Economic Backdrop

Equities tumbled around the globe during the first quarter after climbing to record highs in late January. Several partial rebounds had varying degrees of success and staying power, depending on the country and region—the US and China fared better than Europe, the UK and Japan—but most stock markets ended March near the low end of their quarterly range. Government bond yields rose across all maturities in the US (yields move inversely to prices) and generally declined in Japan. UK and euro-area yields mostly increased, although longer-term yields declined. Oil prices fell with the initial stock selloff, but recovered to finish the first quarter higher than where they began.

The one-year countdown to Brexit Day began at the end of the quarter, shortly after UK and EU negotiators struck a provisional agreement on the post-divorce transition period; this tentatively extended the horizon for uncertainty about the terms of their relationship out to January 2021. The agreement includes a backstop plan for avoiding a hard Irish border; UK negotiators have already offered a fix that combines their preference for a unified UK market with a UK-EU trade proposal (which may be too ambitious for the European Commission).

US President Donald Trump volleyed a series of tariffs as the quarter progressed, beginning with specific consumer products, then moving to industrial metals, and concluding with a round dedicated to China. These invited a range of proposed retaliation measures (as well as a concrete response from China at the beginning of April). Several countries received exemptions as an incentive to hammer out trade deals with the US.

Fresh on the heels of retired term limits, China’s President Xi Jinping launched a restructuring of the country’s financial regulators as part of a broad reimagining of the bureaucracy. North Korea commenced a diplomatic charm offensive, including a showing at the Winter Olympics held just south of the 38th parallel; an agreement to hold separate talks with US and South Korean leaders; and Supreme Leader Kim Jong Un’s first international trip since taking power in 2011, for a surprise meeting in Beijing with President Xi.

The Bank of England’s Monetary Policy Committee did not make policy changes during the first quarter, although a unanimous vote in February was spoiled by two dissenters in March favouring a higher bank rate. US Federal Reserve (Fed) Chair Jerome Powell was sworn in shortly after his

predecessor, Janet Yellen, presided over her final central bank meeting in January. The Fed increased its funds rate in March, as anticipated; it maintained its outlook for two additional rate hikes this year, but boosted the number of expected rate hikes for 2019. The European Central Bank (ECB) and Bank of Japan took no new actions at their respective January and March meetings, but the ECB removed some dovish language from its forward guidance during the latter meeting.

Retail sales in the UK appeared set to disappoint in March, based on a preliminary distributor’s survey, while February was a modestly strong sales month following a decline in January. The claimant-count jobless rate finished February matching its year-end 2017 level after climbing in January; overall unemployment for the November-to-January period came down to 4.3%, and average year-over-year earnings growth increased to 2.8% following an upward revision to the prior period. The final reading for overall fourth-quarter economic growth held at 0.4% (just below the third-quarter pace) and 1.4% year over year.

Eurozone manufacturing and services growth moderated during the first quarter after nearing red-hot levels in the prior three-month period; economic sentiment also slid, as optimism waned on both the industrial and consumer fronts. Labour-market conditions improved at a measured pace as the unemployment rate edged down to 8.5% in February after remaining unchanged in January. The consumer price index declined in the two months through February on a year-over-year basis, due to a large one-month drop in January. Total economic growth in the fourth quarter of 2017 was unchanged at 0.6% for the three-month period and 2.7% year over year.

US manufacturing conditions remained vibrant throughout the first quarter. The unemployment rate held at 4.1% throughout the quarter; average year-over-year hourly earnings jumped in January (bearing some of the blame for the early February stock selloff, as investors feared it may trigger more hawkish Fed actions), and the labour-force participation rate followed suit in February. Personal-income strength held at 0.4% through February, outpacing consumer spending, while personal consumption expenditure prices (the Fed’s preferred inflation gauge) edged upward. The US economy expanded at a 2.9% annualised rate in the fourth quarter, based on the final reading of gross-domestic product for the period.

Our View

We suspect the bull market in US equities is somewhere near the beginning of the end, while it may be somewhat closer to the end of the beginning in other countries. To be clear, we are not saying that the bull market in US stocks is ending. Rather, we are noting that the fundamental, technical and psychological factors driving equity-market performance appear consistent with the latter stages of an up cycle. This particular phase can last a few years if all goes well, but the ride will likely be bumpier than in recent years. We still do not see many serious signs of overvaluation or economic imbalances in the US that would suggest imminent danger of a severe correction, much less a devastating bear market on par with the 2008-to-2009 experience.

Although equity markets underwent their first real correction in some 20 months during February and March, the pullback does not look like the start of a more serious decline. At SEI, we see two fundamental drivers behind the correction in equities and the return to more-volatile price action. The first is the upward shift in investors’ interest-rate expectations as the global economy kicks into a higher gear. The second is concern that the Trump administration’s recent actions on the trade front will lead to a broader trade war that could hurt global growth and push inflation higher sooner.

There certainly are cyclical pressures pushing yields up from their historic lows. The long bull market in equities and other risk-oriented assets has been sustained by the extraordinarily expansive monetary policies of the world’s most important central banks. And the subsequent decline in yields across the maturity spectrum reached levels never seen before. In our view, this 37-year tailwind is turning into a headwind.

But the US Treasury yield curve remains upward sloping and, in our opinion, can narrow further without causing too many problems. Interest-rate spreads for investment-grade, high-yield and emerging-market debt also remain near cycle lows. High-yield bonds, in particular, should be considered the canary in the coal mine. Spreads tend to widen well before the stock market tops out. Even during the recent turbulence in the stock market, the option-adjusted spread on high-yield bonds held surprisingly steady.

As we have pointed out on several occasions in the past, the US equity market has historically managed to withstand the depressive impact of rising interest rates until the 10-year US Treasury reaches a level of 4% to 5%. Owing to the structural decline in bond yields and the elevated equity valuations that have resulted, we now think it prudent to assume that the stock market will begin to struggle if the 10-year Treasury rate approaches 4% (the lower end of the traditional “danger zone”).

While we maintain a positive view of equities and other risk assets, we must admit that our optimism is being tested as the Trump administration uses protectionism as a bargaining tool against friend and foe alike. Impediments to trade—tariffs, quotas and non-tariff barriers—raise prices and reduce demand, leading to a dead-weight loss for society. More jobs are lost by consuming industries than are gained by the beneficiaries of protectionism. A trade war of consequence could add to the inflation pressures that have already emerged as a result of the pick-up in economic activity and the tightening employment situation.

We are in watchful-waiting mode when it comes to trade, but think it’s premature to expect a catastrophe. Our preference is to see what trade sanctions are actually levied, and how target countries respond, instead of assuming the worst from the get-go. Until there is more clarity on the extent of the US protectionist measures being put into place, we think it’s best to focus on the strong fundamental backdrop. Profit growth remains vibrant, inflation is still well-contained and the Fed’s decision-makers would prefer to normalise monetary policy in a steady, predictable fashion. For now, we believe it’s proper for us to maintain a “risk-on” investment orientation.

We’ve been disappointed by the poor relative performance of eurozone equities since the middle of last year. The eurozone economy has been gaining traction since early 2016; we judged the potential for future growth to be much greater in the eurozone than in the US given their respective points in the economic cycle. We also looked for a jump in earnings, as European companies have a high degree of operational leverage, while valuation considerations also provided support to our bullish rationale.

On a fundamental basis, we think investors remain sceptical about the staying power of the European expansion. The ECB is moving away from the asset purchases that have supported the eurozone’s economic recovery and credit markets. And by mid-year 2019, if not sooner, we should see the first steps toward normalising policy rates—although negative yields are an absurdly low starting point.

While the outlook for the eurozone is mixed, it seems bright and sunny compared to that of the UK. As we have mentioned in previous reports, Brexit has become the overwhelming obsession of investors and policymakers. Consumers in the UK are particularly perturbed. Businesses seem to be doing well, owing to the Brexit-related decline in the value of the pound and the buoyant demand arising from the global economic recovery. But uncertainties associated with Brexit have been depressing investment in the UK, and will likely continue to do so until there is more clarity on the country’s future relationship with its biggest trading partner.

The latest wrinkle in the Brexit saga is the backing by the Labour Party leader, Jeremy Corbyn, of a customs union that would keep the UK closely tied to the EU. This is a shrewd political move since it capitalizes on the rifts within the Conservative Party as well as on Prime Minister Theresa May’s low popularity. She has managed to hang on precisely because the prospect of a government headed by Corbyn is beyond the pale for most Conservatives and political moderates. We would expect a radical policy shift to the left, both economically and socially, if Corbyn manages to gain the keys to 10 Downing Street.

Italian politics also retain the potential to depress European equity markets if the populist 5 Star Movement and regionalist Lega (formerly Lega Nord, or the Northern League) parties manage to cobble together a coalition government. At best, this would cause the usual kind of Italian political dysfunction; at worst, it could lead to additional worries about the solvency of the country and its commitment to the euro and the European project.

US congressional elections will take place in November, potentially jeopardising current Republican control of the House of Representatives.Legislating in the US has been tough enough under a “unified” government; it will become next to impossible under split governance, should power become more evenly distributed across the two major parties. We would also expect a Democratic House to ramp up the pace of investigations into the president, his staff and Cabinet.

The past nine years have been full of challenges and uncertainties. The years ahead don’t seem to promise anything different in that regard. Yet, the bull market has managed through it all. Let’s give it the benefit of the doubt for a while longer. Although the ride has turned bumpier, we believe that economic fundamentals justify further gains in US and global equity prices. The synchronized global expansion is still alive and well. Earnings continue to climb briskly around the world. US companies’ cash flows and earnings, meanwhile, are benefiting mightily from tax reform. There really are few signs that a recession will rear its ugly head anytime in the next 12 to 18 months.

Glossary of Financial Terms

Bear market: A bear market refers to a market environment In which prices are generally falling (or are expected to do so) and investor confidence is low.

Bull market: A bull market refers to a market environment in which prices are generally rising (or are expected to do so) and investor confidence is high.

Dovish: Dovish refers to the views of a policy advisor (for example at the Bank of England) who has a positive view of inflation and its economic impact and thus tends to favour lower interest rates.

Federal funds rate: The Federal funds rate is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight in the US.

Fundamentals: Fundamentals refers to data that can be used to assess a country or company’s financial health such as amount of debt, level of profitability, cash flow, inventory size, etc.

Hawk: Hawk refers to a policy advisor, for example at the Bank of England, who has a negative view of inflation and its economic impact and thus tends to favour higher interest rates.

Option-adjusted yield spreads: A calculation used to help determine price differences between similar products that allow different embedded options.
Technicals: Technicals (also known as technical indicators) are designed to help analyse short-term price movements of stocks and are used to try to predict future price levels.

Yield curve: The yield curve represents differences in yields across a range of maturities of bonds of the same issuer or credit rating (likelihood of default). A steeper yield curve represents a greater difference between the yields. A flatter curve indicates the yields are closer together.
Yield spreads: Yield spreads represents the difference in yields offered between different types of bonds. If they tighten, this means that the difference has decreased. If they widen, this means the difference has increased.

Important Information

Data refers to past performance. Past performance is not a reliable indicator of future results.

Investments in SEI Funds are generally medium- to long-term investments. The value of an investment and any income from it can go down as well as up. Investors may get back less than the original amount invested. Returns may increase or decrease as a result of currency fluctuations. Additionally, this investment may not be suitable for everyone. If you should have any doubt whether it is suitable for you, you should obtain expert advice.

No offer of any security is made hereby. Recipients of this information who intend to apply for shares in any SEI Fund are reminded that any such application may be made solely on the basis of the information contained in the Prospectus. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.

In addition to the normal risks associated with equity investing, international investments may involve risk of capital loss from unfavourable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Bonds and bond funds are subject to interest rate risk and will decline in value as interest rates rise. High yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments. Narrowly focused investments and smaller companies typically exhibit higher volatility. SEI Funds may use derivative instruments such as futures, forwards, options, swaps, contracts for differences, credit derivatives, caps, floors and currency forward contracts. These instruments may be used for hedging purposes and/or investment purposes.

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SEI sources data directly from FactSet, Lipper, and BlackRock, unless otherwise stated.