By Joseph V. Amato, President and Chief Investment Officer - Equities, Erik L. Knutzen, CFA, CAIA, Chief Investment Officer - Multi-Asset Class, Brad Tank, Chief Investment Officer - Fixed Income, and Anthony D. Tutrone, Global Head of Alternatives
In January, the heads of our four investment platforms identified the key themes they anticipated would guide investment decisions in 2018. With the year now half over, we revisited these concepts to see how they've played out thus far.
Below, we present a midyear assessment of our expectations and an update for the back half of 2018.
Macro: Global Inflection Point Nears
"Goldilocks" Gives Way to Something More Complicated | True
What we said: Though the strength of global economic momentum is undeniable, a confluence of factors - including tightening central bank policy, plateauing economic growth and rising market volatility - suggests that conditions are unlikely to remain "just right" for all of 2018.
What we've seen: After a placid January, interest rate and inflation pressures and geopolitical disquiet introduced anxiety to markets, even as global economic fundamentals remained supportive, if somewhat divergent.
Both Monetary and Fiscal Policy Are in Motion Globally | True
What we said: As major central banks wind down unprecedented levels of monetary stimulus, their efforts are being met - and potentially complicated - by expansionary fiscal policy and reform initiatives taking root in a number of countries.
What we've seen: Fed normalization has continued apace even as fiscal stimulus and tax reform complicate its path, though trade tensions and contentious elections threaten to exacerbate the already unprecedented challenge facing it and other central banks.
The first half of 2018 stood in stark contrast with the sanguine environment of 2017. While last year's inclination to look past the slow drain of liquidity from the financial system and pile into risky assets extended through January, investors soon after appeared to acknowledge the potential risks of reduced central bank accommodation. These concerns were compounded by an increasingly divisive and uncertain geopolitical landscape, ultimately resulting in widening credit spreads, choppy equity markets and a stronger dollar. Though market volatility pulled back after spiking in the first quarter, we anticipate it may return in earnest in the second half of the year as the ongoing normalization of global central bank policy continues to test many crowded, popular trades - and do so in volatile fashion.
Rising U.S. interest rates are likely to remain a central theme in the markets. As the Fed grapples with the "neutral" level of interest rates that neither stimulates nor curbs economic growth, its efforts are being complicated by a need to reconcile the economic tailwinds of tax cuts and increased government spending with the headwinds of potential tariffs and other geopolitical strains. We expect the Fed to become more cautious as it approaches its terminal rate, especially given markets' reaction to tighter liquidity conditions thus far in 2018 and the likelihood that G-4 central bank balance sheets will begin to contract in 2019 as the European Central Bank finally steps back from bond buying.
Though we continue to expect global economic growth to moderate, near-term recession risk remains low despite ample uncertainty around changing monetary policy, political risks and trade skirmishes, along with signs of regional divergences in the pace of growth. Europe and Japan are likely to pick up modestly after a sluggish first half. The U.S. economy remains solid and should be boosted by fiscal stimulus, assuming it's not completely offset by an all-out trade war. We believe emerging markets can get back on track after a difficult first half in which these economies finally felt the brunt of the stronger U.S. dollar, higher Treasury yields and some negative political developments in certain countries. In our view, the severity of the market's reaction was unwarranted given the significant improvements in emerging market fundamentals, global economic growth and the terms of trade, and a supportive global macroeconomic backdrop.
Risks: Clouds Gather as the Year Progresses
Geopolitical Climate Remains Unsettled | True
What we said: Though 2017 mostly failed to deliver the electoral fireworks of 2016, elections this year in Italy, Mexico, Brazil and the U.S. - in addition to ongoing disrupters like North Korea, special investigations, Brexit, etc. - could upset the current order.
What we've seen: While the Italian election threw markets for a bit of a loop, the backloaded 2018 political calendar offers even greater challenges in the face of increasingly heated trade rhetoric.
China Accelerates Structural Reforms | Partially True
What we said: An emboldened Xi will be more aggressive in reducing leverage and re-orienting China's economy toward more sustainable, high-quality development, to the potential detriment of near-term growth.
What we've seen: China remains oriented toward reform, but trade tensions and their impact on already-slowing economic growth may further test Xi's resolve.
The year-to-date volatility mentioned earlier likely will be exacerbated by the ebb and flow of geopolitical risks, which in general appear to have swelled. Though the elections with the greatest potential for disruption occur in the second half of 2018 - including those in Mexico, Brazil and the U.S. - Italy's trip to the polls in March introduced its own period of discord. Inconclusive election results ultimately led to an alliance between two populist, euro-skeptic parties whose fractious attempts to form a government had markets increasingly on edge and caused some remarkable bond market moves in late May; the systemic spillover was modest, however. While relative calm returned to Italy, the fundamental threats to the political stability of the European Union remain intact. Populist impulses persist, and refugee policy has become the latest flashpoint; tension in German Chancellor Merkel's coalition over this issue is a testament to the current fragility of European governments. Meanwhile, the March 2019 Brexit deadline looms; with many crucial differences between the U.K. and EU yet to be sorted, governments and businesses alike are preparing contingency plans in the event of a worst-case "no-deal" exit.
Though other recurring sources of temporal disharmony surfaced from time to time in the first half, trade tensions were the center of global attention by mid-year. We think the posturing between China and the U.S. is mostly short-term noise and not the beginning of a protracted conflict that will inflict long-term economic damage on either country, as both parties are well-incented to back away from the cliff. The standoff will likely get worse before it gets better, however, which can also be said of the ongoing NAFTA negotiations, as well as trade discussions between the U.S. and the EU.
It remains to be seen what impact this trade brinksmanship will have on the pace of China's ongoing reforms as it continues to transition to a more consumption-based economic model. The biggest test of Xi's commitment may come from an especially poor GDP print or domestic shock that threatens to upset the balance of economic development and social stability. Though first-quarter GDP growth, at 6.8%, was better than expected, more recent high-frequency data suggest the pace has slowed.
Already this year, China has loosened the reins on credit, with the People's Bank of China several times cutting the reserve requirements for certain banks in an effort to boost lending to small businesses. The stimulative bias of the PBOC has contributed to the yuan's recent weakening against the dollar, stoking concerns that China could wield its currency as a weapon, should a trade war break out. This would be a risky maneuver, however; though a cheaper yuan bolsters China's exporters, a significant devaluation would also trigger capital outflows, to the detriment of global markets and economies.
Fixed Income: The Chase Continues
No End to the Search for Yield | True
What we said: Biased higher but still low, long-term interest rates continue to send investors into less-familiar corners of the fixed-income markets in the hunt for yield, with high valuations leaving little cushion to absorb a volatility shock.
What we've seen: To balance the need for income with the more challenging investment environment, investors are exploring strategies with varying degrees of risk, like bank loans, CLOs, lower-quality high-yield, short-duration and private credit.
Credit Drivers Begin to Change | True
What we said: Continued low default rates suggest global credit spreads likely will be impacted less by fundamentals and more by technical developments, such as hedging costs, LDI-related flows and regulatory changes.
What we've seen: Despite an attractive fundamental environment, relative performance in credit was driven largely by technical factors, notably hedging costs and supply/demand dynamics.
With the bonds offering negative yields valued in the multitrillions of dollars worldwide even as policy accommodation peaks, it seems unlikely that investors will soon lose interest in opportunities to pick up additional return from their fixed-income portfolios. For the first time in about a decade, the short end of the U.S. yield curve represents one such opportunity, as the Fed's slow but steady stream of policy rate increases has pushed short-term interest rates to levels that once again appear attractive on an inflation-adjusted basis. While 2.5% on a two-year Treasury might not seem like that big of a deal, the ability to again earn both positive nominal and real rates of return on the short end of the U.S. market represents a significant milestone - not only for the income investors can generate, but also for the impact it likely will have on relative value across financial assets going forward.
The appeal of these and other strategies may be less evident for non-dollar investors at this point, however. With the Fed well into a tightening cycle while most other central banks remain on hold at very low levels, hedging costs have risen sharply and, in many cases, prohibitively; the cost of hedging dollar-denominated assets into euros, for example, recently topped 3% for the first time and has represented a significant headwind to the performance of certain asset classes, including investment grade credit. We believe the dollar's longer-term trend is downward given its valuation on a purchasing power parity basis and the negative sentiment associated with the twin deficits in the U.S., suggesting these hedging costs may ease.
Yield curve volatility has increased in 2018, reflecting an ongoing battle between the flattening influence of "buy the dip" yield-oriented investors such as insurance companies, de-risking pension plans and foreign institutions, versus the steepening pressures exerted by large short positions, ballooning government deficits and assets rolling off the Fed balance sheet. The first group appears to be winning at this point, as the U.S. yield curve has flattened to pre-crisis levels. The flattish Treasury curve has been accompanied by a flattish investment grade credit curve, driving demand to shorter-term corporate paper. High-quality issuance has shifted to maturities in the three- to five-year range in response, a trend we anticipate is likely to continue until the curve steepens and reawakens LDI flows to long bonds. Non-investment grade issuance also is being reshaped by supply/demand dynamics. The seemingly endless demand for senior floating-rate loans has inspired many would-be high yield bond issuers to turn instead to banks for their financing needs, resulting in lower new issuance in bonds and declining underwriting standards in loans.
Equities: Two-Way Markets Return
Market Momentum Could Present Opportunities to Reduce Beta Exposure | True
What we said: Strong earnings growth could fuel equities in early 2018, providing investors with chances to trim holdings in high-valuation stocks and redeploy into more attractive risk-adjusted exposures.
What we've seen: Though equity valuations on a forward basis have eased given expectations for very strong earnings growth in the quarters ahead, caution is still warranted given the ample risks to these forecasts.
Active Management Positioned to Shine | Partially True
What we said: Market dynamics continue to shift in favor of active management, which could extend the comeback mounted by stock pickers last year after a period of underperformance.
What we've seen: Market dynamics have grown less supportive of active management this year, and relative performance has been mixed as a result.
While January represented a continuation of 2017's placid equity markets, conditions soon grew turbulent. After setting a record high in late January, the S&P 500 quickly entered correction territory in February, before strong first-quarter earnings reports helped stocks rebound and ultimately finish the first half up 2.7% on a total return basis. Large daily price swings also returned to markets in the first half of the year; while the S&P 500 Index had only eight sessions during 2017 in which it traded up or down 1%, in 2018 it hit that number by February 12. These sharp movements are perhaps not surprising given the combination of tailwinds and headwinds with which investors are grappling, as discussed earlier, and we don't expect this push-pull dynamic to subside anytime soon.
Equity valuations on a forward-looking basis have pulled back year to date as analysts have steadily raised their expectations for 2018 and 2019 S&P 500 earnings growth. While the market's 12 months forward price-to-earnings ratio now appears more reasonable than it did six months ago, this metric is based on very optimistic growth estimates - nearly 20% for full-year 2018 and 10% for 2019. Between analysts' proclivity for being overly generous in their forecasts and the many risks to earnings growth that we have described throughout this document, we continue to believe there may be opportunities to gain more attractive risk-adjusted exposures.
It also could make sense to consider positioning portfolios to take advantage of late-cycle growth at this point in the business cycle; commodity-related investments, for example, are a classic late-cycle play that, in certain cases, may also help mitigate against geopolitical risk. For investors concerned about downside risk, options strategies may be another possibility; equity index put-writing strategies, for example, offer a more defensive exposure to equity markets, allowing investors to maintain their exposure to the equity markets with less volatility and less drawdown risk.
Our analysis of Morningstar data shows that 46% of active U.S. stock funds beat their benchmarks net of fees and transaction costs in the first half, as correlations moved sharply higher to levels above the post-crisis average while dispersion declined. Though this represents a slight step back after active managers hit 50% for full year 2017, we believe more hospitable conditions for stock pickers may lie ahead as central bank normalization continues and allows fundamentals to once again drive pricing. Further, we'd note that active managers in U.S. growth categories - the best-performing Morningstar style in the first half - delivered strong rates of outperformance across capitalizations (Large Growth: 73%; Mid-Cap Growth: 63%; Small Growth: 66%), while 48% of active managers in the international and global equity categories outperformed their benchmarks.1
Alternatives: Finding Opportunities Amid High Valuations
Low-Vol Strategies for a More Volatile World | Partially True
What we said: Market-neutral and relative value hedge funds may help investors earn returns with lower volatility.
What we've seen: Though volatility eased after a first-quarter spike, we expect the respite to be brief, highlighting the benefit of strategies that can provide ballast against tumultuous markets.
Sharpen Quality Focus in Private Assets | True
What we said: Given high private equity valuations, investors can help mitigate risk by targeting experienced private equity sponsors with a history of adding operational value or by moving up the capital structure to first-lien private debt.
What we've seen: Investment discipline is vital in the current environment, and there remain high-quality opportunities for private equity and debt investors who pick their spots carefully.
Though hedge fund performance in the first half of 2018 was mixed by category, their historical tendencies in rising-rate environments, coupled with the expectation of increased market volatility going forward, present a compelling argument for hedge funds, especially as domestic policies unfold and geopolitical uncertainty rises. For those looking for traditional hedge fund returns with less volatility, uncorrelated strategies - including market-neutral and relative value hedge funds - may prove appealing as more two-way markets emerge.
By hedging away systemic risk and seeking alpha generation through idiosyncratic risks, uncorrelated strategies typically have limited correlation not only to broad equity and bond markets, but also to traditional hedge funds, allowing uncorrelated and traditional hedge fund strategies to be combined in a well-balanced portfolio offering an enhanced risk-adjusted return profile. Another way to access potential uncorrelated returns is through alternative risk premia strategies. By systematically capturing the returns associated with different investing styles or strategies - such as value or momentum - alternative risk premia strategies have the potential for attractive long-term returns that are weakly correlated to traditional asset classes.
Private equity investing often rewards consistency over time, but only if it's accompanied by a rigorous investment discipline. Given rising valuations and the range of investment possibilities as more and more deals come on-line, investors must pick their spots carefully, perhaps now more than ever; for example, while we have seen a number of good, high-quality private equity funds being raised, a lot of deals are also being done that are very aggressive in terms of valuations and leverage. Often, the high-quality funds are led by general partners with a history of not only sourcing attractive private equity opportunities, but also creating value in these businesses through operational improvements, and doing so across business cycles, potentially providing a buffer through challenging markets. We believe investors looking to mitigate risk in private equity while still pursuing its illiquidity and complexity premiums may want to consider moving to a more senior position in the capital structure by investing in the debt of private equity-backed companies.
1 Based on analysis of all actively managed U.S.-domiciled open-end equity funds data from Morningstar, as of July 3, 2018. Performance is based on each fund's oldest share class relative to its primary prospectus benchmark. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
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