Ten for 2017 – Midyear Update

In December the heads of our four investment platforms identified the key themes they anticipated would guide investment decisions in 2017. With the year now half over, we revisited these concepts to see how they’ve played out thus far.

Below we present a midyear assessment of our expectations and an update for the back half of 2017.

Macro: A sea change for economies and markets

1

The Rise of Nationalistic Self-Interest Continues to
Upset the World Order

Partially True

What we said:  After political upheavals in the U.K. and U.S. during 2016, French and German voters will be among those in 2017 to test the persistence of anti-establishment/anti-globalization trends.

What we’ve seen:  Though moderate political forces have maintained power in France and appear poised to do the same in Germany, the geopolitical climate remains unpredictable.

Nationalism suffered its first major setback of the year in March in the Netherlands, where the center-right party of incumbent Prime Minister Mark Rutte fended off a challenge from the far-right firebrand Geert Wilders. In France, Emmanuel Macron—a political newcomer, but one with a centrist, pro-EU platform—defeated the far-right Marine Le Pen in May’s presidential election; his La République en Marche party’s domination of the subsequent parliamentary elections gives the new president a strong mandate to pursue his pro-business structural reforms. In Germany, parties backing Chancellor Merkel have a commanding lead in the polls heading into September’s federal election, suggesting the status quo may hold in the EU’s largest economy.

On the other side of the ledger, U.K. Prime Minister May was dealt a significant setback when her Conservative party won only a narrow majority in the June snap elections, which she had called in anticipation of an easy victory that would strengthen her mandate heading into the now-underway Brexit negotiations. And in the U.S., President Donald Trump’s isolationist tendencies have been front and center. Trump has tested Euro/American relations with his lukewarm commitment to NATO, and he pulled the United States from the Paris climate accord, earning rebukes from some of the country’s strongest allies. In terms of trade issues, Trump withdrew the U.S. from the Trans-Pacific Partnership, and discussions with Canada and Mexico to renegotiate NAFTA are expected later this summer.

   
2

Central Bank Impact Fades

Partially True

What we said:  Global central banks appear to have reached an inflection point and will likely drive an increase in interest rates, inflation expectations and market volatility, and a stronger U.S. dollar.

What we’ve seen:  While the general tone of central bank rhetoric has grown steadily more upbeat throughout the first half, 2017 also has seen a return to the familiar low-growth, low-rates, low-volatility “Goldilocks” environment of the post-crisis years.

We continue to believe global central bank support levels have peaked. The U.S. Federal Reserve appears to have drifted away from its data-dependent approach to policy decisions and is instead capitalizing on the relatively sanguine macroeconomic conditions and robust financial markets to push for continued normalization of rates. After the June rate hike by the FOMC, the federal funds target in the U.S. carries a one-handle for the first time since 2008, and the central bank is laying the groundwork to begin gradually reducing its $4.5 trillion balance sheet by letting maturing bonds run off. Meanwhile, other global central banks—including the European Central Bank, Bank of England and Bank of Japan—have grown increasingly optimistic about their economic prospects, if not explicitly hawkish.

Although the global reflation trade has paused, if not reversed somewhat, in recent months, we believe this trend will re-emerge in the back half of the year. Increased global economic synchronization lends support to a growth reacceleration, as do signals from credit spreads and corporate profits. With real rates remaining negative across many parts of the global term structure, we continue to forecast modestly higher rates and inflation across much of the G10 due both to valuations and expectations for an emergence of fiscal impulse in late 2017 and 2018.

   

Fixed Income: Normalization resumes

3

Real Interest Rates in the U.S. Continue to Push Higher

Partially True

What we said:  Expectations for higher growth and inflation are likely to drive higher Treasury yields and a steeper curve, though we don’t anticipate a break from the global rate tether.

What we’ve seen:  While the Fed’s steadfast commitment to policy normalization has pushed short rates higher, longer bond yields have declined in the face of sluggish growth and inflation, flattening the curve.

After spiking in the immediate aftermath of Trump’s victory, the ongoing division between hard and soft data and mounting impatience around the execution of Trump’s agenda has pushed long U.S. Treasury rates into the lower end of their post-election trading range and flattened the yield curve in the process. Inflation remains elusive; core PCE, the Fed’s preferred inflation metric, has disappointed in recent months, and the central bank recently cut its 2017 expectation to 1.7% (from 1.9%).

The Fed in June bumped up the federal funds rate target another 25 basis points, as expected, and issued a game plan for the eventual reduction of its balance sheet. With inflation running below target, the central bank has room to be patient in the second half of the year, perhaps issuing just one more rate hike. The shape of the yield curve may be a key potential variable in the FOMC decision-making process. One way to “un-bend” the curve would be to slow the pace of rate hikes over the next year. Another would be to trim the balance sheet modestly, as the Fed has discussed, curbing reinvestment of maturing holdings, often in the middle part of the curve.

   
4

Credit Still Holds Appeal

True

What we said:  The credit cycle is mature, but it doesn’t appear ready to turn just yet; when it does, more supportive fundamentals are likely to help absorb the impact.

What we’ve seen:  In our view, the credit cycle is almost certainly closer to its end than its beginning, though the general lack of excess in the economy and financial markets suggests that it still has some room to run.

The credit cycle in June celebrated its eighth anniversary and now stands among the longest in U.S. history.  Perhaps most noteworthy about the current cycle is the sluggish pace of recovery and expansion; U.S. GDP growth has averaged a mere 2.1% annually since the country emerged from recession. There could be a silver lining in this, however, as the below-average recovery may have suppressed the development of excesses across the economy and financial markets, perhaps giving the economic cycle above-average room to run and other economies a chance to catch up.

U.S. investment grade credit has been quite stable year to date, with the market holding on to most of its post-election rally. Market technicals remain strong, with supply moderating after a very aggressive start to the year and demand persisting, particularly from outside the U.S. Fundamentals, meanwhile, have stabilized after a few years of deterioration. Without any imbalances to disrupt the economy, modest growth likely will persist; credit spreads—even from current tighter levels—could perform well in such an environment and could further benefit should tax reform re-emerge as a legislative priority.

   

Equities: Back to basics

5

Pro-Growth Trump Administration Fuels
Outperformance of U.S. Equities

Not True

What we said:  A more business-friendly environment—characterized by lower taxes, loosened regulations and robust fiscal spending—could provide a tailwind for corporate earnings and stock markets in the U.S.

What we’ve seen:  Despite a lack of material progress on the legislative front, robust corporate earnings growth has driven U.S. equity indexes higher—though not at the pace of most non-U.S. markets.

The Trump agenda thus far has been underwhelming; nearly six months into his term, the president is still in search of a signature legislative victory. Though there are lingering hopes for financial deregulation, the “Trump trade” that took hold of markets immediately following the U.S. presidential elections appears to have fizzled out in all other respects, most prominently tax reform and fiscal spending. Despite the lack of progress on the policy front, U.S. equity markets have continued to surge higher during 2017, with a number of major indexes establishing new all-time highs even as they lagged non-U.S. markets for the year to date. Investors appear to have accepted that the aggressive Trump legislative platform will not be a driver of near-term economic or earnings growth, and have instead turned to fundamentals—most notably blockbuster first-quarter earnings growth—to fuel their buying impulses.

However, given the lack of policy clarity in Washington, high valuations and concerns about the emergence of the next earnings growth catalyst, we have moderated our outlook for the relative performance of U.S. large-cap equities. In contrast, we believe the aforementioned “Goldilocks” environment favors small-cap stocks in the U.S. on a relative-value basis. Of course, another leg of broad U.S. equity outperformance could result should any of the pro-growth promises that swept Trump into office actually come to pass.

   
6

Alpha—and Active Managers Able to
Generate It—May Stage a Comeback

True

What we said:  The removal of artificially low interest rates could result in individual stock performance once again being differentiated by company fundamentals, to the benefit of high-conviction, fundamental investors.

What we’ve seen:  As global central banks slowly move toward normalization, so too have the conditions that historically favor active management, driving an improvement in active managers’ performance relative to their benchmarks.

After years of underperformance relative to their benchmarks in the aftermath of the financial crisis, active managers rebounded in the first six months of 2017; across equity asset classes the majority of actively managed funds beat their primary benchmarks in the first half of the year.

A so-called “stock picker’s market” typically is characterized by higher volatility, higher dispersion and lower correlations—conditions that tend to flourish in an environment of higher interest rates in which investment capital is more difficult for companies to access. While we believe 2017 will represent “peak QE” on a global basis, gradually leading to higher interest rates, the normalization process will be slow. The interest rate picture has been mixed thus far, with short rates trending higher as long rates have drifted lower. Market volatility has remained very low, persisting well below its longer-term average despite the presence of any number of catalysts that one would expect to sow doubt and risk aversion among investors. However, there have been signs of improvement in intra-stock and intra-sector correlations as well as dispersion among sectors. We believe the environment will grow increasingly supportive of active investors as central bank normalization proceeds.

It’s also worth noting that, while headline volatility is low, we’ve seen pockets of turbulence—particularly in energy, metals and some currencies—that could be exacerbated by a number of potential developments going forward, including signs of a debt crisis or weakness in China, overly aggressive central bank tightening, consumer weakness, or major moves in currencies or commodities. Moreover, when growth in general is subdued, markets often hunt down and reward idiosyncratic growth prospects that can potentially deliver above-average returns, a dynamic that has already pushed up stock dispersion: Witness recent turmoil in technology stocks and the retail sector.

   

Emerging Markets: Both winners and losers emerge

7

Economic Orientation Counts

True

What we said:  In our view, fears that U.S. policy will drag down the entire emerging world are overblown; improved global growth should be generally supportive, though countries likely will be differentiated based on their key economic drivers—manufacturing vs. commodities vs. domestic.

What we’ve seen:  Prospects for emerging markets in general are looking much healthier as of midyear, as evidenced by the robust first-half performance of both emerging market equities and debt.

Emerging markets were under pressure in the immediate aftermath of the U.S. elections, battered by the potential for higher U.S. interest rates, a stronger U.S. dollar and trade disruptions as a result of the Trump administration’s “America first” policy stance. As we anticipated, however, these concerns proved overstated. Local economic growth appears more sustainable, current account deficits have been slashed and vigorous reforms are gaining momentum in a range of countries, while the emergence of a synchronized global expansion has further bolstered the region’s prospects.

Potential fallout from China’s efforts to manage the trouble spots in its economy (discussed below) poses a significant existential threat to the health of the emerging markets. Commodities, too, remain a wildcard; oil prices, for example, were stable for much of the first half before trending lower as the second quarter wore on. Though this oil price weakness has yet to have a significant impact on the broader emerging market complex, we can all recall the damage the collapse of oil prices in 2015 inflicted. Regardless, these risks highlight the importance of distinguishing among the economic and fundamental drivers of individual markets and companies when making investment decisions in this heterogeneous space.

   
8

China Risks Remain Significant

True

What we said:  The world’s second-largest economy faces a number of ongoing issues—from asset bubbles to currency management—that require a particularly deft touch from Beijing.

What we’ve seen:  China remains a big concern for the performance of emerging markets assets and global growth in general, and the Chinese equity market has lagged as a result.

In late May China saw its sovereign debt rating reduced one notch by Moody’s, as the ratings agency said it expected the country’s financial strength would deteriorate as growth slows and debt continues to rise. As made clear through its recent policy actions and proclamations, the Chinese government appears well aware of the unsustainability of this debt/growth dynamic. Given strong economic activity in 2016 and early 2017, Beijing has begun to rein in rapid credit growth and strengthen its regulatory framework; while positive in the long run, such regulatory tightening has the potential to negatively impact growth and asset prices in the near term. For example, sharp squeezes in liquidity can cause distortions in money market rates and excessive volatility in asset prices, while financial deleveraging can spill over into the real economy via higher corporate funding costs.

While our base case is for a fairly orderly financial delivering, the risks in China—and thus the risks it poses to other emerging markets and global growth—have risen on the margin and require close attention.

   

Alternatives: Helping narrow the return gap

9

Volatility Can Work for Investors

Partially True

What we said:  We anticipate that the difference between long-term investor needs and what can be generated from traditional sources of beta is likely to persist, highlighting the value of alternative risk premia and volatility-capture strategies.

What we’ve seen:  Though volatility has yet to re-emerge, the demand for alternative sources of returns and diversification continues, buoyed by the consistent attractive performance of strategies like equity put writing.  

There’s been little change on this front since early in the year; low interest rates, low inflation, below-trend economic growth and elevated valuations remain, leading many investors to cast a wider net when constructing portfolios. That said, volatility is part of the investment landscape, and higher levels are likely to reassert themselves eventually. We believe that investors should be prepared for this in the context of their long-term time horizons. When volatility spikes, it’s helpful to both avoid indiscriminate selling and, where possible, capitalize on turbulence by adding exposure at attractive prices. Increased volatility could also support long/short hedge fund managers, as alpha becomes more available on both sides of the trade.

In addition, strategies like equity index put writing can potentially introduce reduced beta exposure while benefiting from the high cost of market “insurance,” which investors continue to pay up for despite apparently sanguine sentiment. For example, the CBOE S&P 500 Putwrite Index, which tracks the performance of a hypothetical put writing strategy on the S&P 500 Index, was up more than 6.7% in the first half of 2017.

   
10

Private Debt Remains Attractive

True

What we said:  Despite the potential re-emergence of banks as liquidity providers, it is unlikely that they will rebuild the infrastructure required to compete in similar, less-liquid credit. In addition, increased M&A activity will likely keep the private debt market well stocked with opportunities.

What we’ve seen:  We remain constructive on private debt, whose growing popularity among institutional investors likely poses a greater risk than the potential return of banks to the market.

Private debt has seen increasing interest from institutional investors in recent years given attractive yield, stable and consistent cash flow, and lack of J-curve drag. In fact, this demand is adding to the risk of private debt investment as competition for loans grows more intense. There also are ongoing worries that the easing of financial regulations may enable investment banks to reenter this market and squeeze out alternative liquidity providers in the process, though we’re not overly concerned. A bill repealing the Volcker Rule, which limits banks’ proprietary trading activities, recently made it through the House of Representatives, but its prospects in the Senate are less promising. Regardless, there appears to be sufficient supply in the near-term pipeline to support the expanding popularity of private debt even in the unlikely event banks were to again become meaningful players in the space.

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