What’s Ahead for Stocks and Bonds in Second Half of 2017?

What markets have room to grow? When might volatility reappear? How do bonds look relative to equities for the next six months? Where are the opportunities? Varying views on global markets are expressed by investment professionals from across Natixis Investment Managers in this midyear outlook.

Our Panel Responses

David G. Herro
David G. Herro, CFA®

Deputy Chairman, Portfolio Manager and CIO of International Equities Harris Associates

The stage is set, I believe, for increased rates of global economic growth as we continue into the second half of the year. Such growth should provide a boost for corporate earnings and share prices given current valuations, which still seem relatively attractive.

Global equity markets have marched higher thus far in 2017 (as of June 14) as economic activity continued to strengthen. The Dow Jones Industrial Average is about to notch its seventh consecutive quarterly gain, and the STOXX Europe 600 Index is expected to advance for the fourth quarter in a row. The US personal consumption expenditures (PCE) index surpassed the Federal Reserve’s long-term target in February. The euro zone’s own annual rate of inflation also reached the European Central Bank’s 2% target in February for the first time in four years. Citing improvements to the labor market and economic health, the Fed lifted interest rates in the US on June 14, for the third time since December. It appears on track for one more rate hike in 2017, as well. We also see a strong global consumer, who has been supported by low unemployment, low energy prices and low interest rates thus far. Business confidence appears to be on the rise, as well. I think a lot of this has been driving share prices, not just in the United States but globally.

European expansion
Europe, in particular, seems to finally be coming out of its economic doldrums. We are starting to see better rates of growth. It’s not robust, but it’s growing a little better. The banking system is also showing real signs of recovery. While we have seen a rebound in European equities in 2017, they still trade at a discount to US equities. I’ve always believed that they should trade at a greater discount given the differences and return structure of European companies versus US ones. But today’s discounts may still be too high in certain areas.

Politics as usual
Certainly, we have witnessed a lot of political drama around the globe in recent months. However, at Harris Associates, we look at political events as white noise. We expect the impact to cash flow should be minimal. Though political uncertainty can create volatility, we view it as an opportunity to purchase quality companies at what we believe are at attractive prices.

Geopolitical risks are a constant
Since I began my investment career in 1986, I can barely remember a time when there wasn’t some risk looming: we had a stock market crash in 1987. The Gulf War in 1990, The Iraq War in 2003, the conflict in Ukraine in 2014, and so on. As long-term investors, we just have to realize that these risks are always with us. Again, for the most part, we view these macro events as white noise. They often create lots of fear and volatility, which might impact short-term earnings. However, long-term earnings streams may not to be impacted much.

As always, the short term is difficult to predict, and may have little influence on a business’s value.
David G. Herro, CFA®, is a Deputy Chairman, Portfolio Manager and CIO of International Equities at Harris Associates.

David Herro is the Chief Investment Officer – International Equities at Harris Associates L.P. and serves as a Deputy Chairman and a Portfolio Manager of a number of Oakmark funds. He was named Morningstar’s International–Stock Fund Manager of the Decade for 2000-2009 and Morningstar's International–Stock Fund Manager of the Year for 2016.* Mr. Herro has been managing international portfolios since 1986, previously managing international portfolios for The State of Wisconsin Investment Board and The Principal Financial Group.

Mr. Herro, who joined Harris Associates in 1992, holds a BS in business and economics from the University of Wisconsin – Platteville (1983) and an MA in economics from the University of Wisconsin – Milwaukee (1985). He is a CFA® charterholder.

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Natixis Distribution L.P. is a marketing agent for the Oakmark Funds, a limited purpose broker-dealer and the distributor of various registered investment companies for which advisory services are provided by affiliates of Natixis Investment Managers S.A.

* According to Morningstar: The Fund Manager of the Year award recognize portfolio managers who demonstrate excellent investment skill and the courage to differ from the consensus to benefit investors. The Fund Manager of the Year winners are chosen based on Morningstar’s proprietary research and an in-depth evaluation by its manager research analyst team. Up to five awards are given every year for managers from each of the following asset classes: Domestic Stock, International Stock, Fixed Income, Allocation, and Alternatives. According to Morningstar: The Morningstar Manager of the Decade Award (2000–2009) is selected by Morningstar Fund analysts. The award is decided by evaluating the risks managers assumed to achieve investment return taking into account asset size, strength of the manager, strategy and firm’s stewardship. There are five nominees for each award: domestic, foreign and fixed-income.

David Lafferty
David Lafferty, CFA®

Senior Vice President and Chief Market Strategist Natixis Investment Managers — US Distribution

As we move into the second half of 2017, there is a sneaking suspicion among investors that something is askew. While the market news flow is heavy, the markets themselves are eerily quiet. Realized and implied volatilities across global stocks, bonds, and currencies are near all-time lows. Global stocks continue to move higher but few investors believe in this rally wholeheartedly. Adding to the confusion is the modest rally we’ve seen in global bonds, with yields falling from their March peak. Should stocks (risk assets) and high-quality bonds (relatively safer assets) be rising at the same time? And which market is foreshadowing the true outlook for the global economy? Maybe both. We believe the investment environment today is characterized by two countervailing forces: improving fundamentals offset by relatively high valuations. This combination of forces is prompting both investor apathy and low market volatility.

Fundamental support, valuation pressure
The fundamental side of the global economy appears to be picking up steam. Activity metrics such as the Purchasing Managers Indexes (PMIs) are now experiencing a synchronized expansion across the US, Europe, and emerging markets for the first time in years. After a soft Q1, US GDP is expected to grow at close to 3.0% in Q2 and just over 2% for the full years of 2017-18.2 Likewise, Europe is awakening from its slumber. Real GDP is approaching 2%, unemployment is falling, credit demand is rising and the fear of deflation is waning. Emerging markets are gaining traction paced by China, where the growth rate has stabilized in the last year, and India, which is rebounding well from demonetization.3 Consistent with stronger global growth, corporate earnings estimates are rising, creating fundamental support under risk assets like stocks and corporate bonds – hardly a bearish background as we move into 2H:2017.

Not to be forgotten is that behind this economic environment, asset valuation is far from compelling. No broad asset classes that we can identify are “pound the table” cheap. Depending on which central banks you want to include, global quantitative easing (QE) programs have added $14 to $18 trillion in assets to the banking and financial system. This has resulted in equity valuations that are extended (but not exorbitant) globally while both interest rates and credit spreads remain low across the bond market. As a result, asset prices are compressed into a trading range, supported from below by improving fundamentals but limited in their upside by stretched valuations. This has in turn led to generally declining levels of volatility across most asset classes since mid-2016.

Prudent participation
Caught between improving fundamentals and constraining valuations, the global equity markets should offer positive returns moving into the second half of 2017 and into 2018. However, this return will be predicated on “clipping the coupon” (an expression usually reserved for bonds) of earnings growth, not a broad expansion of price-to-earnings (P/E) levels. In bonds, the massive dislocation between negative interest rates (expensive high-quality bonds) and wide credit spreads (cheap corporate bonds) in early/mid-2016 has largely been eliminated. With yields quite low, investors may still want to consider the additional carry available across the corporate sectors of the bond markets. However, prudence should still prevail as we get later in the credit cycle.

Periods of abnormally low volatility cannot persist forever. While we see little evidence of systemic risks in the global economy, we expect the remainder of 2017 will offer some negative surprises and increased volatility. Assuming these setbacks don’t undermine the upward trend in economic activity, they may provide a chance to rebalance into better valuations.
David Lafferty, CFA®, is a Senior Vice President and Chief Market Strategist at Natixis Investment Managers — US Distribution.

David Lafferty is Senior Vice President and Chief Market Strategist at Natixis Investment Managers. He is responsible for assessing economic and capital market trends and their implications for investment portfolios. His team also works with affiliated asset managers to develop portfolio insights. He has been with Natixis since 2004. Previously, Mr. Lafferty was senior vice president responsible for fixed-income and asset allocation products at State Street Research & Management, developing investment strategies for institutional clients with assets ranging from $10 million to $2 billion. From 1998 to 2001, he was a senior investment strategist at MetLife, structuring asset allocation programs for institutional clients with assets totaling $600 million. From 2008 to 2012, he served on the Board of Directors of Caspian Capital Management/Caspian Private Equity, a New York based hedge fund and private equity firm.

Mr. Lafferty is a frequent speaker at industry events and is often quoted in Barron’s, Bloomberg, The Wall Street Journal and other financial publications. He received his BA from the University of New Hampshire and his MSF (Master of Science in Finance) from Suffolk University. He is a member of the Boston Security Analyst Society, the CFA Institute, and the National Association for Business Economics (NABE) and has more than 20 years of investment industry experience.

François-Xavier Chauchat
François-Xavier Chauchat

Global Economist and member of the Investment Committee Dorval Asset Management1

We believe the global economic environment remains exceptionally constructive for equities. Global gross domestic product (GDP) growth has accelerated to 3.5% in the first quarter of 2017, and could approach 4% by the beginning of 2018. Moreover, growth is now largely spread all over the world, with only a few geographically small countries in recession, out of 190 countries for which the IMF produces forecasts. This is the first time this has occurred since the years 2004–2007. However, global real interest rates have remained below what many observers feared at the start of this year, which I believe is very positive. In other words, global growth has become more and more satisfactory, but likely not yet strong enough to produce instability.

The backdrop for European equities should remain very supportive, with GDP growth reaching 2% in the euro zone, and with the European Central Bank (ECB) still very accommodative as inflation remains well below target. Growth has now spread to new economic areas, including Italy, which has helped with the deleveraging of the banking sector. Moreover, Greece could get partial debt relief. Median earnings-per-share growth of listed equities in the euro area has already reached 13% in Q1, and we believe could remain in the double-digit area well into next year.

European valuations on the rise
We believe the comparative valuation advantage of European equities versus US equities has diminished considerably in recent weeks, thanks to the sharp decline in political uncertainties following Emmanuel Macron’s victory in France. Since the Brexit vote in June 2016 up to the presidential elections in France, we estimate that European equities suffered from a 10% to 15% discount versus their US peers. The discount is now closer to 5%. All in all, the median price-to-earnings (P/E) of euro zone equities has reached 16.5 times forward earnings, which is significantly above its historical long-term average of 14.5 times.4 However, the equity risk premium of euro zone stocks remains very elevated, with European equity yields standing almost 6% higher than corporate bond yields, versus 3% to 4% before the crisis of 2008.

Periphery opportunities
With European growth spreading to the entire region and with now much lower political risks, companies directly or indirectly exposed to the euro zone periphery may offer more opportunities. We thus like financials, and small and mid-caps in Italy, Spain, and even Greece. We also favor stocks that are the most sensitive to construction and investment spending in continental Europe. We are also attracted by European companies exposed to growth in emerging markets, which we believe will recover last.

Potential volatility on the horizon
With now much higher investor confidence and valuations for European equity markets, risks seem to be more asymmetric: high expectations may imply that good news may have less impact, and bad news more impact on the market. Also, the budgetary process in America this autumn could bring volatility, as the magnitude and content of the US fiscal easing remains subject to high uncertainties.
François-Xavier Chauchat, is a Global Economist and member of the Investment Committee at Dorval Asset Management1.

Joining the firm in 2016, his responsibilities also include macroeconomic framework and asset allocation. Previously, he managed the asset allocation of a large family office and was Chief Economist Europe at GaveKal Research. He has also held the Chief Economist position at Cheuvreaux. With 28 years’ experience, François-Xavier began his career as a market economist at Banque Indosuez, before joining BNP. He is a graduate of Sciences PO Paris and has a degree in monetary economics from the Sorbonne University. He currently teaches economics and finance at the Paris-Dauphine University, as well.

Igor de Maack
Igor de Maack

Portfolio Manager DNCA1

Our outlook for European equities remains constructive and positive for the next six months of 2017, especially for the euro zone. The macroeconomic situation appears to be continuously improving on most topics (decrease in unemployment ratio, strong momentum in credit distribution to households and corporations, accommodating monetary policy). The political risk seems to have also lessened since the May election of Emmanuel Macron in France. This pro-European leader has already announced France’s will to change Europe and move towards a better cooperation with Germany.

Attractive stock prices in Europe
The valuations of European equities look attractive to us, especially relative to the American markets. The 2017 P/E in Europe is at 15.4x, showing a discount of around 15% compared to US stocks (as measured by the S&P 500®’s P/E of 17.6x for 2017). The French equity market is even lower (the CAC 40 P/E for 2017 is at 14.8x). We believe American markets are currently overpricing the US GDP momentum and potential fiscal measures.

Implications of upcoming elections
We do not expect dramatic volatility in European markets this September because of the German elections as Chancellor Angela Merkel has won every regional election in 2017 (Saarland, Schleswig-Holstein, Rheinland-Westphalen). On top of that, I believe the political and economic situation in Germany is very sane. Notwithstanding this, we believe some volatility may emerge in the run-up to the elections in Italy. The return to power of pro-Europe Matteo Renzi is a possibility that could please investors as it could be seen as a step forward in keeping the Eurozone intact. The past experiences indicate that international investors can overestimate the consequences of elections on valuations.

Macro risks in the world
The Middle East region has been, is and probably will be for some time a zone to closely watch for two main reasons: 1. It is the largest oil-producing region in the world. 2. It is a military conflict territory. The religious tensions between Iran and Saudi Arabia cannot be ignored. Also, Asia under the Chinese leadership (economically and politically speaking) is key to the global growth pattern.

Areas of opportunity
We still believe that the European markets, and especially the euro zone equity markets, appear favorable. Equity markets appear to be enjoying a good macro and micro momentum. Dividends are currently generous, particularly in the “value” equity markets of the euro zone (France, Italy, Spain). Asia is also interesting because it is the fastest-growing region in terms of GDP growth (between 5% and 7% from Malaysia to China or India). Economic reforms are also under way (India is a market mover clearly regarding this matter). China is experiencing a massive technological and industrial transition. Last but not least, Japan’s revival with a cheap yen could be the best surprise of 2017.

Large global trends we believe possess attractive long-term opportunities include digitalization, robotization, cybersecurity, technological breakthrough in military and defense industries, artificial intelligence, medical innovation, ecological transition, green energy, and demographic aging. Some of these crucial themes may already be priced in by investors, but those trends open new opportunities and potential value creation. The current revolution and its consequences are still to be understood.
Igor de Maack, is a Portfolio Manager at DNCA1.

Igor de Maack is a Fund Manager at DNCA Finance. He joined the Paris-based firm in 2007. Prior to that, he was a senior vice president of equity capital markets at Lazard-IXIS. He began his investment career at BNP Paribas in project financing. Mr. de Maack is a graduate of HEC Paris School of Management and a qualified member of the French Financial Analysts Association. He also holds a postgraduate degree in international taxation.