Economic trends

Economy

The U.S. economy continues to grow at a modest pace. However, weakness in foreign economies, rising government debt levels, and a strong dollar are acting as headwinds. Looking forward, we expect the expansion to continue, but with a growth rate below the norm. Accordingly, our central bank may be able to raise interest rates, but we expect a gradual pace of rate normalization. 

Inflation

Inflation remains quite low, but it has been trending upwards. In fact, this year it has been hovering around 1% after spending much of 2015 close to zero. The increase is driven by the strength in prices for medical care, services and housing. Looking forward, we expect inflation to rise modestly given aggressive stimulus policies, a strong employment market and the rebound in commodity prices. 

U.S. Dollar

The U.S. dollar has been strong due to the relative strength of our economy and expectations for an eventual rate hike by the Federal Reserve. In the coming months we expect the dollar to remain elevated since the Fed is seeking higher interest rates while most other central banks have an easing bias.    

Asset Class

Cash and Money Market Instruments

New SEC rules governing money market mutual funds have resulted in higher interest rates for non-government securities that have short-term maturities. The new rules are intended to give investors more transparency on a daily basis and additional protection during rare periods of market stress. As a result of the new regulatory environment, money market funds have been net sellers of non-government bonds which has driven up interest rates on these securities while yields on Treasury Bills have remained relatively constant. Of course, the ultimate impact on the supply and cost of short-term loans will become clear after the markets have had time to adjust to the new rules. In the interim, expectations for an eventual rate hike by the Federal Reserve should result in an upward bias to interest rates.   

Intermediate Government and Credit Bonds

In the face of relatively stable but subdued global growth, central bank actions are the primary drivers of the fixed income markets. In the U.S., improving economic data and a calmer international backdrop have increased the probability of a rate hike later this year. Even with a hike, bond yields will likely stay low and fluctuate within a narrow range given the strong influence of foreign inflows from countries whose governments are pursuing negative interest rates and quantitative easing policies. Investment grade corporate bonds remain our preference in taxable bonds as this sector benefits from modest economic growth and continued strong demand.

Tax-Exempt Municipal Bonds

The fundamental backdrop for municipal bonds is generally sound, but we are seeing some deterioration in a few pockets across the country as a result of slower tax revenues, underfunded pension liabilities and the downturn in oil prices. Though new issuance of bonds is expected to be high, strong investor demand should easily absorb the supply. Our portfolio strategy currently emphasizes an enhanced laddered approach focused on intermediate-term bonds, which provides flexibility in a variety of future interest rate environments.

U.S. Equity

The stock market has been volatile, but has provided solid gains through the first nine months of the year. Stabilization in China’s economy, increased stimulus in Europe and Japan, a rebound in oil prices and a modest decline in the U.S. dollar helped to boost equities significantly from their February lows. Looking forward, we expect the stock market to move higher, driven by a continuation of the economic expansion and a rebound in corporate earnings growth. However, volatility is expected to remain elevated as the presidential election approaches, European banks struggle with the need to boost capital and global growth remains modest.     

International Equity

In response to difficulties in their attempts to generate an enduring economic expansion, foreign governments continue to utilize a myriad of strategies, including aggressive monetary policies. Given the strong actions by these governments and attractive valuations, international stocks are compelling from a long-term perspective. However, in the short term we expect these markets to remain volatile given the rising political discord in many countries, a lack of consistent economic growth, an undercapitalized banking system in Europe and excessive debt levels.

Commodity

After declining dramatically in recent years, commodity prices remain relatively subdued, but they have rebounded from their lows. Oil and agricultural markets have been particularly volatile, but reduced supply growth has led to a substantial rebound in oil prices. In contrast, abundant supplies led to a decline in agricultural commodities in the third quarter.  Looking forward, the trajectory of commodity prices will primarily be determined by the extent of production cuts in the coming months and the success of foreign governments in boosting their economic growth rates. As the process develops, we expect significant levels of volatility.

Potential Threats

Risks and Notable Items to Watch

Policy Risks

Globally, the fiscal policy response to low growth rates has been debt financed growth initiatives, but there has been little restructuring designed to provide broadly based support. As a result, monetary policy has been the de facto solution. The combination of aggressive monetary policies and rising debt increase the risk of an economic shock.      

China

Growth in China has slowed as the country attempts to shift its growth driver from debt-financed investment, such as infrastructure projects, to domestic consumption. The combination of reduced growth rates and high debt levels increases the risk of a hard landing for their economy.

Geopolitical Risks

Conflicts in many parts of the world have escalated with Russia’s involvement in Syria and a number of terror attacks in Europe. In addition, heightened tensions in the South China Sea also present some risk.

Debt Related Issues

Sovereign debt levels continue to grow throughout much of the world generating conditions associated with low rates of economic growth. In addition, high yield and emerging market debt have shown some signs of stress this year providing evidence that the credit cycle is maturing.

Deflation

There are persistent deflationary forces in the current environment. Low commodity prices, high debt levels, a transition in the structure of China’s economy and divergent monetary policy between the U.S. and most other countries have resulted in low economic growth rates and rising economic imbalances.    

Cyber Security

Cyber security is becoming a significant issue given persistent attacks on the international money transfer system, known as SWIFT, and on systemically important financial institutions.