By Erik L. Knutzen, CFA, CAIA, Chief Investment Officer - Multi-Asset Class
Markets shift focus after U.S. post-election tear.
After the post-election tear delivered by U.S. stocks, the Neuberger Berman Asset Allocation Committee (AAC) turns its attention to markets that appear to offer more attractive valuations, particularly in Europe and the emerging economies, which have benefitted from a global economic upswing. At the same time, the AAC is also looking for meaningful progress on U.S. tax reform following the new administration's recent failure to repeal and replace the Affordable Care Act. Indeed, markets generally are anxious about the pace of legislative change in the U.S. and will be eager to see hard evidence of the administration making headway with its initiatives.
Since the election of Donald Trump as U.S. president, global markets have been transfixed by the events unfolding in the U.S. Buoyed by promises of tax cuts, regulatory easing and increased infrastructure spending, U.S. equities surged to new highs. At the same time, fears of the negative impact of "America first" policies outside the U.S. have yet to be realized, and concerns about trade wars, currency imbalances and rising volatility have faded into the background - at least for the moment.
But while U.S. stocks have been on a tear since the election, more recently they have shown signs of pausing for breath, as illustrated by a modest pullback in late March. Investors have been riding market momentum - and it may continue for some time yet - but in our view, the longer the rally continues, the greater the chances the market will experience a correction.
Indeed, there does appear to be a growing disconnect between the headlines and the underlying data, with positive sentiment seemingly driving much of the recent fund flows as fundamentals lag. This shouldn't unnerve investors unduly, however; such disconnects happen often and are part of the natural workings of the market. Against this backdrop, though, investors may want to prepare themselves for the possibility of short-term corrections, while remaining alert to attractive buying opportunities.
Given the huge weight of expectations surrounding the election of Donald Trump and the Republican congress, there is also the potential for some disappointment at the pace of legislative change. Indeed, the failure to repeal and replace the Affordable Care Act (aka Obamacare) in March - with House Speaker Paul Ryan pulling the plug before it even went to a vote - will only compound these concerns. The new administration is now expected to focus its efforts on tax reform, with markets keen to see evidence of progress sooner rather than later. Infrastructure spending, meanwhile, appears likely to be placed on the back burner and may not be passed until early next year.
We were particularly encouraged, however, by signs of a revitalized U.S. Federal Reserve, which, under Chair Janet Yellen, is moving swiftly and decisively to return interest rates to normalcy. As Brad Tank, our CIO of Fixed Income, observed in a recent CIO Weekly, "Pitch Perfect - Yellen Hits a High Note," the Fed now has the opportunity to be much more preemptive in its decisions to raise rates, avoiding the need to chase inflation later in the economic cycle. Indeed, the confident manner in which the most recent rate hike was implemented cheered bond and equity markets alike. We believe there will be two or three more rate hikes before the end of the year.
Meanwhile, global conditions have been steadily improving. In Europe, the economy is slowly but perceptibly recovering after years of moribund growth. Business and consumer sentiment are improving, and economic indicators are ticking up. Eurozone PMIs recently hit a six-year high, for example. Indeed, the European Central Bank is expecting economic growth of 1.8% this year and something similar next year.
In Asia, Japanese equities have been benefiting from the weaker yen and the upturn in global growth, even as questions remain about the progress of prime minster Shinzo Abe's economic reform program. Elsewhere in Asia, concerns about a hard landing in China are on the back burner, with net capital inflows into China turning positive in February for the first time in three years, according to the Institute of International Finance. Emerging markets, more broadly, are enjoying a renaissance, with companies seizing the opportunity to grow their businesses more rapidly, besting major markets over the year to date. Indeed, year to date through March 31, emerging markets equities are up 7.5% in local currency terms and 11.1% in U.S. dollar terms as measured by the MSCI Emerging Markets Index. EM debt, meanwhile, has risen by 6.5% as measured by the JP Morgan GBI-EM Global Diversified Composite Unhedged USD Index. EM valuations do look stretched in some areas, and there are nagging concerns about the possibility of renewed trade tensions, but in aggregate, emerging markets currently look attractive.
Market/Regional Views: All Together Now
The conditions described above amount to a synchronized global recovery. True, at this stage it's still quite fragile, but the positive signs are all there. Combined with attractive valuations outside the U.S. and continued accommodative central bank policy worldwide, improving global fundamentals may nudge investors away from a myopic fixation on the U.S. to expand their focus to a broader set of opportunities.
Given these developments, we recalibrated our asset allocation outlook to account for shifting opportunities. We remain positive about the American growth story, maintaining a slight overweight on U.S. small- and mid-cap equities, which are less likely to be hurt by potential international trade tensions or an overly strong dollar. At the same time, we trimmed to neutral our outlook for U.S. large-cap equities in recognition of the spectacular run they've enjoyed over the last four-plus months.
Outside the U.S., we moved to a slightly overweight position on developed market equities, encouraged by the global growth story and improving fundamentals. We also adjusted our emerging market equities position from slightly underweight to neutral, as the asset class is increasingly attractive on a relative basis as fears of aggressive anti-trade policies from the new U.S. administration have moderated.
In fixed-income markets, we continue to prefer credit relative to U.S. Treasuries and other developed market government bonds. As mentioned previously, the U.S. Federal Reserve is setting the pace in terms of interest rate hikes. Central banks in Europe and Japan, however, remain cautious; until there are clear signs of entrenched inflation in the system, policymakers outside the U.S. are likely to maintain an accommodative bias. Our view, however, remains that interest rates will rise globally this year, driven by higher economic growth and burgeoning inflation. The risk, of course, is that the onset of normalization by the ECB and other major central banks may inspire a big move up in rates, which likely will have a significant impact on bond and currency markets.
With the prospect of higher inflation in the pipeline but still modestly priced, one area of government issuance we find attractive is inflation-linked bonds such as TIPS. In credit, we grade high yield as neutral, but prefer it over investment grade debt. We moved our emerging market debt view from slight underweight to neutral, consistent with our improved outlook for developing countries as fears of anti-trade actions from the U.S. administration have abated.
In alternatives, we lowered our outlook for commodities to neutral due to increased supply in industrial metals and energy, where U.S. shale production is cranking back up and concerns grow about OPEC members' ability to adhere to production limits. We remain neutral in private equity; while mindful that current valuations are elevated, we still believe private equity and private debt strategies can deliver an illiquidity premium over public markets. In hedge funds, new alpha opportunities are emerging on both the long and short side of the trade as inter-stock correlations subside and interest rates have normalized. In terms of strategies, both distressed debt and global macro continue to look attractive, especially if volatility starts to rise.
What Lies Beneath
Headline volatility remains low. Indeed, we are surprised that the CBOE Volatility Index (VIX), sometimes dubbed "the fear index," is currently so subdued. This indicates investor sentiment is still strong, so in that sense it's positive; however, we have no doubt that volatility will rear its head again. In fact, we saw a modest rebound toward the end of March, for example, when it rose slightly after lying dormant for nearly two months. This occurred as the S&P 500 had its largest one-day fall since last October and the dollar's rise was halted in its tracks.
More generally, we are starting to see pockets of volatility emerge elsewhere in the world, particularly on a single-name or single-sector basis. The lack of headline volatility is partly explained by a collapse in correlations across sectors and securities. Post the financial crisis, stock prices have largely moved in tandem with one another, but this relationship may be breaking down as the Fed nudges rates upward while central banks elsewhere in the world maintain their loose monetary policy. This also suggests that central banks are no longer driving asset prices to the extent they once were.
Volatility may also rise as a result of increased political risk. Joe Amato, president and CIO of Equities, discussed this recently in an article about the many potentially contentious elections taking place in Europe this year. The Dutch election in mid-March resulted in incumbent Prime Minister Mark Rutte winning the largest share of the votes, allaying market fears of another populist upset in the form of far-right populist Geert Wilders. Political risk is likely to remain elevated, however.
The U.K., in late March, triggered Article 50 of the Treaty on European Union, formally launching "Brexit" negotiations. The second round of French elections will come in May, when it's likely the independent center-left candidate Emmanuel Macron will go head to head with the right-wing nationalist Marine Le Pen, and German federal elections loom in September. If these elections have favorable outcomes from an investment perspective - with Macron winning in France, for example, and Chancellor Angela Merkel maintaining power in Germany - risk will likely recede, which could fuel a meaningful lift to European equities.
Against this backdrop, we believe investors need to look beyond the political noise and focus on the fundamentals, while also preparing themselves for the possibility of renewed volatility - in other words, to make volatility their friend. We believe investors can work volatility to their own advantage by diversifying their portfolios using volatility capture strategies. These can include income-oriented strategies, which are particularly helpful in a rising interest rate environment. And there are many other tools available that seek to capture return while mitigating risk.
We observed at the beginning of the year that it would probably take longer than expected for the new Trump administration to find its feet and start implementing meaningful economic reform - and this has indeed been the case. In the meantime, investors have the opportunity to further diversify their portfolios by taking advantage of opportunities emerging elsewhere in the world, most notably in parts of Europe and Asia.
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