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Key Private Bank's Quarterly Market Outlook

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Key Private Bank's Investment Management Team follows a rigorous and disciplined process as we evaluate markets and manage client portfolios. Our quarterly newsletter highlights our research and strategy teams' current thinking on the most important trends likely to shape the market behavior and serves as a foundation for constructing client portfolios. Inside you'll find greater detail on our market, equity, and fixed income outlook.

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Executive Summary

Conditions remain favorable for dollar strength

Last year, the combination of strong growth and higher interest rates helped push the dollar up relative to other currencies. While that rise was overdone in the fourth quarter, the fundamental conditions remain favorable for more dollar strength in the coming months..

We expect interest rates to rise modestly over 2017

We expect two additional Federal Reserve rate hikes this year.

Lower volatility for equities

We believe the year will be challenging, but we also believe that lower volatility should point the way higher for equities.

Something other than the new administration is responsible for the market's strong first quarter

Many have been quick to credit the incoming Trump Administration for the market's performance, but the data presents a different case.

Market Outlook, April 2017

U.S. Large-Cap Equities

The investor enthusiasm that drove equity markets higher after the election continued through the first quarter. Valuations are very high and extreme investor optimism argues for a market correction (usually a decline of roughly 5% to 10%), but prices have held close to their highs after a strong run.

The expensive valuation of equities makes many investors nervous. The problem is that bonds and most other investments are even more expensive. Investors can sit in cash, but that offers no offset to the ongoing cost of inflation and therefore makes sense only if a serious downturn seems likely. At this point, however, the odds of anything more than a minor correction seem relatively low.

Commentators talk about the "Trump rally," but the equity gains are also due to the economic improvement in the United States and overseas. That recovery over the last year, particularly for the industrial side of economy, has given investors both better results and reassurance that the expansion will continue. At this stage of the economic cycle, we do not expect strong earnings growth. But with little risk of recession, the likely growth should give equities room for moderate gains without shoving valuations higher.

Rising interest rates should not threaten the economic cycle over the next year, but they should make bonds less appealing. At some point, as bond prices decline, investors looking for a higher return may be forced to consider adding more equity exposure. That buying pressure could help extend the equity gains.

The Trump administration remains a wild card. Some of the anticipated changes seem more likely to occur than others, but many business leaders feel this administration will be more business friendly. If the administration can successfully navigate the treacherous waters of trade and can implement at least some tax and regulatory easing, improved business confidence could lead to some growth gains in 2018.

Growth in the United States still compares favorably with most other regions of the world. Last year, the combination of strong growth and higher interest rates helped push the dollar up relative to other currencies. While that rise Market Outlook, April 2017 was overdone in the fourth quarter, the fundamental conditions remain favorable for more dollar strength in the coming months. A strong dollar gives domestic equities a strong advantage. The potential for strong relative U.S. growth and more currency appreciation make a continuing emphasis of domestic large-cap equities attractive.

Key Takeaways

Emphasize

Large-cap domestic equities remain an attractive area with respect to potential growth and comparative stability. Strong market performance and solid fundamentals have also made mid-cap stocks an area to emphasize modestly.

Neutral

Many areas of the developed international region have stabilized, but most continue to grow more slowly than the United States. With improving fundamentals for small-cap U.S. stocks and the emerging markets region, we would consider adding to those areas where appropriate.

De-emphasize

Unless investors need the stability or predictable income of bonds, we would modestly de-emphasize that allocation in accounts.

U.S. Small-Cap and Mid-Cap Equities

The case for smaller U.S. equities has also become stronger. Historically, earnings growth for smaller companies has that of the large-caps, which has provided a long-term performance advantage. While the smaller companies have not held their historic edge until recently, they seem to be reestablishing that growth premium. The recent period of lagging growth and underperformance also made the valuations of the smaller stocks much more attractive.

Smaller stocks can struggle late in an economic cycle, but the pattern of interest rates and bond spreads both suggest current conditions remain favorable for the smaller stocks. Moreover, any regulatory simplification could have a much stronger impact on the smaller companies.

Smaller stocks rocketed ahead of other equity sectors after the election, but have consolidated back over the first quarter. With the short-term pullback and a favorable outlook, this is a good time to consider whether there is room to add exposure to this area.

Developed International Equities

After flirting with a downturn in early 2016, the developed international economies accelerated nicely over the remainder of the year. Two factors should define how well equity investments in those markets will do for U.S. investors in 2017.

The first factor is the relative growth. While international growth has tended to U.S. growth, the overseas economies arguably have more room to improve. Improving growth often does more to drive price gains than the absolute level of growth. With overseas economies at earlier points in their cycles, companies operating there may have more room to drive faster earnings growth with margin gains.

The second factor is the strength of overseas currencies relative to the dollar. A weaker dollar this quarter helped overseas equities perform better. Yet it looks like that may have been the correction of extremely strong fourth quarter gains more than the start of longer-term dollar weakness.

Strong relative U.S. growth combined with a stronger dollar would make it difficult for the developed international markets to outperform. Given the outlook, we recommend emphasizing the domestic equities over the overseas regions.

The Brexit process has finally begun, and some of the political pressure for more withdrawals seems to have eased in other European countries. Realistically, however, the underlying discontent with the European Union and Eurozone will probably not go away. The Eurozone in particular provided a way for Germany to sell more into the peripheral European countries. Over time, Germany's advantage has produced major problems for the other European countries. Unless the peripheral countries can match Germany's efficiency, the problems and discontent will likely continue. For the Eurozone as a whole, GDP growth has been modestly less than in the United States. Earnings trends have been more equivalent, in part because the Europe has not advanced as far. Eurozone equities outperformed U.S. large-cap in the first quarter, although that was with the benefit of a weakening dollar.

To this point the U.K.'s economy has not suffered the way many expected as the country prepares to leave the European Union. Actually, GDP growth and manufacturing have both been stronger than in the United States. Weakness in the pound helped to generate stronger economic growth in the U.K., but it eliminated that benefit for U.S. investors once the gains in pounds were translated into dollars. As the Brexit process unfolds and the impact on future growth becomes clearer, we will see whether the country holds favorable prospects for U.S. investors.

Japan was the weakest of the major economies for much of 2016, where GDP growth has remained well below most of the other countries in the developed world. At the same time, futures prospects have improved, as manufacturing growth has accelerated and earnings expectations have picked up significantly. While nothing as yet suggests significant outperformance for Japan, the improvements to date suggest the Japanese economy may grow more in line with the other major economies.

For the developed countries of Asia ex-Japan, reported and projected earnings accelerated sharply in the first quarter as the dollar weakened. Relative equity gains were not quite as strong, but prices for that region clearly outperformed. Mixed trends for the Australian economy, the dominant economy in this region, suggest currency trends may be crucial to this region's relative outlook going forward.

Canada's earnings trends, net of translation, remain solid. The improved earnings growth was supported by accelerating GDP over the second half of 2016. Prices of Canadian equities lost ground relative to large-cap U.S. equities, however. Canada has benefitted from rising natural resource prices, so growth there could ease if resource prices lose their momentum.

Emerging Markets Equities

The emerging markets showed solid relative earnings trends through 2016 and even stronger relative price performance. Over the first quarter, all three trends strengthened significantly. Weakening growth in the developed world would make relative growth in the emerging markets even stronger.

The Emerging Markets offer much more attractive valuations than other regions of the world. In concert with better growth, the attractive valuation would give securities in this region more room to run.

Fixed Income

Longer-term interest rates have stabilized despite signs the Federal Reserve intends to continue raising rates. Long-term rates rose as investor anticipated large fiscal deficits, and so could pull back if actual spending and tax bills fall short of expectations. Still, inflation shows signs of strengthening, which could put more pressure on rates in the coming months. The improving economic dynamics does not provide a favorable outlook for bonds, and we recommend a continued de-emphasis.

Equity Outlook, April 2017

Perspectives from Key Private Bank's Equity Research Team

Off To A Rousing Start

Global equities turned in a fantastic first quarter, with international markets the clear leaders, as the U.S. dollar reversed direction and the world economy displayed signs of growth. Chinese employment grew for the first time since 2012 while activity indicators such as global PMIs continued their recent expansion. U.S. domestic equities had a solid quarter too, with the S&P 500 posting a +5.9% advance, marking both its best start to the year since 2013 and its third best start since 2000. With their heavy domestic focus, U.S. small-caps unsurprisingly struggled in the rapidly evolving macro environment, notably trailing both Large-caps and mid-caps while still finishing slightly in the green. Emerging markets were the standout on the international stage in the first quarter, posting double-digit gains in U.S. dollar terms. Growth differentials relative to the developed markets seem to have bottomed and earnings are also accelerating after having reached 15-year lows.

Quite a Streak

Unlike recent quarters, the performance does not hide intra-quarter volatility this time around, as the S&P 500 completed a 109-day streak without a -1% decline, its longest stretch in nearly 22 years. The benchmark index also went 55 trading days without a 1% daily move in either direction, its longest since 2014. In other instances where the market experienced a prolonged period of upward biased stability, stocks typically rebounded to new highs shortly following an abrupt but shallow decline. In fact, in the eleven prior times the market has gone more than 100 days without a 1% decline, stocks were higher nine times with an average return of +2.3% one month after the end of the streak. One year later, the market was higher nine times, sporting an average gain of +17.9%

It Was All Trump, Right?

Many have been quick to credit the incoming Trump Administration for the market's performance, in some instances even the President himself via his Twitter account. The data presents a different case, as the stocks that investors believe would benefit most from proposed policy changes—high effective tax rate companies, infrastructure plays, etc.—have actually under performed since the beginning of December, after rallying sharply during the three weeks after the election. Put another way, something other than the actions of Washington D.C.'s newest resident are at play here. Maybe, just possibly, could it be the fact that corporate earnings are set to grow this quarter for the first time since first quarter 2015? Of course, the risk from here is that if earnings momentum fades, then so could stocks, as the cacophony of daily news flow then becomes more than just a distraction.

CHART: ISM Manufacturing & S&P 500 Total Return (Y/Y%): Economic Strength Driving Stocks, NOT Politics.

Policy Changes Still Equal Potential Upside

Given that we believe the market has not risen on policy moves, then policy moves remain an unambiguous source of potential upside for equities, in our view. The focus for market participants should be laser-like on the passage of corporate tax reform. The failure of the health care reform bill last month has led investors to question the Administration's legislative effectiveness. Rightly so! However, we do not believe that the lack of sufficient Republican support to replace the Affordable Care Act is a negative for equities. It is more likely that the failed vote could potentially pull forward the timeline for corporate tax reform, which has broad and more bipartisan support than the health care bill. Currently, the market does not seem to be pricing in much upside from pro-growth policy reforms.

CHART: S&P 500 NTM P/E: Still Room to Move Higher

How Much Upside?

Even if the tax reform comes in weaker than expected, there is upside for both earnings and equity values. For example, a move to an effective corporate tax rate of 27.5%, the midpoint between current 35% and the 20% rate originally proposed by the GOP, and excluding any highly unpopular border adjustment or value-added taxes, estimate should add $8 to aggregate S&P 500 EPS. If rates are lowered by only 4%, similar in magnitude to the last Reagan tax cut in 1986, aggregate earnings should still see a $4 gain. While a reduction in statutory tax rates should accrue mostly to domestic companies, a potential move to a territorial taxation system including cash repatriation would benefit U.S. multinationals disproportionately. This infusion of foreign cash could provide another source of upside.

What Could Go Wrong?

So if things are so rosy, what could possibly go wrong? In two words: Fed policy. The Fed's stance remains relatively stable, while global growth continues to improve and the dollar reverses from higher levels. With unemployment low - the job market is neither hot nor cold - and core inflation running near its 2% target, the Fed sees nearterm risks to the economic outlook roughly balanced and continues to reiterate that the path of future hikes will be data dependent. It is also not unreasonable to expect that President Trump might appoint more dovish members to the Federal Reserve Board, which could have an outsized impact, with two vacancies already and possibly two more likely to open in the next year on the seven-member board. An upside surprise to inflation could cause even a reconfigured Board to increase policy controlling rates at a faster than expected pace.

Summing Up

Setbacks in policy execution, whether foreign or domestic, continue to present the most significant obstacles to positive equity momentum during the incoming Administration's first year of office. While we still believe the year will be challenging, we also believe that lower volatility should point the way higher for equities.

Key Takeaways

Something other than the actions of Washington D.C.'s newest resident is at play in the market's strong first quarter performance.

In our view, clear signs of global growth are the reason for the ebullient mood, with any policy changes that come down the pike being an additional upside kicker.

Setbacks in policy execution, whether foreign or domestic, continue to present the most significant obstacles to positive equity momentum.

Fixed Income Outlook, April 2017

Market Overview

Despite a rate hike by the FOMC in March and a more Hawkish tone by several voting members, U.S. Treasury yields were mixed during the first quarter as concerns over gridlock in Washington rose. A failed attempt by the Trump administration to repeal and replace the Affordable Care Act (a.k.a. Obamacare) resulted in investors beginning to wonder if corporate tax reform will be able to live up to expectations, prompting lower yields and longer-dated Treasuries.

CHART: U.S. Treasury Curve

News from Washington will remain a considerable source of uncertainty for the bond market. Should there be a substantial tax cut, Treasury yields would likely be driven higher allowing the Fed to continue increasing rates. If no meaningful tax cuts take place, we expect Treasury yields to remain range bound until we see clear evidence of further economic growth.

The $4.5 trillion elephant in the room is looming. At some point, the Fed will begin to pare back its re-investment of maturing mortgage-backed and Treasury securities. This is likely to occur late in 2017 or early in 2018. We expect the Fed to pause on additional rate hikes as it begins to wind down its balance sheet as the impact of this action is uncertain.

For the remainder of 2017, we expect two additional rate hikes, but the timing of the moves could depend on the amount and timing of any fiscal stimulus from Washington. We expect long-rates to rise modestly throughout the year with the 10-year yield ending 2017 in the range of 2.75%-3.00%.

CHART: FOMC Rate Hike Probability

Key Takeaways

We expect rates to rise modestly in 2017 with two additional rate hikes by the FOMC.

We continue to favor Investment Grade credit despite the asset class' rally over the past year.

We maintain a cautious outlook on High-Yield credit given the uncertainty in the global economy and Washington. We favor bank loans over High-Yield.

Investment Grade Corporate Bonds

During the first quarter, Investment Grade corporate bonds performed well returning 1.22% as investors, expecting a strong economic environment, added to risk assets. Lower quality credits again led the performance with 'Baa' credits returning 1.48% and 'A' credits returning 1.00%. Overall, spreads were 4bps tighter ending the quarter at 118bps. New issue supply continued to rise sharply as companies issued near record new debt in anticipation of higher rates on the back of an active Federal Reserve. We expect new issue volume to remain strong this year, likely setting a new issuance water mark.

While we remain constructive on corporate debt, we expect some volatility in this space due to uncertainty over the Fed's actions, the pace of legislative changes and strength of the global economy. However, we believe that investor (both domestic and foreign) demand for corporate credit will help keep spreads relatively tight in the near-term. We expect to see some weakness in fundamentals in the nearterm due to a combination of investors' hunger for yield and corporations' desire to lock-in near record low interest rates.

We remain constructive on corporate debt and do not see a catalyst for significant spread widening in the near-term as default rates are expected to remain low. We believe that the very front-end of the curve offers attractive yields for investors sitting on cash in anticipation of rates rising. With money market reform now passed and the FOMC raising rates twice in the previous four months, yields on 18-month and less corporate bonds are attractive relative to cash for investors that do not have an immediate need for liquidity.

High-Yield/Leveraged Loans

High-Yield credit continues to be in demand as investors look for yield in an environment where most developed economies offer negative nominal yields. The Barclays High-Yield Index has been the best performing credit asset class this year returning 2.70% as lower-rated credits continue to outperform with 'Caa' rated credit returning 4.66% during the quarter and 'Ba' rated credits returning 2.06%.

We expect the High-Yield bond market to continue to remain highly correlated to both commodity prices and U.S. economic strength. Year-to-date around $80 billion in High-Yield bonds have been priced as investors continue to pursue higher yielding securities. We are concerned that many investors are purchasing High-Yield for income with little regard to the risk of default or spreads widening. Year-to-date, despite the solid returns, investors pulled $6.0 billion out of High-Yield funds.

We continue to maintain our cautious outlook on the High-Yield market given its high beta to the energy and material sectors and the uncertainty around the global economy. Within the High-Yield space, we continue to prefer Leveraged Loans over High-Yield bonds given their lower exposure to the energy and material sectors. Leverage loan demand was strong during the first quarter as investors added over $15.0 billion into Leveraged Loan funds during the quarter. We prefer Senior Secured Bank Loans to High-Yield due to their priority over other borrowers and their floating rate nature.

Mortgage Backed Securities

During the quarter, MBS underperformed duration matched Treasuries and corporates as interest rates fell across the board and spreads over Treasuries rose. Consequently, we believe the slight yield advantage over Treasuries does not offer a compelling reason to overweight mortgages. For the remainder of the year, we expect underperformance from the MBS sector.

Asset-backed securities (ABS) continued to rally during the quarter as the hunt for yield drove investors toward more esoteric securities. We remain positive on non-agency MBS and believe that the asset class offers high relative spreads, a low default risk, and strong technicals. We are positive on select sectors including high-quality auto loans and CLO's but recommend avoiding student loans at this point. In CMBS, we prefer legacy securities, among recent issuance we prefer high-quality single issuers over conduits. We are, however, extremely cautious on lowerrated commercial mortgage-backed securities (CMBS), as we believe retail stores (e.g. Sears, JC Penny) will continue to exit the space and retail based outlets will find it difficult to secure new renters. In MBS, we like the Vanguard Mortgage-Backed ETF (VMBS) to gain exposure to the asset class. For active funds, we recommend the PIMCO Mortgage Opportunities Fund (PMZIX) or the Victory INCORE Fund for Income (VFFIX).

International

We are cautious on international developed bonds and slightly positive towards emerging markets (EM). For developed markets, rates were higher as investors started to price in higher economic growth and the potential for rising inflation. We believe the ECB, the JCB, and the BOE will likely maintain their highly accommodative monetary stance to boost their economies and consequently their respective currencies (euro, yen, and pound) will likely remain under pressure. In our opinion, the continued easing from global central banks should lead to U.S. dollar strength and consequently remain negative on developed ex-U.S. bonds.

In emerging markets, spreads continued to fall as markets priced in expectations of an uptick in growth and rising commodity prices. Both sovereign and corporate spreads remain wide and look attractive on both a relative and historical basis; however, concerns over their near-term growth prospects lead us to a relatively cautious outlook. We believe there is an opportunity in the local currency debt market for investors with higher than average risk tolerance and a long-term investment horizon. For EM exposure, we like a modest position in the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) and recommend Franklin Templeton Global Bond Fund (TGBAX) for active investors.

Related Disclosure Information

Any opinions, projections or recommendations contained herein are subject to change without notice and are not intended as individual investment advice.

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