Systematic Equity 2018 Annual Outlook

Equity Markets Poised for a Constructive 2018, but Risk and Volatility Remain in Sight
We believe the global economic backdrop will remain on solid footing in 2018. A combination of steady economic expansion, accommodative monetary policy, deregulation, and continued strength in corporate earnings are supportive of equity markets. Deflationary forces have abated, while inflationary pressures remain benign allowing for an orderly and measured unwinding of the unprecedented monetary support that’s been building since 2008. However, expansionary monetary policy will likely not provide the tailwind to markets in previous years, but can act as a floor limiting downside risk to equity investors. A continuation of a slow-measured approach to removing stimulus from the system should not be disruptive to risk taking.

However, that’s not to say the economic environment and equities are free from a correction in 2018. Rather, we are moving into 2018 with lofty expectations and will not be able to lean on valuations in the event expectations are undershot, supporting an outlook of increasing volatility. Certainly the bond markets are signaling a bit of healthy skepticism. The yield curve is flattening with the long-end of the curve stubbornly entrenched signaling a lack of conviction in the pace of economic growth and the corresponding rise in inflation and interest rates.

Looking across regions, developed U.S. and non-U.S., as well as emerging markets, should continue to sustain attractive economic growth. In the U.S. economic growth will remain on course with upside scenarios playing out with the passage of tax reform at the end of 2017 or early 2018. However, with tighter monetary policy looming, the expansionary economic cycle is moving into the late innings. Earnings should remain strong, but margins are also at a cycle high, so the upside may be capped. Small-cap stocks, which generally pay higher corporate tax rates and garner more revenues domestically versus large-caps, stand to benefit the most from tax reform and interest rate policy supportive of a stronger dollar.

Contrast that to the Eurozone where economic growth is hitting its highest level since early 2011 and still accelerating. The expansionary cycle remains in early phases and interest rates should remain subdued. In Japan, there are more hurdles to overcome but the combination of fiscal and monetary policy seems to be working. Inflation is rising and loan growth expanding. Compared to the U.S., these two regions have greater leverage to continued economic growth and should experience top line and margin growth. Emerging Market equities should continue to maintain a greater growth trajectory verse developed markets, but it is unlikely to deliver returns on par with 2017. Despite its growth advantage, the asset class remains sensitive to shocks stemming from a stronger dollar, rising U.S. rates, or a significant slowdown in China. A pullback in global trade or commodity prices would also be a major headwind. In regards to China, it remains a bit more insulated to these risks supported by stronger domestic consumption and policy initiatives.

While the geopolitical environment was fairly benign in 2017 it remains an area that could upset the apple cart in 2018. An uptick in North Korea tensions or a derailment in Brexit negotiations are two known areas that require monitoring. Policy actions, or inactions, are also an area of sensitivity, In the U.S., given increasing expectations for economic growth, a political stalemate of the passage of a pro-growth U.S. tax bill or an uptick in protectionism may be viewed negatively by market participants. Signs of a slowing Chinese economy, particularly in the Real Estate segment are starting to surface and may require management from its government. A significant change in inflation expectations or monetary policy in key cogs of the economic engine (U.S., Europe, and Japan) would also roil current market optimism.

Info Tech Remains a Fertile Ground and Conservatism Surrounding Consumer Discretionary
The Systematic Equity investment team takes a long-term approach in building portfolios that we believe will add value over the long-term driven by bottom-up stock selection. Our process is quantitatively driven and rooted in research identifying long-term drivers of stock returns through a combination of valuation, momentum, and market sentiment measures. A return forecast is estimated for each security across the global equity universe. We integrate these stock level forecasts within a risk management framework targeting an expected level of risk in our portfolios. Our process is not focused on making top-down calls across asset classes or within equities in terms of country or sector selection. However, when viewing opportunities from a bottom-up perspective, there are some noteworthy themes and insights that help shape our views heading into 2018.

Info Tech continues to be an area we see opportunity. While valuations have moved higher, earnings have thus far justified this move and based on the data we look at should continue to trend higher in 2018. In the U.S., Software and service providers is an area we believe can continue to garner higher top and bottom line growth as corporations look to upgrade their tech infrastructure after years of underinvestment. Outside the U.S., in Emerging Markets Asia and Europe, Semiconductor companies look attractive as demand trends remain strong and is reflected in strong earnings momentum and price trends that we view as favorable.

In Consumer Discretionary internet based retailers have significantly outperformed brick and mortar companies. While it’s tempting to wage a big bet on this continued trend our systematic process is pointing towards conservatism. The performance spread between the two segments is stretched and in the short to intermediate term susceptible to reversion. As such we hold some traditional retailers that have shown resilience and earnings upside as well as for risk management purposes.

Broadly, we favor cyclicals over defensives. Areas such as Industrials, Metals & Mining, and Financials are poised to outperform verse defensives and yield-producing equities given their attractive valuations and the backdrop of continued economic expansion and rising U.S. interest rates. In the U.S., this is further supported in a parallel between 2013 and 2017. In both years, the S&P 500 Index rose significantly and growth outperformed value. However, in 2014, the payoff to valuation-based fundamentals was very strong as investors were more discerning within their stock selection following an outsized growth rally.

Potential Bumps in the Road for Stock Selection
Challenges in 2018, from the viewpoint of our investment process, would result if over short-term horizons the characteristics that deliver stock selection strength over the long-term are temporarily out a favor, resulting in an increased probability of underperformance within strategies. One of the main pillars of our systematic security evaluations relies on assessing multiple dimensions of a company’s peer relative valuation. In 2017, the efficacy of these fundamentals in security selection was challenged. Generally, many of the attractively valued names today are aligned with reflationary elements and expectation of a rising rate environment. To the extent, much like 2017, if the yield curve does not steepen or the global economy undershoots expectations, these characteristics may come under pressure.

Additionally, with such a strong earnings and price momentum trend in place we would not be surprised for some mean reversion of the performance and increased volatility of these signals in the short term. It may also be impacted by fund flows, especially to and from ETFs. Also, if there is any type of shock or risk to the stability of the current expansionary environment, it would be within our expectations that these characteristics of our stock selection process would face pressure in the short term. We have started researching flows and constituents in some of the biggest equity ETFs with the goal of positioning our portfolios away from the most crowded trades that are most likely to revert should such rotations occur, while still staying true to our systematic stock selection process.

2018 Should Remain an Attractive Area for Equities and Active Management
Overall, we remain constructive on equity markets heading into 2018 and our long-term approach to stock selection. We recognize 2017 returns will be very hard to duplicate especially now that the expectations have been raised. However, relative to other asset classes, we believe equities will remain one the most attractive areas of investment in 2018. The equity rally in 2017 brought valuation levels to nearly record highs. In the U.S., we see a parallel between 2013 and 2017. In both years, the S&P 500 Index rose significantly and growth outperformed value. However, in 2014, the payoff to value was very strong as rational stock selection returned to the market. This could be indicative of 2018 and ultimately beneficial towards our systematic approach to active management.