Capital Market Line: The Global Growth Marathon

Author:
Michael J. Kelly, CFA
Global Head of Multi-Asset
New York

17 January 2020

Last year proved to be a turning point. Word of an imminent trade deal between the US and China represented a peak in trade escalation and uncertainty. Global manufacturing – the epicenter of the trade war – began to register signs of stabilization. Forecasts of global recession were frustrated once again by this long cycle’s perpetual pessimism, which continues to preempt late-cycle imbalances from forming in the first place. The third mini-cycle of the post-GFC era is bottoming, with growth set to reaccelerate in 2020 and 2021.

This long expansion began from dire conditions. As a result, it has been and will continue to be a marathon, not a sprint. The starting point represented a much deeper hole in global slack than is typical for a recessionary bottom. Its rebound has been slower given classic post-financial crisis drags. The creativity of monetary policymakers has also allowed markets to register normal rebounds despite slower growth. Nonetheless, monetary magic is exhausted. Ahead lies an opportunity or a risk. The opportunity is for fiscal stimulus to begin without withdrawing monetary support. That will allow politicians to get ahead of populist demands and extend the cycle. Risk comes in the form of continued delay.

Until now, in the midst of tepid growth teamed with a liquidity trap, fiscal austerity has been combined with monetary excess – a terrible policy mismatch for today’s backdrop. Some are now moving away from this, although Europe refuses to let go, paying a high economic and political price. Resolution appears to await the 2021 German elections. Fiscal/monetary harmonization is coming, with the only remaining question being whether it shows up early enough to be preemptive and productive, or is forced through either recession or populism.

Meanwhile positive structural developments are shaping the US economy. Into this technologically vibrant era, productivity has quietly broken out of its doldrums driven by rising investment directed toward intellectual property and R&D. Delayed retirement by baby boomers on DC plans, teamed with burgeoning labor force participation by women and the large Generations Y and Z age cohorts will continue to expand the workforce well beyond what those focused on the unemployment rate expect.

China, on the other hand, is facing formidable challenges. Its shrinking workforce will need to become much more productive to avoid the “middle income trap.” With its trade practices now under a global microscope, transfer of technology will not come as freely. China must restore the confidence of its innovative and productive private sector and is moving to address these issues. Its success, in turn, will play a critical role in shaping Europe’s future, given the latter’s overdependence on external demand and its continued policy mismatch for the conditions it faces.

While we still see few signs of late cycle imbalances in the economy, markets are another matter. There, excess is evident in the form of a savings glut overlain with QE, resulting in too much capital chasing fewer opportunities. Post-crisis pessimism has continued to steer these flows away from equity toward fixed income and private markets, where cycle-ending imbalances could emerge. Meanwhile our Capital Market Line (CML) signals a clear preference for assets whose cash flows can run this marathon, growing their way out of the conundrum.

Capital Market Line as of 31 December 2019 (Local Currency)

PineBridge Capital Market Line

Please see Capital Market Line Endnotes. Note that the CML’s shape and positioning were determined based on the larger categories and do not reflect the subset categories of select asset classes, which are shown relative to other asset classes only.

Capital Market Line as of 31 December 2019 (USD View, Unhedged)

PineBridge Capital Market Line

Please see Capital Market Line Endnotes. Note that the CML’s shape and positioning were determined based on the larger categories and do not reflect the subset categories of select asset classes, which are shown relative to other asset classes only.

Insights From Today’s CML

The slope of our CML flattened, yet remains reasonable. Our fundamental forecasts underpinning the CML incorporate the fading of post-crisis drags from developed market (DM) private sector deleveraging and the global regulatory spike, as well as supportive macro policy. We also recognize the crucial role played by productivity and the changing nature of China’s growth contributors (and their impact on commodities) in defusing cost pressures. We see a growing role for fiscal policy without the withdrawal of monetary largesse in the years ahead, yet unlike many investors, we see the medium-term impact to be positive for growth assets. Recent price performance of risk assets has resulted in a flatter CML, yet risk assets remain far more attractive than safety assets, in our view.

DM core yields to rise less than prior PMI upward inflections, supporting risk assets. Flexible policymakers are contributors in turning this expansion into a marathon, not a sprint. They are doing so by anchoring bond yields and flooding markets with excess liquidity at the first signs of trouble. Yet we may also see a rolling back of negative interest rates, as the costs of this policy experiment become clearer. Sweden’s Riksbank was one of the early adopters of negative rates and recently returned them to zero. The Bank of Japan appears to be taking note, and Europe may not be too far behind. If coordinated with higher fiscal spending, we expect the signaling effects of this policy mix to be net positive. While the pool of liquidity will continue to at least keep up with economic needs, rotation within this pool to the safest areas helped the US rates curve disproportionately in 2019, and 2020 should see less hedging by long-only investors through the risk-free curve.

Moderate, sustainable growth on the horizon. We are experiencing the end of the third mini-cycle of the post-GFC era, with each mini-cycle triggered by a different negative shock. Meanwhile, China is adapting its policy mix to focus on the quality of growth, refraining from a repeat of its boom/bust approach. Combined with adaptive and cautious central bankers, we see a global economy that is converging toward a moderate, sustainable growth trajectory. This baseline growth path will likely be punctuated by natural cycles within goods-producing sectors and require policy support as offset, without causing full-blown downturns. We believe these mini-cycles will continue to represent alpha opportunities for dynamic asset allocators. Manufacturing and housing should lead in 2020 with capex returning in 2021 after election uncertainties are resolved.

Credit markets remain the Achilles heel. We generally consider the level of imbalance in the global economy to be low/moderate. Within public markets, it is only in credit markets that there are visible signs of excess. Leveraged loans are following the typical pattern of ever-worsening credit fundamentals that is characteristic of previous credit cycles. However, other credit markets have been healing over the last few quarters, reducing their leverage ratios and curbing their capital expenditures. These include emerging market (EM) corporates as well as US high yield corporates. More recently, we see some stabilization in US investment grade credit quality. The growth environment we expect to see remains sufficiently supportive to avoid a large default spike or sharp credit spread widening. However, current spread levels leave limited scope for tightening and constrained return potential. Moreover, it is the credit deterioration in opaque private credit markets that worries us, as some recent default dynamics hint at the buildup of risks in this unregulated corner of the credit market. A unique feature of this cycle is the growth of private credit, which in recent years is also taking more than its fair share of credit risk.

Emerging markets face lower structural growth levels than in the previous cycle. We think EM economies with deeply negative output gaps are well-positioned to benefit from the benign macro environment ahead on a cyclical basis. A commitment to structural reform is the other critical ingredient for secular growth to be unlocked and sustain the cyclical upturn. Currently, Brazil and India are prime examples of these dynamics, with above-trend growth potential in the years ahead. Yet over the coming cycle, many EMs will benefit less from intellectual property transfers and foreign direct investment as automation costs fall and EM cost advantages erode. Demographics are generally not supportive either. On a structural basis, therefore, we believe EM is morphing into more of an attractive duration play than a growth play, hence requiring a highly selective approach to EM equity market allocation.

Most private assets remain unattractive, in our view. We have been consistently cautioning that continued attractive returns were the result of investments made in 2010-2012 that are now being monetized and still carrying the overall returns, yet should not be viewed as representative of realistic returns for new investments. The insatiable global demand for private assets appears to have abated somewhat in 2019, as such views became more accepted. Overall, we find that current conditions nonetheless continue with characteristics of poor vintages. This cycle is playing out very similarly to previous cycles, albeit over a longer time frame. In private credit, we have ongoing concerns about the quality of underwriting, which seems to be deteriorating faster than in public markets and in larger deals. In private equity, we see increasingly unfavorable investment terms in the form of fees and expenses, as well as fewer investor rights.

The Fundamentals Driving Our CML

The “re-abnormalization” of core bond yields has begun. Central banks will likely need to keep monetary policy extraordinarily loose to offset headwinds from trade tensions, weak demographics, and a slowing Chinese economy that is less supportive of manufacturing exporters. In Europe, monetary policy will likely take interest rates deeper into negative territory, and resumption of QE will tug on global bond yields, including those in the US. Japan will also contribute to this trend over the next few years. We have reduced our forecasts for real yields, more so in Europe and Japan than in the US. Concurrently, populist forces will continue to pressure governments into looser fiscal stances, as “QE for the capitalists” morphs into “QE for the masses” in the form of stepped-up public infrastructure spending. There is a good chance that some fiscal stimulus will eventually occur in Europe, and the new ECB head may be instrumental in convincing policymakers of this need.

US demographics and consumption growth are improving. After more than 20 years of declining working-age population growth, the next few years in the US will likely see a gradual re-acceleration as a result of the Generation Y and Z cohorts entering the workforce. The size of this combined cohort is larger than the Baby Boomer generation; even with their more prudent consumption profile, their contribution to consumption growth will rise meaningfully over our intermediate-term horizon. A key beneficiary of this trend will be the housing market, in our view, especially rental properties. Coupled with rising productivity growth (see below) we see an improving potential growth path ahead for the US. Sadly, the US stands alone in this respect, with other economies seeing either slowing population growth or outright contraction. This sets up the US to continue to be a secular engine of growth for the global economy. The key risk to this view is a potential victory of a progressive Democratic candidate in the 2020 US election.

The productivity wave continues to build. The uptrend in productivity, which we had anticipated, continues to develop. We see clear confirmation from both top-down and bottom-up data points that a global investment cycle is firmly underway, albeit with some recent setbacks due to the trade war. Although these investment activities include traditional manufacturing-related capital expenditures, they are predominantly taking the form of technology-focused investment for the purpose of enhancing corporate capabilities to stave off disruption and become more agile and efficient at delivering services to end markets. This trend is predominantly US-led so far, with profoundly positive implications for growth and inflation, as rising productivity generates growth while simultaneously dampening inflationary pressure and improving margins. It is unclear whether similar trends will build up in other regions, but Japan shows some promise.

Supply chains will adjust gradually on the margin. The recent turmoil around trade has been damaging to corporate confidence, but recent developments indicate a peak in uncertainty. As the dust settles, firms will be evaluating their supply chains and re-orienting them by factoring in the new tariff landscape, as well as risk management considerations. Yet evidence thus far indicates that perhaps only 20%-30% of production will migrate away from China over the next few years. Technology will remain the core of the conflict. To sell into China, most companies will retain a substantial manufacturing presence there, yet perhaps be choosier about the technology content. So the separation of supply chains will be evolutionary rather than revolutionary.

China will continue to slow, yet avoid a “hard landing.” Policymakers in China have shown remarkable discipline in managing a slowing economy while also reeling from the trade war, avoiding a repeat of the boom-bust patterns of 2012-2016. Yet considerable fiscal resources will be required to engineer the re-balancing toward a consumption- and services-based economy. China will need to accelerate its reforms and open its economy in order to offset a poor demographic profile. Reforming industrial policies, state-owned enterprises, and market regulations based on competitive neutrality principles is crucial to creating a level playing field for all firms. This, in turn, holds the key to unclogging the major bottlenecks in the expansion of the private corporate sector, and thereby boosting consumption, investment, and productivity growth. Overall, we expect China to continue on a gradual glide path to lower, yet more sustainable, growth.

The EM-DM growth differential will widen from cyclical lows, but only in select economies. EM growth has been decelerating for over a decade as a result of several factors, including the structural slowdown of China and the unwinding of the commodity super cycle. More recently, disruption to global trade has also had a disproportionate effect on small, open export-based economies. Going forward, we see challenges to the tailwinds of IP transfer and foreign direct investment into EMs, as automation costs fall and localized production processes are required to meet customized demand from end consumers. The result will be a stagnant growth differential versus DM; we expect only a handful of markets to buck this trend.

Capital Market Line Endnotes The Capital Market Line (CML) is based on PineBridge Investments’ estimates of forward-looking five-year returns and standard deviation. It is not intended to represent the return prospects of any PineBridge products, only the attractiveness of asset class indexes, compared across the capital markets. The CML quantifies several key fundamental judgments made by the Global Multi-Asset Team for each asset class, which, when combined with current pricing, results in our annualized return forecasts for each class over the next five years. The expected return for each asset class, together with our view of the risk for each asset class as defined by volatility, forms our CML. Certain statements contained herein may constitute “projections,” “forecasts,” and other “forward-looking statements” which do not reflect actual results and are based primarily upon applying a set of assumptions to certain financial information. Any opinions, projections, forecasts, and forward-looking statements presented herein are valid only as of the date of this document and are subject to change. There can be no assurance that the expected returns will be achieved over any particular time horizon. Any views represent the opinion of the investment manager and are subject to change. For illustrative purposes only. We are not soliciting or recommending any action based on this material.


About the Capital Market Line

The Capital Market Line (CML) is based on PineBridge Investments’ estimates of forward-looking five-year returns and standard deviation. It is not intended to represent the return prospects of any PineBridge products, only the attractiveness of asset class indexes, compared across the capital markets. The CML quantifies several key fundamental judgments made by the Global Multi-Asset Team for each asset class, which, when combined with current pricing, results in our annualized return forecasts for each class over the next five years. The expected return for each asset class, together with our view of the risk for each asset class as defined by volatility, forms our CML. Certain statements contained herein may constitute “projections,” “forecasts,” and other “forward-looking statements” which do not reflect actual results and are based primarily upon applying retroactively a simulated set of assumptions to certain historical financial information. Any opinions, projections, forecasts, and forward-looking statements presented herein are valid only as of the date of this document and are subject to change. There can be no assurance that the expected returns will be achieved over any particular time horizon. Any views represent the opinion of the investment manager and are subject to change. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

The CML quantifies several key fundamental judgments made by the Global Multi-Asset Team after dialogue with the specialists across the asset classes. We believe that top-down judgments regarding the fundamentals will be the largest determinants of returns over time driving the CML construction. While top-down judgments are the responsibility of the Multi-Asset Team, these judgments are influenced by the interactions and debates with our bottom-up asset class specialists, thus benefiting from PineBridge’s multi-asset class, multi-geographic platform. The models themselves are intentionally simple to focus attention and facilitate a transparent and inclusive debate on the key drivers for each asset class. These discussions result in 19 interviews focused on determining five year forecasts for over 100 fundamental metrics. When modelled and combined with current pricing, this results in our annualized expected return forecast for each asset class over the next five years. The expected return for each asset class, together with our view of forward-looking risk for each asset class as defined by volatility, forms our CML.

The slope of the CML indicates the risk/return profile of the capital markets based on how the five-year view is currently priced. In most instances, the CML slopes upward and to the right, indicating a positive expected relationship between return and risk. However, our CML has, at times, become inverted (as it did in 2007), sloping downward from the upper left to the lower right, indicating risk-seeking capital markets that were not adequately compensating investors for risk. We believe that the asset classes that lie near the line are close to fair value. Asset classes well above the line are deemed attractive (over an intermediate-term perspective) and those well below the line are deemed unattractive.

We have been utilizing this approach for over a decade and have learned that, if our judgments are reasonably accurate, asset classes will converge most of the way toward fair value in much sooner than five years. Usually, most of this convergence happens over one to three years. This matches up well with our preferred intermediate-term perspective in making multi-asset decisions.