The Dynasty Economic & Market Outlook: Volatility is the New Black

How we see the world…

The word for the current state of affairs is desynchronization:

• The consensus estimate for Q2 GDP growth in the US is a sizzling 3.6%. GDP growth is expected to remain strong but decelerate through Q3 (3.0%) and Q4 (2.9%); (source: The Wall Street Journal);
• There remains some uncertainty regarding this forecast, however, as the outcome of ongoing trade negotiations could change the economic outlook for the US over the remainder of the year;
• Specifically, current trade negotiations seem to be taking a protectionist-leaning turn for the worst, which has already resulted in retaliation policies that will affect both inflation and global growth. Of specific concern are agricultural products, including soy beans, which are a major source of exports to China;
• Politically, these policies affect many of the voters who helped propel Donald Trump into office. We can expect that Congress people and Senators from states most affected by increased tariffs will increasingly speak out against current policy;
• Both the US manufacturing and services sectors remain well in expansionary mode (58.7 and 58.6 in May, respectively; any reading above 50 is considered expansionary), and after several month-overmonth declines seem to be accelerating again;
• The manufacturing index has been in expansionary territory for 109 consecutive months, while the non-manufacturing index notched its 100th consecutive expansionary month (source: Institute for Supply Management);
• Inflation (as measured by CPI) rose 2.8% year-over-year in May, slightly above market expectations, driven largely by increases in gasoline and housing costs;
• The Personal Consumption Expenditure (PCE) index – which is the Fed’s preferred measure of overall inflation, increased 2% year-overyear in May, in line with the Fed target rate (source: TradingEconomics);
• We continue to believe that inflation will tick up over the rest of this year, but that it does not yet constitute a primary risk to economic growth. Further, we continue to believe the Fed will allow inflation to run slightly “hot” before stepping in more aggressively;
• After raising rates (as expected) in mid-June, the consensus estimates are that the Fed will raise rates at least two more times in 2018. This may change depending on what unfolds with the outcome of current trade negotiations – a negative turn of events may slow down the planned steady tightening initiatives;
• After a sharp decline in yields in late May due to the Italian political crisis, interest rates continued their “grind higher” path through most of June, before dropping yet again toward month-end as trade war fears swept the market. The 10-year Treasury yield is once again below the mental barrier level of 3%, currently trading at approximately 2.9%;
• We maintain our outlook that rates in the US generally will inch steadily higher, with periodic reversals during market disruptions;

Through the second week of July, there is less than 30 basis points difference between the yield on the 2-year and 10-year Treasury. We do not anticipate (or fear) an inverted yield curve – should one occur, we believe it will be because of investment flows and Fed actions, not a harbinger of an imminent recession;

The US dollar continues its second quarter strengthening momentum, rising steadily against the euro, yen, and British pound. We believe the dollar will continue to strengthen through 2018, as the US economy, interest rates, investment flows, and inflation all pick up steam. This may have negative effects on US large cap export-driven companies (source: Ycharts);

As Q2 ended, in the US, earnings are expected to increase 18.3% on 8% higher revenues. While this represents solid expansion, it also signals the beginning of a forecasted deceleration in US earnings growth as we head through the rest of the year (source: Zachs Earnings Report);

Manufacturing all across the Eurozone remains expansionary, with the Markit Manufacturing index falling slightly from 55.5 in May to 55.0 in June, continuing a slow month-over-month deceleration in manufacturing growth in Europe. Contrarily, the Services index rose to 55.0 in June from 53.8 in May. (source: TradingEconomics);

Eurozone unemployment fell slightly to 8.5% in April, the lowest level since 2008, and annualized inflation went up 1.9% in May, with most of the increase coming from rising oil prices;

Expected inflation for Q2 is 1.7%, and remains under 2.0% for all of 2018, another reason we simply do not see a major inflation spike in 2018 (despite market fears) (source: TradingEconomics);

Now that the Italian political crisis has abated (at least, for now), ECB President Mario Draghi has announced his “tapering” program.

Draghi recently indicated that the ongoing bond buying program will begin to decline starting in September, but he also said he would not move to increase interest rates until well into 2019. This was viewed as a largely “dovish” move and the euro weakened as a result;

Japan’s GDP contracted 0.6% (annualized) in Q1, after expanding 1.6% in 2017, its first contraction after eight consecutive quarters of growth. The consensus estimate for 2018 GDP growth is 2.2% (source: TradingEconomics);

China’s (official) GDP growth in Q1 was 6.8% (annualized), after growing at 6.9% in 2017, and (official) estimates for 2018 suggest a slight slowing to 6.5% -- 6.6% (source: TradingEconomics)

Market Outlook: “Volatility is the New Black”

Tax reform driving share buybacks

But CAPEX and dividends also improving

But companies just doing what shareholders prefer

But is the bloom coming off the rose for financial engineering?

Mixed signals on valuations

Cape fear?

Non-US valuations look more attractive, but risks are higher

Earnings are solid, but expected to decelerate in Q3 or Q4

And banks are lending again

Non-US earnings positive, but below US

Momentum still in your favor

Spreads are tight, but so are defaults

Spreads widening, rare risk regime

Remains a rough year for yield hunters

Ex-oil, mixed bag for “real assets”

But “valuations” look ok

Modest year for most HF strategies

Liquids alts not delivering, so far

Building “All Weather” Portfolios

Reminder: no free lunch anymore

Are you being adequately rewarded?

Who you gonna call?

Not very many anti -volatility tools

How we see things…

• The global economy continues to expand, though there is a “desynchronization” of growth. The US economy appears to be accelerating as the full effects of regulatory and tax reform work their way through the system. At the same time, the rest of the world appears to be decelerating – still expansionary, but slowing down;
• We believe going forward that an expanding US economy, rising inflation rates, continued tightening of Fed policy, and strong investment flows will further strengthen the dollar;
• Inflation is trending higher, but we maintain our belief that it (as of yet) does not represent a problem for continued economic expansion. Wages finally are starting to increase, though slowly, as there currently are more job openings in the US than qualified workers to fill them;
• Outside the US, inflation simply is not a problem, despite rising oil prices. We also maintain our belief that the Fed is inclined to let inflation “run hot” before stepping in;
• In the US, tax and regulatory reform currently are trumping (pun fully intended) monetary tightening. Adding stimulatory fat to an already raging economic fire remains an unknown with respect to the longer term impact on deficits and inflation.
• We continue to believe this is at least a contributing factor to ongoing market uncertainty and volatility;
• Solid US GDP growth, and solid earnings and revenue growth, make for a generally positive market environment, and we still think stocks will end the year higher than where they began. However, decelerating earnings growth and rising interest rates will most likely combine to push valuations down and volatility up;
• Market volatility will also be affected by what seems to be a continuing series of geopolitical events. The most current (and probably the most feared) is the ongoing trade tensions.

If this trend continues, we do not see a positive outcome, and this represents by far the largest threat to the current “Goldilocks” economic regime;

EM and EAFE markets continue to be hurt by the strengthening US dollar and a “risk off” mentality driving significant investment outflow.

We still like EM and EAFE as longer-term positions, but investors almost certainly are headed into increased volatility;

The US yield curve remains flat (there is currently less than a 30 bps difference between the 2-year and 10-year yields), as lower longerterm expected growth rates and technical investment flows combine with only modest inflation expectations on the long-end of the curve, but we believe the risk of inversion is low;

We maintain our view that rates will “grind higher” over the course of 2018, with periodic market corrections and a corresponding “flight to quality” response from investors;

At these rates and credit spreads, the public credit markets still look very expensive to us. Further, we are concerned about high yield liquidity and refinancing risk and the growing level of “covenant lite” bank loans. We are nearing the end of the current credit cycle and risks are increasing;

For investors who can access the private markets and handle some degree of illiquidity, we still believe there are better opportunities in the private markets versus the public markets, though investors face compressed premiums versus historical levels, driven by huge investment flows over the past 18-24 months;

Alternative investments, both Hedge Funds and Liquid Alts, have disappointed so far this year. Investors will begin to question and vote with outflows if they don’t deliver on expectations in what should be a conducive market environment for many strategies;

We remain constructive on real assets and the commodity complex, as both inflation and demand increase, though we believe oil prices may soon begin to stabilize after their recent rally;

While we generally are constructive on the global economy and overall market performance, the public markets still are not cheap;

We see little reason (barring exogenous geopolitical events, such as a trade war) why the market cannot move higher over the rest of the year, with increased volatility;

We also believe, however, that clients need to have their expectations managed as to what a globally diversified portfolio can deliver over a full market cycle.

Boring but true: diversification and compounding work

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This message is intended for the exclusive use the Dynasty Network of registered investment advisors for educational purposes. It is not intended for any other persons, clients or other entities. It should not be construed as an attempt to sell or solicit any products or services of Dynasty, Dynasty Wealth or any investment strategy, nor should it be construed as investment, legal, or tax advice.

Dynasty Financial Partner is a U.S. registered trademark of Dynasty Financial Partners LLC (“Dynasty”). Dynasty is an integrated services provider to the independent channel of registered investment advisers. Dynasty is a brand name and functions through Dynasty's wholly owned subsidiary, Dynasty Wealth Management, LLC (“DWM”) a registered investment advisor with the Securities and Exchange Commission. References herein to DWM as a “registered investment adviser” or any reference to being “registered” does not imply a certain level of expertise. Dynasty conducts business through DWM when providing investment advisory services. A copy of Dynasty Wealth's current written disclosure statement discussing our advisory services and fees is available for your review upon request. Dynasty's wholly owned subsidiary Dynasty Securities LLC is a U.S. registered broker-dealer, member of FINRA and SIPC and may receive referral fees on brokerage transactions.

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