This quarter’s Outlook is all about how surfaces can hide complexity and opportunity. As the S&P 500 Index breaks new records even as U.S. Treasury yields fall in anticipation of rate cuts, we believe it is time to be more cautious in overall stock and bond allocations. We see opportunities, however, to take advantage of underlying market dynamics. High-beta, small-cap and pro-cyclical stocks have not fully participated in the market advance, and we see pockets of attractive value and yield in global bond markets. As such, even as we move toward more neutral high-level asset-class views, we are pursuing stronger ideas for sub-asset class positioning, just beneath the surface.
One of the biggest puzzles facing investors in 2019 has been the way equity valuations have surged on a wave of apparent optimism at the same time as safe-haven government bond yields have plumbed new depths of apparent pessimism. One of these markets must be getting the outlook badly wrong, says conventional wisdom. Which is it?
We are not convinced there are pieces missing from this puzzle. We can go some way to explaining the phenomenon with simple mathematics: as bond yields fall, so do the discount rates on future earnings. All other things being equal, equity valuations will therefore rise. More pieces of the puzzle fall into place when we consider that both equities and bonds are pricing in the more dovish stance adopted by the major central banks—that has dragged down yields, but also supported stock markets as investors begin to anticipate the resulting stimulus effect. Both markets are manifestations of the looser financial conditions that form the objective of the new policy stance.
But we think the picture really becomes clear once we take a closer look at what has been happening within equity markets. For sure, most equity indices have performed well this year. It is important to note, however, that the U.S. has outperformed the more pro-cyclical, global trade-oriented European and emerging markets despite the apparently attractive relative valuations available there in January. Investor caution is evident in global equity allocations.
That caution has also been evident within the U.S. market. During this year’s rally, large-cap stocks have significantly outperformed the more pro-cyclical, lower-quality mid and small caps. Things look even starker when we split the market into low- and high-beta stocks: low-beta has been outpacing high-beta for years, and has opened up a near 14-percentage-point gap over the past 12 months alone. High-beta stocks are the more volatile of those stocks that are the most sensitive to the movements of the overall market—again, this pattern betrays how much caution and desire for safety underlies the new record highs being set by the S&P 500 Index.
That caution is warranted. The tensions between the U.S. and China on trade have been worsening for much of this year rather than easing, as many had expected. Concerns about deflation have gripped markets following recent soft Consumer Price Index (CPI) releases in both Europe and the U.S., and volatile U.S. non-farm payrolls and wage data. The message from the European Central Bank (ECB) and the Federal Reserve about the importance of maintaining their inflation targets over the long term has become more urgent.
We think we may be in the trough of economic performance and sentiment, however. Investors were cheered by the apparently productive meeting between presidents Donald Trump and Xi Jinping at the G20 meeting at the end of June. The U.S. dropped its threat of new tariffs and adopted a softer stance on Huawei, and both sides pledged to keep talks open. On inflation, while CPI releases appear weak, we believe some of this is due to temporary effects, such as gaps in the data due to the U.S. government shutdown at the start of the year. After undershooting expectations in May, U.S. payrolls data bounced back strongly in June. And beneath the surface we see potential evidence of higher future inflation creeping into some of the more leading indicators (see “Up for Debate: Are We Finally Going to See Some Inflation?”).
We do think that the Fed will deliver 25 to 50 basis points of cuts by the end of the year, but, particularly after the June payrolls print, we also think we will see clearer evidence of higher inflation before the central bank has time to deliver all of the cuts that futures markets are currently pricing in. At that point, the prospect of a more benign, moderately rising inflation environment, as well as the stimulus of looser global financial conditions coming from the potential long-awaited weakness in the U.S. dollar, could make investors more inclined to adopt risk.
That could be tough for core government bonds and positive for risk assets. Nonetheless, for now the AAC has reserved a strong underweight view only for deeply negative-yielding markets such as German and Japanese government bonds. It retains a moderate underweight in U.S. Treasuries. In addition, this quarter it decided to downgrade its view on global equities to neutral.
The third quarter tends to be a time of scant liquidity and high volatility. We also anticipate a few more weak economic data prints before the picture turns around more decisively. And while the market can get things wrong, it is risky to bet against it when it expresses the kind of certainty we currently see in bond and rates pricing. As a result, our high-level asset class views have moved toward neutral market weights.
Beneath the surface, however, there are nuances to this view. The AAC has begun to identify opportunities as its outlook gets firmer. The clearest example is our less-than-favorable view on the important U.S. large-cap market. With 2019 S&P 500 earnings growth projected to come in around 3%, according to FactSet, and the forward price-to-earnings ratio having already leapt from 14-times to 17-times in the first half of the year, we think there is limited scope for further appreciation, relative to some other markets.
In short, U.S. large caps appear fairly valued to us, whereas other markets appear somewhat undervalued. To identify those other markets, we think it helps to envision a potential future rotation from low-beta to high-beta exposure, and from low to high global exposure.
For example, the AAC has maintained its overweight view on Directional Hedged Strategies while moving to a neutral view on Lower-Volatility Hedged Strategies. This is largely a recognition of the poor opportunity set in relative-value and arbitrage strategies when correlations are so high and interest rates are so low, but it also reflects members’ willingness to retain some beta within its overall view on alternatives. The AAC has upgraded its view on U.S. small caps, which have lagged large caps by 16 percentage points over the past year, as they can be a good source of high-beta exposure, especially if we see an eventual recovery in risk appetite and inflation that is accompanied by higher energy prices.
A little more tentatively for now, but something to watch, is the AAC’s view on Japanese and European equities. Today these trade at similar valuations as the S&P 500 six months ago, and they can bring a combination of both high-beta and high global exposure.
We do not think that Japan’s domestic economic indicators have bottomed-out yet, and the proposed sales-tax hike in October will likely be an additional headwind. But Japan’s stock market is much more tightly geared to the global than the domestic economy, more so than any other developed market. Share buybacks are currently running at their highest levels since 2006, reflecting attractive valuations and insiders’ expectations for upward earnings revisions later this year.
In Europe, by contrast, the domestic challenges that have dominated risk in the past decade have been receding for some time already. The banking system, lending levels, employment, wages and consumer confidence have been improving steadily for two years or more. Earnings and equity market multiples have been held back by rising tensions around global trade and specific problems for the auto industry.
As in the U.S., there has been extreme divergence between the performance of defensive and pro-cyclical sectors in Europe, with the latter pricing in an environment of persistent zero growth. Should trade tensions cool, inflation stabilize and global financial conditions improve, this will likely look overdone. It is notable that, just as the U.S. Manufacturing Purchasing Managers’ Index (PMI) has entered a steep decline, the Euro Zone Manufacturing PMI appears to be bottoming-out. The same bottoming-out is evident in Europe’s pro-cyclical stocks. The AAC’s marginal downgrade to a neutral view overall on non-U.S. developed market equities conceals, beneath the surface, a cautious but firming bias in favor of more cyclical, globally geared sectors.
An easing of trade tensions between the U.S. and China, together with a shift in the balance of risks toward a weaker U.S. dollar, might also be expected to benefit emerging economies. Emerging markets have lagged U.S. large caps by some seven percentage points so far this year. The AAC remains cautiously optimistic that China’s stimulus efforts will continue to gain traction and return us to the upside data surprises that characterized the first quarter of 2019. While a weaker dollar would be a tailwind for emerging market equities and currencies, supporting the Committee’s overweight views on both asset classes, members also noted that growth concerns weigh a little heavier here than in non-U.S. developed markets.
Given our core outlook, it is inevitably more difficult to find places to spend risk budget in fixed income. We favor inflation-protected securities, where we believe deflation fears have left attractive valuations, even if inflation turns out to be weaker than we anticipate (see “Up for Debate: Are We Finally Going to See Some Inflation?”). The only other places we find attractive for sovereign risk are emerging markets and the southern euro zone—again, these are higher-beta exposures that leaven the general underweight view in fixed income and credit.
The AAC is favorable toward high yield bonds and loans, where supply-and-demand technicals are supportive, but it sees particular value in high-quality, BB rated credits as the market becomes more discerning on fundamental risks. This view is also supported by the fact that the relative value case for emerging markets hard currency debt against U.S. high yield is not as clear as it has been over recent quarters.
In summary, while the AAC’s index-level views show a moderate underweight in fixed income assets and a largely neutral stance with regard to equity markets and other risk assets, beneath the surface the Committee is preparing for a rotation into a broadly inflationary, risk-on environment. The catalyst for that rotation could be further positive news on trade relations, firmer growth and inflation data, especially from outside the U.S., or, perhaps ironically, the first Fed rate cut in more than a decade.
These views remain cautious for now, however, as we wait for seasonal, technical and fundamental dynamics to play out over the coming quarter. By the next Outlook, we hope to see clearer confirmation of the next leg of what is now the longest expansionary cycle in modern U.S. history.