2018 started off strong but in the second quarter we saw steady US equities returns offset by negative returns in emerging market equities and debt. We’re watching very carefully for signs that politics or policy will push inflation, interest rates or both higher at a significantly faster pace.
3Q:2018 Capital Markets Outlook Presentation
CMO 3Q18 TRANSCRIPT
We're halfway through the year and while 2018 started off on a strong note, what once were backburner issues have evolved and heightened investor concerns which has implications for the capital markets.
We saw this in the second quarter where steady returns in U.S. equities were offset meaningfully by negative returns in both emerging market equities as well as debt.
So going forward our view is one of moderating economic growth. Think of it as growing but slowing. We continue to see core inflation and short term interest rates increasing over time. And all eyes are focused on the Fed's central bank balance sheet activity and particularly what the Federal Reserve is currently enacting and what the ECB may enact in the future.
But the wildcard in all this is politics and policy as this has implications for how we navigate the economic cycle going forward. So as we look to 2019 we anticipate the economy to transition from a phase of rising growth in benign inflation to one of moderating economic growth and rising inflation.
However it depends on one where resides in particularly in the euro area. We still see positive signs of consumer activity which could lend to economic strength in that region.
No region is without its worry in the euro area that happens to be Italy and particularly that country's concern over political uncertainty has many investors wondering if this will be a replay of 2011 when Greece itself had its own political challenges. Our expectation is that that will not be the case given many of the monetary backstops in place to mitigate that risk.
It’s not lost on us that Italy's economy is substantially bigger than Greece's. So this bears watching. But perhaps a bigger threat to global economic growth is an increase in tariffs because at the end of the day a tariff is a tax increase which leads to an increase in prices which is inflationary.
We've seen this manifest itself in key commodities ranging from wood aluminum to steel. This has implications for things as small as washing machines as well as construction projects. With all the crosscurrents that we're dealing with from a fixed income perspective we still advise a barbell approach to your fixed income portfolio because what we've observed over the last roughly 20 years is that 95 percent of the time this has been a very effective structure that's delivered positive results. And the remaining 5 percent of the time that it hasn't, it's been short lived given that there's been no rolling 2 year period where global fixed income is generating negative returns.
Sticking with the global bond theme, it makes eminent sense considering that when U.S. bond markets do well you're capturing most of that upside but perhaps even more importantly when U.S. bond markets don't fare so well, you could capture considerably less downside. But you need to be active. That allows a manager to avoid potential hotspots like in Italy while focusing on better opportunities.
And currently we're finding opportunities in European financials as well as select emerging market debt. Another area in the fixed income space that we like is the floating rate structures and particularly credit risk transfer securities are CRTs. In fact these CRTs have actually outperformed the less liquid bank loan products that are out there and is an area that still has appeal for us.
Turning to equities many investors are curious as to what happens when the earnings growth moderates off of its blistering pace. We feel that that's not going to be problematic because historically when we've seen such transitions equities still generate a nice return for investors.
But balance sheets matter. We've seen corporations go on quite the borrowing binge over the last five to seven years. And this is important because if economic growth moderates you want a strong balance sheet to weather the storm.
The good news is as companies with strong balance sheets are on sale whether one is looking through a U.S. lens or taking a global approach. Companies these with these characteristics are trading at meaningful discounts than a long term historical average.
Another area still ripe for opportunities is the U.S. small cap market. They've done quite well year to date but they still traded a meaningful discount to the large cap counterparts. And as with your fixed income portfolio, Take a global approach with your stock portfolio. This allows one to cast a wider net to capture those companies that have a high level profitability, but bear in mind that not all companies are created equal.
That is, not all have the ability to go the distance over time to maintain that high level of earnings growth. Here's where you need active management to capture that opportunity which can enhance your returns. So if there's one bit of advice I'd like to leave you all with is continue to do your homework.
There's no substitute for thorough research which aligns well with our ever growing advice: to be active, stay balanced in your portfolio construction, and adopt that global approach to enhance your return potential for your portfolio. Thank you for your time. We'll see you next quarter.