Capital Market Line: Pullbacks Enable Bull Markets To Endure

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

18 April 2018

Markets’ heightened volatility has shaken some investors’ confidence, but for reasons we see as short-term noise.

The global output gap is decidedly midcycle, despite nine years of recovery, having crawled very slowly out of a very deep hole. None of today’s causes of higher volatility – monetary normalization, trade tensions, potential regulatory troubles for certain FAANGs, and the end of selling volatility for carry – threaten the current acceleration of cash flows. While the length of the recovery might look long, cycles die from excess, not old age; just ask Australia, which is in its 26th year of recovery. Inflation around the world continues to converge, emphasizing that global slack is what matters, not isolated bottlenecks like US labor force tightness.

The end of private-sector deleveraging, which has lifted a wet blanket that had held back the global economy, has boosted confidence and has led to rising business investment focused on new disruptive capabilities rather than raw capacity. Another new growth driver is the end of fiscal drag, which has morphed into fiscal thrust composed equally of supply-enhancing corporate tax cuts and demand-inducing consumer tax cuts. Demographic trends should continue to restrain demand-side thrust, but on the supply side, after the long post-crisis winter of corporate underinvestment, a new globally competitive tax rate together with the fear of disruption is pushing US companies to invest into new technologies to boost productivity. This should notch up macro stability and growth for several years before widening the gap between winners and losers, a backdrop that can easily morph into micro instability. As a result, we don’t see end-of-cycle overheating from the tax cut, but Congress’s new spending itch must be monitored.

Capital Market Line as of 31 March 2018 (Local Currency)

PineBridge Capital Market Line

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 relative to other asset classes only.

Capital Market Line as of 31 March 2018 (USD View, Hedged)

PineBridge Capital Market Line

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 relative to other asset classes only.

Seeing less threat of inflation, central banks may cease policy normalization once they achieve “neutral.” Markets have a history of rallying into neutral, then faltering as tightening continues. Since neutral itself rises with sustainable growth, the bad news is that most fixed-coupon and principal investments remain unattractive. The good news, for select growth assets where cash flows will rise rapidly, is that discount rates should have a hard time keeping up given the lingering global savings glut.

One cloud is the US-China relationship. Despite the risks, we do not envision a trade war. Presidents Trump and Xi both need growth, which itself presents any number of win-win solutions for incremental reciprocity. We see more trade down the road, not less.

The net result remains a set of powerful conditions for select growth assets, albeit with a widening gap between winners and losers in this gradually unfolding disruptive environment.

Insights from Today's CML

We continue to find growth assets to be most attractive. The capability-focused investment wave we see developing (see below for further details) enables firms to offset cost pressures while also benefiting from higher top-line growth. Because higher highs in fundamentals lie ahead, short-term fluctuations and inventory cycles should be kept in perspective and portfolios should continue to be positioned for sustainably higher growth. Attractive growth assets are available in developed and emerging markets (DM and EM), enabling investors to build diversified exposures that will likely benefit from the higher baseline level of growth.

DM bonds remain unattractive to us despite higher yields. Our CML continues to reflect the process of global monetary policy normalization, which is a clear headwind for DM sovereign bonds. Outside of the US, term premiums are likely to rise even more as central bank balance sheets stop their rapid ascents and begin to unwind later in 2019, steepening those curves. We note that the “distance of travel” for yields is limited by structural drivers such as demographics, which have reduced the equilibrium level of core yields relative to previous cycles. As a result, downside risk from DM sovereign bonds may be limited. Yet bond-equity correlations are breaking down, reducing the hedging benefits of these instruments.

Credit assets will likely fall behind. In recent years, as extraordinary monetary policy encouraged the search for yield and tepid growth was supportive of credit fundamentals, credit markets were arguably the best performing asset class. In the current and coming environment, credit assets will likely struggle to keep up with other risk assets, given rising rates and shareholder-friendly behavior by companies as they ramp up capability-focused investments. Although we do not expect a spate of defaults, today’s spreads limit total returns from credit, and the disruptive period ahead for business models is a wild card. Within credit assets, we continue to favor moving up the capital structure and credit curve. Floating-rate exposure will mitigate the headwinds rising rates pose to total returns.

Exposures linked to the global investment cycle are attractive, in our view. Across our network, we are seeing clear confirmation of accelerating investments. Providers of productivity-enhancing technology will drive disinflationary growth at the macro level, and we find them attractive as intermediate-term investments. These exposures have the added benefit of not being subject to the regulatory risks of the mega-cap consumer-focused technology companies that have attracted many investors.

India is once again uniquely poised to deliver on growth. The nation recently enacted a series of positive reforms, though they were disruptive in the short term. These included the November 2016 demonetization event and the introduction of the Goods and Services Tax in 2017. Growth also had been stymied by an undercapitalized banking system and weak corporate balance sheets. With the short-term disruptions now history, progress has been made on many fronts. A new bankruptcy code was put in place and is already bearing fruit in the form of asset sales that are mobilizing private-sector investments. And in January the government announced a recapitalization plan for public sector banks. The stage is now set for India to begin approaching its true potential, with attractive returns for equity investors a real possibility.

Industrial metals look well positioned to benefit from the new regime. We have been negative on commodities throughout the long supply supercycle which ended in 2014. Over the last few years, mining companies have cut back capital expenditure and slashed costs. Capital discipline is now top of mind. Given the recognition that China’s commodity-intensive phase of growth is largely over, we do not expect to see a rapid rise in supply in the next few years. The industry is now set up to be in deficit due to robust global demand on the back of synchronized global growth. We find industrial metals as well as metals and mining stocks attractive as we progress toward the later stages of the business cycle.

Private assets continue to experience unfavorable supply/demand dynamics. The insatiable demand for private assets continues to grow, and alternative asset managers continue to churn out mega funds. Yet the funds are unable to deploy capital fast enough to prevent a growing mountain of dry powder. Long-dated assets, such as private infrastructure, are particularly vulnerable as they also have to contend with rising bond yields. We favor the segments of private markets that have a truncated J curve, such as secondaries. Overall, however, we do not believe investors are being sufficiently compensated for illiquidity, particularly considering where we are in the business cycle. For many business models, the disruptive nature of the period that lies ahead argues for either future-proofing one’s private investments or keeping one’s powder dry (and liquid).

The Fundamentals Driving Our CML

We see clear confirmation of the investment cycle. Both top-down and bottom-up data indicate that a global investment cycle is firmly underway. Although investments include traditional manufacturing-related capital expenditures, they currently are more likely to take the form of technology-focused enhancements designed to stave off disruption and enable companies to become more agile and efficient. This trend is global and widespread, with positive implications for growth and inflation. The result is likely to be a disinflationary rise in growth as technologies that were conceived 30 years ago finally become fully commercialized and are adopted on a global scale. Rising productivity is like pixie dust for markets; it generates growth while simultaneously dampening inflationary pressure and improving margins. At the same time, the period may be one of great disruption at the micro level, as many previously well-established business models falter.

Rising neutral interest rates delay monetary policy restrictiveness. The neutral rate of interest (commonly referred to as “r-star”) is a useful, if unobservable, concept that is increasingly central to policymakers’ decision-making framework regarding monetary policy. Importantly, this rate of interest, which represents the rate above which monetary policy switches from being accommodative to being restrictive of economic activity, is not static. We expect supply-side benefits from tax reform and a revival of corporate productivity-focused investment activity to gradually raise the level of r-star globally. The implications of this are that rates can rise more than they could previously before they become restrictive, and this is likely to extend the length of the cycle. Moreover, we continue to expect that the naturally formed global savings glut will dissipate, but only slowly; this also will contribute to a fairly benign rate environment. In sum, rates will rise, but slowly.

Fiscal policy to continue contributing to growth. After nearly a decade of detracting from growth, fiscal policy has become a positive contributor and is accelerating. US fiscal stimulus, in the form of tax cuts and higher spending, is likely to contribute to growth for the next two to three years and, alongside corporate investment, helps to broaden the sources of growth. This contrasts to the recent past when growth was almost entirely driven by the consumer. At a global level we do not see further acceleration of fiscal stimulus; simply removing this consistent drag on growth will contribute to solidifying the growth forces underway.

China enters a new phase of economic transformation. China’s ruling party and its leader have consolidated power very smoothly and are signaling a new phase of economic development focused on sustainability. Although growth will continue to decline gradually, below the surface very important improvements are occurring to its quality and sustainability. Supply-side reforms are continuing, with a particular emphasis on raising environmental standards, which helps reduce the world’s overcapacity problem and puts a floor on disinflationary pressures. The new government is emphasizing financial deleveraging and is taking concrete steps in this direction, which is a very healthy development for the global economy because it reduces implicit systemic risk.

No trade war, but no trade peace. In contrast to media hysteria about a trade war, we see the US and China engaged in a large scale renegotiation of trade terms (as well as geopolitics, including the North Korea issue) that ultimately will result in more trade rather than less over the next few years. We are witnessing what we believe will be a persistent push by the US government to change the trading status quo whereby China continues to benefit from out-of-date terms and conditions that were put in place prior to its current status as an economic powerhouse. The subsequent outlook for global trade is likely to be positive, reducing global imbalances incrementally.

EM growth should pick up speed, but observe output gaps. Emerging markets are earlier in their recovery cycles after sustaining multiple shocks from the commodity price collapse and China’s self-inflicted hard landing in 2015-2016. As a result of healthy commodity markets, synchronized global growth, and macroeconomic stability of their external accounts, EM growth is likely to accelerate. Yet selectivity will be key for investors, as the dispersion of performance is likely to be high. Countries with wide yet shrinking output gaps, such as Brazil, are best positioned to sustain above-trend growth rates over the next few years, in our view.

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.