16 July 2019

Capital Market Line: The Threat of Split Supply Chains

Capital Market Line: The Threat of Split Supply Chains

An important issue loomed at the core of last quarter’s exceptional chaos. Just as global manufacturing appeared to be bottoming, China emulated Trump and walked away from a trade deal, resulting in the US ratcheting up tariffs on another $200 billion of imports and triggering a sharp but narrow drop in global manufacturing. Yes, China’s move reflects President Xi’s new political need to balance nationalist and reformer factions. But with 5G technology on the cusp of supercharging AI, robotics, and the cloud – potentially creating a new world order – intellectual property (IP) protection has emerged as a new hurdle facing the global economy. China and the US will take their time to get this right, creating a painful pause and uncertainty for businesses that have pulled back on investing while revisiting their supply chains.

Traditionally, IP was kept at home, with just enough of it, along with manufacturing capacity, placed in major consumption markets to permit market access. The balance of manufacturing was always on the move toward lower-cost locations. To continue selling into China, most manufacturers will retain a presence there despite US tariffs, yet perhaps be choosier about technology content. With national security a concern of China’s and now the US’s, governments have become more of a factor in determining the location of corporate IP. Any bifurcation of the global tech supply chain along IP lines will make innovation and R&D harder and could damage the efficiencies gained through globalizing supply chains over the last few decades. Given the increasing importance of technology to global growth, this is a material development. It could slow the current expansion and pull forward its end to the vicinity of 2021.

Nonetheless, on balance, we remain encouraged about other cycle-extending and growth-enhancing developments. First, there is the gradual re-acceleration of the working age population in the US after years of decline due to the entry of Generations Y and Z. Now, US demographics join fiscal spending, private sector deleveraging, and regulation as forces inflecting from headwinds to tailwinds. A further positive development has been the rise in US productivity. The recent trade turmoil has set back investment, which is necessary to extend this burst of productivity, yet technologyfocused corporate spending is holding up reasonably well.

Also doing their part are the world’s key central bankers. Given their insufficient dry powder to pull economies out of recession, they are acting early to pre-empt downturns in the first place. A global easing cycle has commenced and the QE glut is about to reboot, courtesy of the European Central Bank. The imbalance between excessive capital available for investment and insufficient cash flow in which to invest will be with us for years to come, perpetuating high valuations across major asset classes, although pockets of opportunities will exist.

Overall, the slope of our Capital Market Line remains satisfactory, while dispersion remains high due to policy-driven market distortions and technology-driven disruption to business models.

Capital Market Line as of 30 June 2019 (Local Currency)

PineBridge Capital Market Line

Capital Market Line as of 30 June 2019 (USD View, Unhedged)

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 Capital Market Line (CML) remains supportive for risk-taking. Fundamental forecasts underpinning the CML incorporate the fading of post-crisis drags – namely, deleveraging in the developed market private sector and a surge of regulation – as well as monetary policy ceding power to fiscal policy. We also recognize the crucial role of productivity and the changing nature of China’s growth contributors (and its impact on commodities) in defusing cost pressures. Equally important is the recognition that neutral interest rates are substantially lower than in prior cycles, and – crucially – that pragmatic central banks have learned important lessons about post-crisis inflation dynamics. Investors, companies, and central banks remain highly sensitive to a perceived imminent end to the expansion. Since cycles often end from the imbalances stemming from overconfidence, this pervasive caution continues to elongate this cycle.

The collapse in bond yields sets up growth assets as the clear outperformers for years to come. Proactive central banks are underwriting the expansion by suppressing bond yields. We expect yields to remain anchored by weak growth dynamics in Europe and Japan, as well as the massive global savings glut and central bank excess in expanding their balance sheets in the absence of distressed conditions. This sets up financial conditions to be very accommodative for an extended period, providing support for growth and equity valuations, in our view. Yet our CML also signals the need to be selective, as major benchmarks such as US large-cap growth are less attractive to us than pockets of value such as the productivity basket, which targets a slice of technology stocks (see below).

Capital investment will remain focused on technology. Despite all the uncertainty caused by the trade war, firms continued to spend on technological solutions to enhance capabilities and reduce costs. We expect this to continue, potentially benefitting several areas including software and automation solution providers. We continue to calibrate our growth expectations as these businesses evolve, yet we find their attractiveness on the CML remains undisputed. Beyond improving existing business operations, the innovations create new digital products and features, introduce new delivery methods, and power new business models. We continue to see this as the single most underestimated and unrecognized driver shaping the cycle ahead and making it fundamentally different from the previous cycle.

Credit assets will likely benefit from the moderate growth environment, but total returns remain capped. Many 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 (both investment-grade and high yield) as well as US high yield corporates. The growth environment we expect going forward remains sufficiently supportive to avoid a large default spike or sharp credit spread widening. The exceptions are in the investment-grade and bank loan markets. Here, corporates continue to show stretched credit fundamentals. Overall, we expect credit markets to deliver modest returns given low defaults yet tight credit spreads and low risk-free yields.

We expect EM equities to display wide dispersion and modest outperformance relative to their developed market (DM) counterparts. Slowing demographic gains and challenges to the global trading status quo pose challenges for many EM economies. On a cyclical basis, Brazil and India, for example, can erode their negative output gaps and deliver above-trend growth if they enact reforms. Structurally, many EMs will likely benefit less from IP transfers and foreign direct investment as automation costs fall and EM labor cost advantages erode. EMs should therefore be approached with selectivity. They require an ability to be nimble in order to capture cyclical moves supported by stimulus measures rather than structural tailwinds.

The insatiable demand for private assets has abated somewhat since late 2018 due to unfavorable supply/demand dynamics. For example, when adjusted for sector biases, market cap, and leverage levels, entry multiples for private equity are likely to be higher than those for listed equity markets. And as record levels of dry powder are put to work, forward-looking returns are likely to be lower. Private assets are also potentially vulnerable to disruptive technologies in a wide range of sectors and the inability to exit if disruption strikes. Therefore, these warrant a cautious approach, particularly in large cap private credit markets. We recommend “future-proofing” private investments, or otherwise maintaining dry powder through a focus on liquid assets until a better entry point is discernable.

The Fundamentals Driving Our CML

US demographics and consumption growth are becoming more, not less, healthy. After more than 20 years of declining working age population growth, the US will see a gradual re-acceleration over the next few years as a result of Generations Y and Z entering the workforce. The size of this combined cohort is larger than the Baby Boomer generation. Even with a more prudent consumption profile, their contribution to growth will rise meaningfully over our intermediate-term horizon. Coupled with rising productivity growth, this trend leads us to 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 capability cycle will fuel a productivity wave. We see clear confirmation from top-down and bottom-up data points that a productivity cycle is firmly underway, albeit with some recent setbacks due to the trade war. Although investment activities such as traditional manufacturing capacity-related capital expenditures are particularly vulnerable to the trade war, technology-focused investment for the purpose of enhancing corporate capabilities, to stave off disruption and to become more agile and efficient at delivering services to end markets, continues. This trend largely is being led thus far by the US, but is likely to broaden. It has positive implications for growth and inflation, as rising productivity generates growth while simultaneously dampening inflation and improving margins.

We expect global yields to remain anchored at or below already low neutral rates and fiscal thrusts to develop momentum. The recent growth slowdown is the result of several factors, yet it is clear that tighter monetary policy has been a contributor, at least in the US. This highlights the low level of neutral rates, even in the US. In Europe and Japan, 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 these manufacturing exporters. 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.

Trade and technology are in a state of flux. The recent turmoil around trade has been damaging to corporate confidence. As the dust settles, firms will be evaluating their supply chains and reorienting them by factoring in the new tariff landscape, as well as risk management considerations. Technology will remain the core of the conflict. To sell into China, most companies will retain some manufacturing presence there, yet perhaps be choosier about the technology content. Certainly, most new capacity will go elsewhere. Core manufacturing should rise in the US, China, and eurozone as tariffs and the protection of IP increase in importance. So the separation of supply chains will be evolutionary rather than revolutionary.

We expect China to continue slowing down yet avoiding a ‘hard landing.’ Thus far, China has successfully managed a glide path toward lower growth, albeit with several mini-cycles along the way, as it approaches its potential growth rate from above. Considerable fiscal resources will be required to engineer the rebalancing toward a consumption and services-based economy. China will need to accelerate its reforms, aim more of its available resources to the private sector, and open up its economy in order to offset a poor demographic profile. Reforming industrial policies, SOEs, and market regulations based on competitive neutrality principles is crucial to creating a level playing field for all firms. This, in turn, will hold the key to unclogging the major bottlenecks for the expansion of the private corporate sector, which will boost consumption, investment, and productivity growth.

We expect the EM/DM growth differential to widen modestly from cyclical lows but remain capped by structural shifts in production processes. 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 supercycle. 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 re-optimization of supply chains is likely to create significant winners and losers across EM. It will be critical to avoid extrapolating from previous cycles when developing expectations around future growth potential.


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 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.

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.

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