A Gentle Descent Back Into Balance
As 2018 drew to a close, the leaders of our investment platforms gathered to talk about the evolution of the investment environment over the past 12 months and the key themes they anticipate for 2019.
Erik Knutzen: It’s been said that mature part of the business and credit cycle is the hardest time to invest, and the volatility of 2018 highlighted the reasons. From here, market participants know that a late-cycle melt-up is always a possibility, but they are also starting to look over the horizon at recession risks, and the result tends to be heightened volatility and tighter asset correlations. We certainly saw that in 2018, really for the first time since the financial crisis. I think we would all anticipate similar dynamics in 2019, albeit with a low probability of seeing signs of recession over that period.
Brad Tank: In the fixed income team right now our main thesis is one of a “soft landing” for the U.S. and, by extension, global markets. We see U.S. GDP growth decelerating from 3.5% to 2.0 – 2.5%, and the Fed hitting the pause button for at least the first half of the year.
Joseph Amato: Should we be worried about a flat or inverted yield curve?
Tank: We don’t think so. Rates at the short end of the curve are certainly influenced by the Fed and the U.S. economy, but at the long end it’s all about global growth and inflation. A flat yield curve today is just the result of Fed rates being higher than rates in most of the rest of the world, which in turn is just a sign that these economies are at different points in the cycle.
Amato: In the U.S., it appears that we are closer to late-cycle than mid-cycle now. We see liquidity coming out of the system, and we can see the peak of the rate-hikes mountain through the mist. Global growth slowed through 2018, the U.S. is likely to slow in 2019. But as Brad says, it’s hard to generalize because we are at different stages of the cycle in different regions. Some of our research is starting to pick up on signs of recovery in non-U.S. growth. The data is not fully demonstrating that yet, but it’s part of our outlook for 2019, which is the main foundation for continuing with our overweights on emerging markets, both debt and equity, in our multi-asset class views. If we thought that global growth was going through a broad slowdown, then we wouldn’t maintain that sort of risk-asset exposure.
Anthony Tutrone: Does this include China? I think it has to, as what happens in China will determine much of the view on risk in Europe and the emerging world. All through 2018 what I was hearing about was weakening in China.
Knutzen: Right, and the two key risks I’ve found that our clients have been focused on are the risk of a Fed overshoot, which we should come back to later, and the risk of a hard landing in China.
Amato: Last year we anticipated that China’s structural reforms—President Xi’s pivot from pace of growth to quality of growth—could suppress short-term performance. That’s exactly what happened in the first half of the year, but since then the authorities are back in stimulus mode.
Knutzen: There are still big questions around China, both domestically and in terms of the trade tensions with the U.S. How strong and how effective will the stimulus be? Is there an effective transmission mechanism without pumping up bubbles in wealth management products and real estate? So far I think we have to give the benefit of the doubt: even as they seek to stimulate, they are not pumping up the old bubbles, there is still restriction of wealth management products, and still a desire to open domestic markets. Combine Brad’s “soft landing” in the U.S. with an effective stimulus in China and perhaps some easing in the trade tensions, and that could add up to a decent tailwind for re-convergence in non-U.S. growth and global risk assets.
Tank: There are risks out there that can conspire to produce a negative quarter or two—things like a total breakdown in talks between the U.S. and China, or growing political and policy risk in Europe—and while I don’t think negative growth will materialize in 2019, some of those drivers could make themselves evident. In terms of our views on non-U.S. markets, I think it’s important to recognize that the action on politics and policy in 2018 has been focused in the U.S., with the change in leadership at the Fed, tax cuts and the trade issue, and in emerging markets, especially Turkey, Argentina, Brazil and Mexico. There is no doubt that the Democrats getting back control of the House of Representatives could lead to a certain amount of mayhem if they launch a raft of investigations of the White House. But, overall, 2019 is likely to see the spotlight move more decisively over to Europe. Brexit is due at the end of March, Italy has to implement the budget it has agreed with the EU, a clash with the populist governments in the east is a possibility, the situation in Ukraine is worsening again, and we have the end of the Merkel era in Germany and the end of the Draghi era at the ECB. Who would have predicted, 18 months ago, when France was flying high on the Macron election, that we’d be seeing widespread civil disturbance and tear gas on the streets of Paris at the end of 2018?
Amato: The risks are real. Of course, the surprise could be that, as in 2012, Europe doesn’t implode, and an easing of tensions leads to economic and market recovery being realized. Overall, however, it supports the case for tilting toward emerging markets and Japan over Europe when looking for risk exposure outside the U.S. If you accept that recession probability is low in 2019, and if Europe gets through the year unscathed, you could stand to benefit through emerging markets without so much exposure to the potential downside risks.
Tutrone: How do lower oil prices relate to these views?
Amato: The move in 2018 was certainly supply-led rather than demand-led. It doesn’t appear that U.S. supply is about to slow, so the future direction probably depends on decisions out of Russia and OPEC. Our view is that there is upside from here—even if we only went back to the 2017 OPEC quotas, the market would have 1.3 million barrels less per day—but it makes sense to be cautious, given short-term supply uncertainties. Overall, the developed world plus China is a net user and the emerging world is a net supplier, as a rule of thumb; and subdued oil prices, and therefore subdued inflation and a weaker dollar could support non-U.S. recovery and convergence.
Fixed Income: The Pause That Refreshes
Tank: Mention of inflation and the dollar feels like a good opportunity to run through our views on Fed policy.
Amato: If you’re expecting a soft landing for the U.S. in 2019, is this a case of “the pause that refreshes”? And what are the risks to that? It seems to me that the Fed is caught in a tricky balancing act: it would be easy to overshoot with rates, but it would also be dangerous to blink in the face of a few soft data points or a particularly volatile session in the markets.
Tank: We think the Fed will now pause for at least the first half of 2019. To be clear, we don’t expect any change to balance-sheet policy, so we are still transitioning from QE to QT, but slower growth and subdued inflation will likely cause the Fed to pause. As Erik noted, however, people we speak to still rank the risk of a Fed overshoot, premature tightening, among their top risks. That is understandable. When we get a couple of strong data points on the U.S. economy the markets are still reacting by flattening the yield curve. That suggests they see the possibility of premature tightening if the data continues to be strong, pushing the front end up on rates and the long end down on a tightening-induced recession. It is notable that some of the forecasts we are seeing talk about a substantial slowdown in global growth but still hikes from the Fed because of inflation, driven primarily by the tight labor market, in the pipeline.
Tutrone: Where do you see credit markets? They’ve clearly become more volatile lately, and in the private markets we have started to see some of the financing for more aggressive capital structures and weaker underlying businesses fail—investors are starting to show signs of fatigue and weariness about the current market environment.
Tank: For 2018, we anticipated that investors would continue to seek yield outside of their credit normal comfort zones and we definitely saw that, right up until October and November. The first half of the year was marked by substantial non-U.S. participation in U.S. credit markets, spread markets in general held up remarkably well, given the volatility going on in equities, there was huge demand for BBBs in investment grade and bank loans in high yield, and CCCs in particular outperformed. That switched around in the last three months of the year. Investors refocused on fundamentals rather than allocating to trends. As the U.S. economy slows next year and credit markets become more two-way in their trading, we expect that sector-by-sector and credit-by-credit differentiation to become still more important. From a top-down point of view we still like emerging markets, which went through their major correction in 2018, when the rest of the credit complex was so becalmed.
Equities: Attractive Valuations Are Back
Amato: That’s a theme in equities, too, going back to the point I made earlier about the U.S. experiencing late-cycle dynamics while the rest of the world is more mid-cycle. For the U.S., our base case is that top lines will be under pressure from slower nominal GDP growth, and margins will be squeezed a little by rising wage inflation. However, starting from modest multiples, we believe that 5% earnings growth and 2% in dividend and buyback income could leave us with a high single-digit total return for 2019 that most of us would be happy to take to the bank in the current environment. The thing about the late stage of the cycle, however, is that sentiment can take over: if the Fed is done with rate hikes the market can start pricing in a more extended cycle, and then multiple expansion and above-average returns are an imaginable outcome; if the Fed overshoots, earnings growth comes into question, and we could see further pressure on equity returns, and 2019 being a down year. The potential range of outcomes is wide. Some of that uncertainty could be taken out if you tilt your equity exposure from the U.S. to non-U.S. markets, simply because they are starting from even lower multiples, and with more mid-cycle dynamics behind their earnings.
Knutzen: I would take two points from that. First, any late-cycle melt-up in U.S. equities is likely going to come from multiple expansion rather than an upside earnings surprise, and therefore, we believe the thing to watch as a sign of excess or a trigger for any rally to expire would be unsustainable valuations. And second, emerging markets and Japan, rather than Europe, for the reasons discussed earlier, may be where the opportunities lie outside the U.S.—with what happens in China being a bit of a wild card for risk appetite overall.
Alternatives: Opportunities as Fundamentals Come Back into Play
Tutrone: In terms of market dynamics and structure, all of this points to the same thing we got in 2018—just more so. More volatility, volatility spreading to credit markets, higher asset-class correlations but greater fundamental differentiation within asset classes. That ought to be a favorable environment for hedge fund and absolute return strategies, both to find trading opportunities and to show that they can dampen portfolio volatility. As it turned out, while some of the relative-value strategies that we favor managed to perform well throughout 2018, in general managers gave much of what they generated early in the year back again after October.
Knutzen: The timing of some of the volatility shocks in 2018 caught managers out, it seems, and some were wrong-footed by crowded trades, especially in certain factors and risk premia.
Tutrone: I think that’s right. I believe higher volatility will continue, and there will be a worsening outlook for equity returns, so it remains to be seen whether the hedge fund industry can do a better job of capturing that in 2019. The picture in private markets is much clearer, given the inflated valuations and aggressive leverage have gone in the traditional private equity buyout sector. It is true that commitments made now will be put to work over the next three or five years, so the current environment should have less of an impact on your ultimate performance in five or seven years’ time. Having said that, investors should still be thinking about selecting managers who are disciplined, who don’t over-leverage their companies’ balance sheets, and who focus on creating value through operational improvements that generate alpha rather than just generating leveraged beta exposure. I believe we are seeing that, actually. There is more and more interest in strategies that are not exactly “niche,” but are different from the traditional large buyout strategies. Good examples in our own business would include buying minority investments in alternative asset management firms themselves, healthcare and trademark royalties, and private debt and specialty finance strategies.
Knutzen: Earlier you mentioned that some of the financing of these buyout deals was falling through.
Tutrone: That’s right, and I think that could be the key to opportunities in one such off-the-beaten-track strategy in 2019. In private debt, appetite for some of the riskier capital structures and weaker businesses is not what it was, and deals have started to be pulled that would have gotten done six months ago. When those companies come to refinance in 2019, more and more of them are likely to hit problems. On top of that, there is a record amount of barely investment grade credit in the BBB sector which, if downgraded, could put pressure on the high yield market to absorb it. Private credit strategies that invest through the secondary markets could, given the volatility that may be coming, find opportunities over the coming 12 months.
Knutzen: Let’s summarize our key themes for 2019, then. At the macro level, we anticipate a moderate slowdown in growth in the U.S., paired with a modest recovery in the rest of the world, helped along by stimulus out of China. Risks to that include a failure of that stimulus, European political risk and a worsening of the trade outlook. That view would translate into a more dovish Federal Reserve, with rate hikes pausing earlier and lower than currently expected although the risk of premature tightening is still on the table given underlying wage-inflation dynamics. It would also imply modest returns from U.S. equities, driven by higher valuations rather than higher earnings growth, and modest returns from U.S. credit, driven more and more by fundamentals rather than trends. Risk assets in the rest of the world, and particularly emerging markets, may deliver better returns as performance re-converges with what we got from the U.S. in 2017 and 2018. All of this reflects our belief that the U.S. is probably late in its cycle while the rest of the world remains in mid-cycle. And finally, we believe that volatility and cross-asset correlations will remain elevated, making a case for hedge funds and for more niche or opportunistic private markets strategies, away from the traditional buyout herd. It will be interesting to revisit these themes at our mid-year meeting in 2019.