March 2017 Perspective

March 07, 2017 | Market Commentary

The U.S. Economy

Two of the first pieces of national economic news released each month are the Institute for Supply Management (ISM) Reports on Business. The first report covers the manufacturing sector, which is followed by a release covering non-manufacturing activity. These surveys can have a meaningful influence on investor and business confidence due to their broad, nationwide coverage. Recently, these survey measures have gradually improved, with their data indicating continued expansion in U.S. economic activity. Along with the more upbeat tone indicated by these surveys, consumer confidence reached an over 15-year high in February, and business confidence stands at a 12-year high.

The sharp rise in confidence began in earnest following the U.S. presidential election, and indeed, much of the increase was based on expectations regarding the potential for pro-growth policies under a Trump administration related to tax reform, reduced regulation, infrastructure spending, or some combination of the three. As seen in the following chart, although surveybased expectations have improved, economic “hard data” in aggregate (i.e., housing, industrial, labor, household, and retail) has not yet caught up to the run in sentiment. This has led us to an important juncture. That is, will economic reality follow the recent survey and confidence data higher?

Sharp increases in sentiment—such as what we’ve seen in recent business and consumer surveys—are typically what you would see early in an economic cycle. However, this is inconsistent with where we actually are according to other indicators such as high earnings, peak margins, tightening labor markets, full equity market valuations, and increasing short-term rates. These indicators, and a majority of the data we look at, suggest that we are clearly mid- to later-cycle. When considering all of this in aggregate, there remains a risk that economic activity falls short of expectations, which could result in increased market volatility moving forward. It is important that investors be prepared for this.

In the event that volatility does arise, investors can expect us to be selectively active, as we do not believe that capital risk is a significant near-term concern and would view any pullback in the market as a buying opportunity. Considering the macroeconomic backdrop in the U.S. at a broad level (i.e., rising interest rates, a steepening yield curve characterized by yields on long-term bonds rising faster than yields on short-term bonds, a slowly growing mid- to later-cycle economy, and broader range of equity valuations as characterized by higher dispersion following low dispersion), we believe individual companies that can grow in what is now an otherwise growth-challenged environment will be rewarded. This is consistent with how our portfolios are currently positioned.

The Global Economy

Indications of a slow eurozone recovery are beginning to materialize in the form of rising inflation, better growth, and a steepening yield curve. In contrast to the U.S., the yield curve in the eurozone is steepening because shorter-term yields have been falling while longer-term yields have been rising. This steepening of the curve is typically a sign that investors anticipate rising inflation and stronger economic growth going forward.

Inflation in the eurozone has certainly picked up. Less than one year ago the region was mired in deflation, but since then prices have steadily marched higher toward the European Central Bank’s inflation target of “below, but close to, 2%.” It is notable that in January, for the first time in nearly four years, all eurozone member countries were free of deflation. Across the region, prices rose 1.8% year-over-year, but it is important to keep in mind that much of the pickup reflected sizeable upward base effects and recent increases in energy prices. These base effects resulted from abnormally low levels of inflation one year ago largely due to the bottoming of crude oil prices.

Core inflation, meanwhile—which excludes energy and unprocessed food—indicates that underlying inflationary pressures remain subdued, coming in at 0.9% year-over-year for the second consecutive month.

As seen in the preceding chart, lending to eurozone households and corporations continues to accelerate. Broad money supply also expanded at a solid pace according to the latest release. These data suggest that overall monetary conditions in the eurozone remain supportive of a continued economic recovery. Recent survey data from the manufacturing and services sectors indicate growth across the region that is approaching a six-year high due to very healthy job creation, strong growth in orders, and increasing business optimism. The upward moves were driven by the region’s two largest economies: Germany and France.

The euro currency, however, remains weak amid political uncertainty centered on upcoming French elections. Investors are concerned about far-right euro-skeptic presidential candidate Marine Le Pen’s advance (and current lead) in the polls. While there are many moving parts in this election, we believe that Emmanuel Macron has the likeliest chance to win the French presidency, followed by Francois Fillon, as polls show that either candidate would defeat Le Pen by a wide margin in the second round of voting. In all, the politics remain positively tilted in France as both Fillon and Macron will likely pursue a reform agenda that would make the French economy more competitive. In regard to the weak euro, we view this as one of the driving forces behind improved manufacturing activity in the eurozone, along with marginally better demand from China following record amounts of stimulus last year. We view the recent economic trends in aggregate as positive for European multinational companies.

Our Perspective

U.S. and international equity markets produced positive returns during February, and are up approximately 5-6% on a year-to-date basis. Valuations in the broad U.S. stock market remain somewhat elevated and became incrementally less attractive in February. However, we continue to see few unsustainable excesses in the U.S. economy that would suggest the economy is at risk of collapsing under its own weight. In this environment, discernment and flexibility are critical.

Given the slow global growth environment, in portfolios geared toward investors that need capital growth, we are targeting investments in fundamentally strong businesses that are not heavily reliant upon macroeconomic growth to drive sales and earnings. More specifically, we see value in businesses that we believe have control of their destiny and are taking share in large, established markets or are creating new markets on their own. The goal is to identify companies trading at attractive valuations relative to their growth potential.

For fixed income investors and investors with a shorter time horizon or current income needs, we still see value in the corporate bond sector, and portfolios maintain a sizeable allocation to corporate securities. We continue to view the economic outlook as being supportive of credit, but remain mindful that we are in the later stages of an economic expansion, and valuations are becoming less compelling. As such, we may reduce credit exposure over time as credit spreads tighten or if our outlook for the economy and/or macro risks change. Regarding government debt, portfolios have a notable allocation to U.S. Agency and nominal U.S. Treasury securities.

Portfolios also generally maintain a modest duration. Despite the spike in interest rates toward the end of 2016, they remain historically low. Given that, we maintain our view that investors are not being adequately compensated to hold significant amounts of long-term debt. Should interest rates increase to more attractive levels, we would look to increase duration through the purchase of longer maturity Treasuries or Agencies to take advantage of higher levels of income. Conversely, if rates consolidate and prices rise, we may look to reduce duration.

In our view, short-term and income-oriented investors should also explore equities that display stable fundamentals and are trading at attractive valuations. We believe companies that generate strong, stable cash flows and pay an attractive dividend could be compelling options for these types of investors in the current environment.

Sources: Bloomberg and Thomson Reuters. Analysis: Manning & Napier Advisors, LLC (Manning & Napier).

Manning & Napier is governed under the Securities and Exchange Commission as an Investment Advisor under the Investment Advisers Act of 1940.

All investments contain risk and may lose value. This material contains the opinions of Manning & Napier, which are subject to change based on evolving market and economic conditions. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

This newsletter may contain factual business information concerning Manning & Napier, Inc. and is not intended for the use of investors or potential investors in Manning & Napier, Inc. It is not an offer to sell securities and it is not soliciting an offer to buy any securities of Manning & Napier, Inc.

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