INSIGHTS

On November 14, 2017

HIMCO 3rd Quarter Market Commentaries

Equity Market Outlook (as of September 30, 2017)

Another solid earnings season passes on the baton of growth to renewed tax talk. Despite ongoing geopolitical drama and an increasingly hawkish Fed, the S&P 500 rallied into quarter-end to close at an all-time high of 2519, a total return of +4.5% for the quarter. Companies reported solid earnings in Q2 with 49% of companies beating estimates on sales and earnings (vs. 35% historical average), but these results had little impact on FY2017 (full year 2017) earnings growth expectations of +11%. Consequently, nearly all price return was attributed to expanding multiples, particularly as investors baked in details of the latest Trump tax package; forward P/E (price to earnings) ratios climbed nearly a full turn from 18.3x to 19.1x, holding firmly ~2-standard deviations away from historical means.

Aside from mid-quarter saber-rattling between the United States and North Korea, market volatility was subdued with the VIX index often returning to near all-time low territory. Nearly all sectors in the S&P 500 experienced positive returns, with IT (+9%), Energy (+7%) and Telecom (+7%) leading the market rally’s bullish growth-minded tone. Consumer Staples (-1%) was the only sector with negative returns as it continued to digest Amazon’s newly minted footprint in traditional grocery space.

From a quantitative perspective, YTD themes generally remained intact with growth and sentiment factors outperforming while quality and value factors lagged over the quarter.

• Russell 2500 Growth vs. Russell 2500 Value: +5.78% VS. +3.83% (+195 basis points)

• Russell 2000 vs. S&P 500: +5.67% VS. +4.48% (+119 basis points)

In what could be considered a late-cycle indicator, “negative alpha” was a major theme of this past earnings season. Investors rewarded companies that beat top and bottom line estimates with essentially flat performance. On the other hand, companies in the S&P 500 that fell short of expectations suffered large drawdowns, dropping on average ~4% after sour earnings releases. The last time such market behavior was this prominent was in 2007.

Despite less encouraging signals from technicals, fundamentals, and valuations, we are still moderately bullish on equity markets. That said, we believe there is greater risk of underperformance in Q4 (4^th quarter) as analysts price in nearly double the growth vs. the coming quarter. Possible factors that could affect this outlook include monetary policy becoming too tight too quickly, before a handoff to fiscal policy is completed, as well as the possible drag to capital expenditures from lower oil prices.

REITs/Utilities Market Outlook (As of September 30, 2017)

REITs (Real Estate Investment Trusts)

The Russell 3000 REITs Index returned +1.3% in the third quarter, underperforming the broader S&P 500 Index which returned +4.5%. Most of this underperformance was driven by headwinds in REITs exposed to the Health Care sector. Health Care REITs (-5.3%) continued to underperform after enjoying a post-election jolt in late 2016, driven by expectations of policy reform. Industrial and Mortgage REITs provided offsets in performance. Industrial REITs have benefitted from the growth in e-commerce and the subsequent demand for high-quality storage space in urban areas. Equity markets have continued to extend their bull run for yet another quarter. There were short-lived bouts of volatility, but the VIX index stayed near all-time low territory for most of the quarter, and 10-Year UST (U.S. Treasury) yields remained range bound between 2.00-2.40%.

REIT performance in the 3^rd quarter was influenced more by property fundamentals than in 3Q16 (3^rd quarter of 2016) when interest rates were key. For instance, apartment REITs are facing slowing rent growth due to new construction in key urban markets. Office REITs face the risk of falling property values as transaction volume dries up. Retail REITs are suffering through the near-term headwinds of retailer challenges. Low interest rates continue to support asset prices which help determine REIT valuations. The Bloomberg REIT index declined in September, even as broader equity markets rose. Increasing 10-year Treasury yields hurt REITs in the month. Through the first nine months of 2017, REITs focused on technology outperformed peers that target traditional commercial real estate, while mall owners lagged.

For the remainder of 2017, we expect that performance in the REIT sector will be driven more by fundamentals rather than rates. Certain subsectors are expected to outperform, such as Industrial and Data Centers, while Apartments, Retail and Storage subsectors are expected to underperform.

Utilities

The utilities sector, measured by the S&P 500 Utilities Index, returned 2.9% in the second quarter lagging the broader S&P 500 Index which returned 4.5%. With an improving U.S. economy, gradually-increasing inflation, and a corresponding rising-rate environment, utilities are facing challenges as more yield-based options become available to investors. Within the utilities sub-industries, Independent Power Producers (+20.7%) led while Independent Multi-Utilities (1.8%) lagged. Outside of the dampened Trump Trade, markets were largely well-behaved despite another rate hike by the Fed in June. There were short-lived bouts of volatility, but the VIX index stayed near all-time low territory for most of the quarter, and 10-Year UST yields remained range bound between 2.00-2.40%.

Looking forward, we remain cautious on fundamentals as utilities have historically been particularly susceptible to rising rates. In addition, if higher growth expectations come to fruition, we expect utility multiples to contract on a relative value basis as utility growth rates remain stable. In this backdrop, we note utilities have remained attractive to yield-focused investors as the sector was delivering a 3.4% yield through the second quarter but remind investors of the potential of loss of capital.

Possible factors that could affect this outlook include: fiscal policy under-delivering, monetary policy tightening too rapidly, growth-reducing trade conflicts, commodity price volatility, and heightened geopolitical tension.

High Yield Fixed Income Market Outlook (as of September 30, 2017)

The high yield market continued to grind higher in the 3rd quarter (Q3) of 2017, building off the strong returns of 2016 and the first half of 2017 with another quarter of positive performance measured on a total return basis. There were similar themes in play during that we have been referencing since mid-2016 which have helped the market continue to rally from its February 2016 market lows. These themes include stable to increasing commodity prices which have been supported by OPEC (Organization of the Petroleum Exporting Countries) and its members’ desire to stabilize world oil markets. Although WTI (West Texas Intermediate) and Brent Oil have become more volatile of late, the current range of $45-55 remains intact. Also, easy global central bank policy has helped quell market volatility and support continued economic growth as loose/accommodative monetary policy has stimulated demand and economic activity over the past 2 years. In addition, a pro-business and pro-growth Trump/Republican administration has acted as an economic “shot in the arm” here in the United States as investors have started to price in what this type of presidency could mean for different sectors of the economy as far as growth, expansionary Cap Ex and shareholder returns. Finally, corporate earnings have continued to improve as first and second quarter 2017 numbers have matched or surpassed most expectations allowing companies to slowly de-lever as top line growth and margin expansion take hold. Given the supportive backdrop described above, risk markets rallied further during the 3rd quarter as the Bloomberg Barclays U.S. High Yield Index returned +1.98%, building upon the market’s strong first half performance of +5.02% and 2016’s full year return of +17.13%.

During 1Q (1^st quarter) 2017, the lower quality sectors and capital structures within the high yield market outperformed continuing their performance trends from 2016. However, in 2Q (2^nd quarter) 2017, we saw a bit of a divergence from recent performance trends as investors sought out a bit more safety given recent performance and current trading levels. This trend continued throughout the third quarter as single Bs once again lagged the overall market, double-Bs as well as triple Cs. Single-Bs returned +1.75% which was behind double-Bs (+2.01%) and triple-Cs (+2.5%) but ahead of distressed (Ca/D) which returned only +1.38% in 3Q17. On a year to date basis, the distressed (+12.85%) and triple C (+9.26%) segments of the market have outperformed the double B (+6.9%) and single B (+6.11%) parts of the market while the broad market index (Bloomberg Barclays U.S. High Yield Index) has returned +7% through three quarters in 2017.

From a sector standpoint, refining (+8.36%), oil field services (+6.53%), transportation services (+5.05%), independent energy (+4.96%), pharmaceuticals (+3.61%), electric (+3.6%) and metals & mining (+3.41%) outperformed the overall market while supermarkets (-6.67%) and wirelines (-1.99%) were the only two negative sectors in 3Q17 with healthcare (+.29%), leisure (+.55%) and retailers (+.59%) barely in the black. Looking through a year-to-date (YTD) lens, refining (+14.81%), pharmaceuticals (+13.14%), transportation services (+11.61%) and banking (10.4%) are the top four performing sectors while supermarkets (-4.45%), retailers (+1.52%), wirelines (+2%) and independent energy (+3.54%) are bottom four market laggards so far in 2017.

After hitting market wides of +839 option adjusted spread (OAS) in February of 2016, the high yield market has staged a meaningful recovery as global recession fears have eased as central banks have committed and re-committed to accommodative monetary policy. The high yield market has also benefitted from a strong move higher in oil from $25 to $50 per barrel over the last seven quarters as well as further stabilization in copper and iron ore pricing. Also, a Republican administration led by President Trump has been viewed as business friendly and pro-growth. In addition, corporate earnings have stabilized and expanded over the past several quarters which has allowed the market to price in continued and future top line growth, margin expansion and balance sheet de-levering. In our view, all of these factors allowed spreads to rally another 10 bps (basis points) this quarter to close at +348 OAS.

Over the next few quarters, there are many factors to consider as we think about relative value in the high yield market. Currently, given our outlook of slow to moderate economic growth, stable commodity prices and continued supportive monetary policy within the current credit cycle, which we see as peaked as far as credit quality, defaults and recovery rates, we see +350 OAS as fair value for the high yield market pricing in all of the above. The 2016-2017 commodity-led default wave within the current credit cycle has played out and many lower quality names have been re-structured out of the market. We see defaults returning to their normal 2.5-3% in 2017 with recoveries moving closer to their long term averages. Risks to the downside include policy error (either central bank or Trump-induced, or a combination of the two) along with slower than expected U.S. and global growth as economic activity wanes and the market begins to question the ability of central banks around the world to stimulate global growth and the possibility of a U.S. recession is put back on the table. In this case, we could re-test the 2016 wides of ~+800 OAS. Given that we see the previous scenario as a low probability event, we think the high yield market OAS range fluctuates between +325 and +425 during 2017 with a floor of +300 and a ceiling of +450. These levels will likely be driven by the global economic picture as well as Central Bank and Government policy, corporate earnings power, commodity pricing and currency shifts.

Municipal Bond Market Outlook (as of September 30, 2017) 

Municipal performance for the 3^rd quarter was again positive with the Bloomberg Barclays Municipal Index posting a total return of 1.06% (versus 1.96% in 2Q) bringing the YTD total return to an impressive 4.66%. Despite the concerns surrounding the Federal Reserve Bank raising interest rates and the proposed tax reform, the municipal market continued to benefit from healthy technical conditions including steady demand and lower supply. Performance has varied across the curve with the front end outperforming again during the quarter as short term municipal yields as a percentage of Treasuries (specifically 2-year and 5-year bonds) reached its tightest levels in over two years before settling in a little wider in late September. As a result, the ratio curve continued to steepen as performance lagged with some investors hesitant to extend duration during this period of Fed tightening, tighter credit spreads and tax reform on the horizon. The 2s/10s yield curve slope steepened 15 bps versus Treasuries while the 10s/30s slope steepened 6 bps.

Municipal supply continues to underwhelm, down 23% this quarter compared to last year, while demand remained consistent with ten straight weeks of mutual fund inflows (+$3.9Bn) and strong seasonal reinvestment cash flow⁴. Net supply was roughly negative $20Bn for the quarter. Refunding activity remains muted given lower rates and fewer refinancing opportunities while new project debt has not picked up despite the growing infrastructure needs of state and local governments. Even eight years of economic recovery has not enticed government officials to increase spending on infrastructure. The reason is that municipal issuers continue to face pressures to spend more on pensions, public education and other priorities, which is curtailing investment in infrastructure and a broad range of capital assets.

Chart sources: HIMCO | Past performance is no guarantee of future results.

Credit fundamentals remain generally healthy. Economic growth continues to support the credit quality of tax-exempt securities, particularly the more cyclical and essential service revenue sectors like healthcare, transportation, special tax, and education. However, headline risks related to state budget problems coupled with energy risks and natural disasters continue to detract slightly from credit performance. U.S.-North Korean tensions remained the focus in September, but quickly switched to the three hurricanes that wreaked havoc in the Gulf, southeastern United States, and the Caribbean. This led initially to a flight to quality bid, but the Fed’s announcement of balance sheet normalization in concert with further rate hiking (despite subdued inflation), and the long-awaited release of the tax reform proposal put pressure on yields by quarter end.

That being said, we still recommend a cautious approach to the market at current valuations and suggest not being overly aggressive until valuations become more attractive.

Investment Grade Credit Market Outlook (as of September 30^th, 2017)

Q3 Review: Investment Grade Credit (IGC) spreads moved tighter once again, as the spread of the Bloomberg Barclays U.S. Credit Index finished the third quarter seven basis points (bps) tighter at 96, just three bps away from the post-crisis tights. As of quarter end, the index was yielding 3.08%. Supportive commodity prices (e.g. WTI oil rose over $5 to close the quarter at $51.67) and optimism around tax reform were the biggest drivers of investor appetite for high quality spread product during the quarter.

Q4 and 2018 Outlook: Current market levels are within range of our year end targets, and as such, we expect Q4 returns to be driven more by security and industry decisions, rather than outright directional risk. While the market appears to be embracing the potential for significant tax reform, we believe any closure on tax policy is a long way from fruition, and what is eventually agreed upon may be materially different from what has been proposed. In addition, over the course of the fourth quarter the market will have to digest the beginning of the Fed taper, an ECB (European Central Bank) announcement regarding their own taper, the possibility (probability?) of a Fed hike, angst around North Korea, and debate around the next chairperson of the Fed.

Looking further out in 2018, we believe the improving global economic backdrop and increasing corporate profitability should be sufficient to keep credit spreads in check. We expect any impact on credit markets from the Fed’s tapering of UST (U.S. Treasuries) and MBS (Mortgage-Backed Securities) purchases to be relatively small and aren’t overly concerned.

Arguably the most relevant driver of credit spreads for 2018 lies in the details of tax reform. There are several potential changes (tax cut, loss of interest deductibility, cap-ex expensing, and repatriation) that could have significant (positive) ramifications for credit spreads. However, we expect it will be the 1^st quarter of 2018 at best before anything is agreed upon.

If the ultimate conclusion on tax reform is similar to what has been proposed, we expect credit spreads to react positively and move tighter still. However, without that incremental catalyst, we believe credit spreads will remain range bound in 2018. We advocate a small overweight to credit and do not feel now is the appropriate time to “reach” for risk.

Risks to our thesis include a failure to implement any meaningful tax reform, an escalation in geopolitical risks (e.g. North Korea), an upside surprise in inflation, Fed policy error, and disappointing economic growth.

CRN: 2017-1103-6240R

AAM is not affiliated with The Hartford Financial Group, Inc. or HIMCO, and was not involved in the preparation of this article. The opinions expressed herein are solely those of HIMCO and do not necessarily reflect those of AAM.

Hartford Investment Management Company (HIMCO) is a registered investment adviser subsidiary of The Hartford Financial Services Group, Inc. SEC registration does not imply a certain level of skill or training; nor does it imply that the SEC has sponsored, recommended, or otherwise approved of HIMCO.

The forecasts, opinions and estimates expressed in this report constitute HIMCO’s judgment as of September 30, 2017 and are subject to change without notice based on market, economic and other conditions. The assumptions underlying these forecasts concern future events over which we have no control. The assumptions may turn out to be materially different from actual experience. There can be no guarantee that any target or forecast will be realized.

Sectors referenced should not be construed as a solicitation or recommendation or be used as the sole basis for any investment decision. All data referenced is from sources deemed to be reliable but cannot be guaranteed as to accuracy or completeness.

Investment Risks: All investments involve risk, including the possible loss of principal. Fixed income investments are subject to credit and interest rate risk, as well as inflation risk and default risks. Additionally, fixed income markets, like all investment markets, can be subject to volatility.