Outlook: 4th Quarter 2018

Economy

Growth in the U.S. economy has been accelerating fueled by low interest rates and the recently enacted tax reform. In contrast, there has been a gradual softening outside of the U.S. driven by a host of factors, most of which are country specific. Looking forward, the expansion is expected to continue with growth of approximately three percent in the U.S. this year followed by a modest deceleration in 2019. The deceleration is expected as the stimulative impact of the tax reform will fade next year and the Federal Reserve plans to continue moving away from the crisis-based policies it has employed since the Great Recession. The Fed’s current guidance suggests it will raise interest rates one more time this year and three times in 2019 while continuing to reduce the size of its balance sheet. In contrast, the European Central Bank and the Bank of Japan continue to utilize aggressive stimulus policies targeting interest rates near zero.

Inflation

Inflation rates increased steadily in the first half of the year, rising from the 2% range in January to almost 3% in July. Since that time, inflation readings have been softening with the Consumer Price Index coming in at an annual rate of 2.3% in September. Inflation, excluding the volatile food and energy segments, is also modest and is currently close to the Federal Reserve’s 2% target. Looking forward, we expect inflation to remain contained with gradual price increases fueled by a continuation of the economic expansion.

U.S. Dollar

The U.S. dollar maintained the gains generated in the second quarter given expectations for a series of interest rate hikes by the Federal Reserve, slowing growth in some foreign economies and rising trade tensions. Looking forward, we expect these trends to remain in place, keeping the U.S. dollar within its recent range, but the process of negotiating trade agreements is likely to boost the volatility of the currency.

Asset Class

Cash/Money Market

Instruments Higher interest rates are now evident in cash and money market instruments thanks to eight Federal Reserve interest rate increases since the end of December 2015. Heightened Treasury Department borrowing, to finance the growing deficit, is also generating tremendous supply in the short-end of the market and is a factor that is driving yields higher. Given its desire to stay ahead of inflation, which continues to remain well contained, the Federal Reserve appears committed to one more rate hike this year and possibly three in 2019.

Intermediate Government/Credit Bonds

Government bond yields have increased since the beginning of 2018. However, the rise in yields has not been uniform across the maturity spectrum as the upward movement has been more pronounced on shorter dated Treasury bonds. The Federal Reserve, as anticipated, raised rates another 0.25% during their September meeting and since the beginning of October, rates have increased with the yield on the 10-year U.S. Treasury rising from 3.06% to 3.21% on November 6th. The increase in rates, especially on the long-term bonds, corresponded with sustained strength in U.S. economic data, reflecting an increase in real yields as opposed to higher inflation or rising inflation expectations.

While the timing of the temporary surge in interest rates was unexpected, higher rates in the context of strong U.S. economic data appears sensible. Prospectively, we believe macro factors ranging from the relationship between the U.S. and China, concerns about corporate earnings growth, as well as Italy’s budgetary negotiations with the EU will likely result in greater volatility in both interest rates and other asset classes. Given this backdrop, investment grade spreads have been unusually stable. As a reminder, we welcome higher rates as it allows us to reinvest proceeds from interest payments and maturities into higher yielding bonds.

Tax-Exempt Municipal Bonds

Municipal fundamentals are generally stable, as solid economic growth and continued strength in the housing market have been supportive of tax collections. During the twelve months ended on June 30, state revenues from individual income taxes grew by 10.5% according to the U.S. Census Department. Corporate income taxes and local property tax revenues rose by 10% and 5% respectively. Pension obligations, however, remain an ongoing overhang on certain issuers, including Illinois and New Jersey, to name a few. U.S. Equity U.S. stocks provided strong returns through the first three quarters of the year but sold off in early October on concerns of a deceleration in future growth rates, rising interest rates and margin compression. Year-to-date, earnings growth has been exceptionally strong fueled by the ongoing economic expansion and the newly enacted tax reform. In fact, profits are expected to increase 20% this year and 10% in 2019. Given strong earnings growth and the recent volatility, valuations remain reasonable with stocks trading close to the long-term average at less than 16x the expected earnings for the next twelve months. The combination of strong earnings growth and reasonable valuations should result in a continuation of the bull market. However, we expect volatility to remain elevated given the upcoming trade negotiations with China, continued tightening by the Federal Reserve and the eventual deceleration in growth rates.

U.S. Equity

U.S. stocks provided strong returns through the first three quarters of the year but sold off in early October on concerns of a deceleration in future growth rates, rising interest rates and margin compression. Year-to-date, earnings growth has been exceptionally strong fueled by the ongoing economic expansion and the newly enacted tax reform. In fact, profits are expected to increase 20% this year and 10% in 2019. Given strong earnings growth and the recent volatility, valuations remain reasonable with stocks trading close to the long-term average at less than 16x the expected earnings for the next twelve months. The combination of strong earnings growth and reasonable valuations should result in a continuation of the bull market. However, we expect volatility to remain elevated given the upcoming trade negotiations with China, continued tightening by the Federal Reserve and the eventual deceleration in growth rates.

International Equity

International equities declined modestly in the first nine months of the year given a strong U.S. dollar, an escalation in trade tensions, softening growth in some foreign economies and debt related issues in countries such as Turkey and Venezuela. Looking forward, we expect the foreign markets to remain volatile as economic growth is expected to slow in Europe and China, Italy’s government continues to seek approval for its proposed budget, China and the U.S. are working towards a trade agreement, and Brexit negotiations continue. As an offset, valuations are attractive, and governments are combating any signs of weakness with significant amounts of stimulus. We will be watching the foreign markets closely in the coming months. This has the potential to be a transformative quarter as there are numerous catalysts that can set the tone for foreign stocks in the early stages of 2019.

Commodity

Commodity prices were mixed last quarter with declines in metals and agricultural products partially offset by strong gains in the energy segment. Expectations for a slower pace of global growth and strength in the U.S. dollar were drivers of the declines in many commodities, but the pattern of returns is also consistent with each segment’s exposure to tariffs. Portions of the metals and agricultural segments are subject to tariffs and that has had a negative impact on prices. In contrast, energy is not significantly impacted by the trade dispute and it continues to benefit from the combination of both disciplined supply management and the global economic expansion. Looking forward, we expect the slower pace of global growth to act as a headwind to higher commodity prices but acknowledge that a positive resolution to the trade dispute could result in at least a short-term rally.

Potential Threats: Risks and Notable Items to Watch

Declining Growth Rates

Growth rates for earnings and the economy are expected to decline in 2019. If the deceleration is too dramatic, asset valuations may decline as well.

Trade Disputes & Rising Protectionist Sentiment

Trade tensions between the U.S. and China remain high. While some of the rhetoric is likely a function of positioning for negotiating leverage, the newly enacted tariffs are having a meaningful impact to some companies and industries. If additional tariffs are implemented, they are likely to have a greater impact and could affect the global economic expansion.

Rising Interest Rates and/or Inflation

A shift from the current environment of low interest rates and benign inflation is likely to be problematic if it occurs too rapidly. Structural forces such as aging populations and the proliferation of technology have kept inflation at low levels, but a marked upward shift would reduce profit margins and may force the Federal Reserve to raise rates more aggressively.

Increasing Government Regulation of Technology Companies

Several of the leading technology companies have established dominant market positions and they have few competitors. If the power of these companies continues to increase, government regulators may place them under greater scrutiny in assessing their privacy policies, acquisition plans and competitive practices.

Geopolitical Risks

Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. Events in Saudi Arabia are important to monitor as are developments across the Middle East and the South China Sea. While there are always sources of concern, the establishment of diplomatic ties between the U.S. and North Korea is a positive development.

Debt Related Issues

Sovereign debt levels continue to grow throughout much of the world, generating conditions associated with low rates of economic growth. In response to the low growth rates, there has been a meaningful shift in the willingness to use fiscal policy to stimulate these economies. However, if the initiatives are debt financed, they run the risk of exacerbating the issue and creating more significant problems in the long-term.

Policy Risks

The Federal Reserve has announced its intention to continue to raise interest rates and reduce the size of its balance sheet. At the same time, central banks in other major economies are considering when to alter their policies to a more restrictive stance. If the world’s central banks reduce stimulus too quickly, there is a heightened risk of slowing economic growth.

Cybersecurity

Cybersecurity has become a significant issue as evidenced by last year’s Equifax data breach as well as persistent attacks on both the international money transfer system, SWIFT, and on systemically important financial institutions. The global cost of cybercrime was recently estimated at $600 billion annually, up 20% from 2014. The rising costs are primarily caused by the significant increase in theft of intellectual property and confidential business information. Notably, 53% of all attacks cost more than $500,000 in financial damages, according to recent reports by McAfee and Cisco Systems.