From Reflation to “Goldilocks”: What Comes Next?

Asset Allocation Committee Outlook 3Q2017

Which markets can thrive when the range of potential outcomes is so wide?

The optimism of the reflation trade that closed 2016 has now given way to the low-growth, low-rates, low-volatility “Goldilocks” environment familiar from the post-crisis years. Back then, it was broadly supportive of risk assets. So far in 2017, strip out commodities, and just about every major stock and bond market you can think of has performed well this year. However, now that asset prices have appreciated but growth and inflation expectations remain modest and quantitative easing (QE) is being withdrawn, the risk profile appears different. Today, “Goldilocks” is a more fragile regime. In our view, that means it offers opportunity only where valuations remain attractive and risk levels can be monitored. It is likely that, despite the very low levels of volatility, the negative left tail of potential returns could be fatter now that valuations are full and central banks are pulling back. The bullish, right tail poses risk, too, however, given the big consensus against the “Trump Trade”. The AAC asked itself which markets could thrive when the range of potential outcomes is so wide.

Charts at a Glance

The summary of the Asset Allocation Committee’s views shows that we have upgraded our outlook for equity markets outside the U.S. While we have revised our outlook for U.S. large caps downward, we remain optimistic on U.S. small caps. Our view on government and investment-grade bonds remains underweight; inflation-protected securities and high-yield were held at neutral. We have increased our stance on emerging markets debt to overweight. In line with this lack of conviction on market risk, we downgraded our view on directional hedge funds but remain positive on lower-volatility hedge funds.

Let’s take these changing positions and explain how they fit with our current world view.

“Goldilocks” Environment Can Still Present Opportunity

Following a brief reflationary rally, the AAC sees the market pricing for an environment familiar from the quantitative-easing years, when growth and inflation were low, but ample central-bank liquidity limited the risk of recession.

We see the potential for positive returns in such an environment. It has generally favored equity and credit risk over duration, but return potential will likely be muted, risk-taking is likely to be modest, and volatility could remain suppressed. When economic growth and yield in general become scarce, defensive growth stocks have tended to be favored over cyclicals (as we have seen this year), and growing-and-yielding regions have tended to be favored over those that seem to be stalling or priced for perfection.

That is the main reason why the AAC upgraded its 12-month outlook for both emerging market debt and equities, where economic growth remains respectable and valuations are still recovering from their 2011 – 15 bear market. Things could be upset by a wrong step by China as it manages its growth slowdown and credit expansion, or a lurch lower for global growth, but as long as the familiar not-too-hot, not-too-cold scenario plays out, we believe emerging markets can outperform.

We also maintained our overweight outlook for non-U.S. developed market equities, in contrast to our downgrade for U.S. large caps. In our view, economic and survey data out of the Eurozone has been solid enough to beat expectations this year (and its recent GDP growth has been solid enough to beat that from the U.S.). Furthermore, while the U.S. and the U.K. appear to stumble from one political problem to the next, the tide of populism that many feared would envelop Continental Europe last year has ebbed substantially.

After the Dutch and French rejected the extreme right in their respective elections, the ruling CDU party won some key local elections in Germany, the Italian parliament rejected a change in the law that would have brought on a general election, and June saw the latest tranche of bailout funds released to Greece with minimum fuss.

The low-growth “Goldilocks” environment tends to be supportive of risk assets, and we believe that may be the base case now. But when it is combined with high valuations, low volatility and high uncertainty, return outlooks for risk assets are positive but modest, and markets tend not to move in any clear direction. It makes sense to work harder to find the idiosyncratic growth opportunities, or hedged strategies, that can generate above-average returns. Dispersion of stock performance often rises, and correlations fall, which, in our view, could create a potentially rewarding backdrop for active management in general, and lower-volatility hedge funds in particular. This can eventually be the catalyst for a return to higher market volatility—as indicated by the recent turmoil in technology stocks, and across the retail sector when Amazon made its play for Whole Foods.

Risks on Both the Upside and the Downside

If it is true that even today’s apparently dull “Goldilocks” environment can be a source of above-average returns for those looking in the right places, it is also a fragile regime where caution is warranted. Risk can break either way with surprising speed.

When growth and return outlooks are so muted, the margin for error is tight both for policymakers and investors. It doesn’t take much to hurt confidence, inflict a growth shock, and wipe out modest return outlooks. Mixed signals from equity markets, soft data points such as business confidence surveys, and first-half earnings reports on the one hand, and hard economic data, commodity prices and flattening yield curves on the other do not help to alleviate the uncertainty. These divergences will need to be resolved, either higher or lower, and when the business cycle is as extended as this one and the Federal Reserve wants to “normalize” policy despite softening data, a poor number, a policy stumble or a geopolitical shock can trigger a more pessimistic turn in the markets.

That pessimism is arguably already evident in commodity prices and the U.S. Treasury yield curve. It certainly informs the AAC’s decision to downgrade our view on U.S. large caps, where high valuations are combined with concern over where the next earnings-growth catalyst will come from given falling commodity prices and uncertainty around legislative progress in Washington.

There is also risk in the consensus that the so-called “Trump Trade” is over, however. The performance of bank stocks suggests lingering anticipation of financial deregulation, but in all other respects that consensus may now be complete. But any sign of the pro-growth legislation promised in the early days of the Trump administration could renew confidence that we are still only midway through the current business cycle. The reflationary optimism of late-2016 could be back.

Focus on Idiosyncratic and Relative-Value Opportunities

That prospect, together with a feeling that their recent underperformance could be due for some mean-reversion, informs the AAC’s decision to maintain its overweight outlook for U.S. small caps, even as we downgraded U.S. large caps. We believe the relative-value story would favor U.S. small caps in a continuation of the “Goldilocks” environment, too, which makes them a good insurance policy against a return of the reflation trade.

In a way, the U.S. small caps view is a good summary of where the AAC thinks we are at the moment. When the world is struggling to generate a growth lift-off, when many markets are priced for perfection but supported by low inflation and still-abundant central-bank liquidity, investors may want to focus on idiosyncratic and relative-value opportunities. From emerging markets to lower-volatility hedge funds, the changes to our 12-month outlook reflect this quite clearly.

 

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, averaging around 25 years of experience.

Committee Members

Joseph V. Amato | Biography
President and Chief Investment Officer

Erik L. Knutzen, CFA, CAIA | Biography
Chief Investment Officer—
Multi-Asset Class

Thanos Bardas, PhD | Biography
Portfolio Manager, Head of Global Rates

Alan H. Dorsey, CFA
Chief Risk Officer

Ajay Singh Jain, CFA | Biography
Head of Multi-Asset Class Portfolio Management

Andrew Johnson | Biography
Head of Global Investment Grade Fixed Income

 

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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