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Chief Investment Officer
American Century Investments
Investors were dour heading into the new year. After a rocky fourth quarter, doubt hung over the market due to lingering trade tension between the U.S. and China, uncertainty surrounding Brexit, the U.S. government shutdown, and forecasts for slowing global economic and profit growth. With these macro concerns weighing on investors’ minds, it was hard to be optimistic about markets moving up significantly in 2019.
The mood is sunnier a few months into the new year. Global markets are higher, and through the first two months of 2019, U.S. stocks were off to their strongest start since 1991. The Federal Reserve (Fed) pausing its rate-hike regime, end of the government shutdown and progress in U.S./China trade talks have removed some of the uncertainty.
Still, there’s plenty for investors to ponder and many potential threats to the relative calm. Negotiators are continuing to hash out the details of a potential U.S./China trade deal and it could be quite some time until negotiators finalize terms of the UK’s exit from the European Union.
Though we believe any worries about recession are premature, it’s clear that global economic growth is slowing. The trajectory of earnings growth is also trending downward. Even so, the most recently completed corporate earnings season demonstrated that expectations were too pessimistic as S&P companies posted their fifth straight quarter of double-digit earnings growth. On the downside, however, analysts predict a decline in first-quarter earnings.*
Our investment teams continue to find opportunities against this backdrop, and I’ve highlighted some of their observations for this issue of Investment Outlook.
Investing is a long-term endeavor that requires patience and conviction. The volatility we experienced last year was normal, and we expect more of the same as 2019 unfolds. Therefore, we encourage you to approach these rough patches with the same level of discipline as our portfolio managers. Be forward-looking and have a clear vision of your long-term objectives. Understand your risk exposure and ensure it’s aligned with your goals.
We expect U.S. year-over-year economic growth to moderate toward trend levels of 2.0% to 2.5%. Although it is slowing somewhat, the U.S. economy remains stronger than the growth rates in other developed markets. Trade negotiations with China remain a key factor, and a resolution to the conflict would likely boost U.S. growth.
Uncertainties about trade, tariffs and Brexit are pressuring growth and business confidence in Europe and the U.K. However, a tight labor market is a bright spot in the U.K. Growth in Japan remains weak, as trade issues and an upcoming sales tax hike cloud the outlook, but upcoming new fiscal measures should ease the burden on consumers.
Our outlook for EM growth remains stable overall, but emerging markets are not immune from the global growth slowdown. A dovish Fed remains broadly supportive, but an easing of U.S.-China trade tensions, fiscal stimulus in China and improving growth in developed markets would aid developing markets.
Annual U.S. headline inflation recently fell to 1.6%, the lowest level since June 2017. Weaker year-over-year contributions from the energy component primarily accounted for the decline. As those effects fade, we expect headline inflation to increase modestly, converging with core inflation and stabilizing near the Fed’s 2.0% target.
Weaker energy prices recently drove eurozone annual headline inflation to a nine-month low of 1.4%. We expect headline inflation to settle in a range of 1.5% to 2.0%, with core inflation of 1.0% and 1.4%. Similarly, U.K. headline inflation fell to a 12-month low of 1.8% in January. We expect U.K. headline inflation to converge with core inflation
After falling to 0.2% in January, year-over-year headline inflation in Japan continues to face headwinds from lower energy and mobile-phone service prices. Although a late 2019 increase in the nation’s consumption tax should boost inflation, the implementation of a free education policy would likely offset the effects of higher taxes.
After raising rates nine times over three years, the Fed is on hold, gauging the effects of slower global growth and trade and political uncertainties. We believe the Fed will keep rates steady in the first half of 2019 and may hike again in late 2019 or early 2020.
With European growth slowing, the European Central Bank (ECB) is boosting its stimulus efforts, pushing out its first rate hike to 2020, at the earliest. Additionally, beginning in September, the ECB will launch a new stimulus plan for banks. Meanwhile, we no longer expect any rate hikes in the U.K. this year, given the ongoing Brexit challenges.
Against a backdrop of slow growth and muted inflation, the Bank of Japan is keeping interest rates unchanged at -0.1%. The central bank continues to target a 0% yield for the 10-year government bond and is maintaining its asset-purchase plan at an annual pace of 80 trillion yen.
U.S. Treasury yields continue to face downward pressure from slower global growth and geopolitical uncertainty and upward pressure from better-than-expected U.S. data. Nevertheless, we believe yields ultimately will trend higher, albeit gradually. Near term, we expect the 10-year Treasury yield to trade in a range of approximately 2.50% to 3.10%.
The ECB remains accommodative, and European rates are at historical lows. The recent conclusion of the ECB’s bond-buying program should nudge up rates. U.K. rates remain slightly higher, as growth is stronger and policy normalization is already underway. Rates in Japan will remain low while under the Bank of Japan’s yield curve control policy.
Better relative growth and the three-year Fed tightening campaign are keeping U.S. rates higher than 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.
S&P 500® Index companies reported their fifth straight quarter of double-digit earnings growth to open 2019. However, we can see evidence the tailwinds that supported this high rate of growth are subsiding as the economic cycle matures. For example, the fourth-quarter earnings growth rate of 13.4% was solid, but the first period below 20% since the fourth quarter of 2017. Looking ahead, financial data company FactSet estimates first-quarter 2019 earnings will decline 3.2% compared with the same period last year, which would mark the first year-over-year decline in quarterly earnings since 2016.
We believe this backdrop favors companies benefiting from durable long-term growth drivers rather than stocks that are more dependent on cyclical economic growth. Cyclical profit growth comes from the latent earnings power driven by the economic cycle. Secular growth occurs independent of the economic cycle, driven by long-term trends, innovation or a company- or industry-specific earnings dynamic. As a result, cyclical growers have tended to outperform when the market expects sustained improvement in the economic environment. In contrast, secular growers have typically outperformed when economic growth becomes scarcer.
Though stocks rebounded to start the year, volatility remains a threat as we move later in the cycle. Long/short positions may be appropriate for investors who want to remain invested in stocks while limiting downside risk when the market declines. Many strategies have the flexibility to adapt to changing market conditions dynamically by increasing market exposure in trending environments and trending environments and reducing market exposure during downturns. We prefer long/short strategies that take a disciplined approach to investing in inexpensive, quality companies with strong growth prospects and positive market sentiment—and shorting companies with the opposite characteristics.
Market neutral strategies offer another alternative for managing risk. They have historically demonstrated low to negative correlations to traditional equity and fixed-income investments. Because their performance tends to be independent of broader market results, adding these types of strategies can provide diversification and seek to reduce downside risk during volatile periods. Market neutral strategies may offer an alternative for generating returns without exposing investors to the risk of the overall equity market.
Going forward, we are constructive on the opportunity set for these strategies. As rates have moved higher, market neutral strategies have benefited because they earn interest on their cash balances. In addition, increased volatility means greater dispersion in stock performance, which provides more opportunities to generate return from stock selection.
We’ve seen a wave of high-profile health care mergers. Integrated pharmacy CVS closed a deal with Aetna in November 2018. In January 2019, pharmaceutical giant Bristol-Myers Squibb and biotech firm Celgene announced a merger, while Eli Lilly announced the planned acquisition of Loxo Oncology with its suite of potential cancer treatments. More recently, Johnson & Johnson acquired robotic surgery company Auris Health.*
These transactions are part of a long-running trend toward consolidation throughout the health care sector. Size and scale have competitive advantages, and acquisitions can be an efficient way to identify and acquire new drugs and devices that can drive future growth. For businesses such as pharmaceutical companies, which face pricing pressure and regulatory scrutiny, acquisitions can help reduce costs and drive innovation with new products that may offer greater pricing power. Other factors to consider—we believe stock prices are attractive after the fourth quarter sell-off, and companies have significant cash on their balance sheets to fund acquisitions.
Consolidation also underscores our long-term view that the health care sector remains a very attractive segment of the market. When companies are acquired, we see that as a sign that valuations are compelling and another way for investors in innovative companies with solid fundamentals to potentially realize a return on their investment.
Though U.S. banks have been key beneficiaries of the Trump presidency, market sentiment has been a rollercoaster ride. As expected, bank fundamentals have improved materially, benefiting from tax reform, deregulation, improving economic growth, and higher net interest margins. More recently, however, these improvements have been overshadowed by the flattening yield curve, widening credit spread and premature worries about a potential recession. These concerns peaked in the fourth quarter of 2018 and regional banks fell almost 20%, their worst one-quarter decline since the financial crisis.
The group entered 2019 trading at historically low valuations. In our view fundamental improvements and record capital levels, coupled with our expectations for a more benign credit cycle, have reduced risk and should warrant higher valuation multiples. This is a critically important datapoint that we believe the market has not yet recognized.
Oil prices staged a strong rally to start 2019. On the supply side of the equation, key producers have shown restraint even as commodity prices have risen. OPEC and Russia are working to limit production, and recent reports from U.S. producers have shown increased restraint as well. On the demand side, the International Energy Agency forecasts that demand will increase each quarter this year, though the agency believes upside is limited by slowing economic growth. Demand growth is also supported by a pause in the Fed’s rate-hike regime and progress toward a trade agreement between the U.S. and China.
We believe select opportunities exist in the sector even though strong gains in commodity prices have pushed energy stocks higher this year. Our value teams think large integrated oil companies are close to fairly valued after a stretch of strong performance. Even so, the team believes these companies are still attractive due to their healthy balance sheets, stable cash flows and strong dividend payments. Though much more volatile, the team believes select exploration and production (E&P) and oil services companies offer better valuation opportunities given the large drawdowns in their share prices since oil prices peaked last October.
*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.
"Consolidation underscores our long-term view that the health care sector remains a very attractive segment of the market."
Absent clarity in Brexit negotiations and how trade conflicts ultimately effect China’s economic performance, non-U.S. markets continue to underperform the U.S. While deteriorating sentiment has led to negative earnings revisions in Europe and Japan— both significant exporters to China—we see several reasons for optimism once markets receive some resolution on the Brexit and U.S.-China trade fronts. We believe slowing growth trends are accurately reflected in stock prices, as evidenced by the sharp recovery after December’s oversold conditions. Stocks reacted positively to earnings announcements in the first quarter, suggesting that investor sentiment had turned too negative late in 2018.
U.S. stock outperformance has been driven by faster growth in the U.S. However, as we progress through 2019 and markets adjust to deceleration in most regions, it’s worth noting that growth is decelerating most in the U.S. This situation has created opportunities in non-U.S. developed markets, where we expect growth rates to remain above the historical average. Additionally, as divergence in growth rates lessens, and non-U.S. equity valuations remain relatively lower than those in the U.S., we believe many non-U.S. stocks are attractively priced. Consistent with our bottom-up investment process, we continue to seek high-quality growth businesses trading at discounted valuations as many of these stocks declined in the fourth quarter despite positive fundamentals.
We believe opportunities still exist for growth investors as the global economy enters the next phase of the macroeconomic and corporate earnings cycle. Growth continues to slow, and earnings are decelerating, but trends remain positive. In this environment, it’s necessary to be more selective, remain disciplined and focus on company-specific growth drivers that can withstand the effects of slower global economic growth.
We retain a bias for companies that are beneficiaries of long-lasting growth drivers. These opportunities are generally independent of the overall swings in macroeconomic cycles. For example, our investments within the information technology sector include companies that we believe will benefit from long-lasting, multiyear trends and opportunities such as the shift of advertising budgets to the online space, online retail, electronic payment, and the rollout of 5G technologies.
We also prefer businesses that have a relatively high level of revenue visibility. Companies providing services under long-term contracts, subscription-based businesses and companies that rely on “aftermarket” sales of consumables are attractive.
Finally, we seek companies exhibiting company-specific growth drivers. These drivers may range from new product innovation, restructuring or “self-help” programs to other market share gain initiatives. All represent various catalysts that allow for the potential for sustained revenue and earnings.
"In this environment, it’s necessary to be more selective, remain disciplined and focus on company-specific growth drivers that can withstand the effects of slower global economic growth."
Emerging markets rebounded in the first quarter of 2019. The possibility of a resolution in U.S.-China trade relations, a moderating U.S. dollar rally and lower relative valuations after the sharp decline in the fourth quarter despite solid fundamentals combine to improve the outlook for EM equities.
We continue to see opportunities in companies positioned to benefit from improving economic conditions in Brazil. Firms in financial services and manufacturing are benefiting from the overall economic improvement. Consumer-facing retail and car rental companies are similarly gaining on increased consumer activity and improved sentiment.
Three developments provide renewed optimism about the Chinese economy. Growth data is showing signs of stabilization, the annual National People’s Congress (NPC) reiterated plans to broaden economic reforms and foreign investors have been granted greater access to mainland China A-share stocks.
Data stabilization. Caixin China General Manufacturing Purchasing Managers’ Index (PMI) data ticked up to 49.9 in February following a three-year low of 48.3 in January. Even though readings below 50 represent economic contraction, it’s worth noting that output and new orders expanded. Readings are projected to rise higher as the government continues to support growth through accommodative monetary policy and tax cuts. Because China is one of the few global markets seeing upgrades in earnings per share, this is likely to provide upside for Chinese equities.
Reform implementation. The annual NPC in March focused on economic stability and supply-side reforms. We expect Beijing to remain focused on supporting growth, with increase fiscal easing providing the impetus. While gross domestic product (GDP) growth targets have softened to a range of 6.0% to 6.5%, having the policy easing in place and tax cuts in the pipeline could lead to growth above consensus views for 2019.
A-share expansion. Two recent changes have increased the profile of China’s mainland A-shares for global investors. In March, market index provider MSCI announced it would quadruple the inclusion of A-shares in the MSCI Emerging Markets Index to 3.3% in three phases throughout 2019. This change will make the index a better representation of the overall Chinese equity market. It will also boost demand for China A-shares as institutional investors rebalance portfolios to reflect the new index composition. The Qualified Foreign Institutional Investor (QFII)* quota was doubled to U.S. $300 billion in January, granting foreign investors greater access to China A-shares.
*Qualified Foreign Institutional Investor (QFII) - This Chinese goverment program permits certain licensed international investors to trade on stock exchanges in Shanghai and Shenzhen. Access to particular investments is limited by specified quotas.
"Growth data is showing signs of stabilization, the annual National People’s Congress (NPC) reiterated plans to broaden economic reforms and foreign investors have been granted greater access to mainland A-share stocks."
Overall, we believe Treasury yields will gradually rise. Over the next three months, we look for the 10-year note to trade in a range of 2.50% to 3.10%, as growth moderates and inflation remains muted. We believe the flattening of the yield curve is due to the Fed’s interest-rate normalization, elevated new issuance of shortmaturity Treasuries and lower inflation expectations. We continue to underweight Treasuries in favor of more attractive spread sectors.
We believe year-over-year headline inflation, which has moderated recently due to weakness from energy-related components,
eventually will converge with core inflation and stabilize near 2%. Longer-term inflation expectations are climbing toward historical averages.
We expect to opportunistically reduce exposure to securitized bonds (but maintain our overweights), taking profits given recent strong performance. We continue to favor fixed- and floating-rate mortgage credit securities, 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, which we continue to underweight, and better yield and total return opportunities versus Treasuries.
We believe recent spread tightening has brought valuations more in line with fundamentals. Accordingly, we are taking profits in recent tactical trades. In the short term, we believe global growth, trade policy and central bank strategy will influence spreads. Corporate fundamentals generally remain upbeat, but the late-stage nature of the credit cycle warrants a selective approach. From a longer-term perspective, we plan to reduce risk in spread sectors, expecting spreads to widen down the road.
We are maintaining similar cautions in the high-yield credit sector. We continue to underweight high-yield corporate securities, particularly those from corporations 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.
Finances of state and local municipalities remain stable. New muni supply in 2019 should slightly increase versus 2018, while demand for tax-exempt munis should remain strong, particularly in high-tax states. We favor higher education, transportation and hospital sector munis. Additionally, given our outlook for slowing growth, rangebound interest rates and generally healthy credit fundamentals, we have a modest bias toward lower-quality securities (investment-grade securities with BBB credit ratings) and higher-yielding sectors (charter schools, continuing care retirement communities and special tax).
European government bond yields remain low, but we expect a gradual normalization as the European Central Bank removes accommodations. U.K. rates remain modestly higher, but the Bank of England is on hold due to Brexit uncertainty. We are underweighting European sovereigns, particularly in Germany and the U.K., where rates are well below their historic gap to Treasuries. We prefer markets where rates are likely to fall or remain stable, including select local emerging markets (EM).
We continue to find attractive valuations within the European banking and insurance industries. Credit spreads in these industries remain attractive due to regulatory enforced improvements in capital ratios and risk management. Elsewhere in the European investment-grade universe, valuations appear expensive, particularly within the industrial sector.
We are focusing on opportunities with improving or stable fundamentals and attractive valuations. A more-dovish Fed and an easing of U.S.-China trade tensions are the most likely near-term supportive factors for EM bonds. Faster-than-expected moderation in global growth and a hard landing in China are likely the biggest risks. EM sovereign and corporate spreads have tightened since late 2018, but we believe valuations remain fair overall, particularly among certain high-yield issuers. We remain selective, though, due to heightened idiosyncratic country risks. Overall, we favor local-currency bonds over U.S. dollar-denominated EM debt, following recent gains in external debt and declines in EM currencies. We favor local rates positions in Peru, Indonesia and Mexico and currencies of select commodity exporters. We believe the U.S. dollar is nearing its peak, which should aid local currency holdings. Global trade policy uncertainties, slowing global growth and the unwinding of developed market central bank balance sheets remain market influences that we are monitoring.
Credit instruments, such as bank loans, asset-backed securities and collateralized loan obligations, have historically proven resilient through a range of market environments. Though credit yields have recently rallied along with more traditional fixed-income securities, valuations are reasonable in our view and we believe there are still promising opportunities even though we are late in the credit cycle.
Though defaults are at historically low levels, these opportunities don’t come without risk. For example, we’ve seen an increase in loan issuance to highly levered borrowers. This includes a rise in so-called “covenant-lite” loans, which put fewer restrictions on the borrower while offering fewer protections for the lenders. These aren’t necessarily “bad” loans, but buyers do have to work harder to understand what they’re getting into and to ensure they are compensated for the risks they are taking. Covenants are just one of many factors to consider when evaluating the risk/reward potential associated with an investment.
Markets are in an odd place—in late 2018 we were in the midst of a sharp sell-off, but in the last few months, stocks have put together their best start to a year in 28 years. One reason for the earlier sell-off was worry about the health of the global economy. Two months later and the prospects for global growth are … worse.
Maybe the rally is justified by corporate earnings growth? It’s true that through the fourth quarter of 2018, we experienced five consecutive quarters of double-digit earnings growth. But the stock market is supposed to be forward looking, and it turns out that analysts have predicted slower earnings growth for the first quarter of 2019 and barely positive growth in subsequent quarters. So why the dramatic stock market rebound?
It appears largely due to a single factor—the change in Fed rate policy. In October 2018, Fed Chair Jerome Powell said interest rates were “a long way from neutral,” which arguably put the match to stocks’ fourth-quarter fire. But in early January, perhaps chastened by recent market action, Powell said the Fed would be “patient” with both interest rate increases and the drawdown of its balance sheet.
Perhaps the one certainty amid the volatility—in both directions—is the importance of sticking to your financial plan and maintaining a well-diversified portfolio. It’s this careful attention to managing risks that explain our bias toward large-cap U.S. equities relative to non-U.S. securities and more economically sensitive small-cap stocks.
Strong earnings growth to date and a sharp fall in bond yields during the fourth quarter mean stocks still offer attractive earnings yields relative to bonds. But we’re reluctant to overweight stocks following a huge rebound with more modest expected earnings growth going forward and volatile short-term conditions.
Given the sharp swings in the market and uncertainties around global growth, our bias is toward U.S. large-cap equities. Earnings yields are also more attractive on U.S. equities now than those of non-U.S. alternatives.
A comparatively high-volatility market regime and portfolio risk management considerations point to U.S. equities over EM stocks in multi-asset portfolios. The Fed’s late-2018 interest rate increase and continued strength in the greenback also complicate the outlook for EM companies and countries.
Consistent with our bias toward caution and risk reduction within equities, we are favoring large-cap stocks over small caps. We believe large-company stocks tend to be less volatile and have more avenues to maintain profitability when growth slows.
We’re staying close to home in terms of our growth/value exposure. The prospect of slower growth tends to support a growth stock overweight; however, sentiment and valuation factors favor value. As a result, we’re neutral by style.
We see modest global growth and contained inflation in both developed and emerging markets with very few exceptions. Our fixed-income allocations remain neutral to short duration in both the U.S. and Europe. The recent rally in fixed-income spread sectors means valuations are less attractive than a few months ago, and we are looking to take profits and trim overweight positions.
We maintain our neutral strategic allocation to global real estate investment trusts (REITs), which offer portfolio diversification benefits. Within our underlying allocation, managers favor the U.S., U.K. and select European markets over Asia outside Japan.
Q2 | 2019
Q2 | 2019 Deck
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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.