Nine months ago, we wrote a long-term outlook, Investing at a Crossroads, in which we said that the economy and financial markets were going through a profound change. Both the transition and the environment on the other side would need a fresh investment playbook, very different from the one that worked over the past 20 years.
While it is still too early to confirm that we will ultimately arrive at the environment we described, interest rates have adjusted meaningfully and now appear to be reaching a near-term peak. Does the playbook we described still apply?
With Investing at a Crossroads, we observed that the global economy and financial markets had benefitted from four decades of significant tailwinds. Inflation moderated and stabilized; global interest rates declined; geopolitical tensions eased during the 1990s, creating the conditions for the efficiency gains of globalization; labor markets lost pricing power and grew more flexible; corporate tax burdens lifted; and fossil fuel-intensive growth raised living standards worldwide.
We argued that many of those tailwinds were turning to headwinds, that a golden era for investors in long-duration and growth-oriented assets was ending, and a new investment playbook was required. The summary of that playbook is reproduced below.
OUTLOOK: Adapt to Today’s New Challenges
Two multi-decade economic tailwinds are under threat. Globalization is hitting geopolitical, strategic, populist and practical roadblocks, and unsustainable growth powered by fossil fuels faces a difficult transition to ultimately more efficient growth powered by renewables.
Potential economic implications:
- A return to structurally higher inflation and more hawkish central bank policy
- A return to shorter and more volatile business cycles
- A global energy transition
- Favoring the fittest
- Rethinking regional risk
- Harvesting global macro trends, tactical dislocations and volatility premia
- Accounting for “Net Zero”
- Prioritizing real assets: Commodities, real estate, infrastructure
RETURNS: Mind the Gap
Lower and more volatile growth, together with higher inflation and interest rates, could slow the performance of many equity and bond indices, opening a wider gap between targeted returns and return outlooks. This “exhausted beta” phenomenon, together with the potential for higher price volatility and an upward bias in rates, is likely to make return profiles more reliant on income, illiquidity and niche-market premia, as well as active management (asset-allocation, stock-selection, corporate engagement and operational “alpha”).
Potential portfolio implications:
- Lower asset class return outlooks, with higher volatility
- Looking beyond “exhausted beta”
- Going short as well as long
- Rebalancing toward value investing
- Becoming fully flexible in fixed income and credit
- Prioritizing income across asset classes
- Integrating public and private market investments
- Exploiting your natural advantages while seeking effective partners
RISK: Diversify Differently
Higher volatility and economic uncertainty, as well as the use of increased portfolio risk to align return profiles with return targets, make portfolio diversification more important than ever. Diversification could be more difficult to achieve, however, as equity-bond correlation tends to rise in more inflationary environments.
Potential portfolio implications:
- Higher equity-bond correlation leading to higher portfolio volatility
- Adding flexibility and shortening duration in fixed income
- Seeking out uncorrelated markets and strategies
- Prioritizing inflation-sensitive real and financial assets
- Identifying and hedging the tail risks that matter to you
Since then, we have updated our five- to seven-year capital market assumptions for a range of asset classes. The resulting picture looks very different from the one we faced at the start of 2022 (figure 1).
Figure 1. NB Capital Market Assumptions: 2023 vs. 2022
Estimated annualized return and volatility, five- to seven-year term (USD base currency)
Estimated annualized return and volatility, five- to seven-year term (EUR base currency)
Source: Neuberger Berman, Bloomberg, Cambridge Associates, FactSet. Analytics as of December 31, 2021 and April 30, 2023. In the bottom chart, non-Euro assets are hedged to EUR using three-month forwards (-2.54% USD to EUR for 2023 & -0.79% USD to EUR for 2022). The performance and risk projections/estimates are hypothetical in nature and reflect the Neuberger Berman’s Capital Market Assumptions. The estimates do not reflect actual investment results and are not guarantees of future results. Actual returns and volatility may vary significantly. Asset classes are represented by benchmarks and do not represent any Neuberger Berman investment product or service. Please see Additional Disclosures at the end of the presentation for asset class and index definitions and Neuberger Berman Capital Market Assumptions. Investing entails risks, including possible loss of principal.
Strikingly, the line showing the average relationship between estimated return and volatility for these asset classes flattened notably over the course of 2022, rising to the left and falling to the right. There is much less marginal estimated return for each marginal unit of risk, but also a higher level of estimated return for lower-risk assets. Our research suggests that fixed income now appears significantly more favorable than equity.
The main reason for this shift in estimates is the adjustment that major asset classes went through last year. The U.S. fed funds rate moved from 0.25% to 4%. The 10-year U.S. Treasury yield more than doubled from 1.5% to 3.9% and the German Bund yield rose from well below zero to 2.5%. And while benchmark global, U.S., European and emerging market equity indices were down between 10% and 20%, this was outweighed by revised estimates for narrower profit margins, and higher risk premia and lower multiples.
This is all very much in line with the argument we put forward in Investing at a Crossroads—that 2022 was an important long-term inflexion point and “not just another turn in the business cycle.” Nonetheless, these were substantial adjustments. Have they reinforced the long-term playbook we set out six months ago, or forced a re-think?
Now that the interest rate cycle appear to be peaking, we revisit some of the key playbook themes to confirm that they have been reinforced by last year’s market adjustments, not challenged by them.
CROSSROADS THEME: MIND THE GAP
With the changes in estimated returns shown in figure 1, in risk-adjusted terms fixed income now appears more favorable than equity. We would now regard fixed income as close to fair value for the new environment described in Investing at a Crossroads, meaning that investors in these markets have less need to “Mind the Gap” between estimated returns and their return objectives. While equity market valuations have come down, however, we do not think they have come down far enough to account for the valuation and margin headwinds of the new environment. Without a further reduction in valuations, equity investors still need to “Mind the Gap,” in our view—and, as we will emphasize below, our argument for prioritizing income across asset classes has been reinforced and may be one way to close that gap in equities.
CROSSROADS THEME: PRIORITIZING INFLATION-SENSITIVE REAL AND FINANCIAL ASSETS
We urged investors to “Diversify Differently” because “equity-bond correlation tends to rise in more inflationary environments.”
While the worst of the recent inflation shock appears to be behind us and bond prices now have more room to rise, we would still caution against relying too heavily on “textbook” equity-bond diversification. Bond yields can potentially hedge growth shocks at their new price levels, but their inherent duration means they cannot be relied on to hedge inflation shocks. As we anticipated, inflation has proven persistent, reinforcing our concerns about secular inflationary pressures. While the very close and sustained equity-bond correlation of 2022 may not be the new norm, we are unlikely to be heading back to the negative correlations associated with the past 20 years. Instead, we expect correlations to normalize toward the long-term average of around 0.20, with occasional spikes whenever inflation threatens to become a problem. With that outlook, inflation-sensitive assets would continue to play an important role in portfolio diversification.
CROSSROADS THEMES: EXPLOITING YOUR NATURAL ADVANTAGES & HARVESTING GLOBAL MACRO TRENDS, TACTICAL DISLOCATIONS AND VOLATILITY PREMIA
“Do you have more freedom than most to hold illiquid or more volatile investments?” we asked last year. “Shorter, more volatile cycles and less-liquid markets make value dislocations more likely: do you benefit from a lighter governance structure that makes it easier to move quickly?”
These were two examples of how to exploit natural advantages in the new investing environment. As the real economy adjusted to higher rates, it was always likely that 2023 would provide the first tests of these themes. From the attractive discounts in private equity secondaries and the difficulties at U.S. regional banks, to the storm clouds gathering around some areas of commercial real estate and real estate debt, a range of phenomena has underlined the opportunities available to liquidity providers in this environment, especially those able to step into lending and liquidity gaps left by retreating banks.
CROSSROADS THEME: LOOKING BEYOND “EXHAUSTED BETA”
When we wrote about “exhausted beta” in equities, we were referring to the factors that significantly outperformed between 2009 and 2021, when rates were declining: U.S. large- and mega-cap growth stocks. These stocks outperformed so much that they came to dominate some important broad market indices, such as those for large-cap U.S. stocks and global stocks. These distortions persist even after the market declines last year.
We argued that equity investors could exceed the modest prospects for the broad market by focusing on five major themes: quality, income, value, regional diversification and active management. We address each theme below.
CROSSROADS THEME: FAVORING THE FITTEST
We wrote that “quality and fundamental selectivity are likely to be more important determinants of return outlooks from now on,” as “owners of capital face growing headwinds.”
This is an important reason why last year’s valuation adjustment has not improved estimated risk-adjusted returns for equity indices to the same extent as for fixed income assets. Much of last year’s equity market adjustment reflected the shift to higher rates. A further adjustment is required to account for weaker earnings as those higher rates begin to bite into the economy, in our view.
A weaker economy will be difficult for most companies, but more difficult for lower-quality companies. We think aggressive use of accounting accruals—which essentially represent best-case financial assumptions and create disconnects between reported net income and actual cash flow—is an important indicator of lower quality. As figure 2 suggests, accruals have been at a multi-year high, and they tend to get written down severely when the business cycle turns negative.
Figure 2. Corporate Earnings Quality at Multi-year Lows
Level of accrued earnings, U.S. and Europe
Source: FactSet, Piper Sandler, Neuberger Berman. Data as of December 31, 2022.
While equity indices have generally performed well, they have been driven by a very concentrated group of high-quality technology stocks.
CROSSROADS THEMES: PRIORITIZING INCOME ACROSS ASSET CLASSES & REBALANCING TOWARD VALUE INVESTING
These two equity themes were based on an anticipated rise in rates and bond yields, together with an expectation that valuations would be volatile and sideways-trending, hurting longer-duration assets and making income a bigger proportion of total return.
That is not how things have turned out so far in 2023—although, as we mentioned above, while the performance of some technology stocks has driven equity indices higher, the factor that appears to have outperformed this year is quality rather than growth.
Longer term, we believe these themes will continue to play out. The flattening of the capital market line seen in figure 1 makes fixed income favorable over equity at the asset class level, and income favorable to growth within equities. If we thought that we might return to the low rates of 2009 – 21 from today’s higher levels, we would be more favorable toward growth stocks again, at today’s lower valuations. But we do not think that. We believe higher inflation and rates are structural and long-lasting, and that favors value and income: “cash today” is more attractive than “cash tomorrow” everywhere we look, at our five- to seven-year horizon.
There may be times, like the first half of 2023, when growth stocks outperform value stocks, but we think the decade-long period of outperformance up to 2022 was an anomaly that is unlikely to be repeated.
CROSSROADS THEME: RETHINKING REGIONAL RISK
As we already mentioned, growth stocks have become dominant not only in U.S. large-cap equity indices, but in global and global-developed equity indices, too.
By contrast, while growth stocks outperformed in non-U.S. markets until 2022, they have not come to dominate the core indices (figure 3). It is our view that they were simply not a big enough part of the market to begin with, and they didn’t outperform as much as U.S. growth stocks. For the same reason, large-cap index-level valuations outside the U.S. appear more attractive to us than those within the U.S.
Figure 3. Growth Now Dominates U.S. And World Indices, but Not Ex-U.S. Indices
Proportion of index market capitalization accounted for by the top percentile of stocks by size
Source: MSCI, FactSet, Neuberger Berman. Data as of February 27, 2023. Information on historical observations about markets, asset or sub-asset classes is not intended to represent or predict future events. Historical trends do not imply, forecast or guarantee future results. Past performance is no guarantee of future results.
CROSSROADS THEME: INTEGRATING PRIVATE AND PUBLIC MARKET INVESTMENTS
One important exception to our “cash-today-not-tomorrow” preference is the favorable positioning of private and less-liquid markets in the map of our new capital market assumptions in figure 1.
There are three reasons for this. First, a genuine liquidity premium could counterbalance a long-duration earnings profile. Second, we think the new environment is likely to favor active management, as idiosyncratic dispersion between winners and losers widens against a more difficult economic backdrop. Private equity can be seen as an extension of this tilt toward active management, as private owners have more scope to pursue operational improvements in their portfolio companies and more flexibility to respond to tougher conditions. And third, as we mentioned above, the current environment offers a lot of opportunity for liquidity providers, and this is particularly true in private markets: less liquidity and fewer exit routes have led to attractive pricing in private equity secondary markets; and a contraction in bank lending has opened a space for private credit and capital solutions providers.
CROSSROADS THEME: PRIORITIZING INCOME ACROSS ASSET CLASSES
As we mentioned above, figure 1 shows capital market assumptions that favor fixed income over equity.
The estimated return for high yield bonds has increased by some two to four percentage points, with negligible change in estimated volatility. We now estimate that high yield medium-term returns will be the same as equity returns, with around half the volatility. We believe the challenging conditions over the next few years are a substantial threat to earnings (and therefore to equity market prices), but relatively strong balance sheets and a maturity wall that is still two years away make these conditions less of a threat to bond coupons. Moreover, we believe the attractive yields now available from cash and short-duration, high quality credit mean investors face very little opportunity cost for waiting for better opportunities in equities and other risky assets.
CROSSROADS THEME: ADDING FLEXIBILITY AND SHORTENING DURATION IN FIXED INCOME
Let’s consider the two aspects of this theme one after the other.
Before the adjustment in bond yields that came in 2022, shortening duration was all about maintaining fixed-income allocations while limiting exposure to the price decline that would result from a shift up in yields.
Now that interest rates have risen, we believe the case for short duration is just as strong, but different. As usual, the front end of yield curves has moved more than the long end. The combination of high inflation, a very rapid rate-hiking cycle and low long-term growth expectations led to quite an extreme yield-curve inversion. In U.S. and German government bond markets as well as credit markets, investors can now get substantially higher yields at the front end of the curve than at the long end—although it should be noted that the credit spread curve, with risk-free rates stripped out, has steepened.
Figure 4. Risk-free and Credit Yield Curves Have All Flattened or Inverted
Spread of short-duration yields over long-duration or full-index yields (basis points), Dec 2021 and Apr 2023
Source: FactSet, Neuberger Berman. Yield to worst.
On flexibility in fixed income portfolios, the case before 2022 was often couched in terms of the search for yield. As rates declined, it was tempting to try to maintain yield targets by simply holding longer-dated bonds, investing in lower-grade securities and accepting less liquidity—but these choices all came with added risk, and the lengthened duration turned out to be the key one.
We wrote that “a flexible approach that enables investment and rotation across the widest range of fixed income markets” was “more likely to meet portfolio yield targets with a more diverse spread of risk exposures.”
Today, nearer the peak of the rate-hiking cycle, fixed income markets are less volatile and no longer low-yielding. When you can earn more than 8% from high yield and more than 4% from investment grade bonds, what is the benefit of flexibility and a diverse set of asset classes?
Look again at figure 1. We have already observed that we estimate high yield returns will be the same as equity returns, with around half the volatility. But look at what occupies the space in the top-left of our map of capital market assumptions. If you can consider less-liquid markets (such as leveraged loans) or fully illiquid markets (such as private direct lending), we believe there is the potential to decrease your volatility again without giving up any estimated return—you may even enhance return estimates. Moreover, these investments are often higher in capital structures and may come with protective covenants that you don’t get with bonds, helping to reduce risk exposure as the economy slows and defaults start to become more likely.
This continues to support not only our theme of adding flexibility to fixed income portfolios, but also our theme of integrating private and public market investments. We see advantages in being able to share knowledge and make relative-value judgments across the full fixed income spectrum, particularly as often the same borrowers are active in both loan and bond, public and private debt markets.
New Phase of the Game, Same Playbook
When we set out our views in Investing at a Crossroads, we did so assuming that we were going through a major economic and market transition into a profoundly different set of conditions. The challenge was to develop a playbook that was fit for the longer-term outlook, but also robust during the transition itself. We believe that, so far, the playbook we set out six months ago has stood the test.
This is not to say that the rationale for our themes has not changed. It has. During the transition to our new conditions, the themes of quality, value versus growth and regional diversification in equities, and the themes of short duration and flexible credit allocations in fixed income, were primarily about managing downside risk as the interest rate environment changed. Today, as interest rates begin to peak, they are more about positioning for what we consider to be the most attractive return opportunities in that new environment.