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More than a year ago, we started talking to clients about the return of normal volatility to the capital markets. After an unusually long stretch of relatively smooth sailing, it was a reminder that volatility is a normal part of investing and clients should ensure their portfolios are positioned for choppier market conditions.
As we reach the midpoint of 2019, some investors could be feeling a little queasy from the market’s ups and downs. Coming off the worst year for U.S. equities in 10 years, 2019 opened with a great run for stocks and worries about the Fed, trade conflicts, and slowing economic and profit growth seemed to be in the rearview mirror. Then, quicker than you could tweet #tariff, the U.S. stock market was mired in a four-week losing streak.
Despite the turbulence, we’re in a better place now than we were to start the year. The Fed’s accommodative stance and the discussion of a rate cut have reduced worries about a policy mistake, and corporate earnings are meeting lowered expectations. On the trade front, however, many investors were too quick to buy into the notion that a resolution to the U.S./China conflict was imminent. And to top it off, Mexico, the U.S.’s third largest trading partner, found itself on the tariff hotseat.
When the U.S./China trade talks in Washington broke up without a resolution in early May, American Century Global Growth Co-CIO Greg Woodhams penned a thoughtful article on lessons learned from trade wars. One of his key takeaways was this: Predicting the exact timing of a trade truce can be a losing proposition. He cited soybean farmers who bet on a quick resolution to the trade conflict, but now must find a market other than China to sell their crops.
Our advice is to remain patient. The public posturing may be noisy while the quieter work of resolving trade imbalances and enforcing agreements takes place behind closed doors. In the end, it’s in the best interest of all parties to reach satisfactory agreements as soon as possible.
While these macro events play out, our investment teams continue to manage their risk exposure as they seek opportunities on a security-by-security basis. In this issue of Investment Outlook, they discuss their most recent insights, including:
We appreciate your confidence in American Century and are grateful for the opportunity to partner with you in pursuit of your financial objectives.
The U.S. economy grew at a robust, better-than-expected 3.1% annualized pace in the first quarter, largely due to net exports. However, we don’t expect that trend to continue, given the likely slowing effects from tariffs. Instead, we expect growth to moderate toward trend levels of 2.0% to 2.5%, which is stronger than growth rates in other developed markets.
After slowing sharply in late 2018, European gross domestic product (GDP) appears to be stabilizing at an annualized pace of 1.2%. A tight U.K. labor market helped lift annualized GDP to 1.8% in the first quarter, though Brexit remains a challenge. Elsewhere, growth in Japan improved in early 2019, but trade issues and an upcoming sales tax hike are clouding the outlook.
Our growth outlook for emerging markets remains stable overall. A dovish Fed remains broadly supportive, but ongoing trade tensions and slowing growth in developed markets remain a threat to EM growth. China continues to implement stimulus measures to combat the economic impact of U.S.-imposed tariffs, but those effects may fade.
We believe year-over-year headline and core inflation will stabilize and converge near 2%. Energy sector volatility continues to affect the headline rate, while rising shelter costs and falling apparel costs are holding the core rate relatively steady. Tariffs likely will nudge inflation rates higher, but slower growth should largely offset rising inflation.
Eurozone inflation recently fell to a one-year low, mainly due to falling energy and services costs. We expect headline inflation to settle in a range of 1.5% to 2.0%, with core inflation of 1.0% to 1.4%. Inflation in the U.K. remains moderately higher, and like our U.S. outlook, we expect U.K. headline inflation to converge with core inflation near 2.0%.
While inflation recently edged higher in Japan, it remains weak overall, largely due to productivity gains and stagnant wages. Although a late-2019 increase in the nation’s consumption tax should boost inflation, the implementation of a free education policy likely will offset the effects of higher taxes.
Between December 2018 and June 2019, Fed policy shifted from tightening to pausing to potential easing. Amid escalating trade tensions, the futures market expects at least one Fed rate cut by the end of July. We believe recent softer economic data together with potential adverse effects from trade likely will encourage the Fed to ease policy in 2019.
Against a backdrop of slowing growth and weak inflation, the European Central Bank (ECB) remains accommodative. The ECB further delayed its first rate hike in nearly eight years to late 2020, at the earliest. Despite the Bank of England’s pledge to implement gradual rate hikes, we expect rates to remain unchanged this year, given the ongoing Brexit challenges.
The Bank of Japan is keeping interest rates unchanged at -0.1% and continues to target a 0% yield for the 10-year government bond. The central bank indicated its stimulus policies would remain unchanged at least through spring 2020, given uncertainties surrounding global growth and the effects of an upcoming consumption tax hike.
Global trade tensions and slowing global growth have driven Treasury yields sharply lower. We now expect the 10-year Treasury yield to trade in a near-term range of approximately 1.75% to 2.40%. We believe any yield curve inversion reflects expectations for slowing growth, muted inflation and Fed easing, rather than a looming recession.
The ECB’s commitment to keeping rates at historical lows for an extended period likely means government bond yields in Europe will remain unusually low. U.K. rates are modestly higher, but we do not expect them to move much given the prevailing backdrop. Rates in Japan remain unusually low amid ongoing and aggressive central bank stimulus.
Given the recent downward shift in developed markets rates, we see little room for global rates to rally further. We continue to focus on markets where rates are more likely to fall or remain stable, such as select emerging markets. These include Mexico, Peru and Indonesia.
The initial round of tariffs on Chinese goods had only modest impacts on consumers because retailers largely ate the cost hikes to avoid raising prices. They managed through these higher costs by being more productive or taking hits to their profit margins.
We believe subsequent tariffs on Chinese goods will have a bigger impact because producers and retailers will have little choice but to pass along higher costs. This became clear during first-quarter earnings calls when we learned retailers are looking hard at price elasticity, implying their willingness to raise prices where they can.
Overall, we view the global move away from free trade as a risk to long-term inflation expectations. It’s important to remember that free trade has been a key reason we’ve experienced relatively low inflation since the 1990s. If the global trend toward protectionism continues, we could lose that deflationary benefit. Expectations are important. Therefore, we should interpret the willingness of retailers and intermediary goods producers to pass on tariff costs to consumers as a signal that inflation expectations are changing.
Political risk is one theme cutting across several sectors as Congress and Democratic presidential candidates discuss regulation of Big Tech and changes to the health care sector. One argument is that leading communication services companies such as Facebook and Google-parent Alphabet have amassed unassailable leads in important businesses, giving them virtual monopoly status. Another criticism is that these companies are profiting from user data without properly safeguarding that personal information. The issues are linked because amassing a treasure trove of user information gives the corporate holders of that data a significant advantage over prospective new competitors.
We believe the risks to the stocks resulting from regulation and data privacy concerns are misunderstood. Few realize that the companies themselves are actively working to shape the regulatory agenda. They are spending massively to address concerns about the accuracy and appropriateness of content on their sites. Facebook founder Mark Zuckerberg testified to Congress that the question was the amount of regulation, not whether regulation was appropriate. We are encouraged by that positive, engaged approach to protecting user data and privacy.
Health care is another sector affected by this political headline risk. We believe we’re in a golden age of health care innovation, as new discoveries and technologies create the possibility of developing treatment options for some of society’s most intractable diseases. But sentiment in the sector has become negative amid worries about the potential effects on pricing if U.S. lawmakers pass Medicare for All legislation. We believe passage of the proposal in its current form is unlikely, however, due to the broad coalition of stakeholders that oppose it and a comparable lack of popular support.
The financial media love hot stocks and initial public offerings (IPOs)1. But, for all the talk about unicorns and disruptors, we believe there are still opportunities in some old-school names.
Thanks to the Amazon effect, many investors have lost interest in old-line brick and mortar stores. And, indeed, retailers such as Circuit City, Borders and Toys R Us met their demise due to competitive pressure, lack of agility and poor decision-making as shoppers moved online. Left for dead as investors pushed Amazon ever higher, survivors such as Best Buy, Walmart and Target took advantage of strong balance sheets and good cash flows to retool and adjust to their customers’ evolving buying habits.
Consumer staples provide another example. The trend toward healthier lifestyles and buying local is putting pressure on national companies manufacturing the prepackaged and canned goods that are mainstays of the middle aisles in your local grocery store. Though their stock prices may not reflect it, many of these businesses have the financial strength, management quality and foresight to survive and thrive in a new landscape that prioritizes fresh food and healthy eating.
Our Value teams see examples like this across the marketplace from information technology to real estate. Though they may lack the buzz of glamour stocks, many of these survivors are fundamentally sound, generate strong free cash flow and sport attractive valuations. These are characteristics we believe win over time.
Energy stocks are known for their volatility. Highly dependent on commodity prices, the sector tends to be cyclical with variable profitability. Small-cap energy companies are particularly challenged. We believe many smaller energy stocks are lower quality and, in fact, more than 90% of small-cap energy companies have underperformed the Russell 2000® Value Index over the last five- and 10-year periods as of March 31, 2019. (Source: FactSet.)
This doesn’t mean investors seeking smaller, high-quality energy-related stocks are out of luck. They can add “side door” energy exposure by investing in companies outside the sector whose performance is correlated with oil prices. These include diversified businesses with ties to energy-related end markets, but whose earning power isn’t exclusively driven by commodity prices. Other characteristics we look for include high return on capital, the ability to generate free cash flow and earnings throughout the energy cycle, and attractive valuations.
For example, industrial parts distributor DXP Enterprises generates roughly half of its revenue from energy-related companies, including industry giants Chevron, Exxon and Shell. DXP also serves agribusiness, aviation and food and beverage companies. Its diversified client base, combined with strong financial management practices, has enabled DXP to generate solid free cash flow during periods when the company’s energy clients are pressured by low commodity prices.2
1An initial public offering (IPO) is the process of offering stocks of a private corporation in a new stock issuance that allows a company to raise capital from public investors.
2References 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.
"For all the talk about unicorns and disruptors, we believe there are still opportunities in some old-school names."
Trade tensions have been among the main topics of concern for global investors over the last few quarters, and this quarter is no different. Increased tariffs on goods from China and new threats against Mexico—followed immediately by promises of retaliation by those trade partners—have roiled global equity markets. In addition to the economic impact, these threatened tariffs have created uncertainty, weakened investor sentiment and slowed decision-making for investors and corporations alike.
We believe such dislocations create opportunities. By identifying those companies with less exposure to trade conflicts, as well as those likely to benefit from the effects of a trade war, investors may be able to better weather the storm. Information technology and materials companies are bearing the brunt of the conflict right now, but the pain will likely spread further if additional tariffs are levied by all sides.
Despite the unique risks that come with investing in smaller companies, the revenue and earnings growth of many small caps could be more resilient to a period of elevated global trade tensions because of small caps’ generally domestic focus versus their larger-cap multinational counterparts. Risks associated with small caps include default risk, less access to capital, fewer product offerings, and less available information about companies.
It’s impossible to predict when these trade wars will conclude—and recent market volatility suggests investors no longer expect a quick resolution—but we believe a settlement will be reached over the medium to long term. It’s in no one’s interest to prolong such disputes indefinitely because all sides have constituencies to appease. U.S. businesses are growing increasingly concerned about the impact of tariffs on exports, and consumers are beginning to feel the pinch of more expensive imports.
New financial regulations enacted in Europe last year may serve to make small-cap stocks more attractive for active investors. The Markets in Financial Instruments Directive (MiFID) II law was instituted by the European Union (EU) to protect investors through fairer and more transparent markets. Among the key tenets of the new regulations are the prohibition of asset managers from receiving free research from investment brokers and the requirement to disclose the cost of research received. The practical effect of these changes has been less research coverage of small-cap companies. The number of equity research analysts employed, and number of companies covered has fallen since the new rules took effect over a year ago. The decrease has been more pronounced on the small-cap side of the business, expanding the information gap between large caps and small caps.
We believe this creates opportunities for active investors. With less information available on smaller companies, active investors may be able to uncover attractive investments before the market can fully price in potential revenue and earnings growth.
"Information technology and materials companies are bearing the brunt of the conflict right now, but the pain will likely spread if additional tariffs are levied."
EM stocks have been among the hardest hit by the ongoing trade disputes between the U.S. and China. The renewed trade rhetoric and weaker-than-expected macroeconomic data suggest that economic recovery remains tenuous.
Despite these concerns, we see reasons for optimism. While some macroeconomic data are weaker, consumers still appear resilient. The Chinese government has renewed its commitment to economic and structural reforms and infrastructure programs to support the domestic economy. In this environment, we continue to find opportunities in domestically and regionally focused companies, consumer-facing companies in e-commerce and education, and infrastructure-related companies in railways and construction.
One result of the ongoing trade dispute between the U.S. and China has been a change in the Fed’s tone. Markets previously expected two or three rate increases in 2019 as the Fed sought to carefully reign in the growing U.S. economy and stay ahead of inflation. Uncertainty around trade and the impact on global growth has altered that stance. The central bank’s tone has become decidedly more dovish after an expected resolution of the trade war disappeared in the second quarter and markets declined sharply in response. Markets are now pricing in no hikes in 2019 and perhaps even a rate cut.
All this may be beneficial for emerging markets. Fears of higher U.S. rates and a stronger U.S. dollar had weighed on EM equities and currencies. Removal of those concerns helped support a rally in EM stocks this year after a tough 2018. Investors are returning to considering earnings growth on a company-by-company basis in emerging markets rather than focusing on the potential negative impact of more aggressive Fed moves.
The growth of the middle class in emerging markets continues to create opportunities. Emerging consumers’ desire for better quality of life is manifesting itself across several sectors, notably financials. Consumers are demanding more access to financial products and services, fueling growth in the banking, asset management, insurance, credit and digital payments industries.
Growing penetration into financial systems is benefiting banking and lending companies in Peru, Brazil, India and Indonesia. Microlenders, such as India’s Bharat Financial Inclusion Ltd., are benefiting as consumers previously denied access to financial services can participate more fully in local economies through small personal loans. Bharat has made loans averaging approximately $336 each to more than seven million Indian women. (Source: Bloomberg, 2019.) This is a significant development in a nation where financial services have historically been limited to the wealthy and where men have traditionally managed financial matters.
"Opportunities can be found in domestically focused companies and those less exposed to global trade."
Recent shifts in sentiment due to global trade tensions and the related negative implications for global growth and inflation cause us to be more constructive on Treasuries. Accordingly, we have increased our Treasury positioning and reduced allocations to spread sectors. We expect the 10-year Treasury note to trade in a range of approximately 1.75% to 2.40% over the next few months. The duration and severity of the trade conflict will influence the direction of Treasury yields. We believe the flattening of the yield curve reflects potential slower global growth, lower inflation expectations and prospects for Fed easing.
We believe year-over-year headline and core inflation, which have moderated due to weakness from energy-related components and apparel, will stabilize near 2%. Tariffs likely will nudge inflation higher, but we expect slower growth to largely offset inflation gains over time. Longer-term inflation expectations continue to moderate and present challenges for the Fed.
Within the securitized sector, we are underweight fixed-coupon agency mortgage-backed securities (MBS) and overweight mortgage credit. Given the potential for spread widening, we have reduced exposure to non-agency commercial mortgage-backed securities (CMBS) and CLOs. From a long-term and strategic perspective, we plan to continue to reduce risk while maintaining exposure to high-quality securitized securities. Overall, we believe the securitized sector offers attractive valuations and downside protection.
Despite recent spread widening, we believe valuations within this sector remain generally in line with fundamentals. The credit market is late in the cycle, and we anticipate spread widening in the future as the cycle matures. In the shorter term, we expect macro developments, including global growth, trade conflicts and central bank policies, to drive the direction of spreads.
We are underweight high-yield corporates and have further reduced exposure through tactical trades. This positioning reflects our expectations for a prolonged U.S.-China trade dispute and the resulting threat to global economic growth. U.S. high-yield fundamentals generally remain stable, but companies must adjust their earnings outlooks to reflect a more challenging macroeconomic backdrop. When spreads appropriately reflect these risks, we may increase our exposure with a bias toward domestically focused industries.
Municipal finances generally remain stable. Muni supply is up slightly versus 2018, and demand remains robust, particularly from high-tax states. Given our outlook for moderating growth, low interest rates and solid credit fundamentals, we have a modest bias toward lower-quality securities (investment-grade securities with BBB credit ratings) and higher-yielding sectors, such as charter schools and retirement communities. Among investment-grade munis, we favor securities in the higher education, transportation and hospital sectors.
With the European Central Bank leaving rates unchanged until next year, European government bond yields will remain low. U.K. rates are vulnerable to downside risk from Brexit uncertainty. We prefer markets where rates are likely to fall or remain stable, including select local emerging markets.
Several factors have weakened our outlook for European credit, including the U.S.-China trade dispute, slowing global growth, heightened prospects for a no-deal Brexit, and Italy’s mounting debt. Meanwhile, central bank stimulus has contributed to rich credit spreads for senior unsecured industrial company bonds. We maintain underweight exposure to European industrial companies. We have reduced our allocation to European subordinated financials and hedged some of our remaining exposure. We still see value in some subordinated financial sector bonds, where capital ratios are strong and balance sheet credit quality is improving, despite lackluster profitability. We sold our Italian covered bond exposure after spread tightening, resuming an underweight to European securitized markets on valuation grounds.
We continue to focus on opportunities with improving or stable fundamentals and attractive valuations. A more-dovish Fed provides support for EM assets, while moderating global growth and mounting trade tensions pose risks. EM sovereign and corporate spreads have tightened since late 2018, but high-yield spreads have widened on trade tensions and risk-off sentiment. Among high-yield sovereign and corporate credit, we are finding select bottom-up opportunities. We also see opportunities among currencies in countries benefiting from improving external balances and attractive valuations. We believe the U.S. dollar is nearing its peak, which should aid local currency holdings. Given the recent move in developed markets rates, we see little room for global rates to rally further. Select EM local rates remain attractive, but we have reduced exposure following the recent rally.
Sluggish global growth, muted inflation and dovish central banks have pushed yields sharply lower around the world. Against this backdrop, nearly one-third of non-U.S. government bonds have negative yields. U.S. government bond yields are lower as well, with bond prices rising as investors search for safe sources of income and ballast against rising stock market volatility.
With depressed yields on government bonds of all stripes, cash is moving into higher-yielding asset classes, such as U.S. high-yield bonds. We continue to find opportunities in these areas, though we’re watching for recession risks and late-cycle events such as a pickup in downgrades or an uptick in lower-quality issuance.
Select bank loans, asset-backed securities and collateralized loan obligations also present attractive options. These vehicles have historically proven resilient through a range of market environments. We believe their valuations are reasonable, and they still hold some promise even in the latter stages of the credit cycle.
The risk-on environment through the early stages of 2019 pushed yields on high-yield corporate bonds lower. At the same time, yields on bank loans rose amid outflows from retail loan funds. Looking ahead, we expect more coupon-like returns for both over the next 12 months.
Driven by year-to-date performance, the spread between high-yield corporates and bank loans is below its five-year average. The narrower spread may make bank loans more attractive to some investors due to their generally higher quality. However, these opportunities don’t come without risk. We’re watching the threats from persistent retail outflows, potential loan downgrades, and deteriorating loan quality and covenant protection.
On a related note, our managers are also finding opportunities among collateralized loan obligations (CLOs), pools of bank loans. CLO debt remains well-insulated from default due to the diversity of the underlying loan portfolios and robust structural credit support. We believe collateral fundamentals are solid overall, but we’re watching the nascent trend of worsening credit ratings. CLO spreads could tighten, but we don’t anticipate significant movement due to the robust deal pipeline, ongoing retail loan outflows and macroeconomic uncertainty around trade.
"We're watching out for recession risks and late-cycle events such as a pickup in downgrades or an uptick in lower-quality issuance."
We’re in an odd place where the stock market is acting like good economic news is good news, and bad economic news is good news because it hastens the day when the Fed cuts interest rates. That explains why stocks seem to hang on every word that Fed Chair Jerome Powell utters, hoping for signs that rate cuts are imminent to justify another rally. But the Fed tends to be reactive, rather than proactive—past rate cut cycles have tended to follow the onset of financial crises or recessions. That means that to get Fed action, the economy would have to be in much worse shape—and that’s an outcome no investor wants.
To be clear, while economic fundamentals aren’t great, we’re not calling for a recession. The job market remains strong and falling bond yields support housing and lending activity. But there’s undoubtedly a global economic slowdown underway; corporate earnings growth in the U.S. is slowing; and bond yields around the developed world have tumbled, which suggests that bond investors see the economy downshifting. Add to that the vagaries of U.S. trade policy, and it’s hard to identify what it is that equity investors are getting excited about.
We think it’s more likely that markets will move sideways from here in a choppy pattern for the rest of the year. As of this writing in early June, U.S. stocks are up more than 15% year to date, which would make it a much better-than-average year if we ended 2019 at these levels. So, it’s not all gloom and doom, but it’s hard to see any fundamental justification for a big move higher in markets.
Our tactical model views stock momentum as negative after a difficult May, and the sharp sell-off in commodity prices is a poor indicator of future growth and stock returns. But we’re reluctant to overweight bonds now after a dramatic rally in the last several months. As a result, the simultaneous decline in stock prices and bond yields mean stocks still offer attractive earnings yields relative to bonds.
Both our fundamental and sentiment-based models favor the U.S. over markets in Europe, Australasia and the Far East. Amid a slowdown in global growth, the U.S. remains the cleanest shirt in the dirty laundry. Earnings yields are more compelling on U.S. equities relative to those of companies outside the U.S.
Earnings yields favor the U.S. over EM equities. However, our fundamental analysts are identifying several attractive opportunities in emerging economies. In sum, we’re neutral on U.S. versus EM.
The recent outperformance by large-company stocks compared with small-company stocks suggests a reversion to small-cap stocks in coming months. Relative valuations also argue for small caps, but our consumer model favors large-company stocks. Taking these factors in total, we have removed our large-cap overweight and are now neutral by size.
We favor growth- over value-oriented stocks. Our model recognizes that valuations in growth are stretched, though it depends on which measures and periods are under consideration. However, economic fundamentals and asset flows point us toward growth stocks. In addition, there’s a fundamental argument in favor of companies that generate dependable cash flow growth at a time when the economy appears to be slowing.
Given low interest rates, modest growth and tame inflation, we believe high-quality investment-grade securitized bonds are attractive. After being long duration and benefiting from the significant bond market rally in recent months, our fixed-income allocations are positioned neutral to short duration in both the U.S. and Europe.
While our models lean modestly toward real estate investment trusts (REITs) versus stocks and cash, the case is not yet compelling enough to go overweight. As a result, we maintain our neutral strategic allocation to global REITs, which offer significant portfolio diversification benefits.
Q3 | 2019
Q3 2019 Deck
Quarterly insights videos from our portfolio managers
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.