It is important to recognize that the rise we have seen in volatility has simply returned us to what I would characterize as normal levels (Figure 1). Ultimately, it is healthy—but getting to that realization is going to be a process. My word for markets this year is “endurance.” To borrow a line from Thomas Carlyle that seems appropriate for the current environment: “Endurance is patience concentrated.” And as my daughter would remind me: Patience is the key to joy.
This remains an unloved market, as investors have spent the past few years trying to anticipate the next recession. We’re not there yet. Over the past few months, we’ve gone through a false alarm around U.S. wage inflation, followed by a rapid correction in inverse and leveraged volatility strategies. We viewed that early February market sell-off as technically driven and took advantage of it to add to equity positions. We continue to hold those positions as markets trade in the same broad range.
Upfront, I want to emphasize that we remain constructive on the global economy, and our portfolio positioning reflects that view. That said, markets got off to too strong of a start in January. With higher levels of market volatility, valuations have come down both for equity and credit markets alike. Higher volatility creates and reflects uncertainty, which pushes up demanded risk premiums. However, there is more than just higher levels of market volatility weighing on investor sentiment.
Pros Outweigh Cons, Risks Have Risen
Our economists expect solid and stable global growth over the next two years. That growth should support revenues and profits. We are keeping a close eye on capital expenditures, which can drive earnings. Corporate profits are important but so is business sentiment, perhaps more so currently. Business sentiment is one variable that, given the rising uncertainty around U.S. trade policy, we are watching carefully (Figure 2), not just with regard to investment, but also stock buybacks and hiring.
Current market uncertainty is centered on inflation and the pace of central bank tightening ahead. Investors fear central banks are ready to hit the brakes hard. While central banks are deliberately unwinding accommodative policy, they are beginning from a point of significant easing. “Less easy”—as I’ve said before—does not mean tight policy. The starting point matters.
While we see the European Central Bank stepping back from bond purchases late this year, we do not see higher policy rates until at least the middle of next year. Also, we believe the Bank of Japan remains “all in” on easy policy for now. The Federal Reserve is on track to continue to gradually raise policy rates, with a view that the distribution of risk they see ahead for U.S. growth skews to the upside. So far, so good.
Rising investor uncertainty also stems from a slowdown we are seeing in certain leading macro indicators, particularly in Europe (Figure 3). Ironically, the slower growth in some of these higher frequency indicators is what makes me feel good about the fact that developed market central banks do not need to tighten monetary policy more assertively; inflation is not running ahead of policymakers. Growth is slowing from very high levels; however, it remains above trend.
We expect global growth to be around +3.5% this year and next year; both years have potential for upside. Europe and Japan are likely to undershoot their 2% inflation targets this year and next. The Fed may overshoot its 2% inflation target—that is not said to be alarming. Jay Powell made this point in his first news conference as Chair in March. The Fed may tolerate greater symmetry around its 2% inflation target. Chair Powell presented a view that is bullish on the U.S. economy and not overly hawkish on policy. We agree.
If those concerns were not enough, U.S. trade policy and a fear of tighter regulation ahead for technology companies is also weighing on sentiment. Neither of these issues is going away quickly. There are a few key questions markets need to grapple with. Regarding trade policy: Is this more “bark than bite” and part of a negotiating ploy, or something worse? In the instance of big-tech and social media: Is the regulatory environment about to force a marked change to the business model?
No Trade War and No Trade Peace
There is a Roman phrase I have always liked regarding noise that can spring from politics: bread and circuses. That figure of speech is used in a political context to represent winning public approval by distraction. We have seen quite a bit of distraction across continents recently. To borrow from a quote attributed to Lincoln: “…you cannot fool all the people all the time.”
Markets have been impressive in their ability to ignore political distraction, focusing for the most part on fundamentals, but when policy—and by extension fundamentals—gets dragged into the equation, markets quickly pay attention. We continue to see that around Brexit, not to mention recent elections globally. Today, the potential threat of a tit-for-tat global trade war should be considered a risk to underlying market fundamentals.
Washington is proposing the application of “maximum pressure” on China—as the U.S. Commerce Secretary emphasizes that tariffs are meant to lead to negotiations, not fights. The problem over the next few months is that until there is greater clarity around the details of what is being proposed and negotiated, there is nothing to anchor on except rhetoric.
It is obvious that a trade war is in no one’s interest. No one wins. I encourage you to read the history around the Great Depression and the Smoot-Hawley Tariff Act of 1930. However, if current trade war policy-salvos are eventually viewed as more negotiating bark than bite, this too shall pass. That assumes everyone dragged to the table wants to play “let’s negotiate.” If trade policy concerns escalate into a series of rapid fire tariff-tantrums, sentiment can roll over further, as would markets. That is not our base case, but I expect the ride to be raucous.
A Timeout for Technology
Our investment thesis for owning technology is based on a view that we are in the early stages of a structural transformation that will continue to drive investment in the sector. We expect revenue, earnings and cash flow growth in tech to remain strong versus the broader market. Tech sector balance sheets, in aggregate, are some of the strongest across all U.S. sectors, and equity valuations in tech remain reasonable and in line with the broader market (Figure 4). I could not have said any of that about tech in 1998. Tech does not benefit from tax cuts to the same degree as the overall market, but we believe investors will continue to place high value on the sector’s organic earnings growth.
However, technology may find itself in an environment—like healthcare in 2016—where the sector is given a timeout by investors until we see what happens with regulation. For portfolios where we have U.S. technology as an overweight, we continue to hold onto positions. The sector has not sold off enough to make us want to add to positions, and we have not seen evidence that our fundamental investment thesis has changed—either because of a pullback in investment, or a stall in revenue and earnings growth.
So Where Does This Leave Us?
While markets are left with a mild case of whiplash, we are keenly focused on the fundamentals, which we continue to view as constructive. We are in the late stages of the current expansion and, as I’ve said before, every day further into this expansion brings us closer to the next recession. That said, we do not see a recession directly on the horizon.
And yet, anxiety continues to run through markets. Around issues like trade policy, the current anxiety is deserved. Around technology, some of it feels overdone—but there remains a lot of headline risk ahead of us. Current volatility will continue to create tactical investment opportunities for us across portfolios. Our most recent trades have been about repositioning risk, not chasing after markets.
As markets corrected in February, we added to equity positions. While we added to U.S. equity overweights, we also continued to add to core bonds and reduce exposure to high yield. We remain underweight fixed income, core bonds and duration in portfolios.
With the backup in interest rates in February, we added to core bonds for some downside protection alongside the addition to equities. That downside protection helped in late March. You cannot look at any of those trades in isolation; context comes only from looking at them holistically. Diversifying risk in a portfolio is crucial, especially in the later stages of the business cycle.
At a very simple level, we believe that stocks will outperform bonds this year, but with lower returns and more volatility than last year. We are overweight equities and underweight fixed income. We are not “all in” on stocks for the simple reason that we are late cycle and valuations are not cheap enough to warrant adding to current positions.
When we added to U.S. equity positions in early February, the forward price to earnings multiple on the S&P 500 was back to early 2016 levels—right around 16.5x; close to longer-term averages. If we get +6–8% earnings growth next year (Figure 5), the S&P is trading at close to a forward multiple of 15.5x looking into 2019.
I have been asked quite a bit why we do not own an explicit allocation to emerging market equities in portfolios, particularly as we continue to hold emerging markets debt. We prefer to focus our current equity overweight in the U.S. because we see stronger earnings growth in the U.S. this year. Valuations across global equity markets are in line with history, and I do not believe that emerging markets are inexpensive. Uncertainty around global trade policy has also played a part in our wanting to stay closer to the lower-beta in the U.S. equity market, relative to emerging markets.
We believe that markets have room to run higher, but with a variety of concerns still weighing on sentiment, we are in an environment where investor confidence will take time to rebuild. This earnings season should play a big part in helping investors refocus on fundamentals. Investor, consumer and business sentiment are going to be particularly important to keep an eye on as well. Whiplash takes time to recover from.