A Concentrated View Towards the Future
April 15, 2019
4Q:2018 Capital Markets Outlook
Without question the biggest story in capital markets here today is the massive divergence between U.S. equity returns and the rest of the world. And we've got three culprits largely behind it.
The first is the impact on massive U.S. stimulus on U.S. earnings in 2018 versus 2017, as you can see here. But what you can also see is a big drop off in earnings in the rest of the world. And one of the drivers of that is reduced trade activity on the back of trade policy concerns. And the third is the stronger U.S. dollar which not only flows through directly to those equity returns we showed a moment ago, but also it tends to negatively impact emerging market assets.
Now, if I dive in just a little bit deeper- when we talk about trade, we're talking about tariffs. And those concerns are not going to go away anytime soon. And we should be ready for continued uncertainty and volatility when those news items come out. And eventually if it sticks, that flows through to economic growth and market performance.
But as we focus on the U.S. and China, let's not lose sight of a lot of the countries even more exposed to trade, that are caught in the middle of the supply chain. And likewise, fiscal stimulus benefits have been strong- we just talked about them. But keep in mind as we move into 2019 many of those will start to fade and it will be largely about growth.
What isn't going to fade is going to be the cost of that fiscal stimulus. The world is going to have to digest, not only a larger amount of U.S. Treasury issuance because of the deficits increasing on the back of fiscal stimulus, but at the same time the Federal Reserve is reducing its balance sheet and putting a lot of those bonds that they purchased back onto the market. And we have to keep an eye on what that does to yields because markets are very sensitive to yield levels today.
If I take it all together from a growth perspective, the story of 2019 looks like this: growth is still solid but reduced versus 2018. Inflation rises to a level that allows central banks to continue to tighten policy. And that flows right into our central case, or a base case. Which is that those economic conditions will allow for moderate market returns, if below average relative to history and during the period of the last 10 years of stimulus. But keep in mind, this is a fat tail distribution. What does that mean?
The probability of this happening is only about 50 percent, leaving another 50 percent for upside and downside. And investors have to navigate and find a way to invest on the possibility of all three of these worlds. From a fixed income perspective the way they should consider it, is to first, not fight the wrong bond battles. So much focus on rising rates and the impact on high-grade bonds. But typically, the math doesn't allow large downturns. However, if you are concerned about rates, globalize your portfolio, make it more efficient. But hedge away currency risk to take away that volatility.
And lastly, in the move to credit, compensation for that risk has come down. So rather than continuing to move more assets into credit risk, I'd rather see investors barbell their exposure between rates and credit today.
From the equity perspective, first it's about balance between market exposure and the companies that we choose. We've lived in a period of great rising tides where the boats don't matter but they're mattering more and more. I'd rather see a focus on quality boats. Think about stronger balance sheets, persistency of growth.
As we're building our portfolios as equity investors and we look around the world, I'd rather see a focus less on geography and region, and more on the companies. I want the largest opportunity set for growth and the globe provides me that.
If I look out into the next few years, the tenets of being global and expanding my opportunity set, continue to be the same as they would at any time that I talk to you. But also being balanced takes on special meaning because so many investors are trying to find opportunities, and chasing the crowd is probably not the way to go as we do this.
And lastly, as part of that, be active. Choose the best companies. Choose the best exposures. And use that to walk through the market with an eye toward both participating in that central case that we expect, but defending against the very real tail risk that will be with us for some time.