Solving for 2018: Clouds on the Horizon
Our senior investment leaders consider the positive momentum in the markets and global economy—and what may disrupt it in 2018.
DOWNLOAD YOUR COPY OF SOLVING FOR 2018
TEN FOR 2018
Macro: Global Inflection Point Nears
1 “Goldilocks” Gives Way to Something More Complicated Though the strength of global economic momentum is undeniable, a confluence of factors—including tightening central bank policy, plateauing economic growth and rising market volatility—suggests that conditions are unlikely to remain “just right” for all of 2018.
2 Both Monetary and Fiscal Policy Are in Motion Globally As major central banks wind down unprecedented levels of monetary stimulus, their efforts are being met—and potentially complicated—by expansionary fiscal policy and reform initiatives taking root in a number of countries.
Risks: Clouds Gather as the Year Progresses
3 Geopolitical Climate Remains Unsettled Though 2017 mostly failed to deliver the electoral fireworks of 2016, elections this year in Italy, Mexico, Brazil and the U.S.—in addition to ongoing disrupters like North Korea, special investigations, Brexit, etc.—could upset the current order.
4 China Accelerates Structural Reforms An emboldened Xi will be more aggressive in reducing leverage and re-orienting China’s economy toward more sustainable, high-quality development, to the potential detriment of near-term growth.
Fixed Income: The Chase Continues
5 No End to the Search for Yield Biased higher but still low, long-term interest rates continue to send investors into less-familiar corners of the fixed income markets in the hunt for yield, with high valuations leaving little cushion to absorb a volatility shock.
6 Credit Drivers Begin to Change Continued low default rates suggest global credit spreads likely will be impacted less by fundamentals and more by technical developments such as hedging costs, LDI-related flows and regulatory changes.
Equities: Two-Way Markets Return
7 Market Momentum Could Present Opportunities to Reduce Beta Exposure Strong earnings growth could fuel equities in early 2018, providing investors with chances to trim holdings in high-valuation stocks and redeploy into more attractive risk-adjusted exposures.
8 Active Management Positioned to Shine Market dynamics continue to shift in favor of active management, which could extend the comeback mounted by stock pickers last year after a period of underperformance.
Alternatives: Finding Opportunities Amid High Valuations
9 Low-Vol Strategies for a More Volatile World Market-neutral and relative-value hedge funds may help investors earn returns with lower volatility.
10 Sharpen Quality Focus in Private Assets Given high private equity valuations, investors can help mitigate risk by targeting experienced private equity sponsors with a history of adding operational value or by moving up the capital structure to first-lien private debt.
CIO ROUNDTABLE
Disrupting the Momentum
With the end of 2017 near, the leaders of our investment platforms gathered to talk about the evolution of the investment environment over the past 12 months and what they expect for 2018.
Joe Amato: The optimism of the “reflation trade” that ended 2016 gave way to a “Goldilocks” environment over the course of 2017, fueling the rise of risk assets of all types and geographies. We remain in that “just right” state as we enter the new year, with synchronized global growth for the first time in a decade, low inflation and low volatility.
Tony Tutrone: The economic momentum is undeniable. All 45 countries tracked by the OECD are expected to expand in 2017, which has only happened three times over the past 50 years. The U.S. is running above 3% and nearing full employment. Euro zone growth has broadened beyond Germany and the Netherlands, and the region is finally keeping pace with the U.S. Japan’s in the midst of its longest quarterly growth streak in more than 20 years. China continues motoring along even as Beijing pushes toward sustainable long-term reforms.
Synchronized Global Growth Took Hold in 2017
Source: International Monetary Fund.
Note: IMF projections as of October 31, 2017.
Erik Knutzen: I think all this makes 2018 a particularly challenging year to forecast, especially from a full-year perspective. Though I expect the positive impulse to extend into the early part of 2018, obstacles ratchet up significantly as the year progresses, moving us away from Goldilocks into something more complex.
We anticipate monetary tightening will really start to be felt about midyear, when year-over-year growth in G-4 central banks’ balance sheets is expected to turn negative. Obviously, the Fed is furthest along in terms of normalization. December’s hike brought the upper bound of the fed funds rate to 1.5%, and the Fed is forecasting three more hikes in 2018. While its balance-sheet reduction has been uneventful so far, the runoff accelerates in 2018 and will reach its monthly maximum of $50 billion by the fall. The European Central Bank plans to halve its monthly asset purchases beginning in January, and it may look to move its policy rate off zero later in the year. The Bank of Japan may be slower to act given its multi-decade battle against deflation, but it will become increasingly difficult for the BOJ to defend open-ended stimulus measures with the Fed and ECB heading in the opposite direction.
Brad Tank: In general, I think that the synchronized global growth will transition to a synchronized global plateauing in 2018. The business cycle is aging rapidly, and the tighter conditions Erik mentioned could start to weigh on its ability to persist. That said, I don’t expect a U.S. recession in 2018, though 2019 and 2020 are viable possibilities. China’s continued deleveraging, which may accelerate in 2018 behind an even more powerful Xi Jinping, will also play a role in dampening the global economic acceleration. Less liquidity and slowing but reasonably strong economic growth combined with high valuations should result in renewed volatility across financial markets.
I also see signs that inflation may pick up globally in 2018. In fact, I think conditions are more hospitable for an increase in inflation than they have been in years. The output gap in the U.S., for example, has closed completely, and rising productivity should pressure wages higher. Producer prices in China have climbed sharply in the past two years, which should ultimately be felt in consumer prices in many markets. On top of this, many countries are intent on introducing expansionary fiscal policy and reform initiatives. The U.S. passed a $1.5 trillion tax cut. French President Macron has turned out to be as pro-business as advertised; in just a few months in office he has liberalized labor laws and cut the deficit, and we expect more reform in 2018. Japan’s recent budget calls for growth-oriented fiscal policy. Brazil is looking to trim pension costs in an effort to get its public debt under control.
Should these efforts spur a meaningful acceleration of inflation, central banks may be forced to act more quickly than they had planned to—and more quickly than markets expect.
Amato: It’s really an unprecedented—and precarious—time for central banks as they manage the unwind of years of extraordinary accommodation. We’re basically in uncharted territory, and the Fed has a new hand at the tiller in Jay Powell. He’s been a Yellen ally since he joined the board in 2012, and I expect his approach will be consistent with the groundwork she laid. That said, the degree of difficulty is certainly higher now than it was a year ago. Meanwhile, the seven-member Fed board of governors is understaffed, with three vacancies currently and two more coming in 2018.
Knutzen: The Fed isn’t the only place with job openings. Trump has had a hard time filling the seats in his administration, at both the cabinet and sub-cabinet levels. Only about one-third of the key positions in the administration requiring Senate confirmation have been filled; two-thirds of the Treasury’s positions remain open and half are open at Commerce. While part of this can be attributed to Democratic stonewalling, a lot is due to a lack of qualified candidates willing to serve. And it’s troubling that some of the most capable members of the administration—people like Cohn and Tillerson—don’t seem like they’ll be around much longer.
Tank: I think we can agree that Washington in general seems like it has the potential to be a source of market headwinds in 2018. It looks like the Mueller special investigation will continue to make headlines, whether or not the president ultimately is implicated in any collusion with the Russians. And it’s safe to expect a contentious midterm election season in 2018. There’s a very real chance that the Democrats take back the House in 2018—if they do, that may increase the chances that Trump could be impeached in 2019. With Republicans likely to keep hold of the Senate, the possibility of Trump’s removal is remote, though a divided Congress would result in political gridlock. Come June and July people will start looking toward the polls to see how these races are trending, which may rattle markets.
Tutrone: We managed to get through last year’s slate of European elections relatively unscathed. This year Italy is the only major country up for grabs, with parliamentary elections taking place in March. Italy is still the third-largest economy in Europe, though it also has the second largest debt-to-GDP ratio and a recovering banking system. Polls suggest that there’s a possibility that an anti-establishment, anti-Europe party, like the Five Star Movement, could rise to power there.
There are some interesting emerging markets political races coming up in 2018. Mexico elects a new president in July. The poll leader there—Andres Obrador, a left-wing populist—has been outspoken about his distaste for NAFTA. Should he win, trade negotiations with the U.S. could grow even more contentious. In Brazil, the runaway leader in the polls is a former president who was caught up in the Petrobras corruption scandal and may be facing prison time.
On top of potentially disruptive elections, you have the usual sources of geopolitical discord. North Korea continues to lob missiles and is always unpredictable, as is the potential U.S. response to any provocation. Brexit talks continue in Europe, and while there’s been some progress, a final accord appears far off.
Election Risk Persists: Key 2018 Elections
Source: Neuberger Berman
Amato: In contrast with the wild cards Tony mentioned, there’s much less uncertainty in China after Xi cemented his leadership following the most recent Communist Party congress. As a result I think Xi may be more aggressive than most people expect when it comes to promoting economic and financial reforms and risk containment. China typically doesn’t announce its GDP growth target until March, but it wouldn’t be surprising to see it again set at 6.5% for 2018. While it beat that bogey easily in 2017, this year will be more of a challenge should Xi follow through on aggressively reining in credit and cutting excess industrial capacity.
Knutzen: At the end of the day, we need to acknowledge the positive economic context in which we will be making our investment decisions. In short, strong macroeconomic fundamentals and corporate earnings are real and underscore the case for remaining exposed to growth. The challenge for investors is to do so in a prudent way, with risks skewed as far as possible in their favor.
Asset allocation becomes more challenging in a world of high valuations, a maturing economic cycle and shallow, short-lived market dips. From a multi-asset class investment standpoint, our approach for 2018 must be predicated on finding those asset classes and subsectors where meaningful upside potential is still available, and then seeking to extract that upside potential in more sophisticated, risk-controlled ways.
Fixed Income: The Chase Continues
Tank: While the Fed’s slow-and-steady approach to the normalization of its target fed funds rate has successfully pushed up the short end of the Treasury yield curve, longer-term rates have remained anchored. There are three primary reasons for this, in my view: persistently low inflation, the tethering effect of low global rates on U.S. rates and the disconnect between the Fed and the market in terms of the terminal fed funds rate. I see all three of these pressures easing as 2018 progresses, which suggests that longer-term Treasury rates may be biased higher.
That said, I believe interest rates across the Treasury curve likely will remain well below historical levels in 2018 and beyond. And though the amount of bonds offering negative yields worldwide seems to have peaked, it remains substantial at about $6 trillion. As a result, yield-hungry investors may continue to look to other areas of the markets, with varying degrees of risk, in search of increased yield potential.
For example, we continue to see a ton of inflows into U.S. credit markets from non-U.S. investors; this may become a problem, as non-U.S. investors are vulnerable to a pause in economic growth, rising rates and rising hedging costs. This last point may be the key risk for credit at the moment, as interest-rate differentials between the U.S. dollar and other developed markets are pushing the cost of hedging back to euros or Japanese yen ever higher, complicating the regional relative-value decision and threatening to debase the appeal of U.S. credit for non-U.S. investors.
Government Bonds with Negative Yields Have Peaked but Remain Significant
Source: Bloomberg Barclays.
As of November 30, 2017.
Real rates in the emerging world have continued to attract capital flows as well, and emerging markets have delivered solid returns over the past 12 months. Reflation and an upward bias on global bond yields can pose a risk to the performance of EMD assets. However, a buffer is likely to come from the consolidation of the cyclical improvement in a large majority of emerging economies and ongoing reforms in key markets.
In terms of fixed income positioning for 2018, it may be an opportune time to take a bit of credit risk off as a way to de-risk the whole portfolio as spreads become more two-way and range-bound. Basically, we’ve entered a new zone for fixed income. The cyclical market is over. Yields could go lower over the next 12 months, but the secular bull market has already ended. It doesn’t really feel that way thanks to low correlations among fixed income markets, which have buffered fixed income investors during recent bouts of trouble. But given narrow credit spreads and low rates, the lifeline of low correlations is unlikely to persist. In fact, I think the chance of a broad, cross-markets selloff is higher today than it has been for years.
Knutzen: From an asset allocator’s perspective, cash is in the discussion for the first time in years, at least for U.S. dollar investors. The risk-adjusted return outlook on cash now competes with investment grade credit while also offering the liquidity and optionality to grasp value opportunities that may result from any sell-off in risk assets.
Tank: I’d add TIPS to the category of investments that may see renewed interest in 2018. With breakeven inflation rates tracking well below 2%, TIPS currently present an attractive opportunity for investors who agree with our assessment that that inflation will perk up over the course of 2018.
Equities: Two-Way Markets Return
Amato: I think equity market momentum will continue in early 2018, driven by strong economic and earnings growth. As we discussed previously, however, clouds are gathering on the horizon; these risks combined with already-extended valuations suggest the beta-driven returns delivered by stock markets in recent years may give way to something more nuanced and two-way. While I wouldn’t advocate trying to time markets, strong positive momentum in the new year would present an opportunity to shift equity portfolios to a more defensive posture.
In the U.S., we envision a rebound from the smaller, more cyclical companies that have lagged. Larger, higher-quality companies and growth stocks outperformed to an extraordinary degree in 2017; for example, while the Russell 1000 Growth Index was up nearly 30%, the Russell 2000 Value Index rose a pedestrian 6%. We heard a lot about the market leadership of “FANG” stocks in 2017, and such narrowness of sentiment historically has not been a good sign for equity markets. It could be an indication that investors are chasing winners rather than investing for more broad-based growth—a phenomenon typical of late-cycle behavior. Some catch-up from smaller companies and cyclicals would be reassuring. The tax bill should help, as smaller companies would disproportionately benefit from a lower statutory tax rate given their higher current effective rates.
Non-U.S. equities also should present investment opportunities, in many cases offering exposure to potential growth catalysts at lower valuations. In terms of developed markets, both Europe and Japan are seeing consistent economic growth for the first time in many years, buoying corporate earnings growth. Brad spoke earlier about how emerging markets debt has benefitted from the fundamental improvements and ongoing reform across the emerging markets complex, and we foresee a similar tailwind for its equities.
Non-U.S. Equities Have Lagged Even as Earnings Have Improved
Source: Bloomberg.
Cumulative Indexed Price Performance
Knutzen: Options strategies are another possibility to consider. Equity index put-writing strategies historically have captured more upside than downside from equity markets over the long term, with lower volatility.1 Such strategies may be particularly attractive for equity market investors concerned about downside risk.
Amato: I’d note that I believe the stage is set for active management to do well in 2018 after a solid 2017. Our analysis of Morningstar data shows that in 2017 50% of active U.S. stock funds beat their benchmarks net of fees and transaction costs, compared to only 25% in 2016.2 One reason for the rebound in stock picking has been the collapse in the correlation between stocks. For the S&P 500, for example, correlation has gone from around 0.60 at the beginning of 2016 to less than 0.10 today. Similar trends can be seen in a variety of equity markets globally.
The tenets of capitalism suggest that correlations should go down when the capital allocation process is driven by company-specific factors rather than the macroeconomic influences that have prevailed in recent years. The 2017 rebound in actively managed portfolios is a timely reminder that these relative performance trends have long been cyclical, not structural. We think the cycle may have turned in favor of active.
1 As measured by the CBOE S&P 500 PutWrite Index versus the S&P 500 Index.
2 Based on analysis of all actively managed U.S.-domiciled open-end equity funds data from Morningstar. Performance is based on fund’s oldest share class relative to its primary prospectus benchmark.
Alternatives: Finding Opportunities Amid High Valuations
Tutrone: Hedge fund performance was vastly improved in 2017 and the industry is on track to deliver its best performance since 2013, though it continues to lag broader equity markets. We think the shift to a higher interest-rate environment and the emergence of more volatile, two-way markets could result in an expanded opportunity set for hedge fund managers, particularly those who seek to identify market-agnostic trading opportunities. This would include uncorrelated strategies like market-neutral and relative-value hedge funds, which historically have delivered returns similar to traditional hedge fund categories (long/short equity, for example) with less volatility. By hedging out all market beta and focusing exclusively on alpha generation via very idiosyncratic risks, uncorrelated strategies have little to no correlation with broader financial markets. They also tend to exhibit low correlation with traditional hedge fund strategies and can be combined in a well-balanced portfolio to further enhance the overall risk-adjusted return profile. While these strategies have struggled at times during the risk-on/risk-off markets that have characterized the post-crisis years, they have the potential to be a source of incremental return in the face of a fading beta trade and hazy forward market direction.
Looking at the private markets, with valuations rich and more and more deals coming on line, investment discipline is more important than ever. One way to exercise discipline is by targeting general partners who have a history of both sourcing high-quality private equity deals and creating value in these businesses through operational improvements. This track record should be long enough to capture multiple market cycles, not merely the post-crisis bull market.
Moving up the capital structure to the debt of private equity-backed companies is another way to help mitigate risk in private equity while attempting to capture illiquidity and complexity premiums. We believe going to the top of the capital structure to focus on senior secured first-lien debt offers perhaps the best relative value at this time.
