Macro: Entering a New Age
Fixed Income: Rates Adjust, Investors Embrace Flexibility
Equities: Reflationary Themes
Alternatives: No Longer Alternative
– Erik Knutzen
Macro: Entering a New Age
Brad Tank: We are now settled into this new business cycle, so let’s think about what kind of cycle it’s going to be.
After the disruption of the Great Financial Crisis (GFC), a lot of commentators expected a phase of short, volatile business cycles. There were events like the crisis in Greece and the wider eurozone or the emerging markets and commodities downturn in 2015 that, in previous decades, might have tipped the balance. But nothing knocked the global economy off course, and the record-breaking expansion may well have persisted without the exogenous impact of the pandemic. There has been a trend toward longer cycles in developed economies, due in part to the shift away from manufacturing to services, and to more efficient, globalized, just-in-time supply chains. But the most important new element was the post-GFC ability and willingness to support the cycle with substantial monetary and fiscal policy interventions. That included emergency measures, such as Mario Draghi’s “whatever it takes” extension of the European Central Bank’s mandate, but also measures that far outlived the emergency, from zero rates and quantitative easing (QE) to President Trump’s late-cycle corporation tax cuts. When the pandemic hit, we doubled down with those new tools. QE was extended to all kinds of assets and fiscal policy now appears to be limitless—or at least, the global bond market appears pretty accepting of it, so far. That suggests to me that the base case is another long cycle, backed by a central bank and fiscal policy “put option.”
Joseph Amato: I think the big caveat is that everything is happening much faster in this cycle. Hitting the trough and achieving the recovery was a much shorter process than in previous recessions. And while there is generally a mid-cycle feel to things now, there also seems to be a lot of late-cycle bubbles and substantial inflationary pressures.
We’re also thinking harder about one of the themes from last year: “Supply chains become shorter and more diversified.” We’ve seen that in corporate decision-making. As you’ve written, Brad, one of the reasons we are likely on course for higher inflation in this cycle is because companies are taking long-lasting action to tackle a transitory—but extremely disruptive—supply-and-demand crunch. If you open two or three locations across Asia to take the slack of your big one in China, or you re-shore production, or you start carrying more “just-in-case” inventory, that is likely to eat into earnings for a time, exacerbate inflation, and potentially bring back some pre-1980s volatility to the business cycle.
Erik Knutzen: For some of the reasons Joe outlines, I think we could be in for a long expansion, supported by central banks and fiscal stimulus when necessary, but with heightened volatility. And I mean volatility in economic activity and data, volatility in politics and policy, feeding through into volatility in financial markets.
Tank: I agree there are reasons to expect that kind of volatility over the short term, and that could extend through the coming year. But longer term, I believe that the central bank and fiscal “put option” continues to be a volatility dampener—at least until markets stop believing in it. What could cause a loss of faith? A crack-up in inflation and rates could be a threat, or a bubble bursting. This time last year, we did not see a threat of substantial reflation. We thought 5% was the ceiling and that the peak would be in the second or early third quarter. Well, we just got the September reading and it’s up again, to 5.4%. It’s higher than we expected, and stickier than we expected.
Knutzen: This is why the inflation question is so critical. And it’s not only a question of transitory or secular, but also how much is driven by supply-side, cost-push factors as opposed to demand-pull factors. Right now, I believe it’s both: pent-up spending meets broken supply chains. Over the medium term, however, the new and significant inflationary dynamics are likely to be supply-driven. Joe mentions “just-in-case” supply chains. There’s the sustainable energy transition, where we could see more supply crunches before we get full capacity with renewables. China used to export disinflation to the rest of the world with its low-cost workforce, but that really faded out a decade ago and its more recent strategic orientation appears to cap the end of that era. And China’s “common prosperity” theme could be reflected globally: the tussle between labor and capital for the spoils of growth tends to go through 20- to 30-year cycles, and profits have outgrown wages since the early 1980s. There are political, structural and demographic reasons to expect labor to capture more over the next generation.
How could central banks respond to this kind of inflation? Their policy tools are less effective against supply bottlenecks or rising wages. They can only step in to dampen demand. But demand isn’t the problem, and dampening it could risk triggering recessions. Over the longer term, capex, technology, automation and general productivity enhancements should be the answer. But over the next year, cost-push inflation and how monetary authorities respond to it are likely to be a key source of potential risk.
Suzanne Peck: One could make a list: the energy transition, China’s “common prosperity” objective, President Biden’s “human infrastructure” fiscal program, the E.U. “Next Generation” fund and environmental program, re-shoring essential supply chains, the required investments in productivity enhancement, the role of central banks. Underneath, there’s a real sense that government has a dramatically enhanced role in the economy. That suggests more regulation and more taxation for both corporations and investors. From the standpoint of the taxable wealth management client, that reinforces a point we have been making for some time, which is the key role of tax-efficient investment strategies that take systematic advantage of opportunities for tax-loss harvesting and tax deferral.
Tank: Absolutely, and it goes further. One of the big lessons of the current inflation spike is that government interventions have dampened the role of market price signals in the allocation of resources. Wages are rising and there are vacancies across many sectors, but, in the U.S., the labor participation rate is well below the pre-pandemic level. Energy prices have spiked, but demand is still there, because governments have spent decades supporting and subsidizing energy consumption: gasoline, for example, has tended to become cheaper and cheaper for the U.S. consumer over the long term, so price spikes have less real impact on demand. Many consumers can afford higher fuel taxes, but governments won’t go there. The irony is that the corporate and financial sectors have often led governments on climate change. Compare the commitments made by the Net Zero Asset Managers Initiative, the Net Zero Asset Owner Alliance, and a huge range of companies, with the foot-dragging on Paris Agreement commitments leading up to COP26. We are advocates of market solutions, but the substantial decisions will likely be made in Washington and Brussels, and they fear the political side effects of market medicine when it comes to sustainability.
Amato: This underlines the importance of identifying and managing these potential risks in portfolios. Sustainability-related investments, even if they can potentially deliver long-term growth, could present short-term costs. But the consumer, political, regulatory and investment agenda can change very quickly, and the more they are driven by politics, the more volatile progress is likely to be. It could mean more supply-and-demand mismatches, inflationary episodes and sudden repricing of assets. Adam Smith’s famous “Invisible Hand” has become the conspicuously visible hand of government in Europe and the U.S.—and China’s visible hand is becoming especially assertive.
– Brad Tank
Fixed Income: Rates Adjust, Investors Embrace Flexibility
Amato: Alongside the reversal of 30 or 40 years of deregulation and government removing itself from the economy, we may also be at the end of 40 years of declining inflation and interest rates. What could this mean for the many investors, both institutional and individual, who rely on long-duration assets?
Anthony Tutrone: Might the withdrawal of central bank asset purchases be the catalyst to kick yields up?
Tank: Our view is that rates are on their way up. But the pace of the adjustment is as important as the direction. We believe it will be gradual and orderly. It’s worth remembering that we are into November and we still haven’t reached our year-end target for the 10-year Treasury yield—with inflation above 5%. It felt like we might blow through it back in March, but demand for fixed income assets is overwhelming, and that is keeping yields low, curves flat and credit spreads, in our opinion, priced for perfection. Finding income with modest or no duration will likely continue to be the priority, in our view, and credit selection should take over from the early-cycle, “credit-beta” play, but market disruption or significant credit issues appear unlikely.
Faced with this combination of low and rising rates and tight credit spreads, investors are likely to double down on their search for short duration, floating rate, and less correlated sources of income. They may complement this with more tactical positioning whether that be in interest rate risk exposure, asset allocation or into narrower, niche, but attractive markets. What does that mean, specifically? We think we’ll see more attention on short duration credit, loans, collateralized loan obligations (CLOs) and securitized investments, for income with modest duration. Opportunities such as taxable municipal bonds, local-currency emerging markets debt and China bonds could provide less correlated income for those able to move in those directions. And the tactical opportunities might include corporate hybrid securities in Europe or bank capital securities in the U.S. We believe a mix of these short-duration, less-correlated and tactical sources of income is likely to pay dividends in the year ahead.
Amato: It’s notable that you mention China bonds for their attractive yields and diversification benefits. At the same time, China is the one major market where we are starting to see disruption and significant credit issues. Our local team covering the A-Share equity market emphasizes the continuity in the government’s recent regulatory announcements, but they also note that the new articulation of those goals will create new winners and losers. Sustainable energy and 5G connectivity are likely to receive a strong tailwind, but other types of infrastructure and especially real estate now face headwinds, as do some other sectors, from private education to e-commerce.
Knutzen: Our colleagues in China have written about how important it is to understand that it is a policy-driven market. That policy is evolving—but it doesn’t suddenly make China an uninvestable market. It’s about allocating to the opportunities that the authorities have identified as priorities.
Tank: For fixed income investors, it’s a complex but interesting opportunity set. We do think the government is likely to ring-fence Evergrande, thereby containing much of the volatility in the high-yield property sector. Spreads in investment-grade corporates and financials are tight, due to a flight to quality, but China’s monetary and fiscal policies are now moving in a more accommodative direction than in most developed markets, and that could support China government bonds, offering attractive yields and the potential for spread-tightening against developed market government bonds.
– Joseph Amato
Equities: Reflationary Themes
Amato: In equities, generally speaking, we think the reflationary environment is likely to lend support to sectors such as Materials, Energy, Industrials and Financials over Consumer Staples, Healthcare and Communication Services, as well as value over growth stocks. Longer-duration growth stocks have been recovering since Treasury yields hit their peak in March 2021, but as yields start to edge up again, value is likely to reassert itself. If we get a weaker U.S. dollar over the coming years, which is the Equity Team’s core scenario, that could add impetus to these dynamics.
Knutzen: Our Asset Allocation Committee (AAC) follows through on that with its latest regional market views. We generally favor non-U.S. developed and emerging equity markets over U.S. large caps, which reflects that reflationary, weaker-dollar outlook. Within emerging markets, however, we downgraded our view on China to neutral while upgrading India to an overweight, particularly its technology and innovation sectors, which we see as emerging as centers of development to rival others in Asia.
Amato: I think emerging markets face significant challenges. They have fewer fiscal resources to battle the economic impact of the pandemic. It has generally had less access to vaccines, which has meant either higher incidence of COVID-19 or greater and longer-lasting reliance on lockdowns and social restrictions. They are also generally more exposed to supply-chain disruption, inflation risk and the slowdown in China. There are pockets of opportunity, but I believe emerging markets as a whole are not the clear opportunity they would usually be at this stage of a cycle.
For really attractive opportunities, we think the value style is more interesting, and especially equity income as a subset of value. The price-to-book ratio of the S&P 500 Dividend Aristocrats Index relative to the broad S&P 500 remains 18% below its long-term average and has only just started to recover from its trough during the pandemic.1 Moreover, while there is strong correlation between high starting valuations and the subsequent 10 years’ total return, the more important dividends are as a proportion of a portfolio’s total return, the weaker that correlation becomes. That’s worth noting if you’re concerned about market valuations.
Income is also interesting if you believe we are in an environment of structurally higher inflation. Global dividend growth has been highly correlated with U.S. inflation: dividends tend to grow faster than inflation, because they are generally paid out as a ratio of nominal earnings. That is why, over the past decade of subdued inflation, declining rates and outperforming growth stocks, European and U.S. dividend growth have been very subdued. Since 1945, S&P 500 dividends have grown by 6.5%, annualized, and have never grown by less than 2.2% during any 10-year period, making the past decade very unusual and suggesting a lot of catch-up potential. In addition, the relative stability of traditional income stocks’ earnings and dividend growth has tended to make them much less sensitive to changes in interest rates than the growth stocks that are now so dominant in large-cap indices, and that could be advantageous in a rising-rate environment.
Knutzen: This is really important for investors to bear in mind when they think about the challenge of dampening portfolio volatility and introducing some inflation exposure while also trying to avoid introducing a lot of interest-rate sensitivity. Increasing the traditional government bond allocation raises portfolio duration. Instead of that, dividend income may have a role to play here.
Amato: That may be one reason why flows into developed market dividend-focused funds appear to have picked up quite sharply since the spring of this year.
– Anthony Tutrone
– Suzanne Peck