BY Daisy Tolles, CFASenior Analyst

The U.S. economy continues on a stable path, buoyed by a strong consumer and robust business confidence. The initial estimate for third-quarter real GDP growth came in ahead of consensus, up 3% from the previous quarter, fueled by private fixed investment. Nominal growth rose 5.2%, the strongest pace since 2006. While the impact of Hurricanes Harvey and Irma likely suppressed some business activity, the stronger-than-expected GDP numbers highlight the resilience of the U.S. economy. »

MA RKET PERSPECT IVE& INVESTMENT OUTLOOK

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Underlying this positive backdrop is a tight labor market. The unemployment rate in September fell to 4.2%, the lowest level since February 2001. It has declined from a peak of 10% in 2009 and has fallen below the prior low of 4.4% seen in 2007 (Exhibit 1). The economy actually lost jobs in September, which was the first monthly decline in seven years, but that was likely due to the hurricanes that hit at the end of the third quarter. The 2017 monthly average for job gains (through August) was 171,000 versus a monthly average of 152,000 for the entire expansion. The expansion has now lasted 99 months and is the third longest on record.

Amidst a tight labor market, wages increased in September, with year-over-year wage growth landing at 2.9%. Going forward, we expect compensation levels to continue rising as companies fight to remain competitive and attract skilled workers. Last year, U.S. household income rose to a record high, surpassing the previous peak reached in 1999 (Exhibit 2). Incomes rose across all racial and age categories, while poverty rates fell for most groups. Rising income levels should continue supporting the expansion by sustaining high consumer confidence levels and encouraging consumption.

There are reasons to be excited about the corporate sector as well. Although corporate debt levels are elevated, companies are beginning to use their cash for more productive purposes. Since the financial crisis, companies had been taking advantage of ultra-low interest rates to

borrow money and buy back their stock. Recently, though, buybacks have been coming down — for the 12 months ending in June, buybacks for S&P 500 companies were down more than 14% from the preceding 12 months. Companies have instead started to increase their capital expenditures, spending more on buildings, machinery, and equipment that is used to produce goods or services. Orders for core capital goods, which exclude aircraft and defense, have risen every month this year with the exception of one. As shown in Exhibit 3, core capital expenditures finally started to gain steam toward the end of last year.

The uptick in business spending has coincided with rising business confidence levels. Small-business optimism spiked after the 2016 presidential election and remains elevated. The new administration’s promise of regulatory and »

12%

10%

8%

6%

4%

2%

0

EXHIBIT 1

Source: Bureau of Economic Analysis

01/6

0

01/6

5

01/7

0

01/7

5

01/8

0

01/8

5

01/9

0

01/9

5

01/0

0

01/0

5

01/1

0

01/1

5

NATIONAL UNEMPLOYMENT RATE

Recessions

▲

Sep. 2017

▲

$60,000

$58,000

$56,000

$54,000

$52,000

$50,000

$48,000

$46,000

$44,000

$42,000

EXHIBIT 2

Sources: U.S. Census Bureau, Bloomberg

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

MEDIAN HOUSEHOLD INCOME

2016: $59,039

▲

’75 ’77 ’79 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 ’01 ’03 ’05 ’07 ’09 ’11 ’13 ’15

75,000

70,000

65,000

60,000

55,000

50,000

45,000

40,000

EXHIBIT 3

Sources: U.S. Census Bureau, Bloomberg

Average

NEW ORDERS FOR CAPITAL GOODS (EXCLUDING AIRCRAFT AND DEFENSE)

’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15 ’16 ’17

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tax reform fueled animal spirits as companies looked forward to a friendlier business environment. Washington has indeed been successful in rolling back regulatory enforcement, slashing the number of new regulations and withdrawing previously instated rules. Small- and medium-size businesses in particular are benefiting from such changes, and, in light of the recent progress on tax reform, business confidence should rise even more. This would further encourage productive investment. The health of these businesses is important for the overall economy, as small- and medium-size companies compose more than 70% of total employment.

The economic backdrop is positive overseas as well. However, while the U.S. recovery has been underway for more than eight years, the international recovery is still in its earlier stages. European Central Bank economists expect the European economy to grow 2.2% this year, which would be its best showing since 2007. The International Monetary Fund recently upgraded its projections for world output in 2017 and 2018 — changes that have largely been driven by improved conditions in Europe. Japan has also seen an improvement in economic growth — its GDP has grown for six consecutive quarters, the longest quarterly streak of positive growth since 2006. Growth in both Europe and Japan has been supported by improving business conditions. In Europe, business confidence is at its best level since mid-2007. Even more notable is that business confidence in Germany, Europe’s largest economy, recently surged to its highest level in nearly 50 years. In Japan, the index for business conditions1 is at its highest level since 1991, supported in particular by improving sentiment among large manufacturers. This should help boost business investment, which has already been strengthening with capital expenditures near a 20-year high (Exhibit 4).

The synchronized upswing in global growth has helped equity markets ignore much of the geopolitical noise that has extended from Washington to Asia this year. Investors have been complacent, sending volatility levels to all-time lows while sending stock market

averages to all-time highs. The S&P 500 is up more than 14% year-to-date and has now risen more than 270% from its price level at the market bottom in 2009. The current bull market is officially the second longest in the post-World War II era, and households’ ownership of equities is at the highest since the tech bubble in the early 2000s. Valuations have continued to move upward, but the stock market’s advance this year has also been supported by strong earnings growth. With regard to S&P 500 earnings, the first two quarters of 2017 saw double-digit growth from the same period in 2016. Although growth for the third quarter has been more subdued, a double-digit increase is expected to return in the fourth quarter. The earnings outlook for next year is positive as well — and could be further lifted by corporate tax reform, which should help sustain the bull market. However, we continue to caution that heightened volatility is likely, despite the recent lack thereof.

A potential catalyst for volatility is changing monetary policy, as central banks around the world are reducing stimulus measures. The Fed continues on its gradual tightening path, while it also just began the process of unwinding its massive $4.5 trillion balance sheet. The European Central Bank recently announced its plans to begin tapering its asset purchases next year, with quantitative easing ending after September 2018. The Bank of England just raised rates for the first time in more than 10 years. If global interest rates rise faster than expected, that could send bond markets falling. »

¥90

¥85

¥80

¥75

¥70

¥65

EXHIBIT 4

Source: Cornerstone Macro

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

JAPAN NOMINAL CAPEX (YEN, IN TRILLIONS)

’98 ’00 ’02 ’04 ’06 ’08 ’10 ’12 ’14 ’16 ’18

Q2 2017: ¥86.5

▲

INVESTED WINTER 2018

Stocks would likely fall, too, as we saw in 1994 when the Fed funds target rate overshot the Fed’s projections. There is currently a discrepancy between Fed forecasts and market expectations for rates, with Fed projections ahead of the market consensus (Exhibit 5). A sudden increase in inflation could also spook investors.

With stretched valuations and ultra-low volatility, we remain cautious in our investment outlook for the U.S. and are more excited about the opportunity overseas. Equities in Europe and Japan are trading at a discount to domestic stocks, and the valuation gap between the U.S. and international markets is wide. This is partly because, as mentioned above, the international recovery has trailed behind that of the U.S. The MSCI EAFE Index, representing developed international countries, is still trading at a 17% discount to its pre-crisis peak. The S&P 500, on the other hand, is trading at a 61% premium to its pre-crisis high. European earnings are also still below their prior peak, while earnings for the S&P 500 surpassed their previous high long ago.

Earnings growth has been strengthening in Europe and Japan, though, and, through mid-November 2017, international stock markets were outperforming the U.S. In the second quarter, Japan led all other major stock markets in positive earnings surprises. Profit growth in these regions should continue to improve in 2018.

While international markets are exposed to the same geopolitical uncertainties as domestic markets, we believe the downside risk may be lower overseas, given that international markets are in an earlier stage of their recovery. Cross-country correlations across the developed world have fallen to a cycle low, providing the opportunity for divergence in the presence of volatility. Lower correlations coupled with relatively attractive valuations and an improving economic backdrop overseas provide the basis for our recommendation to increase exposure to developed international markets. That said, we look forward to any buying opportunities that may present themselves here in the U.S. — if volatility ever rears its head.

Flash Update: Approaching the end of 2017, the U.S. economy and stock market remained on solid footing. The Federal Reserve raised interest rates in December for the third time in 2017, underscoring that the U.S. economy remains on track for continued gradual growth. Meanwhile, the improving growth trend also persists overseas. In 2018, we expect earnings to play a larger role in the extension of the current bull market. Earnings forecasts are strong, while stock market valuations in the U.S. still sit at stretched levels.

1 The Japan Tankan Business Conditions Index

7%

6%

5%

4%

3%

2%

1%

0

EXHIBIT 5

Sources: J.P. Morgan Asset Management, FactSet, Bloomberg, Federal Reserve

’99 ’02 ’05 ’08 ’11 ’14 ’17 Long Run

FEDERAL FUNDS RATE EXPECTATIONS

1.25%1.13%

2.75%

1.56% 1.71%1.38%

2.13%

2.69%

Federal Funds RateFOMC Year-End EstimatesMarket Expectations on 9/20/17FOMC Long-Run Projection

FOMC September 2017 Forecasts (Percent)2017 2018 2019 2020 Long Run

Change in Real GDP, 4Q to 4Q 2.4 2.1 2.0 1.8 1.8

Unemployment Rate, 4Q 4.3 4.1 4.1 4.2 4.6

PCE Inflation, 4Q to 4Q 1.6 1.9 2.0 2.0 2.0

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The opinions and analyses expressed in this communication are based on RMB Capital’s research and professional experience and are expressed as of the mailing date of this communication. Certain information expressed represents an assessment at a specific point in time and is not intended to be a forecast or guarantee of future results, nor is it intended to speak to any future time periods. RMB Capital makes no warranty or representation, express or implied, nor does RMB Capital accept any liability, with respect to the information and data set forth herein, and RMB Capital specifically disclaims any duty to update any of the information and data contained in this communication. The information and data in this communication does not constitute legal, tax, accounting, investment, or other professional advice.

Index Descriptions

• The S&P 500® Index is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 7.8 trillion benchmarked to the index, with index assets comprising approximately USD 2.2 trillion of this total. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.

• The Japan Tankan Business Conditions Index is based on a survey that asks enterprises (with at least 20 million yen in capital) for their judgment of general business conditions, primarily in light of their profits — they are asked to choose the most appropriate answer among (1) favorable, (2) not so favorable, and (3) unfavorable. The index is compiled by the Bank of Japan and covers approximately 10,894 companies.

• The MSCI EAFE Index measures international equity performance. It comprises the MSCI country indices that represent developed markets outside of North America: Europe, Australasia, and the Far East.

The Chartered Financial Analyst® marks are the property of the CFA Institute.

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