Capital Market Line: The Capability Cycle is the Business Cycle that Keeps on Giving

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

17 January 2018

Pity this business cycle — it looks older than it actually is. By some valuation metrics the recovery may be long in the tooth, but output gaps, inflation dynamics, and central bank policies all scream “mid-cycle” to us as events unfold that favor continuing growth.

The new tax law is an example. Unlike the Reagan/Bush-II tax cuts, which primarily reduced individuals’ tax rates and stimulated demand, the latest cuts primarily benefit corporations. If companies act as anticipated and meaningfully step up their investments, output gaps would remain balanced, keeping us firmly mid-cycle. Greater investment also could slow the gentle rise of inflation and give central banks space to rest once monetary policy normalizes, instead of lurching into restrictive mode.

The odds the tax cut will be invested and not returned to shareholders is high. But instead of being part of the traditional “capex” cycle, these new investments are part of what we are calling a “capability cycle.” The term describes investments made by companies that have plenty of capacity but are worried that, after not investing in their business for years, they are vulnerable to new competitors. After nearly a decade of rewarding CEOs for financial engineering and hoarding cash, CEOs are now preparing constituencies to expect more balance, with well-crafted investment in new technology and capability aimed at keeping disruptors at bay.

Capital Market Line as of 31 December 2017 (Local Currency)

Based on PineBridge Investments’ estimates of forward-looking five-year returns and standard deviation. The Capital Market Line (“CML”) is not intended to represent the return prospects of any PineBridge products, only the attractiveness of asset class indices, compared across the capital markets. 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 to relative to other asset classes only.

Capital Market Line as of 31 December 2017 (USD View, Unhedged)

Based on PineBridge Investments’ estimates of forward-looking five-year returns and standard deviation. The Capital Market Line (“CML”) is not intended to represent the return prospects of any PineBridge products, only the attractiveness of asset class indices, compared across the capital markets. 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 to relative to other asset classes only.

We cannot overstate the significance of this shift in management direction. The absence of corporate investment over the last decade had been a drag on global growth and a primary contributor to the collapse in productivity. It lowered macro growth to the point of engendering instability (a condition we have labeled the stall-speed regime). At the same time, the safety-in-numbers aspect of not investing when competitors also laid low enhanced micro stability. Each of these patterns is now reversing. Stepped up macro growth will be accompanied by stepped up micro instability, which will lead to more defensive investments and more macro growth.

And let’s not forget China. During the stall-speed regime, China stepped up its investments. That action is now bearing fruit, with a visible transition to services and consumption from capital-intensive and heavily polluting industrial investments. A successful shift in China’s economic mix not only lowers left-tail risk for the global economy and reduces implied risk premiums, but also slows the uptake of remaining global slack inherent in output gaps. China, therefore, is a quiet but important contributor to our mid-cycle call.

Our Capital Market Line (CML) remains positively sloped. For much of the next five years we envision cash flows accelerating, growing into, and some through today’s prices. Dispersion is still high, not only from postcrisis monetary policies, but now from the unleashing of a disruptive capability cycle.

Insights from Today's CML

Reflation favors growth assets. The stage is set for several years of accelerating global EBITDA. Although policy normalization is broadening, global excess liquidity will dissipate only gradually due to central bank policies and the post-crisis global savings glut. This implies discount rates that will rise more slowly than EBITDA, which is bullish for discounted cash flows. Equity markets continue to embed elevated risk premia, which can shrink as fears of China stumbling abate and we leave the stall-speed era further behind.

Policy normalization challenges developed market sovereign bonds. Policy normalization began in the US but is now spreading. The European Central Bank (ECB) began the signaling process in 2017, will end quantitative easing toward the end of 2018, and start raising rates sometime in 2019. Given the starting point, this is incredibly bearish for Bunds. Although the Bank of Japan (BOJ) will be last to tighten policy, it now appears to be signaling a tilt toward the exit sooner than previously expected. Developed market sovereign bonds are very vulnerable, and unlike in stall speed, will not deliver pronounced negative correlations with risk assets.

Reflation leads to divergence between credit and equities. Credit assets were the primary beneficiary of the stall-speed regime, punching above their weight in term of returns, and moving in lock-step with equities. Yet in a reflationary regime these two otherwise highly correlated assets are likely to part ways. In the face of rising yields and already-tight spreads, the capability cycle — in which corporate investments in moatenhancing new technologies and processes increase — will bring about a peaking in free cash flow. This is an important driver for corporate spreads, even as accrual-based earnings rise for years to come, which is important for equities. We favor moving up the capital structure and into floating-rate instruments such as bank loans and investment-grade tranches of collateralized loan obligations (CLOs).

Countries with large yet diminishing output gaps are attractive. Economies that are on the path to recovery but face considerable slack in their labor markets are prime candidates for above-average cash flow growth. Europe is finally enjoying a rebound in consumption and investment. Last year saw a healthy start on this journey, although stock prices paused as a result of a rising euro, which dimmed prospects for export-centric companies. Yet considerable slack remains on the periphery, and pent-up investment demand will translate into strong earnings for domestically focused and smaller companies due to high operational leverage.

In 2017, Brazil exited one of the deepest recessions in its history but still has a considerable output gap to chip away at. Here, too, operational leverage is high, giving corporate margins considerable scope to rise. Elections in October will be an important determinant of intermediate-term fiscal trends, yet underlying consumption dynamics are likely to remain resilient regardless of the outcome.

The broadening capability cycle favors productivity-enhancing technology. The effects of technological disruption are becoming ubiquitous and few sectors will be spared. Corporate management is now springing into action, loosening purse strings to protect business moats and monetize new markets. Providers of these technologies, including cloud computing, fintech enablers, and automation processes, have reached critical impact on their clients’ businesses, and are likely to enjoy years of attractive growth. Therefore, own the providers of the capability cycle. To us these are our productivity basket and financials.

Financials are a uniquely attractive sector in a reflationary environment. Investment cycles must be financed. After a decade of deleveraging and re-regulation, the stage is set at a global level for the financial sector to begin growing again and return capital to shareholders. The end of private sector deleveraging and deregulation continues to make US financials most attractive. Yet European financials also are attractive as rate hikes come into view, domestic growth supports loan growth, and Basel IV provides the regulatory certainty that can trigger a re-rating of the sector.

Volatility will rise, but from a very depressed level. For several years we have expected volatility to bottom and begin rising. Yet the impact of quantitative easing in the form of capital deepening and the lack of investment, which created micro stability of cash flows, caused market volatility to grind lower. These are now both slowly reversing, as will volatility soon. We continue to expect volatility to rise over our forecast horizon, yet we have re-calibrated our forecasts to recognize the lower starting point of volatility across all asset classes.

The Fundamentals Driving Our CML

China’s transformation is healthy and lowers global risks. After the hard landing of 2016, a well-orchestrated fiscal stimulus program accelerated the transition to a consumption-driven economy. The process flowered throughout 2017. Concurrently, the Party and President Xi consolidated their power, setting the stage for a different growth regime ahead. An emphasis on quality over quantity of growth has reduced left-tail risk for the global economy, even if it means China’s contribution to overall growth will gradually diminish. We believe investors are underestimating the potential for private consumption to surprise on the upside.

US fiscal policy supports capital investment. As we had been expecting, the US enacted far-reaching tax reform and cut corporate tax rates to a very competitive level of 21% – better than most participants expected. We expect tax reform to support growth, unleash capital spending, and boost corporate profitability, particularly among smaller firms. Investors appear to be underestimating the significance of this event and its impact on fundamentals.

Policy normalization is accelerating. Signals from the ECB and the BOJ indicate an aggressive pace of policy normalization. We have been expecting partial normalization over our forecast horizon, yet the pace appears to be picking up. This is likely to be reflected primarily in currency markets before transitioning to rates markets. Meanwhile, markets continue to underestimate the Federal Reserve’s prioritization of normalization through rate hikes and balance sheet reduction.

Disinflationary growth prolongs the cycle. We consider the global economy to be more mid-cycle than late cycle. Corporate capital investment began to pick up in 2017 and the trend will extend for several years, making up for a decade of virtual noninvestment. This goal of this capability cycle is efficiency enhancement, and it is already contributing to a lift in productivity, which is the miracle ingredient that can prolong the cycle through disinflationary growth.

Large economic blocs are yet to close their output gaps. Output gaps continue to shrink at a healthy and accelerating pace. Still, some major blocs in the global economy may need several years to close their output gaps and therefore may continue to grow at above-trend rates and contribute meaningfully to global growth. Europe, Brazil, and Russia are at the top of this list. India, too, is now primed for growth acceleration after an important recapitalization of its banking system. Aside from higher productivity trends, these economies also add to the disinflationary growth forces that will be in effect for several years.

Inflation is the primary risk. Now that China appears to have stabilized its growth model, inflation replaces it at the top of the risk scale. The disinflationary forces described above, along with the effects of technological disruption, lead us to expect a gradual rise in inflation rather than a problematic one. Yet we recommend investors track inflation drivers very closely.

Global trade is still fragile. Although 2017 saw a rise in trade to levels not seen since the financial crisis, growth remains fragile. First, a slower growing China will affect commodity prices and trade-sensitive economies. Second, US trade policy may yet prove to be somewhat disruptive in certain cases. We do not expect this to derail the recovery, but it may contribute to a new set of winners and losers as terms of trade change.

About the Capital Market Line

The Capital Market Line (CML) is a tool developed and maintained by the Global Multi-Asset Team. It has served as the team’s key decision support tool in the management of our multi-asset products. In recent years, it has also been introduced to provide a common language for discussion across asset classes as part of our Investment Strategy Insights meeting. 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 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.

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 indices, 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 forecast 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.