slower global growth. They also expect the pace of economic growth to ease in the U.S., Europe and other developed markets.
With the impact of federal tax cuts fading, U.S. earnings growth is likely to fall to single digits during the first half of 2019 after topping 25% in the third quarter. We expect the deceleration to be less pronounced outside the U.S., though the unresolved Brexit and other trade concerns are dampening corporate sentiment. The uncertainty is weighing on management teams, which, in turn is delaying capital spending plans. Meanwhile, analysts predict that EM will improve in 2019.
Even news of an apparent deal to delay sharply higher tariffs on Chinese goods triggered a wild week of global trading. On top of this, Brexit negotiations have gotten messy with the U.K.’s prime minister struggling to find support for a deal with the European Union (EU). If nothing changes between now and then, March 2019 could be an eventful month with the 90-day U.S./China trade truce set to expire March 1 and the U.K.’s exit from the EU slated for March 29.
After following a mostly predictable path toward normalizing short-term interest rates over the last three years, the Fed’s future moves are less clear. We’re getting closer to a “neutral” rate that neither stimulates nor stifles economic growth. But questions remain about how central bankers will define “neutral” and how fast they want to get there.
Once the Fed achieves rate normalization, we expect the Treasury yield curve to resume its normal upward slope. The curve remained relatively flat in 2018, meaning there was little difference between yields on short-maturity Treasuries and longer-maturity Treasuries. We attribute this primarily to Fed tightening, not, as some fear, a looming recession.
Our investment teams can help you pursue your financial objectives by making strategic changes to your portfolio. For example:
As I mentioned initially, we expect the bumpy ride of the second half of 2018 to continue. These rough patches are jarring after a long period of relative calm, but they’re normal and come with the territory if you’re exposed to capital markets. Rather than react to short-term events, we recommend that you review your long-term plan to ensure it’s aligned with your goals and risk tolerance.
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Although U.S. economic growth appears to be moderating, it remains strong relative to other markets. We expect solid corporate earnings and the ongoing benefits of fiscal stimulus to keep the economy growing at a healthy pace into 2019. However, lingering trade tensions remain a risk.
Uncertainties related to trade and tariffs with the U.S. and a Brexit deal with the U.K. are weighing on economic growth in Europe. Positive developments on either front likely would boost business confidence and the region’s growth outlook. Meanwhile, U.K. growth is improving modestly on a tight labor market.
Overall, emerging market growth is decelerating due to slowing global growth, escalating U.S.-China trade tensions, and falling oil prices. Looking ahead, fiscal stimulus in China could boost the growth outlook for many emerging markets, but political risks remain elevated as new leaders in key markets take power.
We expect U.S. core inflation to remain near the Fed’s 2% target. Meanwhile, headline inflation remains slightly higher, but we expect it to continue to moderate and eventually converge with core inflation. Recent steep declines in oil prices should drive down the headline rate. So far, tariffs have had a negligible effect on U.S. inflation.
Although headline inflation in the eurozone recently hit a nearly six-year high of 2.2%, we expect it to moderate. Core inflation remains muted and well below the central bank’s 2% target. In the U.K., headline and core inflation have eased and should remain close to central bank targets.
We expect headline inflation in Japan to remain contained until late 2019, when a sales tax increase should push the annual rate toward 2%. Meanwhile, core inflation should settle near 1% amid rising wage growth and a weak yen.
The Fed remains on a tightening course, unlike its peers in Europe and Japan. However, Fed policy is likely to become more challenging and uncertain in 2019, as the short-term lending rate approaches its “neutral” setting. Traditionally, this rate, which neither spurs nor slows growth, has been between 2.75% and 3.00%.
After ending its bond-buying program in December, the European Central Bank (ECB) is unlikely to hike rates until the second half of 2019. Japan’s central bank is maintaining its quantitative easing program with a mild and gradually tapering of bond purchases.
The Bank of England is likely to hold its benchmark lending rate steady at 0.75% until May 2019. If Brexit unfolds in an orderly fashion, and economic growth continues to improve, we expect additional rate hikes to follow.
After spiking in October, U.S. Treasury yields have eased amid sharp stock market volatility. Nevertheless, we believe the upward trend in yields will resume, albeit gradually, amid solid growth and stable inflation. We expect the 10-year Treasury yield to trade in a range of approximately 2.75% to 3.25% into early 2019.
We expect eurozone rates to gradually move higher as the ECB slowly removes its stimulus programs. Rates should remain slightly higher in the U.K., where policy normalization is already underway. Rates in Japan remain unusually low amid ongoing and aggressive central bank stimulus.
Solid growth, Fed tightening, and robust U.S. Treasury issuance are keeping U.S. rates elevated versus rates in other developed markets. We continue to focus on markets where rates are more likely to fall or remain stable, including select emerging markets, to help diversify duration risk in the U.S. and Europe.
We remain optimistic about the U.S. stock market in 2019 but are concerned that earnings expectations for some companies may be too high given the likelihood of moderating global growth and rising costs. The worry now is that we may be near the end of the cycle. Low interest rates, low inflation and rising corporate profitability were a recipe for high returns on the equity market in the aftermath of the 2008 financial crisis. However, we think stocks are now riskier given the potential for reversion in this Goldilocks scenario.
We believe this environment creates opportunities. First, if economic and earnings growth moderates as expected, conditions will favor higher-quality companies whose earnings are driven by innovation or dynamics independent of the economic cycle. Second, the market is experiencing more normal levels of volatility, creating opportunities to buy or add to positions in high-quality companies that are merely victims of indiscriminate selling.
Value investors have fared better recently in relative terms after a 10-year bear market compared to growth. We’ve experienced brief stretches of value outperformance during this extended cycle, so it’s too early to say if this is another head fake or whether the rotation will be sustained. The most recent shift began in non-U.S. developed markets and EM in September, expanded to the U.S. and continued late into 2018. According to our research, extreme periods of growth outperformance have occurred less than 5% of the time over the last 40 years. We have typically experienced significant reversals after stretches of extreme performance such as this.
The valuation difference between growth and value stocks has been wide throughout the extended growth bull market. Even though we’ve seen the spread narrow somewhat with stronger value performance during the last few months, it remains high.
Beyond compelling valuations, rising borrowing costs could drive a sustained rotation to companies with stronger balance sheets and more predictable earnings streams. When rates were at historic lows, lower-quality companies enjoyed ready access to inexpensive loans through the credit market. As rates normalize, we expect higher borrowing costs to have the biggest impact on companies that are more dependent on debt. Combined with a potential slowdown in economic growth, these higher costs could trigger a hard landing for some corners of the growth market. Ultimately, this could lead to a flight to higher-quality companies.
We continue to find strong growth opportunities in information technology driven by enduring trends toward automation, cloud computing, and digital advertising, among others. Our bottom-up fundamental analysis indicates technology spending is increasing, benefiting semiconductor and communications equipment companies. Internet stocks continue to generate high growth, and online security is another growth segment. Our growth portfolios maintain material exposure to large-cap technology stocks where we continue to see multi-year advances in technology adoption enhanced by the scale and financial strength of these companies.
Trade tensions remain a threat to the tech sector. For example, the semiconductor industry is highly dependent on global trade to operate effectively. Innovation in smart phone and data center hardware often starts in the U.S., components are manufactured in Taiwan and then assembled in China. A threat to global free trade puts the entire supply chain at risk.
We believe we are entering a golden age of innovation resulting in new treatments for cancer and other gene-based diseases. Powerful diagnostic and data analytics provide more efficient research, diagnosis and potentially better outcomes. Advanced medical devices are creating better treatment options for patients as well. As a result, we think health care companies are at the forefront of several long-running trends that can promote strong, sustainable growth for years to come.
Emerging new treatments intersect with demand due to changing demographic trends as populations age and life expectancies increase. In the U.S., for example, not only is the number of people ages 65 and older growing, but annual health care spending for this age group is three times that of those ages 19 to 641. As a result, this long-term demographic shift suggests sustained demand for innovative health care products and services. This global phenomenon represents enduring forces that create strong demand for new treatments and technologies.
1 Lassman and Hartman, et al., U.S. Health Spending Trends by Age and Gender: Selected Years 2002-10, Health Affairs, May 2014.
While uncertainty over trade policies and Brexit negotiations is weighing on corporate sentiment, the outlook for 2019 non-U.S. corporate earnings growth remains positive.
Our research indicates the recent underperformance of non-U.S. stocks is partially due to the divergence in growth rates, with faster growth in the U.S. during 2018. As we enter 2019, the market is adjusting to decelerating growth in most geographies, but the deceleration is most pronounced in the U.S., where the positive impacts of tax reform have largely been realized. Heading into 2019, this creates an opportunity for investing in non-U.S. developed markets as the divergence in earnings growth with the U.S. moderates.
We believe an active approach will be important. As monetary policy normalizes and interest rates rise, dispersion of stock price returns tends to increase. In addition, in an environment where inflationary pressures are increasing, growth is becoming less synchronized. Therefore, we think stock price performance will be differentiated based on company fundamentals. Correlation of stock price returns to earnings has normalized and intra-stock correlation of returns has declined.
As significant exporters to China, Europe and Japan are likely to be hurt by a general slowdown in global trade, but alternative suppliers may benefit. For example, in the lead-up to the G20 summit in December, China sought to replace its U.S. soybean imports with crops from Brazil and U.S.-made aircraft with Airbus planes from Europe.
Until we have some resolution of the current conflict, we’ve been evaluating companies’ ability to pass on higher costs through price increases to identify companies less likely to be adversely affected by a prolonged trade war. This is especially relevant for industrial stocks where we’ve divested those we initially saw as challenged by higher raw materials costs.
Globally, small-cap stocks may represent an area of relative shelter. Smaller companies tend to be more domestically focused with simpler supply chains generally less exposed to trade tensions and other global macroeconomic pressures.
As 2018 wound down, details around the U.K.’s exit from the European Union (EU) were undecided. The various parties in the U.K. and the EU itself were unable to agree on the question about a customs union or a method of avoiding a hard border between Northern Ireland and the Republic of Ireland. The uncertainty around the final arrangements for a deal, or if a deal can be reached at all, continue to cloud the picture for U.K. companies.
We continue to see improving trends in demand for consumer discretionary goods in EM countries, driven by the long-term trend of an emerging middle class and their aspirational spending. We’re finding opportunities in companies based in developed markets and EM, including luxury retailers selling in China, consumer electronics companies with sales in Brazil, and global consumer discretionary companies distributing higher-quality brands.
Despite a bruising year, we believe EM fundamentals are compelling. Inflation is contained, reforms are in place and valuations remain attractive relative to developed markets. Earnings are growing at a double-digit pace, reflecting expanding profit margins across a wide range of sectors. Profit growth is supported by above-trend global expansion and local economies that are growing faster than developed markets. In addition, improvements in current account deficits and other macro imbalances reduce the need for large infusions of external financing. This is significant given tightening global financial conditions.
Investors must be selective, however, because not all emerging markets are alike. There is no single emerging market–there are 24 different countries at different stages of the economic cycle. Each presents unique opportunities and risks.
The Chinese economy has slowed amid uncertainty, in part due to weakening consumer activity as concerns about a prolonged trade war weigh on consumer sentiment. Auto sales in China have dropped significantly, driving a corresponding slowdown in components makers and auto technology suppliers.
In response, Chinese government policy continues to support domestic demand. We are finding opportunities in areas such as cement companies that should benefit directly from increased infrastructure spending resulting from bank lending and fiscal stimulus.
Trade tensions have hurt export-oriented economies in emerging markets. As a result, we favor companies that derive the bulk of their revenues domestically or from within EM, and whose exports to the U.S. account for less than 10% of total revenues. We expect the fundamental impact of trade issues on such companies to be limited.
A stronger U.S. dollar generally acts as a headwind for EM economies and companies because the correspondingly weaker local currency makes goods more expensive in external markets. Countries with unfavorable current account balances and those making payments on dollar-denominated debt also suffer in a strengthening-dollar environment.
We favor companies that derive more of their revenues domestically or from regional trade partners, thereby mitigating the fundamental impact of the strong dollar. We are also finding opportunities in countries with more favorable current account balances with the U.S. (e.g., China, Russia, Thailand, and South Korea).
We expect Treasury yields to gradually rise but remain rangebound over the next few months. Absent significant trade or geopolitical conflicts, we expect stable core inflation and an increase in Treasury supply to keep the 10-year Treasury yield in a range of 2.75% to 3.25%. Given this outlook, we continue to underweight Treasuries in favor of more attractive opportunities in select spread sectors.
We believe headline inflation will moderate and converge with core inflation, which we expect to remain near 2%. Longer-term inflation expectations remain close to historical averages.
We expect certain securitized bonds will continue to offer better yield and total return opportunities than Treasuries. Within the sector, we favor fixed- and floating-rate mortgage credit, including non-agency commercial mortgage-backed securities (CMBS) and non-agency collateralized mortgage obligations (CMOs). We believe these securities offer better relative value than fixed-rate agency mortgages.
We began reducing exposure to corporate bonds in early 2018, and recent widening of credit spreads confirms our commitment to this strategy. Initially, the late-stage nature of the credit cycle, combined with valuation concerns, prompted our cautious approach toward the sector. Corporate fundamentals generally remain upbeat, but we believe recent upticks in market volatility and risk warrant an underweight position in the corporate sector. Although volatile markets often create good buying opportunities, we remain extremely selective. Our approach focuses on finding companies with good balance sheets and cash flows selling at attractive prices.
We are taking a similar selective approach in the high-yield credit sector. Falling oil prices and heightened risk factors (trade war worries, Brexit uncertainty, Italy’s budget woes) have pushed spreads among lower-quality corporate bonds sharply wider. We continue to underweight high-yield corporates, particularly those with more-leveraged balance sheets and large refinancing needs. Meanwhile, we continue to increase exposure to select bank loans. With U.S. rates likely heading higher, we favor the floating-rate nature of bank loans. Also, bank loans are somewhat shielded from market risks originating outside the U.S.
Against a backdrop of generally improving economic data, state and local finances across the country remain fairly healthy. We expect new gross supply, on a year-over-year basis, to remain fairly stable versus 2018, as well as demand for tax-exempt munis, particularly in high-tax states, to remain strong. We continue to favor securities in the higher education, transportation and hospital sectors, as well as bonds that finance charter schools and continuing care retirement communities (CCRC). Additionally, given our outlook for modest economic growth, slightly higher interest rates and generally healthy credit fundamentals, we are maintaining our general bias toward lower-quality securities (investment-grade securities with BBB credit ratings) and higher-yielding sectors (charter schools, CCRC and special tax).
In the wake of moderating economic growth rates and ongoing central bank stimulus, European government bond yields remain unusually low. We expect a gradual normalization of yields, particularly after the European Central Bank ended its bond-buying program in December. Rates remain modestly higher in the U.K., where the Bank of England has paused its rate-hike campaign in response to Brexit uncertainty. However, U.K. growth remains solid, and rates should head higher. In this environment, we are underweighting European sovereigns, preferring markets where we believe rates are likely to fall or remain stable. These include Canada and select local emerging markets (EM).
We continue to find the best European credit valuations within the banking and insurance industries. Credit spreads in these industries remain attractive due to regulatory enforced improvements in capital ratios and risk management.
For most of 2018, EM sovereign and corporate spreads widened amid heightened volatility, a stronger U.S. dollar, and country-specific events. In the wake of this widening, we believe valuations appear fair. High-yield segments are particularly cheap relative to historical averages and versus U.S. credit. However, we remain selective due to heightened idiosyncratic country risks. We generally favor local-currency bonds over U.S. dollar-denominated EM debt. Local currency holdings are less sensitive to rising U.S. Treasury yields. We also remain mindful of the effects of rising oil prices and global trade policy on EM countries.
The rising rate environment has been a headwind for bond investors. With interest rates on the rise and heightened volatility apparently here to stay, overlooked segments of the fixed-income market may be attractive alternatives to traditional bond investments.
Not all fixed-income sectors respond the same way when rates move higher. Mainstream government and corporate bonds tend to underperform when rates rise, while other fixed-income securities have fared better. Examples include asset-backed securities (ABS) and collateralized loan obligations (CLOs), instruments with prices that are less-sensitive to rising rates and yields that adjust along with changes in interest rates. We believe these characteristics may help generate outperformance as interest rates head upward.
ABS represent pools of underlying assets, such as auto loans, student loans, credit card debt and aircraft leases. These assets generally are less-sensitive to macroeconomic events than equities and corporate credit. CLOs represent pools of lower-rated corporate loans. Their coupon payments are tied to the three-month LIBOR2, a key short-term interest rate benchmark. CLOs remain in robust demand, as the Fed’s rate-hike program has pushed other short-term yields, such as LIBOR, higher.
2 LIBOR: The London Interbank Offered Rate is a benchmark representing the interest rate at which banks offer to lend funds to each other in the international interbank market for short-term loans.
JPM Leveraged Loan Index: The J.P. Morgan Leveraged Loan Index is designed to mirror the investable universe of U.S. dollar institutional leveraged loans, including U.S. and international borrowers.
JPM Collateralized Loan Obligation Index: The J.P. Morgan Collateralized Loan Obligation (CLO) Index tracks floating-rate CLO securities created since 2004.
Bloomberg Barclays U.S. Asset-Backed Securities Index: The Bloomberg Barclays U.S. Asset-Backed Security (ABS) Index measures the value of the ABS market for the following collateral types: credit card, auto and utility loans.
Bloomberg Barclays U.S. High Yield Index: The Bloomberg Barclays U.S. Corporate High Yield Index measures the U.S. dollar-denominated, high-yield, fixed-rate corporate bond (defined below) market.
Bloomberg Barclays U.S. Corporate Bond Index: The Bloomberg Barclays U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes U.S. dollar-denominated securities that are publicly issued by U.S. and international industrial, utility and financial issuers.
Current stock volatility reflects a disagreement over the future of corporate earnings. Bears argue: (1) the rate of earnings growth is decelerating; (2) U.S. economic expansion is long in the tooth and bellwethers housing, autos and semiconductors have rolled over; and (3) tariffs and trade disruptions are likely to weaken global growth even more. Bulls, however, contend that soaring corporate profits are driving record share buybacks and dividend payouts, and capital expenditures are growing at the fastest pace in a quarter-century. This dispute won’t likely be resolved anytime soon, so we expect markets to remain volatile for the foreseeable future.
We recommend that investors far from their savings goals or target retirement dates view market declines as opportunities to add equities to their portfolios. Investors nearing their retirement dates or other goals should be much more conservatively positioned because they likely won’t have enough time to recover from large losses.
U.S. Equity vs U.S. Fixed Income & Cash
We believe that now is not the time to deviate from your strategic allocations—rising yields and stock market volatility strengthen the argument for fixed-income assets. However, strong corporate profit growth and still-attractive stock dividend yields mean we remain neutral across the three major asset classes.
U.S. vs Non-U.S. Developed Markets
After a long period favoring the U.S. thanks to stronger relative growth and corporate fundamentals, we have returned to our strategic target weights. This reflects more attractive non-U.S. earnings yields at a time when our fundamental team’s view of the U.S. market has deteriorated.
U.S. vs Emerging Markets
We continue to argue that EM equities offer compelling diversification characteristics over time for all but the most conservative strategic asset allocation portfolios, but we don’t yet believe it’s time to move to a tactical overweight to the asset class.
Large Cap vs Small Cap
Many factors in our model point to large caps over small, but relative valuation strongly supports small caps. We see arguments for both sides—large caps tend to be less volatile and have more ways to maintain profitability while small caps tend to be more domestically focused and less affected by slower growth globally.
Growth vs Value
We’re reluctant to call the turn in the growth/value cycle. It’s true that value has done better because of the correction in the growth-oriented tech sector. But growth stocks tend to perform best when economic growth is slowing, while value tends to benefit from cyclical upswings in growth. As a result, it’s hard to advocate a value overweight.
U.S. vs Non-U.S.
We see the U.S. dollar approaching peak valuations and prefer commodity-related currencies in developing market and EM countries. By sector, there are select opportunities in subordinated European bank and insurance bonds. EM debt valuations have improved, but high degrees of risk mean we remain neutral.
REITs vs Core Assets
Higher interest rates and a slowdown in the U.S. housing market are negatives for domestic real estate investment trusts (REITs). But we believe relative yields are attractive enough and diversification benefits compelling enough to justify maintaining our strategic allocation to global REITs across all our portfolios.
Q1 | 2019
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The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
International investing involves special risks, such as political instability and currency fluctuations.
Historically, small- and/or mid-cap stocks have been more volatile than the stock of larger, more-established companies. Smaller companies may have limited resources, product lines and markets, and their securities may trade less frequently and in more limited volumes than the securities of larger companies.
References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
American Century Investments uses a multifactor stock-ranking model incorporating a variety of stock attributes, which fall into four categories or factor families: valuation, growth, quality, and sentiment.
Diversification does not assure a profit nor does it protect against loss of principal.
Alternative mutual funds that hold a variety of non-traditional investments also often employ more complex trading strategies than traditional mutual funds. Each of these different alternative asset classes and investment strategies have unique risks making them more suitable for investors with an above average tolerance for risk.
As with all investments, there are risks of fluctuating prices, uncertainty of dividends, rates of return and yields. Current and future holdings are subject to market risk and will fluctuate in value.