The Trick Is Not to Blink
Geopolitical tensions and a shifting policy landscape have challenged market participants’ outlooks so far this year. But, as long-term investors, we see the world economy as becoming better balanced and more stable today. Growth is improving, led by the United States and other developed markets (Figure 1). Emerging economies seem to be through the worst of the recent commodity crisis and are stabilizing–but with tremendous dispersion. In times like these, simple decisions seem difficult. The trick is not to blink.
Inflation expectations are rising globally, but not to a degree that central banks should be caught off guard. Energy prices have played a large part in the recent headline inflation bounce. In the United States, the Federal Reserve is on course for a steady tightening, while across other developed markets we continue to expect a bias to maintain accommodative policy. There are risks to our view, but a base case is important to start with. If we are wrong about the pace of rising U.S. interest rates–and it becomes more accelerated–markets may become unsettled. Currently, the economic data isn’t causing concern.
Putting policy, politics and geopolitical risks aside for a moment–I know that is asking a lot–what I’ve described as a base case outlook seems to be an almost “Goldilocks” macro environment. There is a market debate going on about current “soft versus hard” economic data. On the soft data front, expectations and sentiment have improved since the U.S. election as a parade of CEOs in and out of the White House has energized business confidence. Investor confidence, however, has remained more balanced.
With regard to hard economic data, the current macro landscape appears to be neither too hot, nor too cold. We are late cycle, but growth and inflation appear “just right.” Global fiscal stability is improving. Investors, however, seem to feel that there is a heightened risk of a market pullback or even recession. While absolute clarity is rarely possible, the easiest and most important decision to make as an investor is to separate long-term and short-term money. For long-term money, the key lies in clearly establishing appropriate investment goals, setting a risk tolerance and staying invested. Then it comes down to how much tactical investment risk to take in a portfolio, depending on where we are in the market cycle.
Anyone that walked away from markets in the first half of last year understands the point I am trying to make above. Human nature can make the simplest decisions seem the hardest. The trick is not to blink, which can prove to be difficult around volatile markets.
Politics, the Messy Art of Compromise, and Earnings
We expected politics to be a significant market distraction this year, and it certainly has been. Not only in the case of a new U.S. administration learning on the job, but the Netherlands, Turkey and France have offered political distraction, as will a June snap election in the United Kingdom. Geopolitical tensions also remain high. Unfortunately, that noisy backdrop isn’t going away soon.
Markets attached themselves too readily to what has alternately been dubbed the Trump- or reflation-trade, right after the November U.S. election. Deregulation, infrastructure investment, corporate and individual tax reform were supposed to happen almost instantaneously. We cautioned otherwise. Gravity is setting in as markets more realistically ground themselves on what can and can’t be politically accomplished, as well as the likely timing. I think it’s important to put current market choppiness in perspective. Expectations are normalizing; risks are still present.
The policy initiative that broad markets care most about from Washington is tax reform. Meaningful tax reform can make a difference for earnings growth over the next 18-24 months. In our portfolios, we favor U.S. equity markets for their visibility and stable earnings growth (Figure 2), with upside offered from potential tax reform. For non-U.S. equity markets, there is additional technical support as money that was sheltering in the United States continues to move into non-U.S. markets. We favor investment positions in Europe as well as developed Asian equity markets, including Japan, for potential upside surprise to earnings growth.
I think that arguments for any equity market being particularly cheap seem a little forced. Valuations across equity, not to mention fixed income markets, are full. But it’s important to recognize that they reflect strong earnings growth, low and relatively stable credit default risk, and a more resilient global economy.
Valuations are where they are because they reflect underlying fundamentals. That said, across small pockets of subprime debt such as auto loans, we are beginning to see modest pressure. According to TransUnion, subprime auto lending is about 15% of all U.S. auto loans and represents about $180 billion in loan balances. However, to put this in perspective, the amount of outstanding non-financial corporate bonds in the United States stands at over $5 trillion. We are watching the trend but are not currently concerned about subprime consumer debt.
Markets don’t move in straight lines. However, with a few pauses, global equity markets have essentially moved one way since the U.S. election: higher. But markets began to move up in the middle of last year because of improving fundamentals–particularly in earnings. The green shoots have been there since last June and, fundamentally, that is what is supporting current valuations.
Monetary Policy: Easy or Tightening?
Is developed market central bank monetary policy tightening or still easy? It depends on where you look. In the United States, it is very gradually tightening. In Europe and Japan, we believe the bias this year remains toward accommodative policy. And while the Bank of England continues to closely watch the inflationary pass-through from a weaker post-Brexit pound, we believe the bias is to remain on hold. In aggregate, developed market central bank monetary policy remains stimulative. That is an important backdrop for our current macro Goldilocks moment (Figure 3).
We came into this year saying that we thought the Federal Reserve would raise policy rates 2-3 times, and we continue to believe that to be the case. I personally thought the March Fed rate hike was masterful. While it wasn’t initially expected, the Fed got markets focused on the possibility of an early hike, and markets did the heavy lifting. That is how it’s supposed to work–no surprises.
What has been fascinating to watch is the current debate about whether the Fed pulled forward what was presumed to be a June rate hike because there was rising concern that inflation was getting ahead of monetary policy. Was the Fed being forced to play more reactive policy offense because it was behind the curve and had to move faster?
We believe the Fed, so far, is moving at the right tightening pace, and that the March hike was done proactively. Starting at such a low base policy rate, the faster the Fed can initially move from zero buys the Fed optionality in case it has to cut rates. However, that can work against it if it tightens too much, too quickly. Slow and steady wins this race.
The Fed indicated it may begin to reduce assets held on its balance sheet later this year. We see that as a positive signal. Also, it’s an additional policy lever the Fed will have to play with. We would expect a balance sheet roll-off to be phased in, and while reinvestments may stop, it doesn’t preclude the Fed from starting them up again. Going into the Global Financial Crisis, the Fed’s balance sheet held about $900 billion in assets. Today, that figure is around $4.5 trillion.
We think the Fed may hike policy rates again in June and/or September. We hold to our broad range of 2.5-3% for U.S. 10-year Treasury yields by year-end. Those yield guideposts are important to understand current portfolio positioning. For taxable portfolios in the United States, we recently cut target duration to 85% of our benchmark, and for portfolios that track the Bloomberg Barclays Global Aggregate Bond Index, we trimmed back duration targets to 80% of our benchmark.
We trimmed duration because we feel the bond market overreacted to weak first-quarter U.S. growth, which is likely to strengthen ahead. Also, government bonds benefited from a flight to safety around geopolitical tensions in North Korea, not to mention political headlines around the French elections.
Across portfolios, we remain significantly underweight core bonds and continue to favor credit. For portfolios that invest in global fixed income markets, we continue to tilt global bond allocations into U.S. core and credit markets. That may seem counterintuitive, as the Fed is the only developed market central bank we expect to see tightening policy this year. However, with interest rates relatively higher in the United States and rising, the yield differential in the United States offers a better cushion against rising rates (Figure 4).
The outlier that caught many investors off guard this year has been the U.S. dollar. The knock-on effects from the Fed raising policy rates, as other developed market central banks effectively eased, meant investors came into this year expecting a stronger dollar. We’ve seen the opposite. We do not expect developed FX markets–and in particular the dollar–to move much beyond a broad trading range for now. That is exactly what we’ve seen so far this year.
Straight Lines: The Trick Is Not to Blink
I mentioned earlier that markets don’t move in straight lines. As an investor, I anchor first on the macro landscape and on fundamentals. Right now, the fundamental backdrop continues to validate current market valuations–across equity as well as credit markets. Each of those remarks helps to qualify the amount of risk we are taking in portfolios.
We remain pro-cyclically positioned across portfolios because of a steady and a more balanced macro landscape. Because of where we are with both equity and credit market valuations, we aren’t overreaching for risk. Diversification matters more than ever in a market environment where we are late cycle and nothing stands out as inexpensive.
We expect to see pullbacks ahead, including the possibility of a more meaningful correction. We remain better buyers of risk assets on pronounced pullbacks. At the start of this year, as markets kept moving higher, one of the trading floor comments I kept hearing was that traders were “too scared to short” the reflation-trade. My sense is they are a little less scared. We can see that in rising volatility across equity as well as fixed income markets. Higher volatility inevitably creates opportunity. Remember how volatile the first half of last year was.
Markets last year made for a jarring investment journey. We saw what I would characterize as a systemic collapse in alpha across active managers globally–equity, fixed income and alternative assets alike. We took advantage tactically to reposition portfolios, riding though the storm.
Our strong portfolio performance over the last year is the proof statement for why staying invested is so important. I am saying this now as we undoubtedly will see market wobbles again. Like last year, we intend as a global investment team to take advantage of the bumps as presented. The trick is not to blink.
Michael E. Gray