As downside risks to the global economy fade, an upturn in growth expectations is affecting asset classes in nuanced ways. In this paper, our investment professionals outline their thoughts and approaches that are currently aligned with improving global growth. The following is a collection of their perspectives across equities, alternatives and fixed income asset classes.
Emerging markets equities
Despite the cyclical headwinds, demographic and economic development factors will continue to propel relative economic growth in EMs. But the question for investors is not whether they should invest in EMs, but rather, how much exposure should they have and how should they access the EM growth story. We believe there is a strong case for owning the EM asset class directly (instead of through DM multinationals), given that liquidity and profitability within EM companies of all sizes have improved secularly over the past decade. There is also a strong case for active management, since EMs are still one of the least efficient segments of the global equity markets. In fact, the median active EM equity manager has outperformed the index since 2000—with the exception of the years between 2008 and 2011 when markets were dominated by “global macro.” Finally, valuations in Ems remain at historically attractive levels.
International equities (ex-U.S.)
International equities outside of the U.S. are poised to benefit from increasing prospects of economic recovery in the euro area and the impact of “Abenomics” in Japan. In Europe, growth expectations have improved, while equity valuations of European companies remain attractive. Stronger growth in the euro area should benefit European banks in the short term although regulatory intervention could weigh on longer term returns. Hence our managers have been adding more domestically focused European companies in other sectors, such as those in lodging and logistics, to portfolios. In Japan, policymakers’ attempts to restore growth are benefiting Japanese stocks. A weaker yen will drive faster growth for some Japanese export-oriented companies, particularly in the auto sector. Finally, while overall growth rates are slowing in the EMs, our managers are focused on consumer-facing sectors with durable growth themes, such as technology and health care, rather than construction-related stories.
As economic growth picks up and as new sources of innovation stimulate economic activity, our U.S. equity managers expect that the U.S. will emerge as the strongest “developing” market.
Specifically, our managers believe the housing recovery will continue and will benefit housing and housing-related sectors, such as home improvement retailers, auto manufacturers and financial services. Meanwhile, the transition of EM countries to consumption-driven economies will benefit leading U.S. consumer brands. Finally, innovations across a variety of industries, such as shale oil and gas, biotechnology and information technology, are creating more opportunities for investors.
Alternative asset classes include real estate, infrastructure, hedge funds and private equity investments. While real assets, such as real estate and infrastructure, typically display a high degree of leverage to business cycle upturns, hedge funds and private equity perhaps feature the least sensitivity to near-term changes in the economic environment, since managers are generally seeking pure alpha that is uncorrelated to traditional public-market betas. Still, our managers are finding alpha opportunities through the shifting global trends.
Real estate generally displays a strong connection with improving economic growth. In the U.S., the property market is showing strong momentum—although rising interest rates are starting to complicate the picture—while the property cycle in Europe is starting to broaden and deepen as the region emerges from its recession. In both, our managers believe the markets will continue to reward incremental risk taking. In the U.S., there are attractive opportunities in urban and suburban office properties, as well as in mezzanine debt loans. By contrast, the time to invest in U.S. building apartments may be reaching the late stages of its cycle. In Europe, our managers see opportunities in select secondary properties, given the wide spreads between prime and secondary properties. And China office and Indian apartment developments can provide diversification and higher returns to compensate for their additional risks.
Infrastructure assets—which are closely tied to the growth in local economies—can represent a pure play on the growth story in Asia, one of the world’s fastest growing economies. Urbanization and an expanding middle class are two secular trends that are fueling the need for more commercial property and infrastructure investments. But it is not simply enough for institutional investors—many of whom are significantly under-allocated to Asian EMs—to add equities to gain exposure to the region. For one, the companies themselves are increasingly global, while Asian equities are highly correlated with other regional equities. As a result, equity performance is more likely to reflect trends in the overall global economy rather than the growth in home markets. Real assets offer investors the potential for equity-like returns with little correlation to the global markets.
While hedge funds seek to produce alpha independent of the economic environment, changes in growth expectations are offering some opportunities. Broad-based market moves in China and Japan, for example, are creating attractive relative value investments for investors who focus on security selection and company fundamentals, while changes in supply-and demand dynamics within the convertible securities market are opening up alpha opportunities for certain hedge fund strategies. Meanwhile, stronger growth may support select hedge fund strategies, such as equity long/short, activist and event driven funds.
Private equity can generate high returns over the long term through investments that are not typically available through the public markets. For example, it can be easier to find attractively priced opportunities in China relative to the companies’ potential growth rates. In the U.S. and Europe, our private equity managers are finding ripe conditions for doing deals in the small- and mid-sized company space. An improving growth backdrop can help catalyze deal-making in this area, which generally features less competition for each opportunity.
While many investors have likely been shrinking the hedge portions of their portfolios, fixed income retains an important role in asset allocation. Some parts of the fixed income universe will benefit from stronger growth expectations. Our managers, for example, see opportunities at the lower end of the credit spectrum, where issuers particularly benefit from stronger growth.
We believe high yield will continue to deliver strong relative returns in a strengthening economy as it has during other periods of economic growth, helped in part by its higher coupons. First, the low default rate should allow spreads to tighten, partly offsetting the hit from rising yields. Second, companies’ balance sheets remain relatively healthy and supportive of continued low default rates. Meanwhile, the high-yield market is much less sensitive to rising rates and has generally outperformed other fixed-income asset classes during periods of rising rates.
The leveraged loan market looks particularly interesting at this time given its floating-rate characteristic and the associated lack of duration risk. Loans generally outperform bonds in periods of rapidly rising interest rates or significant spread widening. While neither scenario is our base case, the probability and perception of rising rates are increasing, elevating the appeal for loans. At the same time, company leverage is increasing, and some companies—responding to increased investor appetite for risk—are issuing bonds more aggressively. We believe, however, that it will take some time for these early-stage excesses to increase the level of risk in the market.
Emerging markets debt
While somewhat out of favor in 2013, emerging markets debt (EMD) remains a source of long-term value as EM credit quality improves. The question for investors is which type of EMD makes most sense. Investors who believe that global growth will accelerate back to a reasonably strong pace should favor EM foreign-exchange assets and local rates. Hard-currency sovereign debt is likely to outperform in a softer global growth environment. Meanwhile, as EM growth starts to moderate, investors need to be more discerning about the countries and credits they choose. Our managers are finding good country-level stories in several frontier markets in Southeast Asia that are enjoying rapid growth, such as Vietnam and the Philippines, and also in other economies engaged in significant reform efforts, such as Mexico.
As the summaries illustrate, our managers’ search for returns is taking into account the upturn in growth expectations across DMs and EMs. This shift is echoing through portfolios in ways that vary across asset classes. Not surprisingly, the ties to growth-related themes are most apparent in equities and least apparent in alternatives. In real assets and fixed income, managers are looking for value in lower-quality names and secondary managers, while seeking protection from higher rates. In all cases, they seek to generate returns and manage risks through fundamental, research-driven security selection—a process that is particularly effective at this point in the business cycle.