Market Perspectives

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2018 Midyear Global Outlook

07.10.2018

Market volatility returned strongly in the first half of 2018 as trade disputes, geopolitical tensions and uncertain global growth rates provided a choppy ride for investors. On the global economic front, the U.S. continued to set the pace as corporate earnings remained strong and business confidence continued to soar. Against that backdrop, the heightened rhetoric and growing quarrels between the U.S. and key trading partners could unsettle the markets in the remainder of the year. What might the second half of 2018 have in store for the markets and investors?

U.S. economy sets the pace

The health of the U.S. economy remains a pocket of strength for global growth despite a slow start to the year and the looming presence of higher market volatility. The economy delivered a weaker than expected first quarter, as measured by gross domestic product (GDP) growth, due in part to a dip in personal consumption. However, we believe it is poised to recover and show strength for the remainder of the year. The U.S. Tax and Jobs Act signed into law by President Donald Trump in late 2017 and a $1.3 trillion stimulus bill passed in March of this year are likely to contribute to that strength.

IVY VIEW
We maintain our initial U.S. GDP growth forecast of 2.9% for 2018.

Overall business optimism remains strong despite concern over the Trump administration’s position on several issues, most notably the direction of U.S. trade policy. According to the Small Business Optimism Index, small business owners currently are more optimistic than any other time in the index’s 45 year history.

Many small business owners reported record profits, and indicated they plan to use this profit growth to make capital investments and add headcount.1 (Chart 1)

Chart 1: Small business optimism soars
Chart Showing SMALL BUSINESS OPTIMISM SOARS

* Source: “Small Business Economic Trends,” National Federation of Independent Business, May 2018. Index reading is seasonally adjusted, based on baseline of 1986=100, and shows rising and/ or falling rates of optimism.

Large company leaders also are confident, albeit slightly less than their small business counterparts. After reaching a record high in the first quarter of 2018, the CEO Economic Outlook Index — a composite of corporate executives’ sales projections, capital spending forecasts and hiring plans over the next six months — had a modest decline in second quarter, with trade uncertainty a key reason.2 (Chart 2)

Chart 2: Large companies confidence slips over trade

Chart Showing SMALL BUSINESS OPTIMISM SOARS
Source: “CEO Economic Outlook Survey 2Q 2018.” Business Roundtable/Haver Analytics, 06/05/2018. Data from CEO Economic Outlook Survey Diffusion Index; readings of 50 and above indicate optimism about business expansion.

We believe U.S. GDP growth remains on pace with our initial 2018 forecast of 2.9%. While inflation has picked up slightly, it is still in line with the U.S. Federal Reserve’s (Fed) target of a 2% annual rate.

A strong labor market also is contributing to the upbeat U.S. economic picture. The unemployment rate fell to 3.8% in May, the lowest level in 18 years. While improving, wage gains this year have been modest given the low level of unemployment. We believe wage growth will continue to improve in the second half of 2018.

Global economy hums along

Despite the threat of trade disputes, the global economy remains resilient. We believe the U.S. is a key driver of the overall health of continued global economic expansion. We have revised our global economic forecast, projecting growth at 3.8% for the year, down slightly from our outlook in January. (Chart 3)

IVY VIEW
We project global GDP growth at 3.8% in 2018.

Eurozone GDP performance has been tepid and weaker than expected this year, with growth at a 0.4% non-annualized rate. We believe a markedly harsh winter in areas of Europe and an uptick in work absences due to seasonal illness contributed to the less than stellar performance. We think the first-quarter slowdown was exaggerated and expect a slight rebound in growth going forward. A similar phenomenon happened in the U.K., where we also expect growth to rebound, although increasing friction in Brexit negotiations about the U.K.’s exit from the European Union (EU) has created downside risks.

Chart 3: Ivy projects 2018 Global GDP growth may pick up after slow start to the year
Chart Showing Ivy projects 2018 Global GDP growth may pick up after slow start to the year
Chart Showing Ivy projects 2018 Global GDP growth may pick up after slow start to the year

Source: Chart shows actual and forecast annual gross domestic product growth. Source 2017, International Monetary Fund actual data; 2018 Ivy forecasts; all based on purchasing power parity. Past performance is not a guarantee of future results. The forecasts are current through June 2018, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.

The European Central Bank (ECB) announced its plans to halt its quantitative easing program later this year while keeping interest rates at record lows at least until summer 2019. The ECB’s announcement was a noteworthy change from its prior position because it marked the bank’s first move to unconditional calendar-based guidance on its plans and away from its prior approach of issuing guidance based on the state of economic conditions. However, the ECB could delay any changes to its program and prolong its current monetary policy if recent economic weakness continues.

Japan’s lackluster economic performance in the first quarter caused us to lower our growth projection to 1.2% for the year. However, we believe growth could pick up in the second half of 2018 based on our expectations for solid employment growth, fiscal stimulus, an influx of construction projects in anticipation of the 2020 Summer Olympics and an increasing desire for companies to make investments in capital expenditures. Given soft inflation data, we expect the Bank of Japan to continue trailing other central banks in tightening its ultra-accommodative policies.

Emerging market economies are holding up well as global interest rates remain at relatively low levels versus historic norms.

We have amended our forecast growth rate to 7.3% for India, making it the fastestgrowing country among major emerging economies. Our views on China, however, have become slightly more measured. Government efforts to curb pollution resulted in multiple closures of heavy industrial plants, which weighed on growth in the first quarter. In addition, government action to temporarily pause and inspect public-private partnership initiatives has finished. We believe China is poised for a GDP growth rate of 6.4% in 2018. Lingering trade tensions with the U.S. still are cause for concern for China, as well as for other global powers.

U.S. Dollar rally looks more durable

After falling more than 3% during the first quarter, the value of the U.S. dollar (as measured by the benchmark U.S. Dollar Index/DXY) has roared back since mid-April and by midyear was about 6% above its low point in February. The dollar’s decline at the start of the year was puzzling, given that interest rates moved sharply higher during the first two months of the year and they tend to move in tandem with the dollar.

However, when yields moved higher again in April, the dollar returned to the typical pattern and moved higher with them. The dollar’s outperformance also benefitted from the weaker-than-expected firstquarter economic performance in several developed economies.

The ECB’s recent move to rule out an interest rate hike through at least the summer of 2019 was a dovish surprise to the market and we believe it will weigh on the euro in the months ahead. The dollar’s recent appreciation is not surprising, given the rise in yields, and we think the dollar could hold those gains for the balance of the year.

IVY VIEW
The U.S. dollar may hold gains through the remainder of the year.

Emerging market currencies have been hit hard by the appreciation in the dollar and rising interest rates. Oil-importing emerging economies also were squeezed by the move higher in crude prices. This was another unusual occurrence, as the dollar and crude oil prices tend to move in opposite directions. Emerging market currencies could continue to feel the strain of higher U.S. yields, a stronger dollar and tighter global liquidity.

What are the risks?

While we believe the global economy is sound enough to continue modest growth, there are a number of risks to the outlook and we are watching these closely.

IVY VIEW
Trade is the greatest threat to disrupt the global economy.

Trade tensions. Historically, real global GDP growth has been highly correlated to world trade volume. (Chart 4) Because of the relationship between global GDP and trade, we believe the biggest risk to the current economic backdrop continues to be global trade tensions. The Trump administration’s protectionist stance led to tariffs of 25% on steel and 10% on aluminum imports imposed on several western allies, including Germany, France, Canada and Mexico.

Chart 4: The correlation between real Global GDP growth and world trade volume

Chart Showing The correlation between real Global GDP growth and world trade volume
Source: “OECD Total: Real Gross Domestic Product/World Trade Volume,” Organization for Economic Cooperation and Development, Netherlands Bureau for Economic Policy Analysis/Haver Analytics, June 2018.

The EU responded to the steel and aluminum tariffs with retaliatory threats of penalties on U.S. farming and consumer goods. A puzzlingly contentious G7 summit in June only inflamed tensions between the U.S. and its long-time trade partners, most notably Canada.

The administration on June 15 announced it intends to impose 25% tariffs on a wide range of Chinese imports worth about $34 billion, beginning in July. Potential duties on an additional $16 billion worth of imports from China requires public review, according to the U.S. Trade Representative’s office announcement on the new tariffs, which could bring the total to $50 billion. China swiftly announced its own 25% tariff on $34 billion of U.S. goods, including agriculture products, automobiles and “aquatic products.” These actions escalated the strain over trade between the world’s two largest economies and we believe trade frictions with China will linger in the near term. However, we think an all-out trade war still can be avoided, especially if China were to take conciliatory actions such as opening its markets to address its overall trade position with the U.S.

Talks between member nations of the North American Free Trade Agreement (NAFTA) have run hot and cold for much of the year. A deal to revamp NAFTA may be on hold until 2019. U.S.-Canada relations are uncharacteristically cool following the latest G7 meeting and Mexico will hold elections later this year, during which U.S. relations and the trade pact could be key campaign issues.

While there is validity over issues like U.S. intellectual property theft and trade deficits, the relationship between real GDP and trade value is highly correlated. We believe it would be harmful to global growth if the U.S. continues to impose tariffs on more goods and more countries.

IVY VIEW
The Fed will raise interest rates two more times this year.

Interest rates. Yields on the U.S. 10-year Treasury bond have risen by more than 0.5 percentage point since the beginning of the year and a recent move above 3% caused concern that rising interest rates will slow U.S. economic growth. Typically, a rise in interest rates first impacts the housing market. However, data continue to indicate that housing inventory is too low, relative to demand. While we could see temporary dips in demand for housing, we think demographics are likely to continue to support housing demand. The most recent delinquency rates for consumer debt outside of housing have begun to rise but are generally still at low levels. The overall cost for consumers to service their debts is historically low when compared to income levels.

Fed Chairman Jay Powell has followed his predecessor’s practice of telegraphing the central bank’s intentions well in advance of its actions to avoid surprising the markets. This was evident by the hike in interest rates by 0.25 percentage point in June, which put the key federal funds in a target range of 1.75–2.0%. We anticipate the Fed will make two more rate hikes in 2018.

IVY VIEW
The markets will see positives in U.S.-North Korea summit.

Geopolitical ripples. The diplomatic makeover of North Korea has to be the story of 2018 so far on the geopolitical front. In the span of less than a year, Trump and North Korea’s Kim Jong-un have gone from hurling insults and threats at each other via social media to an unprecedented face-to-face meeting in Singapore in June. While it’s unclear if North Korea’s nuclear aspirations have abated, or whether the two sides can agree on what a denuclearized Korean peninsula looks like, we think the summit is a positive first step toward improved relations and we believe markets will view it favorably in time.

One area where we could see a possible halo effect from the Trump-Kim summit is the U.S. midterm elections, which will garner considerable attention from the markets as November approaches. Current polling suggests the Democrats could win the majority in the House of Representatives, but face stiffer competition in the Senate. However, Republicans would certainly like to tout a “peace and prosperity” narrative to help maintain their majorities in both chambers. Should leadership in both houses of Congress change hands, we believe talk of impeachment proceedings will ratchet up, sending another bout of volatility through the markets.

We also are mindful of a couple EU political dramas. In Italy, the Five Star Movement and the far-right Lega party won elections in March and formed a coalition government. These populist parties are opposed to fiscal rules established by the EU, which could lead to conflict going forward. A political scandal in Spain triggered a no-confidence vote in its parliament, leading to the ouster of the country’s prime minister. Pedro Sanchez of the Spanish Socialist Workers’ Party now leads the government. Finally, a cronyism scandal is shaking confidence in Japan’s Prime Minister Shinzo Abe, although he appears determined to ride out the political storm.

Emerging markets volatility. Recent volatility in emerging markets asset prices has garnered much attention. Eventually, the increase in emerging markets debt over the last decade could be a problem as global liquidity declines on the back of central banks ending ultra-easy policies. But the current account positions for many emerging markets have improved over the last few years. We believe concerns are overstated now as problems are more country-specific. We also think steady global growth and little inflationary pressure in emerging markets are likely to allow those economies to remain strong.

Key sectors to watch

TTechnology continues to be the main catalyst of market activity, while rising oil prices fueled a rally in energy and a wave of consolidation in the telecommunications sector could follow the AT&T-Time Warner ruling.

Technology

The impact of the technology sector continues to be noteworthy as it has outperformed the S&P 500 Index by nearly 9% year-to-date. This outperformance is most notable among small- and mid-capitalization companies relative to large-cap names, with the exception of the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google-parent Alphabet), which continue to set the pace for the sector, despite weathering volatility as a result of harsh criticism over privacy issues from consumers and lawmakers earlier in the year. We believe public cloud services, which allow companies to rent IT infrastructure to power all types of enterprises from online storefronts to gaming apps, and the demand for semiconductors to power connectivity, or the “Internet of things,” continue to be supportive themes for sector performance in 2018.

Financials

No other sector is more closely connected to the prevailing winds of interest rates than financials. So it’s not surprising that overall performance to date has been modest as the yield curve continues to flatten. However, we are seeing some dispersion within the sector. Regional banks are up nearly 10% for the year, benefitting from stronger loan and margin growth, as well as the Trump administration’s more businessfriendly stance on regulation. Payment processing systems also are performing well year-to-date as the global expansion has led to increased spending levels while newer players have gained market share. Lastly, the likelihood of rolling back the Volcker Rule increased significantly in June when the Securities and Exchange Commission agreed to seek public comment on a possible overhaul. A repeal of the Volcker Rule, which restricts government-insured banks from engaging in risky investment activity, could have a disproportionately positive effect on the sector.

Telecommunications

The sector received a major boost in June with the rebuke of the U.S. Justice Department’s effort to halt the proposed AT&T-Time Warner merger. A federal judge ruled in favor of the $85.4 billion deal, stating the government failed to prove the merger would result in less competition and higher consumer prices. The ruling could trigger a wave of corporate acquisitions in the space. The price wars between wireless carriers appear to have let up slightly, but that could be short-lived as major cable companies are likely to ramp up their own wireless offerings. Finally, trials of 5G technology could create headlines and buzz in latter half of 2018, which could generate a deluge of new products from carriers.

Energy

Global oil supply and demand trends remain favorable for the energy sector, but the prices of oil in different regions of the world have started to see wide divergences. For example, the price in the U.S. Permian Basin is roughly $20 less per barrel than the international price of some crude oil. This is due to the lack of pipeline infrastructure in the Permian, which raises the cost to transport oil out of the area. As a result, regional oil producers see less upside from higher oil prices than international producers. In addition, U.S. refining companies benefit greatly from the cheaper oil they use in the refining process. This situation is expected to continue for another year until new pipeline construction is completed to alleviate the bottleneck.

In the meantime, we believe two groups of energy companies stand to benefit: 1) producers with access to higher pricing, and 2) downstream refiners that have access to cheap oil. The Organization of Petroleum Exporting Countries (OPEC) has contributed to the oil price recovery over the past year through its constraints on supply. The group has been holding back production in an effort to balance the market and reduce global oil inventories.

Having largely achieved this goal, OPEC voted to modify its policy in June, agreeing to boost output by approximately 1 million barrels a day. This action could create a headwind for oil prices given the low cost source of OPEC production.

Health Care

The sector remains a defensive investment overall in our view as health care reform has become a back-burner issue in Washington. The fundamentals currently are uninspiring with growth rates relatively lower vs. historic levels. The biopharmaceutical industry is trading at relative low levels of valuation, which will likely remain absent a change in fundamental trends. We do see pockets of innovation, especially in the medical device space, which has outperformed the sector, as well as the broader market year-to-date. One theme we like is the incorporation of digital technology in multiple health care applications, including surgery, glucose monitoring and dentistry. An issue that could impact our view is the U.S. midterm elections. A change in leadership would likely spur policy discussions, reigniting consternation between companies and policymakers.

Other areas of focus

Consumer staples: While the dust has yet to settle over the 2017 “retail apocalypse,” traditional retailers that can weather the secular shift to e-commerce and have strong omni-channel capabilities could have an advantage over less-savvy competitors. Meanwhile, Amazon continues to have strong top-line growth but is shifting toward margin expansion as the company seeks greater share-of-wallet penetration.

Transportation: The costs for shipping have gone up. Rising diesel prices and a driver shortage have led to a tight trucking market, but also opened opportunities for growth in the intermodal and rail spaces.

Industrials: Despite sector underperformance and trade concerns in the first quarter, U.S. manufacturing has posted 21 months of growth, according to the Institute for Supply Management.

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1Source: “Small Business Economic Trends,” National Federation of Independent Business, May 2018.

2Source: “CEO Economic Outlook Survey 2Q 2018,” Business Roundtable/Haver Analytics, April 2018.

The opinions expressed are those of Ivy Investment Management Company and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through July 2018, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

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