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Market View

Lord Abbett investment professionals scope out the potential opportunities and risks in the second half of 2018. (Third in a series.)

 

In Brief

  • At a recent roundtable to discuss their midyear investment outlook, Lord Abbett panelists remained constructive on the global economy, despite widening geopolitical tensions.
  • Panelists observed that risk markets tend to be more comfortable with the pace of U.S. Federal Reserve tightening, especially considering how much pro-cyclical fiscal policy has stimulated economic growth.
  • They also believe that while volatility from rising interest rates has led to a flight to safety in U.S. fixed-income markets, there has been broad leadership in the U.S. equity markets, which is now spreading to small caps.

 

How should investors position their portfolios when considering serious questions about monetary, fiscal, and trade policy? Will risk assets, for example, lose some of their appeal as economic fundamentals for the United States and the world diverge?

These and many other questions figured prominently in a recent roundtable discussion with five Lord Abbett investment leaders. The panel featured Lord Abbett partners Robert Lee, chief investment officer; Giulio Martini, director of strategic asset allocation; Thomas O'Halloran, portfolio manager for micro-, small-, and large-cap growth strategies; Daniel Solender, director of tax-free fixed income; and Kewjin Yuoh, portfolio manager for taxable fixed income. (Coming soon: Visitors to lordabbett.com will be able to access video and audio highlights of the panel discussion.)

Likeminded with the world’s major central banks (see Chart 1), Lee and the rest of the panelists remained constructive on the global economy, despite widening geopolitical tensions and a flattening yield curve. One reason for their outlook is that fiscal policy and tax cuts appear to be outweighing the effects of tariffs first imposed by the United States on its trading partners (and the “tit-for-tat” reactions they prompted).  Another reason is the absence of excess (domestic) demand, which typically causes an economy to overheat, resulting in rising inflation. While commenting on relatively low inflation to date, Martini cited the pervasive “Amazonification” of the economy—an allusion to the powerful information platform that allows consumers to survey prices for items so easily and cheaply that businesses feel enormous pressure to hold down their costs and prices.

 

Chart 1. Despite Economic Tensions, No Recession in Sight for a While
U.S. gross domestic product (GDP) growth estimates, in percent 

Source: International Monetary Fund, Federal Reserve, Bank of Canada, European Central Bank, European Central Bank, Bank of Japan, and the Bank of England. Data as of July 10, 2018.

 

Equities: Healthy Earnings Growth Should Continue
As a long-time growth equity investor, O’Halloran naturally would be concerned about a jump in inflation and protracted trade wars, but he exuded an overarching optimism about global capitalism, transformative innovation, and seemingly insatiable consumerism—all of which have driven a phenomenon that Austrian economist Joseph Schumpeter once called “creative destruction.”

“Company earnings have been fantastic [see Chart 2], and I see healthy earnings growth continuing [see Chart 3],” said O’Halloran, who was featured in a recent Wall Street Journal report on top-performing actively managed funds. “Interest rates are very low. The world is awash in money. The U.S. government is deregulating and lowering taxes, which is a good thing.”   

As a result, O’Halloran remains very bullish on equities, because the technology revolution is in full bloom, and is creating tremendous growth opportunities for companies across many different industries that potentially could last for years.

While volatility from rising interest rates has led to a flight to safety in the fixed-income markets, O’Halloran hasn’t seen similar moves in the U.S. equity market. In fact, he has seen broad leadership in the U.S. equity markets (particularly in growth stocks), which is now spreading to small caps.

“Several market strategists have recently commented upon improving breadth in the equity market,” O’Halloran said in a follow-up comment. “These include Tony Dwyer of Canaccord, who said that every internal measure is positive, suggesting broad strength. Dennis DeBusschere of Evercore/ISI and Chris Verrone of Strategas have commented about the performance equivalence of the S&P 500 of equal and market cap-weighted indexes. Jeff deGraaf of Renaissance Macro stated that breadth is good enough and that the market remains in an uptrend.”

Other measures are supportive of improving breadth such as the NYSE advance-decline line hitting an all-time high, O’Halloran added, noting that small-cap stocks are outperforming large-cap stocks, year to date, by 500 basis points.

 

Chart 2.  Analysts Expect Another 20%-plus EPS Growth Quarter
S&P 500® Index quarterly year-over-year earnings growth

Source: Thomson Reuters.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Market forecasts and projections are based on current market conditions and are subject to change without notice.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Chart 3. Prospects for 2018–19 EPS, Sales, and Operating Income All Look Strong
S&P 500® Index annual growth rates

Source: FactSet.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Market forecasts and projections are based on current market conditions and are subject to change without notice.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Where Continued Growth May Come from Next
Expanding on his long-term bullishness about the technology revolution, O’Halloran cited the secular growth opportunities created by artificial intelligence (A.I.), cloud computing, and modern medicine.

  • Massive investments in A.I.-related technology have the potential to increase productivity, streamline operations, transform multiple industries, and boost the global economy in what might be a multi-decade evolution, as global tech giants, and China, vie for hegemony in various markets while building new ones.
  • “The cloud”—a blanket term for the networks of data centers that have expanded the digital universe by delivering services over the Internet—has transformed small-, mid-, and large-cap companies.  Leading-edge tech companies “born” in the cloud have disrupted their respective markets. Others are providing the platform for innovative start-ups to expand rapidly. Among the many benefits are cost savings for providers and customers, resource flexibility, ease of use, and speed of deployment. 
  •  In the fast-moving field of genetics and genomics, for example, thanks to the plummeting cost of sequencing the human genome, significant progress in identifying genetic defects has led to breakthrough diagnostics and preventive medicines, as well as targeted drug therapies, some of which deliver corrective genes into a patient's own diseased cells. The pace of this advance is breathtaking, compared to another example of exponential growth, Moore’s Law, which enabled the computer revolution; genetic sequencing now has sharply outpaced that phenomenon.

“But let's not forget the consumer—that's where 70% of the spending [comes from],” said O’Halloran. “The consumer experience is just getting vastly better, as exemplified by a giant company that gets everything to us cheaper and more conveniently, hot meal delivery services at your fingertips, and innovative pet care and food companies—to name just a few beneficiaries. Technology will continue to improve the consumer experience, while better enabling companies to acquire customers, segment demand, and become more efficient.”

When he was asked about greater regulatory pressure over privacy concerns, O’Halloran predicted that the tech giants most affected eventually will resolve such issues and maintain their secular growth trajectory.

“I think their stock prices will go up a lot more for a number of years, but at some point, the government will probably step in and end their ascent [through regulation and/or legal action],” O’Halloran added. “And when that happens, we will see the effect of it in their stock prices, and we will move on. But for now, I don't think there will be enough government pressure to cause these stocks to stop their upward trends and turn down.”

Taxable Fixed Income: Avoiding Complacency
While consumer confidence may be at all-time highs, Yuoh pointed to the bifurcation that investors have to manage for when it comes to growth. On the one hand, leading economic indicators in the United States are continuing to trend upward. On the other, there are the conundrums facing trade policymakers and the potential impact on global growth amid emerging market weakness and uncertainty about China going forward.

“If you look at current valuations, it's already reflected some of the [recent concerns],” said Yuoh. “High-yield debt is doing well. Investment-grade corporates have weakened over the last few months, and that shift has been pretty dramatic. If you look at commercial mortgage-backed securities and asset-backed securities, commercial mortgage-backed securities focused on domestic real estate, asset-backed securities focused on the consumer, you see they've done very well this year.”

Will trade policy and protectionism dampen performance? Between sometimes confusing pronouncements and conflicting interpretations, there could be healthy debate about what the endgame might be for the Trump administration with regard to sustained trade wars.  “So, without knowing what that endgame is, without knowing how we get there, you have to have a risk premium for that uncertainty,” Yuoh said.

“As investors, we have to make our best scenario estimates of how this trade war might play out, but also focus on the underlying fundamentals,” he added. “The potential impact to U.S. GDP is probably 0.1%—give or take 0.05%.”

Lee’s base case points to an enduring pragmatism. “Cooler heads will prevail, with lots of noise and volatility and, thus, opportunity,” he said. “But one certainly needs to take a step back as well and look at broader, longer-term issues, like populism, economic nationalism, and the change in sponsorship of multinational bodies such as the World Trade Organization and the Trans-Pacific Partnership.”

In any case, another risk in the second half of 2018 is a more hawkish policy by the U.S. Federal Reserve (Fed).  “To the extent that the Fed’s ‘reaction function’ changes and the markets make interpretations as to what the new reaction function means, I think that we could have some term premium return to the marketplace,” Yuoh said.

Tax-Free Fixed Income: Limited Supply/Excess Demand
Unlike his taxable fixed-income brethren, Solender said he has seen a steepening of the yield curve on rates out to 10 years, although it is flattening a bit beyond those maturities. Solender said the municipal bond market is dominated by individual investors who are currently very risk averse and that the composition of investors in the market has been the cause for the differences between the taxable and tax-exempt yield curves.

“Individual investors keep asking questions about whether we think interest rates are going to rise, and what we're going to do with their portfolios in response to interest rates possibly rising—not realizing that [rates have] been rising for two years now, and [that] we've been in a bear market for a while,” said Solender. “As a result, [investors are] going short in the U.S. municipal bond market in a big way, and that’s helping to push down short-term rates. We don't have a lot of supply on the short end. There's excess demand.”

Of course, U.S. tax policy, specifically the limit on state and local tax deductions and property-tax itemizations, has had a tremendous impact on the U.S. municipal bond market this year.  According to Solender, new-issue supply (whereby bonds for new projects come into the market) is down about 20% year to date, in large part because issuers can no longer refinance bonds in advance of their call dates.

Demand, on the other hand, remains robust, especially in high-tax states like California and New York, since the new U.S. tax bill continued to exempt interest on municipal bonds from federal taxation, Solender said.  But with the corporate tax rate dropping, from 35% to 21%, the tax exemption is not as beneficial anymore for major municipal-bond investors such as banks or insurance companies.  Still, with the new-issue supply low, the demand from individuals is more than enough to offset the lower corporate demand, so the U.S. municipal bond market has been performing well relative to other fixed-income markets.

 

IMPORTANT INFORMATION

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk. Credit risk is the risk that debt issuers will become unable to make timely interest payments, and at worst will fail to repay the principal amount. The municipal market can be affected by adverse tax, legislative, or political changes, and by the financial condition of the issuers of municipal securities. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.  There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. All investments involve risks, including the loss of principal invested.

Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. One such comparison involves the two-year and 10-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

Earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability.

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis.

The S&P 500® Index is widely regarded as the standard for measuring large-cap U.S. stock market performance, and includes a representative sample of leading companies in leading industries.

This material is provided for general and educational purposes only. The examples provided are for illustrative purposes only, and are not indicative of any particular investor situation.

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.  If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

MIDYEAR OUTLOOK

Get insights from our investment leaders on key topics for the second half of 2018.

Our Experts Give Their Macro Views
• What Is the Yield Curve Telling Us? 
• Positioning Portfolios
• Muni Matters: Five Key Takeaways

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

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