April Adversity Among Allies

May 7, 2018

Geopolitical story lines came into full bloom during April, creating instances of simultaneous cooperation and tension among allies.

  • President Donald Trump pressed a heavy-handed trade agenda with threats of global tariffs, only relenting in the last hours of April as he granted temporary exemptions for the EU, NAFTA partners, and other allies.
  • European equities advanced, but were outdone by a sharper rebound in U.K. shares; U.S. equities were modestly positive after peaking mid-month. Government-bond yields rose across most maturities in the U.K., EU and U.S.
  • Although the ride has turned bumpier in recent months, we believe that economic fundamentals justify further gains in U.S. and global equity prices.

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Economic Backdrop

Geopolitical story lines came into full bloom during April, creating instances of simultaneous cooperation and tension among allies. The U.S., British and French militaries launched synchronized airstrikes on Syrian military installations in retaliation for President Bashar al-Assad’s government using chemical weapons on civilians in rebel-held areas of the country. The EU and U.S. also coordinated sanctions against Russian institutions and related parties in response to the poisoning of a former Russian spy in the U.K.

At the same time, President Donald Trump pressed a heavy-handed trade agenda with threats of global tariffs, only relenting in the last hours of April—granting temporary exemptions for the EU, NAFTA partners, and other allies (although quotas remained). Trump’s softened stance was likely influenced by separate trips made by French President Emanuel Macron and German Premier Angela Merkel to visit him in Washington, D.C. As for China (the president’s primary target of trade score-settling), stakes were elevated in early April after Trump countered the country’s announcement of retaliatory trade measures with threats of a new, larger round of tariffs. The U.S. administration said in late April that a cabinet-level trade delegation would meet with top Chinese government officials in Beijing at the beginning of May to seek concessions.
 
Rogue-state nuclear programs earned a significant share of the spotlight in April: North Korean Supreme Leader Kim Jong-Un announced a willingness to mothball his country’s efforts and, in an unprecedented display of unity, crossed the border as he clasped hands with South Korean President Moon Jae-in. Elsewhere, Israeli Prime Minister Benjamin Netanyahu televised evidence of the Iranian Republic’s plans to reignite its nuclear ambitions—raising questions about Iran’s adherence to the terms of its multi-party disarmament agreement. Although the International Atomic Energy Agency refuted the claims, President Trump signaled he would back out of the accord in May.

Brexit negotiators continued struggling to find a way around the Irish border. U.K. representatives appeared willing to consider two options: 1) achieve U.K.-EU regulatory alignment—which would eliminate the need for a dedicated solution, but disenchant Brexiteers seeking U.K. institutional independence; or 2) combine “smart technology” customs and “trusted traders” programs designed to expedite passage through a land border. EU emissaries seemed keen on a backstop plan that would bring Northern Ireland into alignment with the Republic and, by extension, the EU, but would erect a barrier between Northern Ireland and the rest of the U.K. The Democratic Unionist Party (the Northern Irish party that serves as partner to Prime Minister Theresa May’s Conservative minority government in parliament) was so put off by the EU backstop proposal that it professed a willingness to dissolve the parliamentary agreement over the matter.

U.S. manufacturing was strained in April, as robust demand was challenged by longer delivery timelines and higher production costs. Consumer confidence remained near historically high levels in April following rising price pressures and employment costs during the first quarter and expanding core consumer prices during March. Preliminary first-quarter economic growth was reported at a 2.3% annualized rate—in line with the typically mild pace of the three-month period ending March, yet slower than the rate of expansion recorded in the fourth quarter.

European equities advanced in April, but were outdone by a sharper rebound in U.K. stocks. U.S. equities were modestly positive after peaking mid-month, although small caps fared better than their larger counterparts. In Asia, Japanese equities climbed throughout the month, while Hong Kong shares advanced and mainland Chinese equities retreated. Latin American stocks were lower as emerging markets trailed developed markets for the month. Government-bond yields rose across all maturities in the U.K., EU and U.S., with the exception of a decline in short-term U.K. rates.

U.K. manufacturing growth fell by more than expected in April, delivering its weakest showing since 2016. Labor-market numbers were mixed: the claimant-count unemployment rate held firm at 2.4% in March despite an uptick in claimants; the December-to-February unemployment rate declined to 4.2%; and average year-over-year earnings growth in February remained 2.8%. Preliminary economic growth data showed an anemic 0.1% expansion in the first quarter and 1.2% in the 12-month period ending March.

The eurozone’s manufacturing expansion continued to soften from its December high-water mark, settling in April at still-strong levels. Economic sentiment recovered slightly in April after sliding during the first three months of the year, with industrial and consumer surveys recording improvements. The unemployment rate held at 8.5% in March despite a decline of more than 80,000 in the number of Europeans out of work, including a 0.2% drop in youth joblessness. An early estimate of overall economic growth measured 0.4% in the first quarter and 2.5% year over year, both slower relative to the prior quarter.

U.S. equities were slightly positive in April, led by small caps, the energy sector, and a handful of well-known technology companies.

Portfolio Review

U.S. equities were slightly positive in April, led by small caps, the energy sector, and a handful of well-known technology companies. Our large-cap strategy performed in line with the benchmark, benefiting from an overweight to energy and favorable stock selection within healthcare. However, this was offset by selection within information technology. Our small-cap strategy was challenged by selection in energy and the consumer sectors; a slight underweight to energy also detracted given the sector’s strong performance. International developed-market stocks outpaced the U.S., but our international equity strategy underperformed the benchmark. Energy sector exposure was the greatest contributor, while industrials and technology detracted. Regionally, selection in Japan was a major detractor, while picks were additive elsewhere in Asia. Emerging-market equities underperformed developed markets, and our strategy was held back by weakness in Asia (particularly the Philippines and Korea). Latin American positioning also slightly detracted, while exposure to Europe, the Middle East and Africa (notably Greek bank holdings) fared well.

Our core fixed-income strategy marginally underperformed amid challenging bond-market conditions during April. Duration was modestly long, slightly detracting as yields increased; a yield-curve-flattening bias contributed as long-term yields increased by less than short-term yields. An overweight to financials was accretive, but positioning within utilities subtracted from relative returns. An allocation to non-agency mortgage-backed securities (MBS) was additive, although a slight underweight to the outperforming agency MBS sector detracted. An overweight to asset-backed securities (ABS) was beneficial, as was higher-quality positioning within commercial MBS (CMBS); an underweight to taxable municipals hurt performance. High-yield was the only positive segment of the fixed-income universe in April. Our strategy performed in line with the benchmark, supported by an allocation to bank loans as well as underweights to and selection within automotives and basic industry; positioning within telecommunication services, energy and media detracted. Emerging-market debt bore the brunt of pain within the fixed-income market during April, and our strategy essentially mirrored benchmark performance. Top contributions came from overweights to local-currency debt in Egypt and Nigeria and external debt in Turkey. An overweight to local-debt in Russia and an underweight to external-debt in Chile were significant detractors.

Major Index Performance, April 2018

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Percent return. Sources: FactSet, Lipper

Manager Positioning and Opportunities

U.S. earnings and economic data remained favorable. Nevertheless, valuations have been stretched, and better-than-expected earnings have had limited positive impact on stock prices. There may be continued volatility due to high valuations, rising interest rates and potential geopolitical instability. We have therefore been cautious at the margin—retaining positive exposure to value and momentum—and expect active management to benefit from increased volatility and the market’s eventual return to focus on fundamentals. Overseas, our developed-market strategy retained overweights to stocks with the highest growth opportunities, emphasizing technology and industrials given their greater reliance on the global (rather than local) economy. Classic defensive sectors (consumer staples, telecommunications and utilities) remained underweight, as did Japan and Australia. Our emerging-market strategy underwent minor repositioning—trimming exposure to Russia and industrials, while Asia remained the largest regional exposure despite being underweight. We continued to emphasize Latin America, with a focus on Brazil and ex-benchmark exposure to Argentina. From a sector perspective, we were overweight industrials, technology and energy, while financials and utilities remained underweight.
 

Fixed-income Performance, April 2018 (% returns)

fixed-income performance

Sources: FactSet, Lipper. See "Corresponding index Descriptions" section for more information.

Regional Equity Performance, April 2018 (% Return)

Chart: Regional Equity Performance

Sources: FactSet, Lipper. See "Corresponding Indexes for Regional Equity Performance Exhibit" in the Index Descriptions section for more information.

Our core fixed-income strategy’s duration posture moved closer to neutral relative to its benchmark, complemented by a curve-flattening bias. We added duration in the middle of the curve, as the growth and inflation outlook continued to increase and yields moved higher; we maintained an overweight to the long end of the curve, as inflationary pressures appear likely to undergo a measured increase. Banks remained the largest corporate overweight due to strong capital positions; we expect to add selective exposure given the industry’s improved outlook, the potential reevaluation of regulatory requirements, and the likelihood of rising yields supporting increased revenues. Overweights to ABS and CMBS remained given their competitive risk-adjusted yields. We maintained an allocation to non-agency MBS, with an eye on the impact (if any) that recent interest-rate hikes or mortgage interest-deduction limits may have on the housing market; agency MBS positioning was nearly neutral at the end of April. High-yield positioning continued to feature a bank-loan allocation, as well as overweights to the media, leisure and insurance sectors. Energy, basic industry and banking represented our largest underweights. Within our emerging-markets debt strategy, local-currency exposure remained overweight. The largest country overweights were to Argentina, Turkey, Egypt and Nigeria, while we were underweight the Philippines and Hungary.

Our View

We suspect the bull market in U.S. equities is somewhere near the beginning of the end, while it may be somewhat closer to the end of the beginning in other countries. To be clear, we are not saying that the bull market in U.S. stocks is concluding. Rather, we are noting that the fundamental, technical and psychological factors driving equity-market performance appear consistent with the latter stages of an up cycle. This particular phase can last a few years if all goes well, but the ride will likely be bumpier than in recent years. We still do not see many serious signs of overvaluation or economic imbalances in the U.S. that would suggest imminent danger of a severe correction, much less a devastating bear market on par with the 2008-to-2009 experience.

Although equity markets underwent their first real correction in some 20 months during the first quarter, the pullback does not look like the start of a more serious decline. At SEI, we see two fundamental drivers behind the correction in equities and the return to more-volatile price action. The first is the upward shift in investors’ interest-rate expectations as the global economy kicks into a higher gear. The second is concern that the Trump administration’s recent actions on the trade front will lead to a broader trade war that could hurt global growth and push inflation higher sooner.

There certainly are cyclical pressures pushing yields up from their historic lows. The long bull market in equities and other risk-oriented assets has been sustained by the extraordinarily expansive monetary policies of the world’s most important central banks. And the subsequent decline in yields across the maturity spectrum reached levels never seen before. In our view, this 37-year tailwind is turning into a headwind.

But the Treasury yield curve remains upward sloping and, in our opinion, can narrow further without causing too many problems. Interest-rate spreads for investment-grade, high-yield and emerging-market debt also remain near cycle lows. High-yield bonds, in particular, should be considered the canary in the coal mine. Spreads tend to widen well before the stock market tops out. Even during the recent turbulence in the stock market, the option-adjusted spread on high-yield bonds held surprisingly steady.

As we have pointed out on several occasions in the past, the U.S. equity market has historically managed to withstand the depressive impact of rising interest rates until the 10-year Treasury reaches a level of 4% to 5%. Owing to the structural decline in bond yields and the elevated equity valuations that have resulted, we now think it prudent to assume that the stock market will begin to struggle if the 10-year Treasury rate approaches 4% (the lower end of the traditional “danger zone”).

Global Equity Sector Performance, April 2018

Global Equity Sector Performance

Sources: FactSet, Lipper, MSCI ACWI Index Components (as defined by SEI)

On a fundamental basis, we think investors remain skeptical about the staying power of the European expansion. The European Central Bank is moving away from the asset purchases that have supported the eurozone’s economic recovery and credit markets.

While we maintain a positive view of equities and other risk assets, we must admit that our optimism is being tested as the Trump administration uses protectionism as a bargaining tool against friend and foe alike. Impediments to trade—tariffs, quotas and non-tariff barriers—raise prices and reduce demand, leading to a dead-weight loss for society. More jobs are lost by consuming industries than are gained by the beneficiaries of protectionism. A trade war of consequence could add to the inflation pressures that have already emerged as a result of the pick-up in economic activity and the tightening employment situation.

We are in watchful-waiting mode when it comes to trade, but think it’s premature to expect a catastrophe. Our preference is to see what trade sanctions are actually levied, and how target countries respond, instead of assuming the worst from the get-go. Until there is more clarity on the extent of the U.S. protectionist measures being put into place, we think it’s best to focus on the strong fundamental backdrop. Profit growth remains vibrant, inflation is still well-contained and the Federal Reserve’s decision-makers would prefer to normalize monetary policy in a steady, predictable fashion. For now, we believe it’s proper for us to maintain a “risk-on” investment orientation.

We may have finally begun to see a shift away from the poor relative performance of eurozone equities that has persisted since the middle of last year. The eurozone economy has been gaining traction since early 2016; we judged the potential for future growth to be much greater in the eurozone than in the U.S. given their respective points in the economic cycle. We also looked for a jump in earnings, as European companies have a high degree of operational leverage, while valuation considerations also provided support to our bullish rationale.

On a fundamental basis, we think investors remain skeptical about the staying power of the European expansion. The European Central Bank is moving away from the asset purchases that have supported the eurozone’s economic recovery and credit markets. And by mid-year 2019, if not sooner, we should see the first steps toward normalizing policy rates—although negative yields are an absurdly low starting point. While the outlook for the eurozone is mixed, it seems bright and sunny compared to that of the U.K. As we have mentioned in previous reports, Brexit has become the overwhelming obsession of investors and policymakers. 

U.S. congressional elections will take place in November, potentially jeopardizing current Republican control of the House of Representatives. Legislating in the U.S. has been tough enough under a “unified” government; it will become next to impossible under split governance, should power become more evenly distributed across the two major parties. We would also expect a Democratic House to ramp up the pace of investigations into the president, his staff and cabinet.

The synchronized global expansion is still alive and well. Earnings continue to climb briskly around the world.

The past nine years have been full of challenges and uncertainties. The years ahead don’t seem to promise anything different in that regard. Yet, the bull market has managed through it all. Let’s give it the benefit of the doubt for a while longer. Although the ride has turned bumpier, we believe that economic fundamentals justify further gains in U.S. and global equity prices. The synchronized global expansion is still alive and well. Earnings continue to climb briskly around the world. U.S. companies’ cash flows and earnings, meanwhile, are benefiting mightily from tax reform passed late last year by the U.S. government. There really are few signs that a recession will rear its ugly head any time in the next 12 to 18 months.

Legal Note

Disclosures
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts. There is no assurance as of the date of this material that the securities mentioned remain in or out of SEI Funds.
There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments.
Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results. Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.
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