Investment Strategy Insights: A Better Prognosis
We are seeing positive inflection points that we think bode well for 2017. Markets have been dealing with deflationary forces ever since the crisis. The US and Europe have been deleveraging, with their tepid consumers drying up export markets for Asia. Post 2012, China began throttling back the speed of its debt-led growth. Without this commodity-intensive, infrastructure-oriented demand, commodities collapsed, spreading pain to Latin America, Canada, Australia, and the Middle East. Fortunately, the twin engines of global growth, the US and China, are now both slowly inflecting upward.
Right on cue, eight years after the financial crisis, we are witnessing the end of deleveraging in the US. Most of this debt growth is healthy, aimed at waking the sleeping giant – the US housing market. Meanwhile, its undeclared, yet painful, rough landing in 2015 convinced China to change course. Despite today’s debt load, China is now of the view that its new economy (less capital-intensive technology and services) is working – it just needs another three to seven years to be large and vibrant enough to take the baton from its old economy and carry China’s overall economy forward. Until then, it will maintain enough credit and fiscal thrust to ensure a minimum speed of growth that is faster than 2015’s actual pace. Unlike prior government-led thrusts, today’s is aimed more at domestic infrastructure than global manufacturing. In fact, the latter is going through a heavy dose of supply-side management. This is why commodity prices are rising concurrently with China’s finished goods prices. Take note: China is no longer exporting deflation.
Better global fundamentals appear to be seeping in. After six quarters of declines, earnings will finally register a year-over-year increase in the September quarter. In Latin America, inflation is peaking and central bankers are just beginning the easing process. Elsewhere, a consensus is forming that governments should begin fiscal stimulus.
While inflation appears to be bottoming in developed economies, Fed Chair Janet Yellen’s language is morphing into thinking out loud about the merits of letting the economy “run hot.” The Bank of England Governor Mark Carney is also now talking up the merits of “run hot.” Have we been invited to a party where no central bankers are poised to take away the punch bowl?
As always, the outlook is far from perfect. Anti-globalization forces are spreading, and we begin this inflection with high and rising financial leverage. Yet the proverbial glass now seems a little more than half full.
INVESTMENT VIEWS & CONVICTION SCORE (CS)
Economy CS 2.75 (unchanged)
Markus Schomer, CFA, Chief Economist, Global Economic Strategy
We continue to forecast higher global GDP growth and inflation in the coming years, and maintain our bullish tilt. Deeper into fourth-quarter 2016, 2017/18 growth prospects become more significant. We think global growth should accelerate closer to the midpoint of our 3.5% central case scenario in the next two years. We are also seeing inflation rising broadly coming off of the commodity price collapse. This time next year, major developed markets should see inflation rates much closer to central bank targets, in our view. In the US, we think a Hillary Clinton win should motivate the Federal Reserve to hike rates again and reduce uncertainty for financial markets.
Rates CS 3.30 (+0.10)
Amit Agrawal, Senior Portfolio Manager, Government and Inflation-Linked Credit
September may have been the inflection point for global inflation. After years of a negative producer price index (PPI) in China, we see positive results. Headline and core inflation in the US have already been rising and a recent oil price increase to above $50 per barrel will likely ensure that year-over-year headline inflation rises and stays over 2%. More importantly, inflation expectations in Europe and the US are rising steadily, with global central banks’ abandonment of negative interest rates for longer-dated bonds perhaps being the catalyst. If ongoing fiscal policy (tax reform, infrastructure spending) rhetoric were to become a reality in 2017, that could boost inflation expectations further. Our range for the 10-year Treasury remains 1.5%-2%, with a bias closer to 2% over the next three months.
Credit CS 3.50 (-0.25)
John Yovanovic, CFA, Portfolio Manager, High Yield Bonds
Despite potential fourth-quarter market volatility from central bank policy actions, we believe uncertainty has declined. Markets are largely pricing in a Fed rate hike, a clear ongoing accommodative bias, and a willingness to err on the side of overshooting on inflation. Earnings expectations have improved across most sectors and should result in an improving trend in credit fundamentals over the coming quarters. We believe the macro environment will continue to support credit markets despite the recent tightening of spreads.
Currency (USD Perspective) CS 3.00 (unchanged)
Dmitri Savin, CFA, Portfolio Strategist and Risk Manager, Emerging Markets Fixed Income
Central bank actions will continue to drive currencies in the near term, in our view. Despite market worries about supposedly imminent tightening in the group of three (G3), other G10 central banks seem happy to ease. We believe UK politics will drive the pound, with Prime Minister Theresa May’s promise to start EU withdrawal in March 2017 increasing chances of a “hard” Brexit. Investors seem to be exceptionally short the pound, so at some point it will become an interesting trade versus the negative-rate currencies. Last week saw another leg down in the Chinese yuan, driven mainly by US dollar strength. More gradual devaluation may be the path of least resistance. Emerging market (EM) currency inflows remain low, so not-so-strong fundamentals dominate. Despite higher oil prices, policymakers prefer weaker currencies to support growth, if only marginally.
EM Fixed Income
USD EM (Sovereign and Corp.) CS 3.75 (+0.25)
Local Markets (Sovereign) CS 3.75 (+0.25)
Anders Faergemann, Managing Director, Global Emerging Markets Fixed Income
Global yields have reversed their summer gains, and with the Fed hinting that it’s ready to pull the trigger in December, the market needs to decide whether it can live with a dovish hike or whether the shift in central bank rhetoric/behavior will lead to a repeat of the December/January sell-off. EMs have been resilient during the recent reversal in US Treasury yields, partly supported by economic stability in China and higher oil prices. The pace of EM capital inflows has abated with no signs of a reversal. Cynics will argue that Saudi Arabia’s recent efforts to bolster oil prices through a potential OPEC oil output freeze plan was part of its strategy to issue external debt.
Multi-Asset CS 2.20 (unchanged)
Deanne Nezas, FSA, MAAA, Portfolio Manager, Multi-Asset
We continue to identify pockets of greater opportunity where fiscal and monetary policies are being harmonized for greater impact, such as Japan, but we find more opportunity in EMs. Strong centralized EM governments are addressing infrastructure improvements and reforming economies. The search for yield in a low rate/negative rate world is driving growth in yield-rich pockets of the market such as EM debt, credit, and liquid alternatives.
We anticipate ongoing coordination of fiscal and monetary stimulus and continued focus on improving corporate governance in Japan. We favor Mexico, India, and Indonesia in EM due to likely growth resulting from structural reforms. We are looking to emerging markets for yieldrich fixed income assets and favor Latin American local currency debt, while also finding yields attractive in markets like Poland and Indonesia. Infrastructure remains an attractive yield-rich alternative asset, as do arbitrage strategies.
Global Equity CS 2.75 (unchanged)
Rob Hinchliffe, CFA, Portfolio Manager and Head of Sector Cluster Research, Global Equities
The run-up to the third-quarter results season has brought a raft of negative preannouncements and profit warnings. Even some reliable performers that traditionally beat expectations have disappointed. The weakness extends to aerospace, corporate IT spending, telecommunications capital expenditures, energy, construction, and agriculture. To offset slow top-line growth, companies continue to take on debt to fund share buybacks and mergers and acquisitions. Subdued corporate updates back our view that no significant near-term growth acceleration is coming, but we don’t anticipate a protracted slowdown. Stabilization and improvement in many commodity prices suggest a more stable economic base, which we believe will continue to drive investors to cover long-held underweight positions in more cyclical sectors that have lagged markets over the past five years.
Global Emerging Markets Equity CS 2.50 (-0.50)
Gustavo Pozzi, CFA, Portfolio Manager, Global Equities
EM equities continue to benefit from improving economic and political conditions in some EM countries and from global investors seeking yield. Selling triggered by fears of a Trump presidency affecting global trade, Samsung Electronics’ Galaxy Note 7 woes, the passing of Thailand’s king, and a likely December Fed hike could provide a tactical entry point. Brazil continues to make progress on economic reforms. Concern remains over the fickle nature of the EM carry trade and how Beijing can selectively calm elements of the property boom without compromising China’s economic trajectory.
We favor consumer staples and industrials but find telecoms and financials unattractive. We are positive on Russia and Brazil and negative on South Korea and Malaysia. We selectively favor consumer discretionary (Indonesia), petrochemicals (Brazil), and property (Philippines).
Haibo Chen, Quantitative Analyst, Quantitative Research
The US Market Cycle Indicator (MCI) continued to stay defensive, with both yield curve and credit spread little changed. Both investment grade and high yield corporate credit were slightly rich in the short end but fair overall compared with long-term averages. We favor basic industry, technology, energy, and capital goods. We don’t like electric, communications, and consumer non-cyclical.
We expect global rate yields to increase; slopes to steepen in the UK, Japan, and Europe, with the US staying unchanged; and curvatures to increase in the EU and UK. In curve positioning, we favor five-year and especially 20-year key rate durations.