Outlook: Second quarter 2018

Economy

The rate of growth in both the U.S. and foreign economies accelerated last year and we have enjoyed a synchronized global expansion. Looking forward to the remainder of 2018, the expansion is expected to continue and the global outlook remains positive despite weakening trends in a few economic indicators. Given the improvement in the U.S., the Federal Reserve continues to move away from the crisis-based policies it has employed since the Great Recession. The Fed’s current guidance suggests it will raise interest rates two more times this year while reducing the size of its balance sheet by approximately 10%. The European Central Bank and the Bank of Japan continue to utilize aggressive stimulus policies, but if their economies continue to improve, it is likely that they will take a less accommodative stance later in the year.

Inflation

After peaking in February of last year, inflation rates moderated and have recently been hovering around the 2% level. In aggregate, the price level is expected to increase marginally this year given the acceleration in global economic growth. However, an aging population, high debt levels and the proliferation of technology will continue to work as structural headwinds that keep inflation from rising dramatically.

U.S. dollar

The U.S. dollar has declined steadily, but remains at a historically high level. Improving fundamentals in foreign economies, an increase in our budget deficit and a modest increase in U.S. inflation expectations have increased demand for foreign currencies. In the coming months, we expect these trends to remain in place, keeping the U.S. dollar somewhat soft.

Asset class

Cash/money market instruments

We expect short-term rates to continue rising throughout 2018. The Federal Reserve is, of course, at the center of the outlook. Policymakers at the Federal Reserve have been gradually raising rates since late 2015 and investors are projecting they will raise interest rates two or three more times this year. Although the best laid plans often go awry, new Chairman Jerome Powell is a steady hand and will likely adopt a gradual approach to interest rate normalization from his predecessor Janet Yellen.

Intermediate government/credit bonds

In addition to rate hikes by the Federal Reserve, bond yields also face upward pressure from fewer central bank purchases, stronger economic growth, tax reform, and hints of rising inflation. While this was the clear narrative entering 2018, fears of trade wars, rising geopolitical risks and a few signs of peaking economic growth have acted as a counterweight to a more dramatic sell-off in bonds. For now, intermediate-term bond yields are near eight-year highs, yet remain low on a historical perspective. Looking forward, the trajectory of inflationary pressures will play a crucial role in dictating the severity of the yield increase.

Tax-exempt municipal bonds

After navigating our way through tax reform and the dynamics of outsized municipal bond issuance over the last few months, a long-awaited period of normalcy appears to have settled into the tax-exempt bond market. With current yield levels hovering near the highest levels in the past year, we are optimistic in our outlook for intermediate-term municipal bonds. A high-quality bias as well as a focus on defensive coupon and call structures should continue to be a central theme going forward.

U.S. equity

After a strong year in 2017, volatility returned to the markets in the first quarter. Improving economic conditions worldwide and rising earnings growth drove stocks to record highs in January, but the markets reversed on trade tensions and concerns about rising interest rates. Looking forward, the ongoing economic expansion and the newly enacted tax reform bill should continue to push corporate profits higher. In fact, many analysts expect earnings to grow 15% to 20% this year, and if that comes to fruition, stocks should rise to higher levels. While stocks are expected to generate solid gains, volatility is likely to remain elevated as we work through trade negotiations and the removal of stimulus by the Federal Reserve.

International equity

In the aggregate, international equities generated slight losses in the first quarter, but returns varied within the group. Stocks in developed markets declined modestly due to some soft economic data and the trade related tensions that impacted U.S. markets. In contrast, emerging market equities increased given relatively attractive valuations and an optimistic outlook on their prospects for economic growth. As the year progresses, strong earnings growth and a continuation of the economic expansion should support higher equity prices. However, in conjunction with the U.S. markets, volatility is likely to remain elevated.

Commodity

Commodity prices were mixed last quarter with declines in metals offset by gains in energy and agricultural products. This year, analysts expect commodity prices to continue the trend of generating mixed results with performance driven by unique supply and demand factors within each segment. While that is the most probable outcome, we believe investors are underestimating the likelihood of a more pronounced increase in prices driven by sustained global growth, supply shortages and rising demand.

Potential threats: Risks and notable items to watch

Rising protectionist sentiment

In many countries, including the U.S., there is rising protectionist sentiment that is fueling a backlash against free trade. While much of the rhetoric is likely a function of positioning for negotiating leverage, there is a risk that global trade disputes act as a headwind to growth.

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 may force the Federal Reserve to raise rates more aggressively which could bring the current expansion to an end.

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 Syria are important to monitor given the recent use of chemical weapons and the response from the U.S, U.K. and France. Also, this quarter, officials in the U.S. are expected to decide whether to remain part of the nuclear pact with Iran. In a positive development, the U.S. and North Korean governments are initiating diplomatic ties and may discuss the denuclearization of North Korea. We are also watching developments in the Middle East and the South China Sea.

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 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.