Quarterly Newsletter
The Kartheiser Group at Morgan Stanley
Family Wealth Management
Classic Late Cycle Uptick
Q2 | 2017
Although optimism is a late cycle phenomenon, history tells us the best returns often
come at the end. It has taken eight long years to get here, but Wall and Main Street
are finally starting to feel a “bit” better about the future, politics aside.
IN THIS ISSUE
1) Quarterly Commentary
2) Rethinking Our US Bias
3)
We Still Like
Joe Why
Kartheiser
International
Equities
Senior
Vice President
–
Wealth Management
Financial
Advisor
4)
Tactical
Asset
312-419-3337
Allocation
[email protected]
5) Stocks Beat Bonds
During Rising Rates
The cyclical upturn that began a year ago has less to do with President Trump and
more to do with the global business cycle that bottomed in Q1 2016. Trump simply
“turbocharged” the cycle and stoked animal spirits on Wall and Main Street, with
tangible effects on the real economy and markets.
Based on Sir John Templeton’s four stages of the investment cycle: "Bull markets are
born in pessimism, grow in skepticism, mature in optimism and die in euphoria." The
end of the cycle is often the best. Think 1999 or 2006-07. In a low-return world,
investors cannot afford to miss it.
Exceptionally loose financial conditions encourage the shift toward investor euphoria.
Meanwhile, our proprietary institutional and retail data suggest US equity positioning
is not extreme, and market technicals are in very good shape. Morgan Stanley’s 12month base case S&P 500 target is 2700*. This is a 15% increase from mid-April.
This forecast is more bullish than most and I’d be happy with half that at this point.
Risks: 1) We are late cycle and the Fed is further along than appreciated. This
tightening cycle began in 2014 with the tapering of QE, which means there may be
less headroom for actual rate hikes this cycle than assumed; 2) Commercial Real
Estate and Autos are canaries in the coal mine that could spill over into broader credit
markets; 3) Oil prices fall further and/or take longer than expected to recover—the
Energy sector is the single largest incremental driver of S&P 500 earnings growth this
year; 4) European Central Bank tapering is not expected but it could happen this
summer when political risks diminish in Europe.
Joe Kartheiser – CIMA®,
CFP®
Executive Director –
Wealth Management
Financial Advisor
70 W. Madison, Ste 5100
Chicago, IL 60602
NMLS 1255344
312-419-3337
[email protected]
Jeff Piwnicki
Financial Advisor
312-419-3353
James Van Cura
Senior Registered Associate
312-419-3316
We are tactically moving money from US equities into international given valuations
and varying stages of the bull market cycle (ie: intl further behind). This newsletter
will focus on that.
*Source: US Equity Strategy: Initiation of Coverage 4/10/2017
Asset Class 2017 YTD Returns
(as of April 14th , 2017)
LEVEL
% CHANGE
S&P 500
2,328.95
4.6%
MSCI EAFE (International
Stocks)
1,777.63
6.6%
960.43
11.8%
-
1.75%
[email protected]
MSCI EMERGING MARKETS
Chase Komatz
312-419-3598
Registered Associate
BARCLAYS U.S. AGGREGATE
(bonds)
[email protected]
Source: Global Investment Committee & Barclays
Quarterly Newsletter
Q2/17
The Kartheiser Group – Family Wealth Management
2
Rethinking Our US Bias
First quarter’s relative underperformance of US assets may continue with valuation, Fed
tightening, late-cycle dynamics, a peaking US dollar and portfolio positioning as headwinds;
US narrative hinges almost exclusively on earnings growth, which may depend on policy
developments; the one-sided division of corporate spoils, which disproportionately favored
shareholders over labor, may be turning; stock and bond market increasingly priced for
disparate outcomes; outside the US, the reflationary recovery offers significant profit
potential.
During the past eight years, US stocks have dominated global equity markets, delivering a
cumulative 80% outperformance relative to the MSCI All Country World Index ex US. (See
below chart). Relatively resilient economic growth, the Federal Reserve’s swift and successful
campaign against deflation, an aggressive clean-up of the banks and corporations’ focus on
profitability have pushed corporate profits as a share of US GDP to a historic 12.7% peak—
and US market indexes to all-time highs. Even so, as we entered 2017, many investors were
certain that relative US market success would persist. After all, sentiment data was soaring
to decade highs on prospects that the Republican-run government would deliver progrowth
policies of tax reform, infrastructure spending and deregulation. In addition, global reflation
was on track, sustaining powerful upside surprises to the fundamental economic data.
Furthermore, 2017 S&P 500 earnings estimates were forecasting 12% to 14% year-over-year
gains. But as the first quarter comes to an end, we are witnessing the second quarter in the
past three in which US stocks have lagged non-US stocks. While US stocks are up about 6%
for the year to date, the MSCI All Country World Index ex US gained 10% and the MSCI
Emerging Markets Index picked up 14%. While the Global Investment Committee (GIC)
remains constructive on US stocks’ total return potential, relative performance is an
important consideration. Could US equities’ long run of outperformance be at an inflection
point?
From here, US stocks face strong headwinds. The forward price/earnings ratio multiple is
about 25% higher than other developed markets—and the dollar is about 25% higher than
its 2012 trough. Somewhat unsettling is that while the Fed is expecting two or three rate
Quarterly Newsletter
Q2/17
The Kartheiser Group – Family Wealth Management
3
hikes this year, the futures market implies just 1.5. Equally disconcerting is that the 10-year
US Treasury is once again at 2.4%, but real rates and thus real economic growth is being
priced at less than 0.5% per year. Such a low rate implies skepticism about the current
reflationary bounce and a distrust of the Fed. It also assumes failure of President Trump’s
progrowth agenda, as success there would be inflationary and demand higher rates.
Outside the US, the story is better. Emerging market (EM) dynamics are quite
constructive. The recovery of commodity prices, global trade and capital spending has ignited
a self-sustaining recovery in many EM countries after nearly three years of recession. Unlike
the US, where profits are well above the normalized trend, profits of companies in the MSCI
Emerging Markets Index are more than one standard deviation below their 20-year trend of
8% annualized growth. Excess manufacturing capacity that had contributed to global
deflation is slowly being rationalized and domestic consumption is bouncing back. The
implication is that operating leverage off of the downsized fixed asset base could be
significant. What’s more, real interest rates are high on a relative basis, so EM debt is
attracting investment flows. This positive dynamic, along with the depreciation of China’s
renminbi, is helping to keep EM currencies strong and has allowed them to uncouple from
their dependence on Fed policy. Importantly, valuations are relatively attractive—just under
13 times forward earnings.
In Europe, the story is equally sanguine. Purchasing Managers Indexes suggest
broadening strength in both manufacturing and services sectors and across geographies.
Graham Secker, Morgan Stanley & Co.’s European equity strategist, recently upgraded his
year-over-year 2017 earnings growth forecast to 16% from 12%. Pacing the gains are
improving prospects in financials as short-term yields may have bottomed and credit growth
has turned positive for the first time in five years. Monetary policy is likely to remain in the
sweet spot: The European Central Bank is moving gradually toward ending Quantitative
Easing but at a pace that keeps the euro weak and interest rates in the peripheral countries
low. Significantly, the profit recovery for companies in the MSCI European Index have ample
runway as even with 2017’s projected gains, profits will only be where they were in 2009.
Here, too, valuations are not overly demanding with a 15.4 forward P/E, in line with history.
In Japan, we also see opportunity. Investor anxiety has focused as usual on the
strengthening yen and lukewarm consumption data, but the real story is about corporate
governance reforms that are driving return-on-equity gains. In our view, shareholder-friendly
actions like share repurchases and dividend increases should add 3.5% to 4% to 2017
earnings growth that is already forecast to be up by 14%. Bottom Line: Investors who have
biased their portfolios toward US assets have disproportionately benefited relative to globally
diversified portfolios during the past eight years. Now, risks are rising: stretched stock and
bond valuations; a Fed on a tightening path that is only partially priced; the peaking dollar;
late-cycle dynamics weighing on profit growth; and dependence on fiscal policy to drive the
next leg of growth. While total returns in US stocks should be solid, the risk/reward
proposition appears better in non-US markets. Watch for further strengthening of the dollar
and/or rising US interest rates, which could be a positive catalyst for further global
rebalancing. Consider adding to non-US stock and bond exposure.
Source: Morgan Stanley GIC Weekly– April 3, 2017
Quarterly Newsletter
Q2/17
The Kartheiser Group – Family Wealth Management
Why We Still Like International Equities
• Europe and Japan both trade at discounts to the
S&P 5oo on a 12-month forward P/E basis; the
MSCI Europe and MSCI Japan indices currently
trade at 15x and 14.3x forward EPS, respectively,
compared to the S&P 500 at 17.5x
• Earnings are expected to grow faster outside
the US as well. In 2017, year-over-year consensus
EPS estimates are pointing toward 18% EPS
growth for MSCI Europe and 14% for MSCI Japan
compared to 10% in the US
• Additionally, international stocks have
underperformed the S&P 500 nearly 100
percentage points since 2008. Though this may
be beginning to turn – Japan, Europe, and EM
have all outperformed the S&P 500 since July
2016. We believe international stocks may be
reaching a support level vs. the US and we
continue to recommend global equities
• Additionally, global economic growth continues
to accelerate and remain supportive of higher
equity prices. The Citi Global Economic Surprise
Index remains elevated at the highest level since
2010
• While we do think there is more upside for US
equities, we believe international equities will
lead going forward
Source: Bloomberg, FactSet, Morgan Stanley Wealth Management Market Strategy as of 3/23/2017
4
Quarterly Newsletter
Q2/17
The Kartheiser Group – Family Wealth Management
5
Tactical Asset Allocation
Capital Preservation
Balanced Growth
Opportunistic Growth
Income
Market Growth
Key
Source: Morgan Stanley GIC – April, 2017
Disclosures:
The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Wealth Management or its affiliates. All opinions are subject to
change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no
guarantee of future results.
Morgan Stanley, its affiliates, Financial Advisors and Private Wealth Advisors do not provide tax or legal advice. Clients should consult their tax advisor for matters involving
taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters.
Interest in municipal bonds is generally exempt from federal income tax. However, some bonds may be subject to the alternative minimum tax (AMT). Typically, state taxexemption applies if securities are issued within one’s state of residence and, local tax-exemption typically applies if securities are issued within one’s city of residence.
Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities
prices will fall. Bonds face credit risk if a decline in an issuer's credit rating, or creditworthiness, causes a bond's price to decline. Finally, bonds can be subject to prepayment risk.
When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose
the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made. NOTE:
High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Morgan Stanley S The MSCI
Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. As of May 30 2011, the
MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea,
Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed
markets, excluding the US & Canada. As of May 30, 2011, the MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark,
Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United
Kingdom. The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. As
of May 30 2011, the MSCI World Index consists of the following 24 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany,
Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States.
Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 11% of the total market capitalization of
the Russell 3000 Index. S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market. An investment cannot be
made directly in a market index.
International investing may not be suitable for every investor and is subject to additional risks, including currency fluctuations, political factors, withholding, lack of liquidity, the
absence of adequate financial information, and exchange control restrictions impacting foreign issuers. These risks may be magnified in emerging markets.
The Barclays Capital U.S. Aggregate Index covers the U.S. Dollar-denominated, investment-grade, fixed-rate, taxable bond market segment of SEC-registered securities. The index
includes bonds from the U.S. Treasury, Government-Related, Corporate, Mortgage-Backed, Asset-Backed, and Commercial Mortgage-Backed Securities sectors. An investment
cannot be made directly in a market index
Morgan Stanley Smith Barney LLC, member SIPC