From Stall Speed to Reflation: A Turning Point for Investing

Download PDF Authors:
Michael J. Kelly, CFA
Global Head of Multi-Asset

Agam Sharma
Managing Director
Portfolio Manager
Global Multi-Asset
New York

Hani Redha, CAIA
Managing Director
Portfolio Manager
Global Multi-Asset
London

21 March 2017

Business cycles rarely proceed evenly or predictably. If they did, investors could relax, knowing they could easily tailor their portfolios to maximize the effects of each stage of the business cycle. And economists wouldn’t need two hands or the disclaimer that “each time is different.”

The idea behind a smoothly functioning business cycle is that temporary periods of excess supply or demand for goods and services – or excess or insufficient liquidity – self-correct, allowing the cycle to proceed from one stage to another. Many investors routinely ask themselves “what time is it?” with the belief that they should favor certain asset classes or strategies over others depending on whether it is early, midway, or late in the cycle. Supply/demand or liquidity imbalances are believed to cause inflation to run high or low, or growth and leverage to accelerate or decelerate. These business cycle characteristics then allow certain assets to do better during some stages than others.

But when business cycles become stuck, these characteristics can linger in what is known as a market “regime.” From 2009 until the middle of 2016, markets were stuck in a post-crisis, stall-speed, liquidity-trap regime. Correlations lingered at high levels – reflecting anxiety throughout the markets – and benefited passive investment strategies. Capital conservation assets did surprisingly well, actually outperforming growth assets during an economic recovery, even if a slow-moving one.

At long last, markets have now entered a new “reflationary” regime. What is reflation? It’s a healthy backdrop for capital appreciation. (Think the 1950s and not the 1970s; the former featured reflation, which was constructive for growth assets, while the latter was about destructive inflation.) Regime changes are big moments, calling for changes to portfolios. While a low-nominal-return environment still lies ahead, reflation of some cash flows introduces the possibility for more asset class cash flows to grow into existing prices. Overall, we expect growth assets and active management to move back into the spotlight as confidence, growth, leverage, and prices improve from unhealthy to healthy levels.

What is a market regime?

Market regimes are time periods that can be secular, spanning several cycles, or contained within one elongated business cycle. They demonstrate persistence of certain characteristics and are caused by long-lasting structural shifts in supply and demand (for labor, goods, services, or capital). These, in turn, have persistent effects on the levels of inflation, growth, and leverage. Regimes are not permanent states of affairs, however, just elongated adjustment periods before one can move on toward the next phase of the business cycle.

Regimes are observable and analyzable, particularly when it comes to their varying effects on cash flows from different asset classes, and therefore the prices asset classes will converge toward as a result of the regime. When regimes become “unstuck,” and shift from one to the next, they are accompanied by a meaningful change in the investing environment. This has been described as phase shifting. Within a short period, markets suddenly act as if everything has changed – as if a light switch suddenly went from off to on.

The post-crisis regime

The post-crisis stall-speed regime was the epitome of persistence, encompassing sticky excess supply, sticky insufficient demand, and an unending deluge of liquidity. It all began with China’s entrance into the World Trade Organization (WTO) in 2001, which connected one billion more people to the global supply pool. This led to a lingering of excess supply of goods that could not rebalance itself within just one business cycle. Sixteen years later, global output gaps are still loose, and are still working their way through this excess.

Meanwhile, the global financial crisis also led to a period of deleveraging, and thus weak demand, that lasted longer than what normally follows a garden-variety recession. When the post-crisis stall-speed regime began in 2009, it was the start of a recovery of sorts. Excess supply from China, plus weak demand growth, induced disinflationary pressures that threatened to spill over into outright deflation. To keep that possibility at bay, central banks took on extra liabilities in the form of quantitative easing to neutralize the impact of the private sector’s desire to shed liabilities. This led to a massive savings glut and “liquidity trap.” Such savings did drive down real and nominal rates to unprecedented levels, yet demand for loans failed to revive, as the private sector was intent on deleveraging.

The post-crisis regime saw record levels of savings and a liquidity trap.

Normal Sources of Liquidity Surged Simultaneously Post-Crisis

As of 31 December 2016. Sources: Haver, Federal Reserve, Bank of Japan, World Bank, and Trading Economics. Gross savings are calculated as gross national income less total consumption, plus net transfers. Estimates are based on World Bank GDP and demand forecasts. Source for 2015 and 2016 Gross National Savings % of GDP forecast: PineBridge Investments. For illustrative purposes only. We are not soliciting or recommending any action based on this material. 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 forecast shown above will be achieved over any particular time horizon.

What had begun as a desire to deleverage morphed over time into an unwillingness to invest. China was still flooding the world with excess goods while a post-crisis anti-business regulatory regime also took hold in the US and Europe. These forces fed off each other to quash Keynesian “animal spirits,” or the emotions that drive confidence, among the business sector. With business fixed investment missing in action, and consumers deleveraging, the stall-speed environment persisted.

High asset-class correlations during the post-crisis regime reflected markets that were atypically focused on systemic risk. Growth was so slow that unexpected exogenous shocks could send the economy back into recession and outright deflation at a time when central banks were viewed as out of ammunition. That backdrop led to pervasive caution, with markets constantly on the lookout for the next disaster and investors hovering in the lower risk asset classes. Instead of the normal focus on the risks and opportunities of individual companies, countries, or asset classes, markets reacted in unison to false sightings of the next systemic risk.

Interestingly, markets had fairly normal returns in aggregate, as efforts by central banks to offset the slowness were more effective at elevating capitalization rates (and therefore markets) than reviving growth (and therefore cash flows). The central banks that were the most active were associated with the markets that did best. Investors continued to worry about the sustainability of this environment and failed to rotate toward more aggressive risk allocations. Yet during prior recovery periods, growth assets outperformed capital conservation assets. In this peculiar post-crisis regime, for the first time ever in the midst of a recovery, low-risk asset classes and factors outperformed their higher risk counterparts.

During the post-crisis stall-speed regime, lower risk asset classes outperformed their higher risk counterparts for the first time in the midst of an economic recovery.

Defensive and Growth Returns From Prior Cycle’s Peaks1

Sources: NBER and Bloomberg as of 31 January 2017. For illustrative purposes only. We are not soliciting or recommending any action based on this material. (1) Business cycle peak is defined by NBER as typically the first point of the cycle where growth is at its maximum. Returns are calculated from “Peak to Peak” as defined by NBER. (2) Prior two cycles are represented by average returns for the following time periods: Prior cycle 1 from 31 July 1990 to 31 March 2001; Prior cycle 2 from 1 April 2001 to 31 December 2007. The inception date for the MSCI ACWI Total Return (Net) Index (“MSCI”) is 31 December 1998. Returns for MSCI prior to this date were calculated by linking the gross index by a scaling factor (the last price of the net index level divided by the last price of the gross index level on the inception date of the net index) that adjusts to provide net returns. (3) Stall-speed regime time period is from 31 December 2007 to 30 June 2016.

In 2016, three things happened that triggered the end of this stall-speed regime. First, China began genuine supply side management, which held back new capital from the old industry state-owned enterprises while forcing production cuts and supply rationalizations. Second, the US segued into a genuine housing recovery that began reversing the deleveraging process. Finally, the 2016 election brought about the possibility of reversing the punitive regulatory environment. Together, these brought the persistent stall-speed growth rate to just above stall speed in a sustainable way. The regime became “unstuck.”

We now believe that 2016 was a segue to a reflationary regime: reflation of confidence, prices, leverage, and growth.

The new reflation regime

Correlations between asset classes recently plunged to their lowest levels since 2006, signaling that a new regime has begun. In this new reflation regime, we see less slow growth, a pickup in demand amid rising private sector confidence demonstrated through releveraging, stepped-up business fixed investment, and a very gradual tempering of excess liquidity that should start to shape the next several years.

Cross asset correlations have broken down, signaling a need for investors to be more active.

Global Correlation Index

Source: Bloomberg, Morgan Stanley Research. As of 28 February 2017. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

Central banks are no longer the only game in town as rising animal spirits among the private sector are reinforced by more vigorous fiscal policies. Central banks are pulling back on the supply of money they are pumping into the financial system as economies move from too little demand to adequate demand. Meanwhile, the ratio of US private sector leverage to GDP finally bottomed in 2015 and even started to turn up slightly in 2016 as businesses are taking on leverage and making investments again.

Private sector releveraging should help drive economic growth.

US - Total Private Credit to GDP

Source: BIS. As of 31 December 2016. Any opinions, forecasts, and forward-looking statements presented above are valid only as of the date indicated and are subject to change. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

We also believe we may have seen the peak in regulation. In every post-crisis regime, there is excessive focus on what caused it. After the most recent crisis, that focus turned on the banks, accompanied by an onslaught of policy-driven changes to their business practices, capital levels, and regulation. Indeed, “over-regulation” became businesses’ number one concern, according to PricewaterhouseCoopers’ 19th Annual Global CEO Survey. The spike in regulation had become a significant economic drag, resulting in a lack of incentive for companies to invest in their businesses. This applies across a broad range of sectors, but perhaps most importantly to financials due to their perceived role in the causes of the global financial crisis.

Recently, markets have rallied globally on the back of promises by the Trump administration to roll back regulations. Trump’s appointees so far show a consistent anti-regulation and pro-business bent. Changing regulation involves Congress, yet changing how regulations are interpreted and applied does not. The heads of all regulatory bodies are being changed quickly and philosophically toward a pro-business orientation.

Given businesses’ low confidence, capital expenditures were a small percentage of cash flow during the post-crisis regime. Now, regulatory risk is falling and growth prospects are rising. Post-crisis, most firms outside of China focused on improving margins on the back of slack labor markets and falling interest rates. The regime ahead is likely to see a reversal. Gradually rising growth, inflation, and interest rates in developed markets and their resulting margin pressures are likely to combine with extensive deregulation and corporate tax cuts in the US. These are awakening animal spirits and seem poised to trigger a virtuous investment cycle that raises productivity, structural growth, and real incomes.

China is also contributing to a bottoming of global inflation. Commodity production controls led its producer price index to inflect into positive territory this year for the first time since 2012. This preceded the Organization of the Petroleum Exporting Countries’ (OPEC) efforts to cut oil production. Despite a sizable output gap, even Europe is now experiencing both growth and inflation bounces.

Rising global CPIs and US 10-year Treasury yield signal the end of deflation.

US 10-Year Yield and US, Japan, and EU CPI

Source: Bloomberg, PineBridge Investments. As of 31 December 2016. Any opinions, forecasts, and forwardlooking statements presented above are valid only as of the date indicated and are subject to change. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

Investing in the new regime

During the post-crisis market regime, high correlations between individual stocks (called pairwise correlations) made life difficult for active managers and added a shot of adrenaline to the ETF onslaught. This translated into insufficient differentiation between the performances of stocks with favorable fundamentals and those with unfavorable fundamentals. Investors who picked the winners did not get enough bang for their buck to offset fees and transaction costs. Now these pairwise correlations have plunged. While the powerful trends behind ETFs will not go away, we believe they are now due for a rest, with more favorable times immediately to come for active management. We expect a more conventional period ahead where growth assets outperform capital conservation assets during expansions (and vice versa during recessions) and a more typical percentage of active managers outperform.

Steady progress in chipping away at the global savings glut and a commensurate rotation to capital appreciation assets will leave in its wake gradually rising interest rates. So many investors’ first concern will be finding the best ways to hedge against rising rates. In this environment, we expect a select allocation to US financial equities will be beneficial from a portfolio construction perspective, particularly given its ability to hedge against sharp rises in US interest rates.

Our positive view on US financials is driven by three strong convictions. First, we expect top-line prospects of financial institutions to improve with releveraging. Second, gradually rising US rates should benefit the net interest margins of US financials, allowing them to function as a hedge to rising rates. And third, the significant increase in regulation post-crisis leaves lots of room for policymakers to ease the regulatory burden on US financials, lowering this cost burden just as top-line prospects brighten. While hedges are supposed to carry a hedging cost, this is one hedge to rising rates that we expect will provide an attractive return.

Other domestically focused segments of US equities have also become attractive given an “America first” policy combined with potential tax reform. Pre-tax cash flows are worth more if corporate tax rates are cut. Reflation of growth and pricing also implies that some cash flows will grow faster, and thus be worth more. In particular, small-cap stocks tend to have the highest effective tax rates and are more insulated than the multinationals are from trade uncertainty.

We also find several equity markets outside the developed world attractive. US trade policy may challenge many economies that rely on global trade. Large economies geared toward domestic consumption, coupled with structural reform, are likely to deliver higher, sustainable growth. We continue to view India as exhibiting these characteristics, notwithstanding its recent demonetization event and the short-term impact on growth. India is making steady progress on significant structural reform. Indian equities appear attractively valued and are also less vulnerable to potential protectionist trade policies in the US.

We see select pockets of value in emerging market local currency bonds. We expect an environment that will likely include higher US rates and a strong US dollar, which will generally be challenging for many local currency bonds. Yet we find attractive idiosyncratic situations where progress toward structural adjustment has already been made, such as Brazil and Indonesia. Brazil continues to work toward restoring fiscal credibility. It remains one of the few markets where financial conditions have been tight and inflation high, with clear prospects for this condition to reverse, making its local debt attractive. Indonesia’s local bonds have been relatively resilient in the face of an intense rally in the US dollar and rates, demonstrating the extent to which macro stability has been restored over the last few years. We consider Indonesian real rates to be attractive and the central bank’s policies to be supportive of the currency.

Finally, US bank loans remain one of the bright spots within the fixed income markets, providing floating-rate exposure and an attractive spread even when incorporating relatively high default expectations. High yield bonds are losing their attractiveness, in our view, as spreads now provide limited scope to compensate for eventually rising default rates and current increases to the risk-free curve. The rise in animal spirits will gradually begin to stretch balance sheets, leaving little room for further spread tightening. Selectivity in credit is becoming even more important.

The long awaited post-crisis stall-speed economy has ended, and the rotation away from defensive assets like fixed income toward offensive assets like equity has begun. In the new reflationary regime, strategies that worked in the past may no longer serve investors well. We see falling correlations as a call for investors to be more active. We recommend incorporating strategies that are opportunistic, that find a balance between risk and return, and that match objectives with exposures. Political landscapes, structural changes, tax changes, and asynchronous valuations also point toward the need to be more selective.

Investors who fail to recognize the changing market regime risk may miss out on growth asset returns. Worse yet: Investors who are complacent may risk losses from assets they perceived as safe (even if expensive) in the old regime.

For illustrative purposes only. We are not soliciting or recommending any action based on this material.