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Quarterly Market Review

Rising corporate profits, a generally improved global economic backdrop, and continued support from central banks sent equities higher across the globe during the second quarter. International equity markets delivered another strong quarter of returns during the April through June period, and have generated approximately 14% year-to-date. This marks the second consecutive quarter that international equity markets outperformed domestic stocks. Growth stocks have performed particularly well, delivering more than 17% in international markets this year compared to around 11% for value names. The breadth of market performance has been notable as well. Of the 30 major indices that represent the largest stock markets across the globe, 26 have generated positive returns thus far in 2017, marking the best start to a year since 2009.

As equities continue to climb higher, there are some interesting characteristics of today’s market environment that are worth noting. International equities have returned approximately 12% on an annualized basis since the 2009 bottom, compared to the long-term average annualized return of around 6%. Along with the rise in equity prices, valuations across most global equity markets have moved to, or somewhat above, what we consider fair value. There are now significantly fewer pockets of cheap valuations remaining compared to the past several years. Nevertheless, due to historically low bond yields across the globe, investors continue to move out on the risk spectrum into stocks in search of yield.

Meanwhile, despite all-time highs in global economic policy uncertainty, volatility across equity and fixed income markets has generally persisted near historically low levels.

At the same time, investor complacency has risen to elevated levels. Indeed, June marked the 51st consecutive month that equity allocations among individual investors were above their historical average, with the data also showing equity allocations at their highest level since 2005.

Although we see little evidence of excesses or extreme speculation in the economy or markets, and none of these factors individually suggest imminent doom for asset prices, they are consistent with rising risks that must be managed. Our view is that it has become increasingly important to effectively manage the risk of capital loss by avoiding areas of overvaluation and/or deteriorating fundamentals.

Manning & Napier Market Insights

European Economic Cycle and Valuation Re-Rating

International investors looking to manage risk should reconsider their allocation to Europe, and to the core economies in particular. In our fourth quarter 2016 International Perspective, we noted PMI data that was supportive of marginal improvement in the European economy. Recent developments suggest that healing across the region continues, and we have become increasingly more positive on Europe from an economic cycle perspective. Broadly speaking, we believe we are seeing a reversal of several factors that have kept investor sentiment toward Europe persistently subdued.

The political, economic, and banking uncertainties plaguing the region, along with poor relative corporate fundamentals, cut investor appetite for European equities for several years. Despite relatively cheap valuations, these dynamics led to European equities underperforming their developed market peers over the past four to five years. Outflows persisted for most of 2016, with approximately $85 billion in capital leaving European equity markets, the worst year for European equity flows since the global financial crisis.

Although economic fundamentals in Europe have been gradually improving since 2012, and euro area real GDP growth has recovered such that the growth differential between the EU and other regions—such as the U.S.—has effectively closed, we believe Europe is much earlier in its economic/credit cycle relative to a more mature U.S. cycle. This gives more scope for profit margins to rise going forward. Leading economic indicators have been on a stable upward trend since mid-2016, and economic data has consistently surprised on the upside since September. The combination of positive data surprises and low real yields should continue to promote risk taking.

Similar to other areas of the world, soft indicators such as PMI measures and surveys have been recently improving. Manufacturing indicators show stronger current production and order books, supported by the improvement in global trade. There are also indications domestic demand is tangibly improving more broadly within Europe. Measures of capacity utilization and employment are trending in the right direction, loan demand and lending growth have picked up, and housing activity looks healthier in many parts of Europe.

Elevated capacity utilization indicates a good chance of stronger investment growth with the synchronized pickup in global and European growth. A manufacturing and investment pickup would broaden the recovery to countries outside of Germany, which has been contributing the most to European growth thus far. Our base case is Europe’s growth is likely to stay well supported by private consumption and gross fixed investment. We do not believe a material acceleration in growth is necessary for our investment call to work.

While growth has improved and healing commodity markets have driven a pickup in headline inflation, core inflation in the eurozone remains stable and well below targeted levels. The significant amount of slack in the broad EU labor market supports our view that Europe’s economic expansion has room to run without stirring up inflation pressures. Accordingly, we anticipate continued accommodation from the ECB, and the slow and gradual normalization of the eurozone’s inflation outlook will ensure financing conditions remain favorable well into next year and possibly beyond.

In turn, we expect the private sector to continue to take advantage of this visibility, with lending growth expected to continue its recovery and show a slow, steady acceleration. The combination of a healthier European economy, limited inflationary pressure, and attractive financing conditions should further support corporate earnings, private investment, and consumption.

Simultaneous to EU growth risks skewing to the upside amid the benign inflation environment, measures of external demand (trade) have been improving. Moreover, EU political headwinds seem to be abating on the margin, and we would point to the string of defeats of far-right anti-EU populists in several recent European elections—Austria, the Netherlands, and France—as indicative that political risks in Europe may be receding. Notably, we believe the results of the French Presidential election and recent state elections in Germany provide a window of opportunity to unify Europe and make tangible progress toward the goal of an “ever closer union” to promote growth and hold off populism.

As the EU remains fertile ground for populist support, there is evidence that EU leaders believe now is the time to be flexible and make European integration irreversible. Specifically, the increased potential for labor market deregulation and other pro-business reforms in some EU countries may provide Germany an excuse to relax eurozone financial conditions. In turn, this could pave the way for higher fiscal spending within Europe, and also enable the development of a new capital markets union and reclassification of public investment in fiscal deficit calculations, further extending the market cycle.

Taking the above into account, we see a potential multi-year investment opportunity whereby the risk premia assigned to the European markets in recent years is and will continue to come down, allowing investors to focus on the improved economic cycle fundamentals that have been unfolding in Europe for some time now. As the risk premium placed on European stocks continues to fall, we expect many core EU stocks to outperform and close their valuation gaps with global peers. We would note, however, that the gap in profitability, returns, and valuations seen in European equities relative to U.S. peers will likely never fully close given structural differences in geographic and sector exposures (i.e., Europe is economically more external facing, and the EU is more exposed to cyclical industries & financials).

We expect that income inequality, uneven wage growth (if not stagnant), and immigration/terrorism issues will continue to create challenges and stressors to EU politics. We expect the adverse effects to be most acute in Italy, which poses the biggest risk to our outlook, both politically and economically. There has been a lack of progress solving the challenges faced by its financial institutions, and NPL levels remain elevated, among the highest in the euro area. Restrictive bankruptcy laws have stymied the ability of banks to dispose of NPLs so that the banking sector can increase lending.

Past performance does not guarantee future results.

The Bank of America Merrill Lynch U.S. Treasury Merrill Option Volatility Estimate (BofAML MOVE) is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options. It is the weighted average of volatilities on the CT2, CT5, CT10, and CT30. `MOVE' is a trademark product of Merrill Lynch (weighted average of 1m2y, 1m5y, 1m10y and 1m30y Treasury implied vols with weights 0.2/0.2/0.4/0.2, respectively).

The Citigroup Economic Surprise Indices are objective and quantitative measures of economic news. They are defined as weighted historical standard deviations of data surprises (actual releases vs Bloomberg survey median). A positive reading of the Economic Surprise Index suggests that economic releases have on balance [been] beating consensus. The indices are calculated daily in a rolling three-month window. The weights of economic indicators are derived from relative high-frequency spot FX impacts of 1 standard deviation data surprises. The indices also employ a time decay function to replicate the limited memory of markets.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets and consists of 23 emerging market country indices outside the U.S. The Index returns do not reflect any fees or expenses. The Index is denominated in U.S. dollars. The Index returns are net of withholding taxes. They assume daily reinvestment of net dividends thus accounting for any applicable dividend taxation.

The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance and consists of 23 developed market country indices. The Index returns do not reflect any fees or expenses. The Index is denominated in U.S. dollars. The Index returns are net of withholding taxes. They assume daily reinvestment of net dividends thus accounting for any applicable dividend taxation.

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.

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