Market Outlook Q2 2018 - Morningstar
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Market Outlook
Q2 2018
Morningstar, Inc. Talking Points
× The S&P 500 gained 3.4% during the second quarter.
Contents
1 Talking Points × Energy, real estate, and consumer cyclical stocks outperformed during the quarter while industrials,
2 Stock Market Outlook: Some Values to
Be Found in Defensive Sectors financial services, and consumer defensive stocks finished the quarter in the red.
4 Second Quarter in U.S. Stock Funds:
Will Tariffs Derail This Market?
× The market-cap-weighted price/fair value estimate ratio for our equity analysts' coverage universe is
6 A Challenging Second Quarter for
International-Stock Funds 1.00, suggesting that the market overall is fairly valued.
8 How Did Bond Funds Fare in the
Second Quarter?
× Healthcare and consumer defensive stocks are undervalued while the basic materials, energy, and
10 Index Returns
11 Fund Category Returns industrials sectors are most overvalued.
× The small growth category led the pack this quarter among style-based fund categories, while value
categories continued to lag their growth counterparts.
× Most international equity categories endured losses for the quarter.
× Among bond fund categories, short-term categories performed best, along with bank loan and inflation-
protected bond funds. Long-term and world-bond funds brought up the rear.Page 2 of 14 Market Outlook | 2Q 2018
Stock Market Outlook: Some Values to Be Found in
Defensive Sectors
Healthcare, breakfast, and gassing up the car are always necessary,
even during downturns.
By Dan Rohr, CFA × The Morningstar Global Markets Index has edged up 1% year to date.
Published 6/27/18
× Weighted by market capitalization, our coverage universe looks fairly valued.
× We see proportionately more opportunities in less-cyclically sensitive sectors like consumer defensive
and healthcare.
Our global equity coverage universe appears fairly valued, in aggregate. The market-cap-weighted
price/fair value ratio across our coverage of roughly 1,600 stocks is 1.00.
Generally speaking, we're more positive on sectors that are less sensitive to the economic cycle, which
might not be too surprising given the global economy is now in its ninth consecutive year of expansion.
Consumer defensive ranks among the more undervalued sectors, trading at a price/fair value of 0.94 on
a cap-weighted basis.
One of our top picks here is General Mills GIS, shares of which have suffered amid volume softness
across the packaged food space as well as skepticism related to the acquisition of natural pet food
company Blue Buffalo. We're more optimistic about the firm's ability to reinvigorate growth through
reinvestment in its brands and integrate and grow Blue Buffalo by following the same playbook it did
with Annie's, which it acquired in 2014.
Healthcare, another sector that tends to hold up well when the economy heads south, trades at 0.98
price/fair value. One of the names we like here is Allergan AGN. In contrast to most of its peers in
specialty pharma, the firm boasts an attractive product portfolio and innovative pipeline thanks to a
successful mix of internal research and M&A.
At the other end of the spectrum, the basic materials, energy, and industrials sectors all trade above to
our estimates of intrinsic value on a cap-weighted basis. In energy, we believe the market continues to
underestimate the shale industry's capacity to throw oil markets back into oversupply. Crude prices have
largely held above $65 per barrel for West Texas Intermediate, or WTI, in 2018, which provides attractive
economics for many U.S. producers. But the reckoning may not happen as quickly as we previously
thought amid supply disruptions. Eventually, we expect pain for oil prices as growing U.S. production
serves as the primary weight to tip oil markets back into oversupply. Our midcycle forecast for WTI is still
$55/bbl.Page 3 of 14 Market Outlook | 2Q 2018
Canadian midstream company Enbridge is one of our top picks in this generally overbought space. We
see nearly 50% upside in the stock, as we believe the market doesn't realize the full potential of the
company's growth portfolio. KPage 4 of 14 Market Outlook | 2Q 2018
Second Quarter in U.S. Stock Funds: Will Tariffs Derail
This Market?
As trade barriers go up, so do U.S. equities—for now.
By Tony Thomas U.S. stocks showed some resilience in the second quarter, even as tariffs moved from rhetoric to reality.
Published 7/2/18
The United States, China, the European Union, and others began erecting trade barriers during the
quarter, causing investors to question the prospects for many multinational large-cap companies. Even
so, the S&P 500 rose a modest 3.4% through June 28, 2018, led by growth stocks such as Facebook FB,
which rebounded from the Cambridge Analytica sell-off, and Netflix NFLX, whose stock price has nearly
doubled for the year to date. These giant caps diluted the impact of smaller index constituents such as
Harley-Davidson HOG, which gave back all of its June gains on the news that it is shifting some
production overseas to skirt tariffs.
Given the international trade disputes, investors looked to small-cap stocks, which typically do the bulk
of their business in the still-strong stateside economy. The Russell 2000 Index jumped 7.9%, enjoying a
relatively steady rise since early May even as trade tensions mounted. For the first time since the fourth
quarter of 2016, value equities led the small-cap rally. Rising oil prices pushed energy stocks higher, and
investors gobbled up U.S.-focused consumer defensives such as Boston Beer SAM and Performance
Food Group PFGC as they sought relief from the trade turmoil.
Winners
Champlain Small Company's CIPSX valuation discipline and higher-quality bias helped it weather the
quarter's choppier market conditions while positioning it well for the small-cap rally. It sailed to an
11.7% gain, landing in the top quintile of its small-growth Morningstar Category. Although manager
Scott Brayman and his team aren't shy about investing in growth sectors like technology and healthcare,
their attention to valuations led them to opportunities in consumer defensives. The fund's overweighting
in that sector gave it an edge during the quarter, with Boston Beer and Treehouse Foods THS among its
top contributors.
While small-cap funds posted some of the second quarter's best absolute returns in the Morningstar 500
(a list of funds in the Morningstar FundInvestor newsletter that meet or clear some fundamental
hurdles), Touchstone Sands Capital Select Growth PTSGX was a notable exception, rising 10.1%. This
highly concentrated fund of 25-30 large-cap stocks loads up on technology, consumer cyclicals, and
healthcare companies. This risky stance paid off during the quarter as the fund scored with big bets on
Amazon.com AMZN, Netflix, and Facebook. Manager Frank Sands, Jr. also found a diamond in the
rough with Loxo Oncology LOXO, which spiked on positive drug-trial results.
Hotchkis & Wiley Mid-Cap Value HWMAX benefited from improving oil prices in 2018's first half. It rose
7.9% in the second quarter on the back of its 25% stake in energy stocks—nearly 3 times the mid-valuePage 5 of 14 Market Outlook | 2Q 2018
category average. The fund's top holding as of April 2018, Whiting Petroleum WLL, has doubled since
the start of the year. Lead manager Stan Majcher's deep-value process also opens the portfolio to
smaller-caps and non-U.S. stocks, with The GEO Group GEO (a REIT) and Ericsson ERIC performing well
in those respective segments.
Losers
Trade tensions, an appreciating U.S. dollar, and another interest-rate hike by the U.S. Federal Reserve
were a triple whammy for funds invested in emerging markets. The pain was particularly acute at Lazard
Emerging Markets Equity LZOEX. The fund fell 15% during the second quarter, ranking among the worst
in its diversified emerging-markets category. It suffered from having more exposure to Brazil than its
benchmark, the MSCI Emerging Markets Index. Four of its top 20 holdings as of March 2018 were Brazil-
based, including Banco do Brasil, Cielo, and Ambev ABEV—each of which weighed heavily on
performance during the period.
Matthews Emerging Asia MEASX dropped 11.2% in the quarter, but the culprit wasn't the U.S.-China
sparring over tariffs that hurt many Chinese stocks. Unlike its MSCI Emerging Asia Index benchmark, the
fund has little exposure to China; instead, it tilts strongly toward frontier markets such as Vietnam,
Pakistan, Bangladesh, and Sri Lanka. Stocks in all four countries cooled off during the quarter (or, in the
case of Sri Lanka, continued its year-to-date slide). Two jewelers were among the fund's top detractors
in the second quarter: India-based PC Jeweller and Vietnam-based Phu Nhuan Jewelry.
Dodge & Cox International Stock DODFX suffered another bout of underperformance at the hands of its
emerging-markets holdings. The same thing happened in 2015 when its picks in developing countries
languished. In 2018's second quarter, the fund sank 6.3% and didn't fare well with its financial-services
names, which made up about a third of the portfolio. Political upheavals in Brazil and Italy upset top-10
holdings Itau Unibanco Holding and UniCredit SpA, respectively. Another top holding, Petrobras, lost its
CEO and a third of its value in the wake of a Brazilian truckers' strike. KPage 6 of 14 Market Outlook | 2Q 2018
A Challenging Second Quarter for International-Stock
Funds
Many funds post losses amid trade concerns and currency weakness.
By Katie Reichart While U.S. equity funds, particularly growth-oriented and small-cap strategies, fared well in 2018’s
Published 7/10/18 second quarter, conditions weren’t as favorable for international-stock funds. Concerns about a trade
war with China and the impact of tariffs loomed large for global companies, with many funds building
on first-quarter losses to stay in the red in 2018’s first half. A strong U.S. dollar and rising interest rates
hurt many developing markets as investors shed riskier assets. Meanwhile, compared with a sanguine
outlook in the United States, projections for growth slowed abroad, setting up a quarter in which the
MSCI ACWI ex USA Index lost 2.6% in U.S. dollar terms even as the S&P 500 gained 3.4%.
Geopolitical concerns hit some countries particularly hard. Brazil’s projections for economic growth
dipped alongside inflation concerns, high unemployment, and a plunging currency. The Latin America
Morningstar Category posted the steepest loss for the quarter at 22.4%. In Turkey, questions about
monetary policy, inflation, and the country’s economic position against the backdrop of a presidential
election led its currency to slide. India, which imports much of its energy resources, was hit by rising oil
prices.
Beyond those country-specific issues, diversified emerging-markets funds sold off broadly, losing
8.9%—the second-worst showing of any international-stock category. China-region funds, hit by
concerns about the impact of tariffs and a broader economic slowdown, were down 5.5%.
There weren’t many winning categories. World large stock and world small/mid-stock, whose
constituents benefited from owning some U.S. companies, posted modest gains of 0.6% and 0.5%,
respectively.
As in the U.S., growth-oriented categories fared better than their value counterparts, but only modestly
so. Foreign large-growth and foreign small/mid-growth funds on average were down 0.7% and 1.7%,
respectively, a tad better than the 2.7% and 3.1% respective losses posted by the foreign large-value
and foreign small/mid-value categories.
Outperformers
Morgan Stanley Institutional Global Franchise MSFAX fared well amid turbulent international markets. It
gained 4.3% in 2018’s second quarter, beating 95% of its world large-stock category peers and staying
2.6 percentage points ahead of its MSCI World Index. The compact fund, which holds around 30 names,
holds mostly companies with economic moats, which provided ballast in a tough environment. It also
benefited from a bidding war for Twenty-First Century Fox’s FOX assets, as well as its lack of emerging-
markets exposure.Page 7 of 14 Market Outlook | 2Q 2018
Currency hedging produced major tailwinds for some funds. FMI International FMIJX was up 2.5%,
landing near the top of the foreign large-blend category. And Tweedy, Browne Global Value TBGVX was
up 2.4%, the only foreign large-value Morningstar Medalist to post a gain in a choppy quarter for value-
oriented funds. Relative to peers, which tend to remain unhedged, the funds benefited from the strong
U.S. dollar, but they lagged the MSCI EAFE 100% Hedged Index.
Matthews China Dividend MCDFX, meanwhile, gained 1.1%, the only China-region medalist to land in
the black. It got a boost from stock-picking within the technology sector, including Hua Hong
Semiconductor. Consumer defensive holding China Maple Leaf Educational Systems also helped.
Underperformers
Invesco Developing Markets GTDDX was a diversified emerging-markets basement dweller. It lost 13.4%
for the quarter, far worse than the MSCI EM Index’s 8% decline. Heavy exposure to Brazil hit the fund
particularly hard.
Moerus Worldwide Value MOWIX was similarly hurt by its Brazil stake. Meanwhile, its relative lack of
exposure to U.S. stocks was a headwind, as was its value-leaning approach. Its 4.8% decline landed
near the bottom of the world small/mid-stock category.
Growth exposure didn’t help all funds. American Funds Europacific Growth AEPGX dropped 2.9%, worse
than about 90% of its foreign large-growth peers. Keeping more than a fifth of its assets in emerging
stocks held it back during the period, particularly Brazilian holdings Petrobras PBR.A and Itau Unibanco
ITUB. Nintendo also weighed on results.
Oakmark Global Select OAKWX had no emerging-markets exposure but still dropped 2.2% in the quarter,
landing in the world large stock category’s bottom decile. Concentrated in 21 holdings, the fund faced
weakness from top holding Daimler DAI, as well as others, including LafargeHolcim and Bank of America
BAC. KPage 8 of 14 Market Outlook | 2Q 2018
How Did Bond Funds Fare in the Second Quarter?
It was a relatively quiet second quarter for most, with the biggest losses in
emerging-markets debt.
By Emory Zink The Federal Reserve elected to maintain rates in May but followed up with a 0.25-point rise in June,
Published 7/3/18 continuing a trajectory of tighter monetary policy that began at the beginning of 2016. Over the quarter,
the yield on the 10-year U.S. Treasury oscillated between 3.0% and 3.3%, driven by expectations of rising
inflation and continued concerns over growing U.S. government debt. The 10-year U.S. Treasury ended
the quarter at 2.9%, well above its 2.5% starting point for the year. In general, yields on short- to
intermediate-term bonds increased more than those on long bonds, contributing to a flattening of the
yield curve. As of June 30, the difference between the 30-year and five-year points tightened to 25 basis
points at the end of the period from 42 basis points at the quarter’s start.
Of particular note, demand for longer maturities remained strong, with a modest drop in those yields,
particularly in May, contributing to a 31-basis-point gain for the Bloomberg Barclays U.S. Treasury Long
Index over the quarter. Stubbornly low yields on longer-maturity bonds have stoked anxieties over the
possibility of an inverted yield curve in the near future, a potential indicator of a forthcoming recession.
Treasury Inflation-Protected Securities delivered 77 basis points on a wave of increased inflation
expectations. Mortgages eked out a 0.25-point return for that same period, while asset-backed
securities, bolstered by strong enough underlying U.S. consumer data and a positively performing auto-
loan subsector, shone in the securitized sphere by generating 42 basis points of return.
Given a backdrop of rising rates and geopolitical tensions, the Bloomberg Barclays U.S. Aggregate Bond
Index held up reasonably well over the quarter, losing a modest 16 basis points relative to the first
quarter’s 1.5% dip. The index’s underlying corporate-credit component was the weightiest drag on
performance. The intermediate-term bond Morningstar Category lost 0.24% for the quarter. Funds with
shorter duration and exposure to ABS and Treasuries had an advantage. For example, Silver-rated
Fidelity Intermediate Bond FTHRX produced 4 basis points of positive return for the quarter with biases
to that profile. In contrast, Gold-rated Western Asset Core Plus Bond WACPX, with its currency
exposure, healthy allocation to investment-grade credit, and 7.2 years of duration, lost 1.5% for the
quarter.
The Highs and Lows of Corporate Credit
U.S. investment-grade corporate credit lost 0.98% for the second quarter, less than its first-quarter 2.3%
drop, but motivated by similar dynamics, including rising interest rates, bellicose U.S. threats around
trade, and a strengthening dollar that has made the hedging costs for foreign buyers unpalatable. In
May, the U.S. imposed steel and aluminum tariffs of 25% and 10%, respectively, on its allies,
contributing to counter-actions and heightened uncertainty surrounding the direction of the global
economy. In contrast, high-yield credit produced 1.0% of return for the quarter, with lower credit tiers
outperforming higher credit tiers, signaling that broad confidence in credit markets remains healthy. ThePage 9 of 14 Market Outlook | 2Q 2018
energy sector benefited from rising oil prices, which were coaxed upward following expectations of
reduced supply given the U.S. departure from the Iran nuclear deal in early May. The West Texas
Intermediate crude oil price rose to around $70 at the end of the quarter, up from around $60 at the
period’s start.
Within the high-yield category, funds with greater exposure to lower-quality tiers of credit outperformed.
Bronze-rated Artisan High Income ARTFX generated 1.2%, well above the high-yield category’s 0.56%
gain, given its larger exposure to CCC rated credits and energy exposures, while more-conservative high-
yield options, such as Silver-rated Vanguard High-Yield Corporate VWEHX, generated a much more
modest 0.34%.
Munis Were a Relative Bright Spot
Against the backdrop of solid economic growth and relatively constrained supply, municipal bonds
posted a solid showing over the quarter, with gains across the muni categories. Longer-maturity muni
bonds and high-yield munis led the pack, with tobacco-backed securities and Puerto Rico turning in
particularly strong performances. As a result, the high-yield muni category posted a 1.7% gain for the
quarter, contributing to a 1.6% return for the year to date. Bronze-rated MainStay MacKay High Yield
Municipal Bond MMHIX was up 2.9% for the quarter.
Outside the U.S.
The U.S. dollar strengthened against the euro and the yen over the quarter. In June, the European
Central Bank reiterated that it would pare back its quantitative easing slowly but surely. However,
pressures on Italian banks, coupled with fiery geopolitical arguments across the eurozone, did little to
bolster the continent’s market outlook. The Bank of Japan continues to grapple with underwhelming
inflation numbers. As a result, funds with heavier U.S. dollar exposure were among the better
performers for the quarter, including AB Global Bond ANAGX and PIMCO Global Bond (USD-Hedged)
PAIIX, which were roughly flat.
Emerging markets have come under even greater pressure in the second quarter, owing to the stronger
U.S. dollar and negative headlines in a handful of countries including Argentina and Turkey. Local-
currency emerging-markets debt experienced the swiftest sell-off for the period. To illustrate, Bronze-
rated TCW Emerging Markets Local Currency Income TGWIX slid by 11%. Funds like Neutral-rated
PIMCO Emerging Markets Bond PEBIX that had some emerging-markets corporate bond exposure, which
held in relatively well for the quarter, fared better. That fund was down 3%. Global-bond funds with
emerging-markets currency exposure were hit harder as well: Silver-rated BrandywineGLOBAL Global
Opportunities Bond GOBIX was down 7% owing to its heavy helpings in the Mexican peso and
Malaysian ringgit. KPage 10 of 14 Market Outlook | 2Q 2018
Index Returns
Source: Morningstar Direct. Data as of 6-30-18. 3-, 5-, and 10-year returns annualized.Page 11 of 14 Market Outlook | 2Q 2018
Fund Category Returns
Source: Morningstar Direct. Data as of 6-30-18. 3-, 5-, and 10-year returns annualized.Page 12 of 14 Market Outlook | 2Q 2018
Fund Category Returns (Continued)
Source: Morningstar Direct. Data as of 6-30-18. 3-, 5-, and 10-year returns annualized.Page 13 of 14 Market Outlook | 2Q 2018
Fund Category Returns (Continued)
Source: Morningstar Direct. Data as of 6-30-18. 3-, 5-, and 10-year returns annualized.Page 14 of 14 Market Outlook | 2Q 2018
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