July 12, 2016
Our Asset Allocation Committee broadly agrees that we are in the last stages of the business cycle and that this may warrant taking some risk off the table in the nearer term, perhaps as soon as 12 months from now. Between now and then, however, sentiment-driven markets and geopolitical risks such as the recent “Brexit” vote make for diverging paths to that consensus.
At our most recent Asset Allocation Committee meeting it was clear what we all agreed on: the risk of an economic slowdown, perhaps as soon as in 12-18 months’ time, is increasing. It was equally clear where opinion was split: on the direction of markets in the meantime. We have come to that stage in the business cycle when investment views become most sensitive to time horizon, and markets are most likely to detach from underlying fundamentals. Add in the political risks—such as the “Brexit” vote that materialized shortly after our meeting and the anti-globalization sentiment that it represents—and it becomes hard to form a consensus.
We can scarcely begin anywhere other than with the U.K.’s momentous decision to leave the European Union. Markets responded dramatically and there are bound to be many more volatile sessions ahead. Having said that, we have cautioned against reacting as though this were a second “Lehman moment,” as some commentators suggested in the run-up to the vote.
“Brexit” Damage Likely to Be Contained
The complexity of exiting the EU is likely to weigh on the U.K.’s economy, assets and business sentiment, although the pain may not be felt evenly. FTSE 100 companies, 80% of whose revenues come from overseas, may be somewhat insulated and even helped by a weaker pound sterling. Smaller, more domestically-focused companies are generally more vulnerable to a fall in consumer demand and higher import costs. That could be a source of opportunity should there be a prolonged sell-off in U.K. assets.
We expect the impact on global economic fundamentals to be marginal, however. This may be another blow to globalization and a spur to anti-EU parties across the continent, but these trends were already well-advanced and understood by financial markets.
Ultimately, we still live in the late-cycle, slow-growth, low-inflation, low-interest rate environment, characterized by sluggish productivity and investment that led us to hold our neutral position over recent months. The fundamental growth prospects for the global economy may or may not have changed as a result of the U.K.’s vote, but the risk of financial conditions tightening as a consequence has the potential to bring forward the decline in the business cycle, as well as to create volatility that delivers opportunity for long-term investors. (See more on the AAC’s discussion on managing political risks).
Neutral Views for Sentiment-Driven Markets
The clustering of the AAC’s aggregated views around “Neutral” has barely moved since the last quarter. The averages, however, conceal some broad dispersion of AAC members’ views. For instance, in Emerging Markets Debt our “Neutral” vote hides three members with an ”Overweight” stance even as another member voted for “Very Underweight”. Similarly, the “Underweight” aggregate view on government and agency bonds balances three votes for “Very Underweight” with one vote for “Overweight”.
In our discussion, one of the few outright bears, Wai Lee, Director of Research in our Quantitative Investment Group, pointed to an unusually high degree of coupling between markets and assets as a sign of an increased vulnerability to systematic risk. But overall, strong conviction about big directional moves in markets was lacking. More than one member opted to favor riskier assets because the other options don’t look viable (and indeed, a few days later the yield on Germany’s 10-year government bonds turned negative). Another reluctant bull argued that the first quarter had flushed out most of the forced sellers who had driven prices down. In the background, of course, was the “Brexit” risk.
Bullish or bearish, it is significant that these views were all based on the technical shape of the market rather than expectations for company or economic fundamentals. Low conviction fits with high uncertainty about where fundamentals are going over the next few months.
But prices can climb—or plummet—without any change in underlying fundamentals. We saw that in the market’s deep V-shape during the first half of this year. We may be seeing it again in response to “Brexit”—it’s just too early to tell. As Joe Amato, Brad Tank and I have observed in our “CIO Weekly Perspectives” notes, the rally in riskier assets leading up to the U.K.’s referendum did not reflect any great improvement in fundamentals so much as the mitigation of three big tail risks that worried markets back in January—a further leg down for the oil price, another leg up for the U.S. dollar, or an economic or currency shock from China.
We are at that stage of the business cycle when sentiment often takes over, we borrow stability from the future, and bouts of amplified volatility create both opportunities and challenges for investors. This is the “wall of worry” of market cliché, when prices are poised between meltdown and melt-up.
My own view is that the S&P 500 Index has the potential to make another run higher once the “Brexit” dust settles. But I think that would be a momentum-driven rally that could take us to 19-times forward earnings or higher. A few more data points such as the poor U.S. jobs numbers we got on June 3 could easily reverse the trend, as could today’s unusual level of political risk—heightened further by the U.K.’s vote. The next few months also promise a contentious U.S. presidential election. Meanwhile, the world’s major central banks may or may not be in control of the economy, and many experts are speculating that “helicopter money” may be the next non-traditional attempt at monetary stimulus, particularly in Japan.
Divergent Views Lead to Diversified Risk Exposures
Our views reflect this environment and the neutral tenor of AAC voting. On the margin we still prefer stocks over bonds. Within fixed income we prefer credit over sovereign nominal bonds. At the same time, we want some interest rate sensitivity in to reflect downside risks and the slow path of U.S. rate hikes now priced into interest rate forwards. To do that we prefer inflation-protected bonds, as the market appears to be underestimating the potential for future inflation.
The only change to our view since three months ago expresses the same lack of confidence in market momentum: directional hedge funds went from “Slightly Overweight” to “Neutral”—although David Kupperman, Co-Head of Alternative Investments, noted that his team is starting to think about distressed debt opportunities on the 12-24 month horizon.
Preference for Non-U.S. Equities and Credit
Within equities, we prefer European over U.S. stocks. In our “Weekly Perspectives” Joe, Brad and I have addressed what we call the “show-me-the-money” theme in U.S. markets: before the “Brexit” vote equities had been creeping higher nervously, knowing that the earnings recession must reverse to justify today’s valuations. A year ago S&P 500 earnings per share for 2016 were projected to be $130: today, expectations are for more like $122. By contrast, while the rise of populism signaled by the U.K. referendum bears watching, in one of my notes in mid-May I drew attention to signs of improvement in company and economic fundamentals across Europe. These improvements are backed up by relatively low valuations and the European Central Bank’s decision to expand its Asset Purchase Program to include investment-grade corporate bonds, even as recent volatility has created potentially attractive entry points.
Within fixed income we still prefer credit risk to interest rate risk, while noting signs of exuberance and credit deterioration in a few corners. Some of the best value in credit may be in private debt: while 2015 saw the average valuation of all private equity buyouts hit its highest ever level, leverage remains modest, credit structures conservative and interest rates low. There is also a developing long-term opportunity for direct lending and collateralized loan obligations (CLOs) to play a bigger role in providing liquidity for these deals as banks are forced to withdraw some of their activity under new regulations.
Last quarter I described the AAC outlook as “driving in neutral”, with the occasional burst of acceleration into opportunistic value (and relative-value) positions. That remains the case as we move into the third quarter. Rising stock prices that are not backed up by improving fundamentals will not cause us to shift gears. That would take clear signs of a relief from the recent earnings recession on the one hand, or further severe political shock or signs of an imminent end to this business cycle on the other.
The transition between the second and third quarters of 2016 has been dominated by a single event: the U.K. electorate’s vote to give up its membership of the European Union. This event was not expected by markets and caused a bout of extreme turmoil despite its ultimate impact on U.K., European and global fundamentals remaining profoundly uncertain. As such, it stands as the perfect illustration why the Asset Allocation Committee has been so reluctant to vote for an active outlook, in either riskier or risk-free assets, over the past two quarters. Bullish or bearish, their views tended to reflect their thoughts on the technical shape of the market rather than expectations for company or economic fundamentals. This fits with our view that low conviction in the markets results from high uncertainty about where fundamentals are going over the next few months.
Prices can climb—or plummet—without any change in underlying fundamentals. With the mitigation of the tail risks that worried markets at the beginning of the year, the stage was set for a sentiment-driven rally. At this stage in the business cycle this kind of rally can develop into a “melt-up”, so caution should be given to positioning too conservatively. At the same time, if the downside risks were not obvious before June 23, they are now. Aside from the unusually high level of political risk attached to the rest of this year, there will come a point at which markets start to price in expectations for a weaker economic environment sooner rather than later. Neutral positioning with opportunistic additions to risk remains our preference.
About the Asset Allocation Committee
Neuberger Berman’s Asset Allocation Committee meets every quarter to poll its members on their outlook for the next 12 months on each of the asset classes noted and, through debate and discussion, to refine our market outlook. The panel covers the gamut of investments and markets, bringing together diverse industry knowledge, with an average of 25 years of experience.
Joseph V. Amato | Biography
President and Chief Investment Officer
Thanos Bardas, PhD | Biography
Portfolio Manager, Head of Global Rates
Alan H. Dorsey, CFA
Chief Risk Officer
Head of Investment Strategy Group,
Chief Investment Officer—Neuberger Berman Trust Company
Ajay Singh Jain, CFA | Biography
Head of Multi-Asset Class Portfolio Management
Erik L. Knutzen, CFA, CAIA | Biography
Chief Investment Officer—Multi-Asset Class
David G. Kupperman, PhD | Biography
Co-Head, NB Alternative Investment Management
Ugo Lancioni | Biography
Head of Global Currency
Wai Lee, PhD | Biography
Head of the Quantitative Investment Group, Director of Research
Brad Tank | Biography
Chief Investment Officer—Fixed Income
Anthony D. Tutrone | Biography
Global Head of Alternatives
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