Economic Outlook - October 2014

Concerns over an earlier-than-expected tightening by the Federal Reserve, increased geopolitical tensions and signs of a weakening global economy weighed on equity markets in September. Despite negative returns in July and September, U.S. large caps were able to post a positive return for the third quarter. Healthcare (+5.5%) and information technology (+4.8%) were the top performing sectors during the quarter while energy (-8.6%) struggled. Year to date, U.S. large caps have posted a solid 8% gain.

While U.S. large caps fared the best, U.S. small caps suffered. The small cap Russell 2000 Index declined -6% in September and was down -7.4% for the quarter. The spread between large caps and small caps was 801 basis points, the fifth largest quarter of underperformance for small caps since the indexes began in 1979. From a style perspective, value underperformed growth across market caps in the third quarter, but value still leads growth in large and mid caps for the year-to-date period.

A strong rally in the U.S. dollar during the quarter, versus both developed and emerging market currencies, put further pressure on international equity markets. Stronger growth in the U.S. combined with further monetary easing in Europe and Japan could continue to support the dollar going forward. In local terms, the MSCI EAFE Index gained 1.0% in the third quarter, in line with U.S. large caps, but the index fell -5.8% in USD terms. The index is now down -1.0% through the first nine months of the year. After a disappointing start to the year, Japan bounced back +5.9% in the third quarter; however, the index remains negative year to date in USD terms.

Emerging markets experienced even greater volatility in the third quarter. The MSCI Emerging Markets Index declined -7.4% in September, and ended the quarter down -3.4%. China, India and Brazil were all positive in local terms for the quarter, but Brazil’s currency weakened significantly resulting in a -8.6% decline in USD terms. Russia’s issues with Ukraine and the impact of sanctions put further pressure on their equity market, which has declined -19.5% for the year to date period. Weaker growth expectations in emerging markets also put pressure on commodities, which fell -11.8% during the quarter.

U.S. interest rates ended the quarter relatively unchanged and fixed income markets were relatively flat. Spreads on both investment-grade and high-yield bonds widened during the quarter. The high-yield market declined -1.9% in the quarter. We view this sell off as driven more by a supply/demand imbalance during the quarter rather than a deterioration in fundamentals. Municipal bonds continue to be helped by a lack of new supply and have outperformed taxable bonds year to date.

While the yield on the 10-year Treasury note has fallen 52 basis points so far this year, yields on shorter-term Treasuries have increased. As a result, the yield curve has flattened; the spread between 2-year and 10-year Treasuries has narrowed 72 basis points since the beginning of the year. We expect long-term Treasuries to continue to trade within a range. Interest rates in the U.S. still look relatively attractive compared to the rest of the world. And even with the Fed stepping away next month, the supply of Treasuries is down because of the narrowing of the budget deficit.

We approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds, and as a result our strategic portfolios are positioned with a modest overweight to overall risk. A number of factors should support the economy and markets over the intermediate term.

Global monetary policy remains accommodative: Even as we approach the end of quantitative easing, U.S. short-term interest rates should remain near-zero until mid-2015 if inflation remains contained, and we’ve seen inflation expectations recede over the past few months. The ECB has taken more aggressive action to support the European economy by lowering interest rates even further and announcing the purchases of covered bonds and asset-backed securities. The Bank of Japan continues its aggressive easing program.
Pickup in U.S. Growth: U.S. economic growth remains sluggish but there are signs of a pick-up. Capital spending appears to be recovering. The steady improvement in the labor market continues and job openings have surged. Both manufacturing and service PMIs remain in expansion territory. Housing has been weaker, but consumer and CEO confidence are elevated.
U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash. M&A deal activity has picked up this year. Earnings growth has been ahead of expectations and margins have been resilient.
Less Uncertainty in Washington: After serving as a major uncertainty over the last few years, Washington has done little damage so far this year. Fiscal drag will not have a major impact on growth this year, and the budget deficit has also declined significantly. Government spending will again become a contributor to GDP growth in 2015.

Risks facing the economy and markets remain, including:

Fed’s Withdrawal of Stimulus: Risk assets have historically reacted negatively when monetary stimulus has been withdrawn; however, tapering has been gradual and the economy appears to be on more solid footing this time. Should inflation and growth measures pick up, market participants will quickly shift to concern over the timing of the Fed’s first interest rate hike. However, the core Personal Consumption Expenditure Price (PCE) Index, the Fed’s preferred inflation measure, is up only +1.5% over the last 12 months and we have not yet seen the improvement in the labor market translate into a level of wage growth that is worrisome.
Global Growth: While growth in the U.S. has picked up recently, concerns remain surrounding growth in continental Europe, Japan and some emerging markets. Both the OECD and IMF have downgraded their forecasts for global growth.
Geopolitical Risks: The events in the Middle East, Ukraine and Hong Kong could have a transitory impact on markets.

Risk assets should continue to perform over the intermediate term as we expect continued economic growth; however, we see the potential for increased volatility and a mild correction as markets digest the end of the Federal Reserve’s quantitative easing program. Economic data, especially inflation data, will be watched closely for signs that could change the expected timing of the Fed’s first interest rate hike.

Equity market valuations look full, but not overly rich relative to history, and maybe even reasonable when considering the level of interest rates and inflation. The median P/E has barely budged this year so we need to look for companies to post solid earnings growth this quarter. Investor sentiment, while down from excessive optimism territory, is still elevated. Momentum has stalled but the market trend remains positive. In addition, credit conditions still provide a positive backdrop for the markets.

Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Asset Class	Outlook	Favored Sub-Asset Classes
U.S. Equity	+	Large caps, dividend growers
Intl Equity	+	Emerging and frontier markets, small cap
Fixed Income	-	Global high yield credit
Absolute Return	+	Closed-end funds
Real Assets	+/-	MLPs, natural resources equities
Private Equity	+	Diversified

Source: Brinker Capital

Brinker Capital, Inc., a Registered Investment Advisor. Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Past performance is not a guarantee of similar future results. An investor cannot invest directly in an index.

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Brinker Capital.

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