[AUDIO INTRODUCTION] Welcome to the Bryn Mawr Trust Wealth Management podcast, providing commentary on what’s moving the financial markets, financial planning, and other timely business and monetary topics. Please welcome your host, Jennifer Fox, president of BMT Wealth Management.
[SPEAKER: JENNIFER FOX] Welcome. I’m here with Ernie Cecilia, our chief investment officer. So Ernie, what do you think are the main drivers of prices in the current market?
[SPEAKER: ERNIE CECILIA] We are strong believers, as you know, in fundamentals. And I’ll define fundamentals as macroeconomic growth, interest rates, and corporate earnings, which we believe are the key issues in the pricing of financial assets. In terms of what’s going on right now, gross domestic product, or GDP as it’s known in the US should accelerate in the current second quarter. The first quarter came in at a rised 2.2% pace. And forecasts are now well into the 3% range.
And domestically, several things are contributing to a favorable backdrop for economic growth. The Tax Cut and Jobs Act passed in December of 2017. Less restrictive regulatory issues in such areas as energy and banking. And even though rates are rising, they’re still low on a nominal basis.
On the corporate earnings front, which again is really important to the pricing of stocks, US corporate earnings rose almost 25% on a quarter-over-quarter basis in the first quarter, with almost all sectors experiencing double-digit earnings growth.
Also, if not more importantly, revenue growth, that is the top line, was a strong 8 and 1/2% for S&P 500 companies in the first quarter. We expect earnings to continue to be reasonably strong for the balance of 2018. And FactSet, which is a database and research service, was currently forecasting a 19% quarter-over-quarter earnings growth rate for the second quarter alone.
[SPEAKER: JENNIFER FOX] So Ernie, I know you mentioned that we have continued low nominal interest rates, but they are rising. What about those rising interest rates?
[SPEAKER: ERNIE CECILIA] Rising interest rates are certainly a headwind to equities, for example, Jen. We expect the Fed– that is, the FOMC, Federal Open Market Committee– to raise rates this week by 1/4 of one percentage point, that’s 0.25%, which would elevate the range from a current range of 1 and 1/2% to 1 and 3/4% to 1 and 3/4% or 2%.
However, it’s really important to understand that the reason for the rate hike is stronger economic growth. And I compare that to intense inflation pressures, which is usually what the Fed reacts to. As matter of fact, the Fed has indicated it’s willing to let inflation run above its stated target of 2% for some period of time before becoming more aggressive in raising short-term interest rates.
At the longer end of the US treasury yield curve, the 10-year US treasury bond is yielding currently about 2.95%, and has been in the area of around 3%, plus or minus or so, for the last month. Inflation pressure, the main influence on longer term rates, have been relatively tame, as I just mentioned.
However, another major influence is that rates available on foreign government debt are lower. 10-year US treasury yield is not only higher than the 10-year yields on government bonds from such countries as Canada, the UK, and Germany, but is also higher than the 10-year yield on Italian government bonds before, of course, currency conversion, euro, and the US dollar. So with US yields higher based on stronger economic growth in comparison to the rest of the world, it will keep some ceiling on US bond rates at least over the near term.
[SPEAKER: JENNIFER FOX] So Ernie, in light of improving economic growth, favorable fiscal policies like tax cuts and deregulation, but also headwinds created by higher interest rates, where does BMT see opportunities in the current market for investing?
[SPEAKER: ERNIE CECILIA] Jen, one of the areas or issues we would strongly emphasize is diversification from a number perspectives, not only in order to gain performance but also to reduce risk. So we would take very much a global view of the markets.
One of the areas that has underperformed US markets this year has been the euro area. And we think that gaining or garnering some euro exposure in portfolios would be advantageous from an investment perspective. These cycles between international and the US tend to play out over long periods of time. So we would favor some additional investment in euro area.
In terms of equities generally and looking at the US for example, and because of the issues with trade, we would tend to favor companies that garner a larger percentage of their revenues from domestic sources. So again, companies down the market cap spectrum, particularly in the small and mid-cap area.
If we further disaggregate equities and go a little bit lower on a sectoral basis, we like financials, but very selectively financials. Regarding financials, particularly like banks, and within banks, regional banks, for a number of reasons.
One we see that US economic growth will drive loan demand. Secondly, we see higher interest rates will improve net interest margins for banks. And thirdly, we do believe that the deregulation that is part of the Tax Cut and Jobs Act is 2017, or is coming out of that, would also be most favorable to a lot of the regional or smaller banks.
Another area that we like are industrials on a very selective basis, because we do believe that global growth will continue at a pretty good pace. And we’ve been very selective in choosing our industrials, but we would look across the entire market cap spectrum.
Finally, we like health care. There’s a stability there. But we would tend to look down through health care and more toward the medical device side rather than the pharmaceutical side. We think there could be pressure on drug prices as this administration moves through the various geopolitical issues. There will be a focus eventually on drug pricing, so we would be looking more into the technology and medical device side within health care.
And then finally in fixed income, we continue to favor investment-grade credit over US treasuries. We think that is an area where a client can get more yield. Again, being very selective, we would be very careful as to looking for companies with high interest rate coverage.
We’d also be very careful on what’s called duration or maturity. Duration is merely a measure of risk as expressed in years. So we would tend to be on the shorter end of the curve.
But we’d also look for bonds that might have higher coupons, which are sometimes known as – I’ll put this in quotes – cushion bonds, which give you a little bit more defensive protection in a rising interest rate environment.
[SPEAKER: JENNIFER FOX] Ernie, thank you very much.
[SPEAKER: ERNIE CECILIA] My pleasure, Jen. Thanks for having me.
[AUDIO CONCLUSION/CLOSE] This has been a production of Bryn Mawr Trust. Copyright 2018, all rights reserved. Visit us online at bmt.com/wealth.
The views expressed herein are those of Bryn Mawr Trust as of the day are recorded and are subject to change without notice. Guest opinions are their own and may differ from those of Bryn Mawr Trust, its affiliates, and subsidiaries. This podcast is for informational purposes only and should not be construed as a recommendation for any product or service.
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