October 2017 GLOBAL INVESTMENT OUTLOOK AND STRATEGY IT IS A STOCK PICKER’S MARKET ❶Equity Markets Increasingly Driven by Company Fundamentals as Central Banks Reduce Liquidity ❷Quantitative Easing Led to High Correlations; Now in a Differentiated, Stock-Picker’s Market ❸PE Multiple Expansion Can No Longer Be Expected; Companies Must Deliver Earnings Growth ❹Stocks Increasingly Punished for EPS Misses; Focus on Companies with Improving Fundamentals Source: FactSet, U.S. Federal Reserve, Merrill Lynch, Sit Investment Associates, 9/30/17 0 1 2 3 4 5 '04 '06 '08 '10 '12 '14 '16 '18 '20 Other Assets Mortgage-Backed U.S. Treasuries U.S. Federal Reserve Assets, $ Trillion Forecast Assuming Maximum Run-off Rate 0% 20% 40% 60% 80% 100% '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 Average Pair-Wise Correlations of All S&P 500 Stock Combinations Clustered/Macro Market Differentiated/Stock Picker's Market -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% '12 '13 '14 '15 '16 '17 Price Chg Driven by EPS Price Chg Driven by P/E S&P 500 Price Change S&P 500 Price Returns, Contribution from EPS and PE -7% -6% -5% -4% -3% -2% -1% 0% 1% '11 '12 '13 '14 '15 '16 '17 Median Share Reaction (%) to Negative Earnings Surprise Average Special Topic: Why Have Dividend-Paying Stocks Lagged? U.S. and World On Track for At Least 2.0%-2.5% GDP Growth Stronger Growth Dependent on Positive Impact of Fiscal Policies Central Banks Worldwide Becoming More Hawkish Now in a Stock Picker’s Market; Fundamentals Matter Again
Transcript
October 2017 GLOBAL INVESTMENT OUTLOOK AND STRATEGY
IT IS A STOCK PICKER’S MARKET ❶ Equity Markets Increasingly Driven by Company
Fundamentals as Central Banks Reduce Liquidity ❷ Quantitative Easing Led to High Correlations;
Now in a Differentiated, Stock-Picker’s Market
❸ PE Multiple Expansion Can No Longer Be Expected;
Companies Must Deliver Earnings Growth ❹ Stocks Increasingly Punished for EPS Misses;
Focus on Companies with Improving Fundamentals
Source: FactSet, U.S. Federal Reserve, Merrill Lynch, Sit Investment Associates, 9/30/17
0
1
2
3
4
5
'04 '06 '08 '10 '12 '14 '16 '18 '20
Other Assets Mortgage-Backed U.S. Treasuries
U.S. Federal Reserve Assets, $ Trillion
ForecastAssuming Maximum
Run-off Rate0%
20%
40%
60%
80%
100%
'08 '09 '10 '11 '12 '13 '14 '15 '16 '17
Average Pair-Wise Correlations of All S&P 500 Stock Combinations
Clustered/Macro Market
Differentiated/Stock Picker's Market
-5%0%5%
10%15%20%25%30%35%40%
'12 '13 '14 '15 '16 '17
Price Chg Driven by EPS Price Chg Driven by P/E S&P 500 Price Change
S&P 500 Price Returns, Contribution from EPS and PE
-7%-6%-5%-4%-3%-2%-1%0%1%
'11 '12 '13 '14 '15 '16 '17
Median Share Reaction (%) to Negative Earnings Surprise
Average
Special Topic: Why Have Dividend-Paying Stocks Lagged?
U.S. and World On Track for At Least 2.0%-2.5% GDP Growth
Stronger Growth Dependent on Positive Impact of Fiscal Policies
Central Banks Worldwide Becoming More Hawkish
Now in a Stock Picker’s Market; Fundamentals Matter Again
2 Sit Investment Associates
Why Have Dividend Payers Lagged? The lagging performance of dividend-paying stocks in recent years has surprised many investors. This underperformance has occurred against a backdrop of historically low interest rates and slower GDP growth, conditions that have traditionally bolstered dividend-based investment strategies.
S&P 500® Total Returns by Dividend Policy
Source: FactSet, Sit Investment Associates, 9/30/17
Dividend-paying stocks have lagged the market for multifaceted reasons. First, a number of prominent dividend-paying sectors such as energy (low oil prices), financials (low interest rates), consumer staples, and telecom (both because of perceived competitive challenges), have been out of favor with investors and trailed the market as a result. Also, many large dividend-paying stalwarts, such as IBM and GE, have struggled to grow in recent years. While corporate earnings growth has largely reaccelerated, it stagnated for a while starting in late 2014, driven by a stronger U.S. dollar and declining capex exacerbated by falling commodity prices.
Second, higher beta stocks, such as the high growth “FANG” companies (Facebook, Amazon, Netflix, Google) and several other high profile names, tend to lead stocks higher during bull markets (such as the one currently in place since the financial crisis). Compounding this dynamic, low economic growth and aggressive quantitative easing programs has led to relatively narrow market breadth as so-called “momentum” stocks surged ahead in recent years. Given this overall backdrop, it is perhaps not surprising that investors sought “secular” growers largely immune to the aforementioned factors.
While “momentum” stocks have led the market for quite some time, we see the potential for a broadening of leadership based on a number of factors. The U.S. dollar has weakened significantly thus far in 2017, energy fundamentals have improved as markets re-balanced, and the capex
environment has benefited from higher business confidence levels. In addition, interest rates appear poised to increase given the U.S. economy looks strong enough for the Federal Reserve to begin gradually reducing accommodative policies. These factors suggest that the outlook for many dividend paying sectors – including capital goods, chemicals, energy, transportation, and financials – appears to have fundamentally improved. Furthermore, we believe valuations for many dividend payers are relatively attractive, highlighted by the depressed valuations of the energy and finance sectors.
Has the Pendulum Swung Too Far?
Source: FactSet, Sit Investment Associates, 9/30/17
We continue to believe that a diversified portfolio of high quality, dividend-paying companies offers an opportunity to participate in market gains, but also provide investors with some downside protection given the “lower beta” of dividend payers, as a whole. While we remain constructive on the stock market outlook, we recognize that high valuations make equities vulnerable to downside shocks. In this regard, we continue to believe a “barbell” approach is appropriate within dividend portfolios, emphasizing a combination of pro-growth/policy beneficiaries, such as industrials, financials, semiconductors, and transports. This is balanced with what we consider to be the most attractively valued defensive groups, particularly health care, defense, and telecom. As previously discussed, there are growth challenges in some traditional dividend paying stocks and sectors; selectivity is critical in identifying sustainable growth potential.
45.4
14.7 14.52.7
24.430.413.6
-0.8
13.8 12.4
2013 2014 2015 2016 YTD 2017
No Dividend Dividend-Payer
Percent
0.3
0.5
0.7
0.9
'01 '03 '05 '07 '09 '11 '13 '15 '17
S&P 500® Financials NTM Relative P/B Ratio
Average
0.60.81.01.21.4
'01 '03 '05 '07 '09 '11 '13 '15 '17
MSCI World Energy NTM Relative P/B Ratio
Average
Global Investment Outlook & Strategy – October 2017 3
GLOBAL MACRO DEVELOPMENTS
The United States
U.S. economic growth expected to accelerate slightly from the average pace of +1.9 percent since the start of the recovery, with potential upside from fiscal stimulus and capex. Fed confident enough in U.S. economy that it will begin to reduce balance sheet.
Hurricanes Unlikely to Alter Positive Trajectory of U.S. Economy Early assessments suggest that the combined economic costs of hurricanes Harvey and Irma could exceed $200 billion. For reference, the National Centers for Environmental Information estimates the inflation-adjusted costs for Hurricane Katrina (2005) and Hurricane Sandy (2012) – the two costliest natural disasters in recent decades – at roughly $160 billion and $70 billion, respectively. Although the recent hurricanes will distort economic data near-term, history shows that even disasters of this magnitude are unlikely to alter the trajectory of GDP growth over a longer horizon. Third quarter real GDP growth has a modest downward bias from the upwardly revised second quarter pace of +3.1 percent pace (from +2.6 percent) given the estimated drag of 20 to 30 basis points from the hurricanes. However, subsequent quarters should get a moderate boost as rebuilding efforts get underway. We currently forecast that the U.S. economy will grow at least +2.0 to +2.5 percent in 2017 and 2018, with potential upside from Trump administration fiscal policies and improved capital spending.
Elevated U.S. Business Confidence Foreshadows Improved Capex Synchronized global growth, improving domestic demand, enhanced profitability, and modest regulatory relief have buoyed business confidence (Exhibit 1). The consequence has been an increased willingness by companies to make capital outlays and build inventory. Private domestic investment in capital equipment increased +2.0 percent year-over-year in first half of 2017 compared to a decrease of -3.4 percent in 2016. Looking forward, the percent of small businesses planning to make capital outlays in the next three to six months is at an eleven-year high according to the National Federation of Independent Business. This jibes with Federal Reserve business surveys that likewise foreshadow an upswing in corporate capital spending (Exhibit 2). Private inventories, which have been a drag on real GDP growth for much of the last two years, also appear poised to improve (or, at least, become less of a drag) in coming quarters.
Exhibit 1: U.S. Business Confidence Exhibit 2: U.S. Composite Capex Plans Index
Source: Chief Executive, NFIB, Sit Investment Associates, 9/30/17 Source: Federal Reserve, Sit Investment Associates, 9/30/17
85
90
95
100
105
110
4.5
5.0
5.5
6.0
6.5
7.0
7.5
8.0
'12 '13 '14 '15 '16 '17
CEO Confidence Index (L) Small Business Optimism Index (R)
May need follow through on tax reform for positive trend to continue
4 Sit Investment Associates
Fed Could Assume a More Hawkish Tone in 2018; FOMC Turnover a Risk The Federal Reserve (Fed) recently confirmed that it intends to initiate its balance sheet normalization program in October. As we detailed last quarter, the Fed plans to reduce slowly the size of its balance sheet over an extended period by letting assets naturally run-off (i.e., mature) at a rate of $10 billion per month for the first three months and then incrementally ramp to a maximum run-off rate of $50 billion per month thereafter. Assuming the Fed continually reduces assets at the maximum monthly pace, which we view as unlikely, the size of its balance sheet would slowly decline from $4.5 trillion currently to approximately $2.8 trillion by late 2020. We believe that a protracted balancing of accommodative monetary policy is unlikely to derail economic growth in the intermediate term. Given possibly significant changes to the composition of the Federal Open Market Committee (FOMC), however, there is a potential that the Fed’s policy stance may become increasingly hawkish. Two notable hawks, Loretta Mester and Mark Mullinix, will become voting members of the FOMC in 2018. In addition, there are four vacant positions with the recent departure of Vice Chair Fisher and a possible fifth when Janet Yellen’s term as Chair expires in February 2018.
Fiscal Stimulus Poised to Increase as Monetary Stimulus Moderates Six Republican leaders of Congress released on September 27 a “framework” for tax reform (Exhibit 3). Funding the plan’s proposed tax cuts without adding meaningfully to the country’s already massive fiscal deficit/national debt will be one of the biggest obstacles to realizing tax reform. Although the plan’s details remain sparse, Republicans have purportedly hammered out an agreement that entails a tax cut of $1.5 trillion over ten years (versus previous calls for budget neutrality). If the tax plan is implemented as proposed early next year, it could add an estimated 50 basis points to 2018 GDP growth. Early analysis from both the Tax Policy Center and the Committee for a Responsible Federal Budget suggest that the tax plan would reduce federal revenue by $2.2-$2.4 trillion over the next decade. Yet, these projections do not incorporate the impact of accelerated growth potential from tax reform. We see little chance that tax legislation passes in its current form as certain components of the plan (e.g., elimination of the state and local tax deduction) will lack support, but remain optimistic that Congress will be able to implement some level of tax reform that will be stimulative to the economy.
Exhibit 3: The GOP “Big Six” Tax Reform Framework
Source: Merrill Lynch, 9/27/17
Personal Tax Corporate Tax
■ Double the standard deduction ■ Reduce corporate tax rate to 20%■ Seven to three tax brackets (12%, 25%, 35%), with a ■ Limit max tax (pass-through) rate for small and
possibility of an additional top rate for the highest earners family-owned businesses to 25%■ Repeal personal exemption for dependents and increase ■ Allow business to immediately write off the cost of
the child tax credit new investments in depreciable assets■ Repeal the alternative minimum tax ■ Deduction for net interest expense incurred by ■ Eliminate most itemized deductions (with exception of C corp will be partially limited
mortgage interest and charitable deductions) ■ Exempt foreign profits when repatriated to the US, ■ Retain tax benefits for work, higher education, and 100% exemption for dividends from foreign subsidiaries
retirement■ Repeal the death tax and generation-skipping transfer tax
Global Investment Outlook & Strategy – October 2017 5
United States: Notable Data Points Better Inventory Levels May Bolster GDP
Freight Demand Outlook Increasingly Positive
Source: BEA, Sit Investment Associates, 9/30/17 Source: Merrill Lynch, Sit Investment Associates, 9/30/17 Manufacturing PMI at Thirteen-Year High
Inflation Expectations Creeping Back Up
Source: ISM, Sit Investment Associates, 9/30/17 Source: Cleveland Fed, Sit Investment Associates, 9/30/17 Deregulation Will Bolster Business Confidence Congressional Budgets Seek Deficit Reduction
Source: NSBA, Sit Investment Associates, 1/10/17 Source: Committee for a Responsible Federal Budget, 9/29/17
-2.0bp
-1.5bp
-1.0bp
-0.5bp
0.0bp
0.5bp
1.0bp
1.5bp2Q
15
3Q15
4Q15
1Q16
2Q16
3Q16
4Q16
1Q17
2Q17
Change in Private Inventories,Contribution to GDP Growth
Inventory growth poised to be a net contributor to GDP; could offset hurricane impact in 3Q17
455055606570758085
'13 '14 '15 '16 '17 '18
Shippers Outlook for Freight Demand 6-12 Months Forward
Domestic freight shipments ahead of 2016 levels; industry tone has been increasingly positive
Indicative of an acceleration in GDP growth
30
35
40
45
50
55
60
65
'08 '09 '10 '11 '12 '13 '14 '15 '16 '17
Expansion > 50
Contraction < 50
U.S. Manufacturing PMI
1.0%
1.2%
1.4%
1.6%
1.8%
2.0%
'12 '13 '14 '15 '16 '17
* model uses Treasury yields, inflation data, inflation swaps, and survey-based measures of inflation expectations to calculate the expected inflation rate
Five Year Expected Inflation*
Trendline
75%65%
51%45%
40%39%
24%21%
16%
Federal Tax CodeAffordable Care Act
Overtime RulesState Licensing
Reporting Pay Data by…Independent Contractor Test
EPA Clean Water RuleWaters of the U.S. Rule
Limit Carbon Emissions by…
Percent of Survey Respondents That Indicate Regulation Area Is "Very Burdensome" or "Somewhat Burdensome"
Percent of GDP
6 Sit Investment Associates
Europe
The Euro Area is on a more solid economic footing, but we see little evidence to imply GDP growth with accelerate further. Brexit continues to restrain the UK’s economic prospects.
Euro Area GDP Growth Has Likely Plateaued; UK Economy Restrained by Brexit The economic outlook for the Euro Area has improved modestly in recent quarters, particularly when compared to reduced consensus forecasts directly following the EU referendum (i.e., Brexit) in June 2016 – see Exhibit 4. However, both the number and magnitude of positive economic surprises continue to diminish as consensus estimates normalize, comparisons become more difficult, and favorable euro exchange rates moderate (Exhibit 5). We forecast Euro Area real GDP growth will remain around +2.0 percent in 2017 and 2018 as we currently see little evidence to suggest that economic momentum will further accelerate. As for the United Kingdom, we continue to project that real GDP growth will slow to an annual pace of about +1.5 percent over the next couple of years as Brexit-related uncertainty continues to restrain economic activity. The British government initiated in March 2017 the formal two-year process of withdrawing from the European Union (Exhibit 6). Yet, the strategic priorities and likely outcomes of the exit remain unclear, putting downward pressure on confidence and spending.
Despite Recent Jawboning, Monetary Policy Will Remain Accommodative Rising inflationary pressures in the United Kingdom and a more solid economic footing in the Euro Area have raised the specter that monetary policy will become less accommodative in coming years. The Bank of England (BoE) last reduced its key policy rate to 25 basis points in August 2016 in the immediate aftermath of the EU referendum and has maintained an asset balance of roughly £400 billion since 2012 (up from £100 billion in 2007). Given the overhang of Brexit and associated depreciation of the British pound, the UK faces the grim prospect of slower economic growth and higher inflation. While the BoE indicated it might soon raise interest rates in an effort to contain inflation, any monetary tightening would likely occur at a glacial pace so as not to dampen economic growth. With respect to the Euro Area, the European Central Bank (ECB) has kept its key policy rate at zero percent since March 2016 and continues to expand its balance sheet, the size of which currently exceeds €4.3 trillion. Beyond slowing asset purchases in 2018, the ECB is unlikely to unwind stimulus within the next year due to relatively benign inflation and ample slack in most Euro Area economies.
Exhibit 4: Euro Area GDP Estimates, Consensus Exhibit 5: Euro Area Economic Surprise Index
Source: FactSet, Sit Investment Associates, 9/30/17 Source: Citi, Sit Investment Associates, 10/1/17
1.0%
1.2%
1.4%
1.6%
1.8%
2.0%
2.2%
1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17
2017E Real GDP Growth 2018E Real GDP Growth
BrexitVote
Estimate cuts post the EU referendum helped set the stage for upward revisions this year
-40
-20
0
20
40
60
80
10/1
611
/16
12/1
61/
172/
173/
174/
175/
176/
177/
178/
179/
17
Inde
x Le
vel (
3MM
A)
However, positive economic surprises in the Euro Area have moderated
Global Investment Outlook & Strategy – October 2017 7
Exhibit 6: Brexit Timeline and Continuum of Possible Outcomes
Source: Nomura Research, Institute for Government, Sit Investment Associates, 9/30/17
European Commission makes a recommendation to
the European Council on "sufficient
progress" to start future relations
Exit deal agreed and concluded between UK and EU, and the ratification process
begins
Deadline for ending talks on the UK's withdrawal terms
from EU
New relationship between the UK and EU enters into force
Brexit negotiations begin
Transitional period and technical talks on the
future relationship between the UK and EU
Negotiating a withdrawal deal
Citizens' rights, exit bill, Northern Ireland
June 19, 2017 Oct-Dec 2017 October 2018 March 29, 2019 By March 2022
Negotiating a "framework for future
relations"
Future trade and non-trade relations (e.g.,
security)
Ratifying the withdrawal deal
Vote in the UK and in the European Council and
Parliament
European Union's Proposed Timetable for Brexit Negotiations
"Softest" Brexit "Hardest" Brexit
❶ ❷ ❸ ❹ ❺ Description European Economic
Area (EEA)-styleConcessional deal with good Single
Market access
Concessional deal with limited Single
Market access
Bare bones free trade agreement
(FTA)
Split with no deal, poor UK-EU relations
Negotiations Amicable, UK leaves EU on good terms
Tough, but fairlyamicable; both sides
happy with deal
Tough, difficult at times, hard-fought deal on both sides
Difficult talks, UK-EUrelationship soured
but survives
Talks worsen,possibly end earlyand in acrimony
Divorce Bill Agreed quickly,paid in installments
Agreed and paid ininstallments
Talks difficult, finally agreed and paid in
installments
Talks bitter buteventually agreed,paid in installments
Zero payment
Single Market/ Customs Union
Remain SM (not CU)member, accept 4freedoms & ECJ
Leave SM & CU butsignificant access via
concessions to EU
Leave SM & CU but significant access via
concessions to EU
Leaves SM & CU;no cherry-pickingso limited access
Leaves SM & CUwithout access
Cliff Edge Transitional deal(2-3Y) agreed
Transitional deal(2-3Y) agreed
Transitional deal(2-3Y) agreed
Transitional deal (2-3Y) but risk of not
being ready in time
No FTA and nointerim adjustment
period to WTO
Future Relationship
Either a member of the EEA or similar
styled FTA
Comprehensive Canada-style FTA;
some services trade, fin. equivalence+
Comprehensive Canada-style FTA;
services trade limited, no fin. passporting
Bare bones FTAagreed with limited
access to SM
WTO rules, EU grab for financial business, UK competitive push (tax cuts, state aid)
Simplified ExamplesBrexit Outcomes
8 Sit Investment Associates
Europe: Notable Data Points ECB Likely to Continue Purchases through 2018 Euro Area Consumer Confidence Improving
Source: European Central Bank, Sit Investment Associates, 9/30/17 Source: Eurostat, Sit Investment Associates, 9/30/17 Manufacturing PMI Aided by Weak Euro UK Confidence and Spending Waning
Source: IHS Markit, Sit Investment Associates, 10/2/17 Source: Eurostat, Sit Investment Associates, 9/30/17 Rising Inflationary Pressure in the UK Merkel Wins Election, but Party Loses Clout
Source: Office for National Statistics, Sit Investment Associates, 9/30/17 Source: Wall Street Journal, 9/28/17
Global Investment Outlook & Strategy – October 2017 9
Japan Growth continues to surprise, supported by exports and stimulus spending. Sustainability questionable given structural challenges and waning support for Prime Minister Abe.
Japan’s economy continues to outpace the modest expectations at the beginning of the year, growing at a +2.5 percent annualized pace in the most recent quarter. Gradually improving growth abroad since the middle of last year has buoyed export demand while last fall’s supplementary budget is now making its way into the economy, providing an added boost. Consumer spending too has perked up. However, our view remains that Japan’s structural challenges, evident in stagnant wages and limited inflation, will prevent a sustained pick-up in domestic demand, capping the country’s growth potential. These structural issues appear all the more difficult to address as Prime Minister Abe’s reform efforts have lost steam and recently called elections are unlikely to spur any meaningful change. Against this backdrop, we expect the Bank of Japan to continue its easing stance as inflation remains stubbornly low. We have raised our 2017 growth forecast to +1.0 percent due to stronger-than-expected activity to date but expect growth to revert to low levels in 2018 as the benefit from stimulus spending fades and consumption slows.
Japan: Notable Data Points Growth Overseas Supporting Exports Wage Growth Still Muted
Source: Japan Customs, Sit Investment Associates, 9/30/17 Source: Japan MHLW, Sit Investment Associates, 9/30/17 Inflation Remains Near Zero Growth Continues at a Tepid Pace
Source: Japanese Cabinet Office, Sit Investment Associates, 9/30/17 Source: Japanese Cabinet Office, Sit Investment Associates, 9/30/17
-15%
-10%
-5%
0%
5%
10%
15%
'12 '13 '14 '15 '16 '17
3MMA - Y/Y% Y/Y%
Japan Export Volume Growth
-6%-5%-4%-3%-2%-1%0%1%2%
'08 '09 '10 '11 '12 '13 '14 '15 '16 '17
Japan Nominal Wages, 3MMA Y/Y%
-3%-2%-1%0%1%2%3%4%5%
'08 '09 '10 '11 '12 '13 '14 '15 '16 '17
All Items Ex. Fresh Food and Energy
Japan Consumer Price Index, Y/Y%
-0.1%
1.5%2.0%
0.3%
1.1% 1.0% 1.0%0.5%
-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%
'11 '12 '13 '14 '15 '16 '17E '18E
Japan Real GDP Growth, Y/Y%
10 Sit Investment Associates
Emerging Markets • China’s economic growth will moderate slightly in 2H17 on reduced policy support,
environmental enforcement, and moderating credit growth. All eyes will be on the composition of the new Politburo Standing Committee (announced late October).
• Post demonetization and Goods & Services Tax, India's GDP growth will strengthen to +6.8 percent this year on improved industrial production and inventory restocking.
• South Korea’s President plans to pursue the policies from his election campaign, which include creating jobs, raising wages, reforming chaebols, and strengthening trade. North Korea's ongoing provocations risk sidelining/delaying his agenda.
• GDP growth has resumed in Brazil, but political risks will curtail rapid expansion.
Power Reshuffle at 19th Party Congress; China’s GDP Growth Will Moderate The Chinese Communist Party’s 19th Party Congress will begin on October 18. The Congress, which focuses on political succession rather than economic policy, will likely result in significant compositional changes to party leadership (Exhibit 7). There is little doubt that Xi Jinping will continue another term as General Secretary, the party’s highest leadership position. However, four to five out of the seven members of China’s top decision-making committee, the Politburo Standing Committee, are expected to step down. In addition, 60 percent of the 376-seat Central Committee – which includes ministers, state industry chiefs, and army generals – will be replaced. Historically, policy
Exhibit 7: Chinese Communist Party Leadership
Source: Wall Street Journal, Sit Investment Associates, 9/30/17
⏹ Expected to retire ⏹ Purged for corruptionTotal Members: 7 ⏹ Expect to remain ⏹ UncertainExpected to Retire: 4 to 5
Politburo Total Members: 25 Includes Standing Committee plus two top generals, heads of major party departments and leaders of major provinces and citiesExpected to retire: 10 to 11
Xi Li ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹Jinping, Keqiang,age 64 62 Central Committee Total Members: 376
Includes Politburo plus state industry chiefs, provincial leaders and senior generalsExpected to retire: about 208 Purged for corruption: about 20⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹ ⏹
Global Investment Outlook & Strategy – October 2017 11
has been accommodative leading up to the Congress to ensure a stable macroeconomic backdrop. While there could be concerns about the economic outlook post the Congress, we expect growth will moderate only slightly in the second half of 2017 due to reduced policy support, ongoing environmental enforcement, and moderating credit growth. We do see slight upside to the consensus estimate of +6.7 percent for 2017, but forecast GDP growth will slow to +6.4 percent in 2018 as structural issues re-emerge.
India’s Economy Still Expected to Strengthen Post Demonetization and GST India’s GDP growth of +5.7 percent year-over-year in the first quarter of fiscal 2018 was below expectations due to weaker private consumption and exports. We believe the last two quarters of sub-6 percent GDP growth are a result of the transitory effects of currency demonetization in November 2016 and implementation of the Goods & Services Tax (GST) on July 1. Industrial production is gradually improving post GST and inventory restocking will likely accelerate in anticipation of rising demand. The Indian government is also considering a stimulus package worth as much as 0.5 percent of GDP to boost the economy. In terms of monetary policy, the Reserve Bank of India cut its repo rate -25 basis points to 6.0 percent during the latest quarter. However, we do not anticipate further rate cuts going forward. We remain positive on India based on stronger consumer-led growth and Prime Minister Modi’s continuation of reforms. We forecast GDP growth of +6.8 percent in fiscal 2018 and +7.2 percent in fiscal 2019.
South Korean Economy Remains on Track Despite North Korean Provocations President Moon Jae-in continues to pursue the policies he pledged during his election campaign (i.e., creating jobs, raising wages, reforming the chaebols, and strengthening trade) and the parliament passed the government’s supplementary budget in July, which should boost economic growth. However, North Korea’s ongoing provocations risk sidelining or delaying implementation of Moon Jae-in’s agenda. In response to new sanctions, Kim Jong Un has threatened to detonate a hydrogen bomb over the Pacific Ocean. We do not expect a military conflict and anticipate that China and the United Nations will continue to urge negotiations to ease tensions. North Korea’s provocations aside, economic trends appear on track to achieve our forecast for GDP growth of +2.8 percent in 2017 and +2.9 percent in 2018. The key driver to the South Korean economy is exports, which grew by +17 percent year-over-year in August, led by semiconductors, general machinery, petrochemicals, autos, and auto parts.
Brazil’s Economy Has Finally Emerged from a Recession, yet Risks Remain Brazil posted second quarter 2017 GDP growth of +0.2 percent quarter-over-quarter seasonally-adjusted, its second consecutive quarter of growth, helped by a strong agricultural sector and recovery in private consumption. Despite improvement in the economy, Brazil’s political climate remains in crisis. Although we do not believe that President Temer will be impeached, the political corruption case against him affects the government’s ability to pass critical reforms, such as pension reform, a key item in containing its fiscal plight. Brazil’s government is embarking on privatization to raise revenue and boost infrastructure investment, but this is not likely to generate enough funding. Therefore, Brazil will continue to rely on interest rate cuts to grow the economy. We expect another -100 basis point cut in rates, as inflation for the first half September of +2.6 percent year-over-year was below the central bank’s target of +4.5 percent. We expect GDP growth of +0.5 percent in 2017 and +1.8 percent in 2018, driven by the consumer. However, the positive impact from improved consumer spending may diminish, as unemployment remains high, capital formation growth is negative, and there is limited government spending available given the debt situation.
12 Sit Investment Associates
Emerging Markets: Notable Data Points China Fiscal Disbursement Frontloaded; Slower Spending Expected in 2H17
Robust Job Market Supporting Chinese Household Income
Source: Morgan Stanley Research, 9/28/17 Source: Morgan Stanley Research, 9/28/17 India Motorcycle and Car Sales Rebounding South Korea Exports Remain Strong
Source: Morgan Stanley Research, 9/30/17 Source: Bank of Korea, Sit Investment Associates, 9/30/17 Brazil’s Economy Out of Recession, For Now Brazil Unemployment Rate Still High
Source: IBGE, Sit Investment Associates, 9/30/17 Source: IBGE, Sit Investment Associates, 9/30/17
Govt. Govt.Expenditure RevenueGrowth, % Growth, % Tracking* Official
2014 9% 9% 1.8% 2.1%2015 16% 8% 3.4% 2.4%2016 7% 5% 3.8% 3.0%H1 16% 10% 3.8% 3.0%Jul-Aug 4% 10%Sep-Dec 3% 8%* The gap between reported budget deficit and tracking deficit was adjusted by Budget Adjustment Fund and fiscal deposits.
Fiscal Deficit
2017
% of GDP
-20%
-10%
0%
10%
20%
30%
2015 2016 2017
Passenger Cars Two-Wheeler
Year-Over-Year Percent
60
80
100
120
140
160
'08 '09 '10 '11 '12 '13 '14 '15 '16 '17
South Korea Export Volume Index, 3MMA
-2.3
-1.4-0.9 -1.0
-0.4 -0.6 -0.5
1.0
0.2
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
2Q15
3Q15
4Q15
1Q16
2Q16
3Q16
4Q16
1Q17
2Q17
Brazil Real GDP Growth, Q/Q% SAAR
4%
6%
8%
10%
12%
14%
'12 '13 '14 '15 '16 '17
Brazil Unemployment Rate (%)
Global Investment Outlook & Strategy – October 2017 13
FIXED INCOME: ENVIRONMENT AND STRATEGY
Taxable Bonds Yield Curve Continues to Flatten Increases in the target fed funds rate have continued to move short-term yields higher and the modest reduction of stimulus has partially relieved fears of rising inflation, resulting in only modestly higher longer-term yields. The yield curve continued to flatten during the third quarter of 2017, as yields rose more in shorter maturities (1-3 years) than in longer maturities (10-30 years). We expect the yield curve will continue to flatten naturally as the Fed continues to raise short-term interest rates and begins implementing its balance sheet reduction program. Increasing Short-Term Rates and Shifts in Federal Reserve Composition In conjunction with reducing its balance sheet, we anticipate the Fed will hike the fed funds rate by another 25 basis points in December. We expect one or two more 25 basis point increases in 2018, but believe this will be data dependent and further influenced by the success of the balance sheet reduction. We also do not anticipate the reappointment of Chair Yellen when her term ends in 2018, as President Trump will likely want to appoint someone who advocates his policies. In addition, new people could fill five of the twelve positions at the Fed. As a result, we expect the tone of the Fed to become more pragmatic, with a better balance of practitioners versus its current academia representation. If this is indeed the case, we would expect the Fed to be less interventionist than it has in the past, which may involve an accelerated pace of balance sheet reduction and the possible elimination of paying banks interest on excess reserves. Taxable Fixed Income Outlook and Strategy We expect economic growth to continue at the current pace, allowing the Fed to continue its path of “normalization.” We anticipate the upcoming quarters will present trading opportunities surrounding the Federal Reserve’s implementation of balance sheet reduction and tax reform legislation. The dampening of interest rate deductibility could spur near-term issuance, initially widening spreads, only to narrow them next year on lower supply. We maintain positions in high-coupon, seasoned agency mortgages as these securities benefit from a slow-down in prepayment activity and exhibit very little interest rate sensitivity. Overall, client portfolios are positioned defensively against a rising interest rate environment and to benefit from a flattening of the yield curve.
Municipal Bonds Tax-Exempt Yield Curve Changed Very Little in the Third Quarter The AAA tax-exempt municipal bond yield curve steepened ever so slightly during the quarter due to a net yield increase totaling 5 basis points 30-years out, relative to a 6 basis points decline for a two-year horizon. Across the entire curve, there were no net yield movements of greater than 10 basis points either up or down. Overall returns were positive during the period, due to strong performance in July and August, while September posted negative results. The yield on the Bond Buyer 40-Bond Index was also minimally changed for the period, ending September with a 4.03 percent yield, relative to a 4.08 percent yield at the start of July. Longer Duration and Baa-Rated Bonds Continue to Outperform All duration indices posted a third consecutive quarter of positive returns, with performance during the period being generally better for longer maturities, particularly those in the 15- to 20-year range (See Exhibit 8). All investment grade municipal bond
14 Sit Investment Associates
index returns continue to be positive on the year. The Baa index has been the best performing category for the year, and this trend was all the more evident in the most recent period. Performance of the High Yield Index continues to be bolstered by exceptionally strong tobacco, GO, and IDR/PCR performance, even as Puerto Rico lags significantly. The joint effects of hurricanes Irma and Maria have brought further physical and financial stress to the territory. Although Puerto Rico debt had already been trading at deeply discounted levels, the storms have made near-term restructuring less likely. Performance variation between revenue bonds and general obligation bonds since June has been negligible. Calendar year to date through September, revenue bonds have outperformed GOs by a modest 34 basis points. Within the Revenue bond index, the hospital sector has had relatively better performance, while housing lagged modestly for the second consecutive quarter. Even so, both the housing and hospital sectors are among the best performers year to date. We will continue to emphasize housing bonds as they traditionally offer strong relative and defensive value over longer periods. Positive Fund Flows with Light Supply Supporting Tax-Exempt Bond Prices Issuance has continued to trail the record pace set in 2016. We expect total issuance in 2017 to finish near the longer-term average, which would be about 15 percent less than last year. Also of note, refundings have comprised less than 40 percent of all 2017 issuance, compared to 50 percent of 2016 issuance and refunding volume is not likely to pick up over the remainder of the year. Municipal bond fund flows continue to be mostly net positive each week and the year-to-date cumulative inflows are reported at just over $13 billion through September. The steady inflows and lighter issuance have led to strong technical support. Tax-Exempt Fixed Income Outlook and Strategy Although the net yield curve changes for the July through September period were fairly minimal, performance during the month of September was much weaker than for the quarter overall. September saw the broad municipal index return a negative 51 basis points, despite total quarterly performance of a positive 106 basis points. With respect to policy, the Senate once again failed to pass a health care bill, and once again the hospital sector has outperformed other revenue bonds for the quarter. Focus in Washington has now shifted to tax reform. Material change to the tax-exempt status for municipal bonds is not widely expected to occur. Perhaps one of the most impactful municipal market proposals, a broad reaching infrastructure bill, now seems to be entirely on the back burner with no action on legislation forecasted before 2018. We do not believe that either piece of legislation will move quickly enough at this point to materially impact tax-exempt bond performance in 2017. We continue to have high confidence in the strong fundamental credit quality that the vast majority of municipal bonds provide. Our tax-exempt investment strategy will continue to place heavy emphasis on investing in bonds that have premium coupons and provide meaningful current income, which we believe is the primary driver of total return over the full market cycle. We expect to maintain most portfolio durations near their current levels while also continuing to focus on investing in bonds with higher credit quality ratings and short call features with limited extension risk. As always, we view diversification as a key tenet in managing portfolio credit risk.
Global Investment Outlook & Strategy – October 2017 15
Exhibit 8: U.S. Fixed Income Index Total Returns
Source: FactSet, Sit Investment Associates, 9/30/17
Global equity markets have remained surprisingly resilient in the face of elevated geopolitical tensions and partisan conflict in Washington. Ongoing strength in larger capitalization, growth-oriented stocks has led U.S. equity markets higher thus far in 2017, with the Russell 1000® Growth Index generating a total return of +20.7 percent in the first nine month of 2017 (Exhibit 9). On the other end of the continuum, the Russell 2000® Value Index produced a total return of +5.7 percent year-to-date (Exhibit 10). The performance of the Russell 1000® Growth Index has been relatively concentrated in 2017, with roughly 40 percent of the Index’s year-to-date returns driven by only ten stocks. Internationally, Chinese stocks have performed extremely well this year, with the MSCI China Index generating a total return of +14.8 percent in the third quarter and +43.4 percent for the first nine months of 2017. The MSCI Europe Index also continued its positive streak, generating a total return of +6.5 percent in the third quarter and +23.4 percent year-to-date. On the other hand, the MSCI Japan Index has generally lagged in 2017. Looking forward, there well could be a “catch-up” trade in relative underperformers and value stocks in the near term, but we also anticipate that investors will continue to gravitate to quality growth stocks given the maturity of the economic expansion and further potential in the growth stock cycle (Exhibit 11).
Exhibit 9: Total Returns of U.S. and International Indices
Source: FactSet, Sit Investment Associates, 9/30/17
Percent, as of 9/30/17 = Top Quartile Performance within Group
International Indices (in USD)MSCI China 14.8🎖🎖 43.4🎖🎖 35.6🎖🎖 33.3🎖🎖 12.8🎖🎖 11.2🎖🎖 2.1🎖🎖MSCI Emerging Markets 8.0 28.1🎖🎖 22.9 22.9 5.3 4.4 1.7MSCI EM Latin America 15.1🎖🎖 27.0🎖🎖 15.1 26.0🎖🎖 0.0 -1.6 -0.5MSCI Brazil 23.0🎖🎖 26.9 16.2 29.6🎖🎖 2.0 -1.3 -1.4MSCI Mexico 1.5 26.4 8.4 16.5 -4.7 -1.0 1.3MSCI India 3.0 24.1 16.4 14.2 4.5 6.6 1.5MSCI Europe 6.5 23.4 27.6🎖🎖 23.0 5.0 9.0 1.7MSCI AC Asia Pacific 5.3 22.0 19.9 18.4 7.6 8.5 2.6🎖🎖MSCI EAFE 5.5 20.5 23.0🎖🎖 19.7 5.5 8.9 1.8MSCI World Index 5.0 16.5 21.0 18.8 8.3🎖🎖 11.6🎖🎖 4.8🎖🎖MSCI Japan 4.1 14.6 15.2 14.5 8.1🎖🎖 10.9🎖🎖 1.9
Annualized
Annualized
3 Months 1 Year
🎖🎖
YTD 2017 Since 11/8 3 Years 5 Years 10 Years
3 Months 1 YearYTD 2017 Since 11/8 3 Years 5 Years 10 Years
▼
▼
Global Investment Outlook & Strategy – October 2017 17
Exhibit 10: Total Returns of Russell Indices Exhibit 11: Growth and Value Stock Cycles
Source: FactSet, Sit Investment Associates, 9/30/17 Source: FactSet, Sit Investment Associates, 9/30/17
As the equity markets shift from a monetary policy driven market (rising tide lifts all boats) to one driven by company fundamentals, stock picking (i.e., finding companies that can consistently deliver quality earning growth) will drive investment performance. We anticipate that earnings growth, rather than PE multiple expansion, will continue to be the primary determinant of stock appreciation going forward. Bottom-up earnings for the S&P 500 Index are currently forecasted to increase +10.1 percent in 2017 and +11.0 percent in 2018 (Exhibit 12), suggesting that 2018 could be another good year for U.S. equity performance. Similarly, bottom-up earnings for the MSCI World Index (excluding the U.S) are projected increase +24.3 percent in 2017 off an easy year-over-year comparison and + 7.3 percent in 2018 (Exhibit 13). Global portfolios are overweight the United States, Europe and Asia (ex. Japan), while underweight Japan and Latin America. As we have highlighted in the past, tax reform and increased infrastructure spending, in addition to ongoing deregulation, have the potential to accelerate U.S. GDP growth further if successfully implemented. Likewise, better business and consumer confidence could also lead to stronger spending growth if there is policy follow-through. However, geopolitical tensions, potential trade wars, partisan conflict, and moderation of easy monetary policy present downside risks. As the range of possible outcomes remains relatively wide, we continue to implement a
diversified “barbell” strategy across client portfolios that encompasses a combination of visible growth sectors and pro-cyclical, Trump policy beneficiaries (Exhibit 14). We have increased our exposure to financials as the sector stands to benefit from a rise in U.S. interest rates, deregulation, and tax reform. We have also added to capital goods stocks with the expectation for an improved environment for capital spending.
While we expect modest political risk associated with post-election coalition building in Germany, the Catalonian secession movement, 2018 Italian elections, and ongoing Brexit negotiations, we remain positive on European equities due to encouraging macro conditions and less expensive valuations relative to the U.S. market. However, we remain mindful of actual and expected changes in central bank policy and their potential impact on market volatility. We are also modestly concerned about the recent U.S. dollar strength and are more cautious on stocks with emerging market exposure as a result.
Given strong outperformance of Chinese stocks year-to-date and our expectation for moderating economic growth, we are incrementally more cautious on China equities. We continue to view the rebalancing theme and ‘New China’ as our key long-term strategies. With that in mind, we remain positive on the information technology, healthcare, and consumption upgrade sectors. We favor quality names that have strong earnings growth, healthy balance sheets, and exposure to secular trends. We also remain positive on the India and South Korean equity markets, despite their strong returns year-to-date as well. India’s robust retail credit growth and strength in the rural economy in a good monsoon season should fuel discretionary consumption. Consumer spending has shown signs of recovery, as two-wheeler sales and tractor sales have grown double digits in August, after slowing to low single digits post currency demonetization. In India, we continue to like sectors related to a stronger economy: consumer, financials, and information services. For South Korea, President Moon Jae-in’s supplementary budgetof new jobs and higher wages should boost economic growth. This is positive for
Exhibit 14: Components of Sit Investment Associates’ U.S. “Barbell” Strategy
Source: Sit Investment Associates, 9/30/17
Below average growth rates, weak balance sheets, currency risk, reliance on
imports, low corporate tax rates
U.S. domestic exposure, high tax rates, pro-cyclical, high beta, strong balance sheets, limited impact from higher interest rates
Global Investment Outlook & Strategy – October 2017 19
consumer and financial stocks. We are also optimistic on the technology sector, given the global secular outlook and strong product cycles. Though valuations remain appealing and corporate profits continue to rise amid strengthening overseas demand and a weakened yen, we remain underweight Japanese equities as policy efforts to boost growth have stalled. Recently-called elections, where a victory by Prime Minister Abe appears likely at this point, will only result in continued disappointing progress in our view. Where we do have exposure, we prefer a mix of overseas-exposed names and defensive consumption stocks. Exporters and multinationals with exposure to more dynamic regions overseas and holding a cost advantage from the weakened yen should outgrow domestic peers. Meanwhile, defensive consumption holdings should perform well in a low-growth domestic environment. We are also underweight Mexico because of concerns over economic growth from falling real wages due to high inflation and the uncertain impact of the NAFTA renegotiations on trade. Though Mexican consumer spending is slowing, it is not collapsing, and remains the primary driver of economic growth. We prefer Mexican consumer stocks that have strong pricing power and are more resilient in a slower retail sales growth environment. We have become slightly more positive on Brazil, as the economy is finally growing again, but remain selective in our exposure. We like the consumer sector and own a balanced portfolio of defensives, consumer staples, banks, and exporters.
NOTICE: This analysis contains the collective opinions of our analysts and portfolio managers, and is provided for informational purposes only. While the information is accurate at the time of writing, such information is subject to change at any time without notice, and therefore, so may the investment decisions of Sit Investment Associates.
