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Investment Outlook and Strategy Summary
by Roger J. Sit – Chairman and Chief Investment Officer
August 15, 2015
The third and final estimate of first quarter U.S. real GDP growth was –0.2%. We believe a meaningful portion of the weak first quarter was due to the unusually harsh winter and other extraordinary factors. We expect to see a rebound in the second, third, and possibly extending into the fourth quarter of 2015.
Real consumer spending rose +0.6% in May, following a soft patch in April. Real PCE, rising +2.3% on strong motor vehicle sales, was a strong contributor to May’s increase. Based on this rebound, we estimate the second quarter Real PCE gain will be roughly +3% if the June figure is between unchanged and +0.2%. This result aligns well with our forecast of +2.5% real GDP for the second quarter of 2015.
Solid job growth of 223,000 was achieved in June accordining to the nonfarm payrolls report released on July 3rd, although somewhat below the expected 233,000. Some were forecasting a more meaningful rebound from the weak, weather-impacted job growth of late winter. The unemployment rate improved to 5.3% from 5.5%, but the labor force participation rate declined to a new low of 62.6%.
U.S. inflation remains well controlled, a trend we expect to continue for the foreseeable future.
Overall, we project the U.S. dollar to remain relatively strong (although it has retreated from its recent highs) as the U.S. continues to be one of the strongest economies in the world.
We continue to expect the U.S. economy to grow at a rate between 2% and 3%. Our estimate for full year 2015 real GDP growth is +2.3%.
Internationally, many of the Euro Area economies demonstrated continued improvement in the second quarter due to weaker currency, lower energy prices, and accommodative monetary policy. We project Euro Area real GDP growth of +1.5% in 2015, up from +0.9% in 2014. Japan’s recovery, following last year’s consumption tax hike-induced slowdown, remains on track. We continue to look for the Japanese economy to grow at a +1.0% pace in 2015. Recent data indicate that economic growth in China may be stabilizing, as it appears the easing policies that began in November 2014 are taking hold on the economy. We continue to expect China’s economy to grow at roughly +7% and inflation to remain controlled in 2015. In Australia, the economy grew +2.3% year-over-year in the first quarter of 2015, which was down from +2.5% in the fourth quarter of 2014. We expect the Reserve Bank of Australia to continue cutting interest rates to stimulate the economy.
Fixed Income
Treasury yields increased during the second quarter of 2015 as the yield curve steepened, reversing the flattening trend that began at the beginning of 2015. At the June meeting of the Federal Open Market Committee (FOMC), the number of committee members that view 2015 as the time for policy firming remained unchanged from March, while market expectations for a rate increase (as measured by the December federal funds future contract) decreased slightly. We believe the Fed will raise its target range for the federal funds rate later this year or early next year as the unemployment rate approaches 5.0%.
All sectors of the bond market provided negative returns for the quarter. Corporate bonds underperformed as yield spreads to Treasuries increased. The sector’s longer duration bonds produced greater price declines as yields rose. Treasuries outperformed for the quarter, as higher-quality bonds outperformed lower-quality bonds. The higher average quality and shorter durations of government agency mortgage-backed securities and other asset-backed securities positively impacted returns.
Tax-exempt yields across the curve ended the quarter significantly higher than at the end of the first quarter and year-end. A meaningful rise in U.S. Treasury rates, along with record first half tax-exempt supply, combined to fuel the rise in tax-exempt rates. Credit spreads began to widen during the quarter after almost twelve months of substantial narrowing, leading to lower-rated investment grade bonds performing worse than higher-rated bonds. A significant credit development during the quarter was the downgrade of Chicago-related debt, which caused spreads on unenhanced debt to widen in many cases. Spreads also widened considerably on Puerto Rico-related debt during the quarter, causing it to be the worst performing sector in the municipal market.
We anticipate the yield curve will resume flattening as short yields rise in anticipation of an increase in the federal funds rate later this year. In taxable fixed income portfolios, we continue to position portfolios along the yield curve opportunistically, while maintaining portfolio yields significantly above their benchmarks. In tax-exempt portfolios, we have continued to modestly shorten duration in anticipation of the interest rate environment, and we expect to continue to shorten duration throughout 2015.
Equities
Recent volatility in U.S. equity markets appears to be related to debate over when the Federal Reserve will begin raising interest rates, along with the ebb and flow of positive economic data releases. Unexpected influences are the turmoil in Greece and the stock market correction in China, which are likely to continue to cause more elevated levels of volatility over the near term.
Positive factors include consumer spending, which is showing signs of improvement and lower energy prices, which have stimulated the economy. We are carefully monitoring energy and the strong dollar, which has been a drag on growth.
Valuations in the stock market, while at the higher end of their historic ranges, can be characterized as fair in the context of the current low inflation environment. This means that price appreciation will be much more reliant on earnings growth from this point, as multiple expansion is less likely at these levels. While still challenging, there are hopeful signs of further improvement in the investment environment.
We continue to position domestic equity portfolios with diversified, high-quality growth companies that should fare relatively well in an environment that favors companies with sustainable fundamentals. We have incrementally increased exposure to the consumer discretionary sector, given the potential for further improvement in consumer spending.
Outside the U.S., we remain overweight Europe, with holdings focused on companies that have exposure outside of Europe, benefit from the weak euro, have secular or niche growth drivers, and/or address domestic markets where there is meaningful pent-up demand. We continue to underweight Japanese equities, as we remain skeptical of the durability of the current recovery. We remain overweight in Greater China and underweight Australia.