Seeing is Believing
What a difference a year can make for markets and sentiment. 2016 was filled with concern that a collapse in energy markets and a fast-building credit bubble in China were set to break what was still a nascent global expansion. We didn’t subscribe to that view and held firm to our pro-cyclical investment positioning across portfolios. That stance seems widely embraced today, but it was not at the time.
Since then, growth is not only better balanced, but in an upswing. There have been broad-based, positive revisions to growth expectations across global markets. One of the reasons we held to our constructive view last year was that we saw the green-shoots of a strengthening global economy. That remains our base case as we look toward next year. Seeing is believing.
Risk assets have had an extraordinary run this year. While valuations have been driven higher, I take solace in recognizing that this remains an unloved bull market. We have not yet stepped into a zone where I believe investors are irrationally chasing markets; they are begrudgingly investing.
There isn’t a market or asset class today that I would call inexpensive from a valuation standpoint. Markets appear fully valued, and that is the case across both bond and equity markets. We have played catch-up this year after what were several back-to-back years of uninspiring returns (Figure 1). The performance rebound this year is coming from a more robust global setting. That makes for a healthy investment backdrop looking ahead.
Confidence in a better-balanced and strengthening macro landscape has grown as uncertainty has declined. Less uncertainty translates into higher valuations, as the risk premia demanded by investors moves lower. From a simple return perspective, equity and credit markets should continue to outperform core bonds, but we hold each in order to diversify risk. I continue to believe that current valuations, across fixed income and equity markets alike, reflect strong underlying fundamentals.
Corporate earnings have been strong, to a large extent driven by top-line revenue growth that reflects a stronger global economy. Markets have benefited from a positive feedback loop coming from stronger growth across global regions (Figure 2).
Policy and Politics: Signal Versus Noise
What has surprised me this year is the market’s ability to both ignore divisive political headlines and a shift towards populism at a time where the geopolitical landscape has been increasingly troublesome. This environment calls for caution; when markets again decide to pay attention, I expect volatility to bite back. For now, politics continue to be discounted as noise.
I’ve never subscribed to the initial enthusiasm that the reform, deregulation and reflation expected from Washington this year would happen quickly. While markets quickly ran out of the gate after the U.S. election last November, what has sustained their move higher hasn’t been blind faith in reflationary policy, but rather strong fundamentals. Investors have focused on those fundamental signals and, for the most part, ignored the hyperbole.
Even as Congress begins to formally debate tax proposals, I do not yet believe markets are pricing in meaningful reform. However, I would argue they are beginning to price in simple tax cuts. One of the elements we are watching closely around corporate tax changes is the possible elimination or capping of interest expense deductibility, specifically as it relates to corporate debt.
The elimination of interest expense deductibility might end up being good news for credit markets as less debt would be issued. Less supply would likely provide stronger technical support. However, sectors like telecom that heavily rely on debt issuance for capital spending may find themselves under pressure. As a sector, telecom represents about 5% of the U.S. investment grade corporate credit market and about 9% of the high yield market. Contrastingly, telecom is only about 2% of the S&P 500.
The potential for a tax bill that incentivizes the repatriation of cash held abroad by U.S. businesses is also something we are watching–it’s likely to be good news for stocks as some of that cash should make its way into higher dividend payouts and stock buybacks. The obvious winners on an overall tax cut to the corporate rate would be sectors with the highest effective corporate tax rates including: financials, retail and small cap stocks.
What Happened to Inflation?
A more significant move higher in inflation is still missing from the current global macro landscape. Substantially stronger inflation would provoke central banks to become more restrictive around monetary policy, and there are still quite a few economists trying to figure out why inflation has not picked up more given current economic strength.
Additionally, there has been a great deal written about productivity gains in developed markets not being effectively captured, and whether the shift we are seeing away from traditional brick-and-mortar retail, not to mention the emergence of a “sharing economy,” is a structural change that has yet to be precisely measured. Productivity growth has been slow, but any change could influence inflation rates (Figure 3).
Weak wage growth, along with low unemployment rates, may partially reflect the influence of demographics as an aging work force slowly rotates out of the full-time labor pool. More experienced and higher-paid workers are being replaced by less-experienced workers that often earn less. That is likely part of the current low inflation, low wage conundrum.
Income inequality may be playing a part in weaker demand. To borrow an illustration: if a billionaire walks into a bar, average income in that bar will rise without affecting the actual income of anyone in the bar. Consumption patterns are unlikely to change much in that bar based on that increase in average income levels.
The opposite happens when the billionaire leaves. If five people walk into the bar as the billionaire walks out, average income will revert back to where it started but consumption will move higher.
Despite these structural headwinds, we continue to expect tighter labor markets ahead along with steadily rising consumption, which should allow the current global expansion to continue. The 30-year bull market in bonds appears to be winding itself down, but we expect interest rates to move higher only gradually.
We came into this year expecting to see 10-year government bond yields in the U.S. end the year somewhere between 2.5–3.0%. We also thought we could see German 10-year government bonds reach 0.6–0.9% by year-end. While our target for German yields still feels aggressive, we might yet reach the lower end of our U.S. Treasury target. The takeaway remains: government bond yields should continue to slowly press higher from current levels across developed markets. That is an investment backdrop that can remain supportive of equity and credit markets alike.
Air Pockets Ahead?
The other missing element this year has been volatility. Equity and credit markets seem stuck in “drive,” without a meaningful pause for consolidation or correction. I believe this reflects a fundamental environment where earnings are strong, corporate defaults negligible, global growth strengthening and inflation contained.
Investors have chosen to tune out politics and focus on the fundamentals, but I expect emotion will eventually creep back into investor behavior. There is a reason that the Nobel Prize in economics this year went to behavioral economist Richard Thaler at the University of Chicago. Air pockets inevitably lie ahead–human nature will demand it.
It’s prudent to acknowledge that we are due for a market pull-back. There is no precision in that statement, just an observation that markets have run hard and could use a pause to catch their breath. It’s similar to frequent calls for recession that we hear today from commentators. Each day an expansion advances, you are one day closer to the next recession.
We continue to believe the broad trend over the next twelve months is for markets to continue pressing higher. We have made sure to diversify risk-taking across portfolios, and we remain pro-cyclically positioned. We believe recession risk is a little lower today than when we started the year because global growth is far better balanced. And yes, we are indeed another day closer to the next recession.
There is going to be a lot of work done around expected revenue and earnings growth ahead as investors shift focus to 2018. Like inflation, don’t forget that earnings are backward looking. The same goes for corporate default rates, which are currently exceptionally low and may move higher.
At current valuation levels, we believe equity returns will predominantly be driven by earnings growth. Credit market returns will be driven by yields, not by further spread compression–in fact, I would view it as healthy if credit spreads backed up a little from their current levels.
We are penciling in global earnings growth for next year at +6–8%, as a starting point. For the U.S., there is upside to earnings growth if we see meaningful tax reform. In Europe, we see potential earnings upside from operating leverage as margins have some room for improvement.
As noted earlier, inflation matters, and as it moves higher, it will weigh on bond prices (pushing them lower) and, at high enough levels, on equity multiples, pushing them lower as well. For those concerned about current equity valuations, we are at the high end of fair value on the S&P 500, looking at current inflation levels. However, we see historical evidence that equity multiples can sustain these levels in a modestly more inflationary environment than what we see today (Figure 4).
While there is a great deal of emphasis on 10-year government bond yields currently, I am keeping a closer eye on 2-year yields. A steady march higher in 2-year rates, even with some curve flattening, is a sign that the expansion continues to move along. We may get to a point where the difference between 2-year and 10-year government bonds becomes so low that it signals recessionary risks are moving higher. For now, it’s a signal that our constructive macro outlook and portfolio positioning is warranted (Figure 5).
The Only Free Lunch
For a year where volatility hasn’t been pronounced, we have been quite active across portfolios. We continue to use alternatives as a complement to core bonds and as a risk diversifier in portfolios. We are generally holding fewer hedge funds in portfolios (for portfolios that can hold them) and have used liquid alternatives as complements to traditional hedge funds. Hedge funds and liquid alternatives should not be thought of as substitutes for one another. Similar to owning both actively managed equity funds and passive ETF investments, we want to be able to use both in multi-asset portfolios.
We remain overweight equity allocations across portfolios–favoring Japan, European and U.S. markets. We feel good about the outlook for each of these markets as we head into next year and we have made sure to diversify our equity overweight across those markets. In certain portfolios, we are overweight: financials, healthcare and technology, as well as small and midcap exposure in Europe and lower-beta style allocations in value and emerging markets. We continue to hold exposure to dividend growers as well.
The “hot-topic” debate on the CIO team is our mix of risk-taking between our equity and extended credit overweights. We rotated a portion of our extended credit overweight into equity markets earlier this year–which has added to strong portfolio performance.
Given where we are with regard to equity and extended credit valuations, we want to make sure we are diversifying investment risk between our two largest overweights appropriately. That includes looking at both the upside as well as downside risks of each investment. The higher valuations become, the less downside protection we expect in a more pronounced market drawdown. We continue to stress test portfolio positioning both for upside and downside market scenarios.
Diversification is said to be the only free lunch when it comes to investing. In addition to holding a diversified portfolio, it is important to stay invested in order to compound returns over time. Ensuring you have the right portfolio that clearly reflects your investment goals, preferences and risk tolerance is absolutely crucial. That is especially the case in a market downturn. The right portfolio is the one that keeps you invested.
Michael E. Gray