First
Fourth Quarter 2017
Capital Markets
outlookThe Economy
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Capital Markets Outlook is published quarterly by Asset Strategy Consultants.
Disclaimer and Sources: The material contained in Capital Markets Outlook is based upon consensus information published by the following sources and does not represent any specific recommendation: Callan, Morningstar, JP Morgan, T Rowe Price, Lazard, Russell, John Hancock, Prudential, HFR, Pointer, Weatherlow,
Lighthouse, Preqin, Pitchbook, PCCP and Perennial.
The theme for 2017 is global growth. The “advance” estimate for U.S. real GDP growth was an
encouraging 3.0% in the third quarter. The U.S. is now in its eighth year of expansion, and now
almost all major economies are partaking. Manufacturing indicators are hot all over the world.
The trend of low growth domestically is not expected to change much: the consensus forecast for GDP growth (from the Wall Street Journal’s monthly survey of sixty economists) has the US at around 2.4% in 2018. The most-significant (if not market-moving) news out of the most-recent FOMC meeting was the announcement that balance sheet normalization would commence in October. The Fed has previously made its plans for unwinding the balance sheet clear. The current balance of Treasuries and mortgage-backed securities stands at 4.5 trillion dollars. And while not all assets will be removed, this will still be a multi-year process. Expectations for significant policy change in Washington has waned. With the tax reform proposal under consideration now, the last chance to effect some stimulus in 2017 is quickly approaching.
ConsumerUniversity of Michigan Index of Consumer
Sentiment is at 101.1 in October. This metric
has trended upward since the financial crisis,
reaching levels of the mid-1990s and mid-
2000s. The Case-Shiller 20-City Composite
Home Price Index marched up to 200.29 in
August, approaching an April 2006 high of
206.65. Debt payments are only about 10%
of disposable income – very low compared to a fourth-quarter-2007 high of 13.2%. This all bodes well for growth moving forward as consumer spending makes up about 70% of GDP.
CurrenciesThe dollar has trended downward since the start of the year relative to a trade-weighted basket of currencies, but is still expensive relative to its
Change in Real GDP
Source: U.S. Federal Reserve Bank
Asset Strategy Consultants
Capital Markets Outlook Fourth Quarter 2017
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Capital Markets
Domestic EquitiesDomestic equities posted positive returns for the third quarter of 2017 as the S&P 500 gained 4.5%, and has now gained 14.2% for the year. The growth style continued outperforming value in all market caps. Small cap stocks outperformed large cap stocks for the first time this year, however, still trail in YTD returns. Technology led all sectors with an 8.6% return in the third quarter and leads all sectors with a 27.4% return for the year. Consumer Staples was the lone sector with a negative return for the quarter, returning -1.3%. Stronger global growth has added a new source of revenue for U.S. companies across the economy, resulting in an earnings growth rebound. In addition, market support is transitioning from the Fed to fundamentals. Seven of the ten composite index leading indicators were positive as the economy strengthened. The impacts of Hurricanes Harvey and Irma did not weigh heavily on 3rd quarter growth, however, spending on rebuilding may bring supporting growth by the 4th quarter. Looking ahead, earnings growth in the third quarter is trending well. Early reports indicate that approximately 75% of the S&P500 companies reporting had beaten estimates. However, starting valuations for equities remain elevated as shown by the S&P 500 12-month forward looking P/E ratio at 17.7x which is ahead of the 25 year average of 16.0x. The S&P 500 is expected to end the year around 2600.
Developed EquitiesDeveloped Markets posted another period of strong gains in the third quarter. Various positive factors aided the equity markets, including improving economic growth, improving manufacturing data, strong corporate earnings, and an increase in oil prices. Both the European Central Bank (ECB) and the Bank of England made no changes to interest rates. The ECB is also expected to slowly start tapering its asset purchases in 2018. The United Kingdom still faces uncertainly due to the ongoing Brexit negotiations, affecting business spending decisions and delaying contracts; but the improving trend in the global economy, especially in developing markets, provide some tailwinds. Looking ahead, despite the recent appreciation in the Euro, the Eurozone’s outlook remains very positive; economic sentiments are rising, inflation forecasts remain subdued, industrial production is increasing, and the unemployment rate is sliding down to a multi-year low. The ECB increased its economic growth forecast to 2.2% for 2017 and 1.8% for 2018. Japanese equities rallied in the third quarter, beating market expectations and outpacing most developed economies. The two biggest contributors to this rally were wage gains and consumption. The Bank of Japan (BOJ) still remains highly
Wage growth increased 2.5% at the most-recent reading. Economic theory would suggest that a falling
unemployment reflects a tightening labor market and that wage growth would subsequently follow, but
wages have remained stubbornly low.
10-year average. If other central banks do not keep pace with US tightening, global interest rates could diverge further, making the dollar more attractive and subsequently strengthening versus other currencies. A stronger dollar would make imports cheaper and undercut inflation but also potentially dampen export demand growth.
EmploymentLabor market is tight in the U.S. The October measurement stood at 4.1%. Most unemployment is likely due to industry reorganization or people voluntarily looking for better jobs. As a benchmark, the Fed considers 4.7% the natural rate. Concerns about low wage growth that have characterized this expansion have not dissipated. Wage growth increased 2.5% at the most-recent reading. Economic theory would suggest that a falling unemployment reflects a tightening labor market and that wage growth would subsequently follow, but wages have remained stubbornly low. Part of this may be because of prime-age (25-54) workers returning to the labor force in the past two years. This could explain jobs growth without wage growth.
Interest RatesThe Fed raised rates in June, but the path forward will be very gradual. At the September meeting, 12 out of 16 participants anticipated a third rate hike this year. As has been the case this cycle, the market (represented by Fed Fund futures) is more tepid about the pace of hikes than the Fed. The Fed is aware of lofty U.S. equity valuations, but is unlikely to intentionally use the funds rate to bring them down. Quantitative easing is ending, with the U.S. at the vanguard. The European Central Bank and Bank of Japan are expected to slow the pace of their asset purchases. The market consensus is that the end of QE will not be detrimental. These central bank moves are not coming as a surprise.
InflationInflation has remained stubbornly muted, especially here in the U.S. Core PCE is at 1.8% year-over-year. This is below the Fed’s understood target of 2%. Wage growth and inflation have historically had a positive relationship, meaning as inflation increases, so does wage growth. The period since the Financial Crisis though has been characterized by stubbornly-low wage growth relative to historically-low inflation. v
Capital Markets Outlook Fourth Quarter 2017
3Asset Strategy Consultants
Alternative Investments
Hedge FundsHedge fund assets hit a new peak of $3.2 trillion at the end of the third quarter. While inflows slowed from 2Q17, they were a big improvement over the net outflows seen in 3Q2016. If this trend continues, 2017 could prove to end the year with net positive inflows. A resurgence in performance also is a positive for the hedge fund industry. As performance has improved in 2017, so has investor sentiment. Long/Short Equity strategies appear to be the most prevalent strategies used by investors, although there have been a number of multi-strategy funds launched in 2017 as well. Over the next twelve months, investors say they plan to allocate more to Relative Value and Macro strategies according to Preqin. HFR president Kenneth Heinz indicated that institutions are looking for ways to insulate their portfolios from potential market corrections. The S&P 500 is closing in on one of the longest periods since 1928 without a 5% correction. The longer the markets go on without a correction could make for an unpleasant reappearance when it comes.
Private EquityA total of 181 funds closed in 3Q17 a decrease of 75 from the second quarter. While the number of funds closed in 3Q17 is 22% lower than 3Q16 the total capital raised rose by 43% to $95B. Investors continue to focus on existing GPs with just 8% of aggregate capital being invested in first-time funds. Venture capital funds accounted for 44% of all PE funds closed in 3Q while buyout funds received 69% of total capital raised. A total of $31B was committed to buyout funds representing an 86% increase from 3Q16. There were 25 fewer VC funds closed in 3Q17 versus 3Q16 and they raised $2B less in commitments.
The private equity market experienced a sharp increase in EV/EBITDA multiples in 3Q17 reaching 10x well above the 7.6x five-year median. Only 8% of deals in 3Q had multiples under 5x compared to 42% in 1Q. A competitive market environment, easy access to credit, and strong global growth will cause acquisition multiples to rise through year end. With competition
accommodative and has shown no sign of tightening its monetary policy. Despite geopolitical risk due to issues with North Korea, Japan’s economic outlook remains positive with improving exports and domestic demand. The BOJ expects its GDP to grow by 1.8% for 2017 and 1.4% for 2018.
Emerging MarketsWith the increasing global recovery, the Emerging markets continued to gain traction and outperformed its developed counterparts. Emerging Asia continues to be the key driver, China taking the lead with better than anticipated growth. The Chinese economic outlook looks positive with good employment rate, credit growth, and private sector confidence. Due to stronger than expected growth, the International Monetary Fund raised its forecast for Chinese economy to grow at 6.8% for 2017 and 6.5% for 2018. The outlook for Emerging markets as a whole looks positive as well, with steady global growth, strong earnings growth expectations, and relatively cheap valuations versus developed markets. Even though growth in Emerging markets is expected to widen over the next few years compared to that of the developed markets, they still face some key risks, including the potential for monetary policy missteps, resurgence of populism, geopolitical risk due to North Korea, and political and economic crises in Brazil and Venezuela. The IMF expects developing markets’ GDP to grow at 4.6% for 2017 and 4.9% for 2018.
Fixed IncomeAs noted in other sections, U.S. growth and growth in other developed markets is on solid footing. However, inflation still remains below the U.S. Federal Reserve target level of 2.0%. Better employment levels have allowed the Fed to continue with its slow and steady process of raising its Federal Funds overnight interest rate. However, this has not resulted in across the board higher interest rates in fixed income markets. The U.S. ten-year treasury rate has been range-bound between levels of 2.1% to 2.5% in 2017. The Fed’s announced plan to further remove stimulus by not re-investing matured mortgage-backed securities actually led to a rally in their value, not a sell off. Corporate bonds continued to trade at values that are very close to Treasuries, but not at their all-time highs. Investment grade corporate bond issuance has continued at a record pace as companies finance stock buy-backs and dividends. Select high-quality high-yield bonds (BB, B) and senior floating rate loans are the areas favored by core-plus bond managers at this time. These sectors can also be viewed as equity risk-reducers with that asset class trading at strong levels. In the meantime, emerging market bonds continued their strong showing in 2017 and bond managers are still constructive on the asset class. In addition to higher existing interest rates on emerging market debt, developed market bonds carry the risk of rates rising from below 0% levels, making an unattractive sector look even less so. v
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A competitive market environment, easy access to credit, and strong global growth will cause acquisition
multiples to rise through year end.
6 North Park Drive | Suite 208 Hunt Valley, MD 21030
Capital Markets Outlook Fourth Quarter 2017
Alternative Investments, continued from page 3
so high, 54% of GPs surveyed believe deal multiples are not within a range to allow for typical PE returns.
Real EstateAccording to Preqin, 2017 is proving to be one of the lowest fundraising periods for private real estate in the last five years. One reason investors may be hesitant to invest right now is the amount of dry powder that has already been raised and the challenge for managers to prove there are still attractive opportunities to invest in. Some investors may just have less of an appetite for higher risk strategies as evidenced by the growth in private real estate debt funds. While fundraising may be a bit challenged for managers in 2017, there has actually been a pick-up in transaction activity back up to 2015 levels. There is liquidity in the market, but banks are remaining disciplined and LTVs are trending down to the 50% level. Within sectors, Retail remains challenged, but the situation may not be as dire as it seems. Fashion-related and clothing stores have been seeing a lot of closures, but convenience and discount stores have actually been adding stores. On the Office side, cities that are benefitting from corporate relocations, job growth and associated infrastructure improvements should benefit. Globally, there has been a shift towards affordable and
convenient living, especially in Europe. Cities like Frankfort, Berlin, Stockholm and Copenhagen have seen a large migration to their urban centers. One way they are addressing the high population growth is through micro-housing. This housing is targeted towards a generation of millennials that are less interested in spending time at home and are using the city as their “home”. In the US, millennials represent 43% of multi-family renters. Cities that have strong population and employment growth should be favored. v
One reason investors may be hesitant to invest right now is the amount of dry powder that has already
been raised and the challenge for managers to prove there are still attractive opportunities to invest in. Some
investors may just have less of an appetite for higher risk strategies as evidenced by the growth in
private real estate debt funds.
