CIO Roundtable: Sizing Up the Next Regime
Low growth, low rates, low inflation. This has been the pattern of global fundamentals over the past couple years, punctuated by episodes of elevated volatility. Are these dynamics changing? For this annual outlook, Neuberger Berman’s senior investment leaders engaged in a broad-ranging conversation exploring economic prospects, monetary policy and opportunities on a global basis.
Economic growth proved disappointing in 2015. What are you anticipating for 2016?
Erik Knutzen: The main tension throughout 2015 has been a tradeoff between improving growth expectations for the developed markets, and growth shocks associated with China and other emerging markets, as well as falling commodity prices. For 2016, the biggest question is where we are in the U.S., European and global economic cycles. And our belief is that there is still a ways to go, and that we will start seeing some pickup in growth in the U.S. and elsewhere in the developed world.
Joe Amato: I think we will look back on 2015 and see market weakness as a mid-cycle correction. It was a year that prolonged the transition of central bank policies, where China’s devaluation led folks to rethink the global growth outlook. In 2016, monetary policy will likely create a sloppy environment as investors adjust to the new rate regime, with growth and China still playing an important role.
Brad Tank: The remarkable thing within fixed income is that almost nothing happened in terms of rate changes in the developed markets, reflecting the wait for growth. In 2016, a couple of factors will be important. One is the rise of U.S. short-term interest rates, which will likely be underway throughout the year. Another is where we are in the credit cycle. If we are still at mid-cycle, as we believe, that should portend well for some of the riskier parts of credit markets, such as emerging markets debt and high yield.
Anthony Tutrone: In private equity, we’ve had several years of inflating asset prices and more aggressive capital structures. So, one positive that came out of the market volatility at midyear was a pullback in that aggressiveness, which is leading to more cautious capital structures and lower valuations. At the same time, the widening of spreads is likely to create opportunities in illiquid and distressed credits, and special situations. In hedge funds, performance has generally been poor, but we believe a lot of that was caused by idiosyncratic events that will not repeat in 2016. For active investors, this should present opportunities.
Risk Assets Look Appealing
Asset Class Yields
Source: Bloomberg, Barclays Capital, JP Morgan. As of November 30, 2015. For illustrative purpose only. Yield profile data are presented solely for illustrative purposes. Yields shown are based on asset classes as of the date indicated and are subject to change without notice. Asset class yields are generally represented by indexes. See disclosures at the end of this material for breakdown. There is no guarantee, and investors should not assume, that any yields or yield profiles shown will be realized. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
There’s a lot of concern about earnings. How do you see things shaping up?
Amato: Earnings growth has basically been flat for S&P 500 companies, which was not the expectation entering 2015. Slow global growth and in particular the strong dollar have been important factors, the latter putting pressure on large-cap U.S. exporters. Our outlook for U.S. corporate earnings is modest but positive, in the mid-single digits. If you combine that with estimates of a 2% dividend yield and a roughly 2% reduction in shares outstanding due to stock buybacks, that would support U.S. equity values without requiring a meaningful expansion in price/earnings multiples.
U.S. Equity Valuations Inch Up, Margins Near Peak
Margins, P/E, P/E-to-Margins
Source: Bloomberg, FactSet. Data through November 2015.
Tank: In the U.S., the challenge with respect to earnings is that they have to be driven by top-line growth. The reason is that profit margins are at an all-time record high, due largely to suppressed wage rates, ultra-low interest rates and commodity prices; so it's hard to get margin expansion from here. But, if you look around the world, there has been nowhere near the margin recovery in the developed markets in Europe—so there is significant room for margin expansion there. Likewise, in developing markets, there has been turmoil in some significant economies, in some cases leading to reduced profit margins, and there could be recovery in those places.
Tutrone: Although Europe is set for higher earnings growth given the weaker euro and easy money, on the micro level, it's more complicated. On the private equity and hedge funds side, we don’t necessarily see the value opportunities in Europe that you might expect. GDP growth doesn’t always translate into an attractive investment environment. So just like in the U.S., I think you have to be very careful and really focus on individual company fundamentals.
Let’s talk more about U.S. rates. How high can they go?
Tank: There has been a big disconnect between the Fed’s expectations and the market. FOMC members anticipate raising the Fed Funds rate up to about 3.5% by the end of 2018, but the market is reflecting about a 2% Fed Funds rate at that time. Generally, when you’re at the end of a cycle, you have a very flat, if not inverted yield curve. So, with the 10-year Treasury bouncing around in 2015 in the 2%-2.5% range, the market view doesn’t imply a huge lift in rates from here. For 2016, in the U.S. we envision increases of around 50-100 basis points, while in Europe and Japan we anticipate short rates remaining ultra-low, and supplemented by monetary easing.
How does this rate environment impact stock selection and asset allocation?
Amato: An important theme for 2016 in the U.S. equity market is, in my view, quality. Over the past six years, rate suppression and easy access to capital regardless of the quality of the business has distorted equity returns quite meaningfully. As you start to move into a normalized rate environment, I think there will be more differentiation between companies. While we think rates are going to remain low, movement toward more normalized rates should start to differentiate between the good, the bad and the ugly.
Knutzen: When you think of your choices as an investor, and compare owning a Treasury or other government bonds at current low yields, versus for example the debt of a high-quality company with solid earnings and a moderate valuation, I would argue that investors are being compensated to move out on the risk spectrum toward investments with higher return potential.
Rates are dependent on growth, and growth could be affected by China. What are your expectations there?
Knutzen: In terms of risks, China is really first and foremost. Its importance was evident in the market reaction to marginal changes in Chinese growth at midyear, and then the devaluation of the yuan. Our view is that China is slowing but that it is not going into a hard landing, and that it will continue to be a contributor to global growth on the margin.
Amato: At the same time, I think you can’t take a hard landing off the table. This is an economy that is moving from an extraordinary level of investment-driven economic activity to one that needs to be driven by consumer activity, and that is a very tough transition to make. The government’s policy intervention has reduced that risk, but I think it’s still there.
Tank: A key takeaway for investors from 2015 is that you have to separate China’s stock market, which is very speculative, from what’s going on in the real economy. The shift you mention is going to take years and will result in lower, more stable growth. But I think China for the foreseeable future is going to be a source of periodic volatility or uncertainty for the markets, in part because policymakers there are still figuring things out.
China Works Toward a Balanced Economy
China Economic Indicators
Source: China National Energy Administration, National Bureau of Statistics of China. Data through September 30, 2015.
What are your thoughts on Japan?
Knutzen: After some delay, you are starting to see the impact of structural reforms including a meaningful improvement in corporate governance in Japan, as well an increase in women in the workforce. The reallocation among pension funds out of bonds and into stocks should also be quite positive. However, that is not yet leading to an increase in consumer spending, wages or inflation—changes to the real economy, which are what we’re really looking for.
Amato: You continue to have enormous demographic challenges in Japan, and productivity will need to rise considerably to maintain recent earnings growth. So we are fairly cautious on Japan, although there will likely be fits and starts as they move more aggressively from a policy standpoint. They have done monetary, they have done fiscal. The structural things, by definition, are much harder to accomplish and take a lot longer to get done.
Tank: That’s a good point about the lack of productivity gains, but Japan is not alone. If you look at Europe and the United States, structural reform could go a long way toward lifting growth potential—and we haven’t seen it.
Amato: It’s interesting to note that from 2010 to 2015, there’s essentially been contractionary fiscal policy in the U.S., driven by the budget deal that occurred a number of years back. And monetary policy was the engine in seeking to stabilize and create economic growth. Now, fiscal policy has actually gotten a bit looser because the budget has come into better balance and the deficit is not as large as it was, and economic growth has been better. So, that may be an interesting counterbalance to the tighter monetary policy that we see play out over the next couple of years.
Do you think election politics will impact the markets?
Knutzen: It’s hard to assess the U.S. election so far in advance, but we think it's unlikely that any one party will have sufficient control of all the different levers of power to be able to make sweeping changes. So, it probably won’t be a major driver of economic behavior and change for the U.S. or globally. Nevertheless, it is likely that we will see some micro bursts of volatility on certain policy issues, as we have seen recently in the health care sector after campaign rhetoric on drug prices, and that could create investment opportunities.
Amato: More worrisome to me are those countries around the globe where economic growth has been more challenging and you have greater risk of a significant shift in policy. When growth is slow, reactionary politicians can come to the forefront and that’s an issue.
The emerging markets have been under stress—but would you say that results have been more diverse than advertised?
Tank: We are now at a stage where investors are gaining sophistication and appreciation for the fact that the developing markets are quite varied in terms of policies, valuations and opportunities, and I think those divergences are going to persist. Some places clearly are going to present terrific opportunities to invest, but there may be others where, for a generation you are going to want to shy away because the leadership and a clear path to a solid future are just not there.
Amato: Three things have driven emerging markets growth over the course of the last decade: the commodity super-cycle, a low cost of capital and structural reform. At this point, the commodity cycle is essentially over, rates are set to head upward and reform has turned out to be very hard. You can’t paint all emerging markets with one brush, so you will see divergent trends, but broadly defined I think it’s going to be a more challenging environment.
Knutzen: There are some bright spots. Some of the Asian markets still have reasonable growth and solid country-level balance sheets but bond spreads have blown out as if they are Latin American commodity-producing countries. For an investor who looks past the current noise, there are some interesting opportunities generally, so it’s important to keep looking at these markets.
Private markets have been quite strong—can it continue?
Tutrone: Although I think private equity’s return potential compares well to other asset classes, the results of the past five or six years will be tough to replicate given higher valuations and slow economic growth. In my view, a key is to back managers who can make significant changes in the businesses they are buying to accelerate earnings growth, and for that they need operational expertise.
One area we’re quite bullish on is private credit. Spreads have widened, and borrowers have been providing an additional premium to investors who are willing to customize the terms of debt to fit specific capital needs. Early venture and smaller growth companies are also interesting. And given weakness in energy and other areas, there are also new opportunities in distressed, across private equity and hedge funds. Cheap credit has helped bail out many weaker companies, but that’s fading, which may present opportunities that more astute managers can capitalize on.
Private Debt Yields Offering Healthy Illiquidity Premium
Source: Bloomberg, Credit Suisse, Barclays, S&P LCD. Data as of November 30, 2015. For illustrative purposes only. Yields shown are based on asset classes as of the date indicated and are subject to change without notice. Asset class yields are generally represented by indexes. See disclosures and end of this material for breakdown. There is no guarantee, and investors should not assume, that any yields or yield profiles shown will be realized. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
How about opportunities in hedge funds?
Tutrone: Some of the trades that worked out poorly in 2015, for example in health care or energy, could do better in 2016. M&A spreads have been wide and could prove rewarding if the environment for deals remains positive, while weak areas in energy and commodities could provide good hunting grounds for long/short managers. As in private equity, distressed is an opportunity. Also, I would just mention that hedge funds as a category have often done well in rising rate environments.
To wrap up, let’s touch on investor concerns. What are they asking about entering 2016?
Knutzen: From an asset allocation standpoint, many investors are grappling with what appears to be a very challenging environment looking forward, where return outlooks have to be moderate. I think approaching these issues from multiple angles makes sense: focusing on a long-term investment horizon, the ability to take illiquidity risk, the use of more non-traditional or complex strategies. And as an asset allocation framework, taking a risk-balanced approach can provide broad diversification across economic environments.
Tutrone: Investors are searching for ways to achieve their return targets through low correlation assets. They are turning to alternatives, because they feel they have few places to go, and they are willing to take on some illiquidity in seeking to achieve their goals.
Tank: The good news on the fixed income side is that value has emerged in a number of places like U.S. corporate credit, particularly high yield and tradable bank debt, and parts of emerging markets. But we’re often asked about the credit cycle. If it is going to be prolonged, as we believe, then this is a pretty comfortable entry point from a valuation standpoint; but otherwise not so much. Central to answering that question is the potential impact of the Fed’s raising rates on a sustained basis throughout 2016. Our view is pretty straightforward: The markets are ready for it and can handle it.
Amato: Whether it’s a pension fund, a financial advisor or individual investor, people are scratching their heads right now. One of the challenges for all of us as we approach 2016 is that the Fed has inflated nearly all asset prices. So as we look across asset classes, it is tough to find opportunities consistent with historical valuation patterns. I am looking forward to rate normalization, which will provide more differentiation of returns across asset classes, and create more opportunity for fundamental investors.
Client 'Outlook' for 2016
Andrew S. Komaroff, Chief Operating Officer, Head of Client Coverage
While the goals of investors have stayed fairly consistent, the challenges of today’s markets—muted return outlooks, low yields, slow growth—have made achieving these goals a new conundrum. Under these constraints, we believe investors can benefit from a broader, more innovative and more unconstrained array of investment solutions. These include new approaches to traditional asset classes, taking advantage of dislocations created by changing regulation, and specialized strategies managed within niche areas of the capital markets. As a result, we see a shifting set of priorities for different investor groups.
Institutions: Looking for New Pathways
In adjusting to new market realities, we believe that in 2016 institutional investors will increasingly look to address their investment goals and liability shortfalls through innovative, creative thinking. As noted by Erik Knutzen, our CIO of Multi-Asset Class strategies (see Multi-Asset Perspective), this may include:
A risk-balanced approach to asset allocation. Risk-balanced methodologies that allocate based on a target risk budget can help to counter the equity risk tied to traditional 60/40 portfolios and, in our view, can provide for a more informed portfolio.
Seeking to capture the illiquidity premium. For those who can lock up capital over longer time horizons, there are meaningful opportunities in private markets with attractive return potential.
Reducing constraints and being opportunistic. Strategies that have more flexibility to pursue returns across markets and asset segments, as well as through derivatives and selective shorting, could offer attractive return potential. Market dislocations may present opportunities for more nimble managers with flexible approaches.
Demanding more of your investment managers. Investors can seek a greater level of customization and value added support from their managers, as well as unlock insights across asset classes. A deeper alignment of interests with managers can also help sharpen the focus on long-term results.
These elements reflect key opportunities available to institutions, including scale and a long investment time horizon. For example, institutional investors can look to specialized private investments that seek to capitalize on specific market factors, and choose separate accounts that provide highly customized solutions. Also, investors may want to rethink their home bias in favor of GDP-based allocations that can seek to capitalize on faster-growth segments, including select emerging markets. Finally, a holistic orientation is leading to the integration of environmental, social and governance (ESG) factors across portfolios based on the notion that they can impact overall investment performance.
Insurers: Adjusting to Market and Regulatory Realities
Insurance companies are facing dual, and at times conflicting, challenges of regulation and economic uncertainty. How they deal with these issues from an investment perspective will have a major impact on their business success moving forward.
Economic/market headwinds. Insurers are preparing for shifting regulatory requirements globally—including Solvency II, ORSA and other regimes—even as the long-term consequences are not fully appreciated. Although fragmented today, standards are slowly converging. More pressing are economic and market conditions, particularly the headwind of low fixed income yields, which are impacting profitability across markets.
Moving to diversify—with caution. Against this backdrop, many insurers continue to diversify portfolios and increase allocations to risk assets. With some variations between regions and regimes, we see continued allocations to public and private credit, including high yield and CLOs, as well as alternative strategies including private equity and hedge funds. As always, insurers are faced with the ongoing balancing act of seeking yield and return objectives within regulatory constraints.
New opportunities for partnership. To facilitate many allocations, insurers are increasingly looking to third-party asset managers for partnership and support with managing investments. Not surprisingly, this activity is coming in areas beyond their traditional expertise, in specialized fixed income as well as equities and alternative strategies.
Positional opportunity. Banking reforms—namely Basel III and Dodd-Frank—have contributed to structural changes in the credit markets, which could create compelling yield opportunities for insurers across a range of asset classes. The long-term funding profile and liquidity of many insurers should allow them to take advantage of illiquidity premiums in the market to enhance yields.
Defined Contribution: Walking a Fine Line
In defined contribution, the search for portfolio growth and yield, along with volatility mitigation options, are front-and-center as plan sponsors grapple with updating plan options to deal with an evolving market.
Searching for growth. In 2016, we see a continued shift in sponsor preferences to add global options to complement domestic ones in the search for growth. In the U.S., mid- and small-cap stock funds offer opportunity tied to greater inefficiencies/less coverage by financial analysts, and greater proportional exposure to the healthy U.S. economy. In Europe, equity markets boast both reasonable valuations and the initial stages of economic recovery, which means that now may be an opportune time for sponsors to augment their international and global portfolio options.
Expanding income options. If anyone is particularity vulnerable to today’s low rate environment, it’s the currently near- or retired population that will rely on portfolio income to maintain their lifestyles. Unfortunately, many DC plan menus have rather limited fixed income offerings, primarily money market and core bond options that trade close to major fixed income benchmarks. In a low-yield environment, this may encourage participants to move further out on the risk-return spectrum, presenting challenges for those with lower risk tolerance. We see sponsors moving to more flexible bond strategies, such as core plus or even unconstrained bond, which can enhance income potential, while alternatives—the “third arrow” of investment planning—can be employed in seeking to mitigate volatility and provide moderate growth potential.
Bringing responsibility to portfolios. More and more, ESG issues are becoming a key consideration for businesses, both to meet societal responsibilities and develop and maintain sound business practices. However, it’s often the case that these same organizations don’t extend these ideas to their DC plan options—despite well-known interest on the part of many participants, particularly those at the early stage of their careers. Fortunately, sponsors are increasingly engaged on ESG topics given participant interest and the attractive historical performance of SRI-oriented solutions.
Individuals and Advisors: Addressing Unique Challenges
For individual investors and their advisors, we see the timeless goals of generating income, seeking growth and managing volatility as underscoring the demand for an expanded toolkit in today’s environment. The need for this wider array of strategies and approaches is magnified by the challenges associated with intergenerational wealth transfer.
Broadening income sources. For 2016, we envision a broadening of the range of strategies available to individuals and their advisors to complement traditional diversifiers to familiar, core positions. With bond yields still hovering in the low single digits, we think it’s critical to evaluate a “new yield order” of non-traditional sources of yield that may be further out on the risk-return spectrum, such as senior floating rate loans, MLPs and, on a selective basis, emerging market debt. Credit long/short strategies too can play a role, given their ability to capture alpha without loading up on interest rate or duration risk.
Managing volatility. Market turbulence is reinforcing the role of investment products that can dampen overall portfolio volatility and still provide some equity-like upside potential. Hedge fund strategies, once the purview of institutions and the ultra-wealthy, are now available more broadly through so-called “liquid alternatives,” which are retail funds that employ hedge fund strategies. Investors increasingly understand the potential value of such vehicles in facing the current low interest rate, volatile environment.
Finding avenues for growth. We believe market dynamics may be shifting in favor of active managers in 2016. Higher U.S. interest rates could contribute to more dispersion in company results, which could bode well for stock pickers. Given the modestly positive U.S. economic outlook, strategies focused on small-caps (with their sizable domestic focus) could benefit. International strategies have the potential to capitalize on the budding recovery in Europe, where in contrast to the U.S., corporate profit margins are far below previous peaks.
Adding a ‘social’ dimension. For some time, environmental, social and governance issues have provided a valuable window through which to assess the individual securities—tied both to potential market opportunities and risks. And, in recent years, companies have increasingly reported on ESG matters and investors have become more cognizant of links between social issues and investing. For 2016, individuals and their advisors can draw on socially responsive investment strategies to build a dialogue and broaden opportunities for return.
The truth of the matter is that there are many ways to assemble portfolios. The challenge of 2016 will be to align them with both current market realities and the long-term fundamentals, while taking into account the client-specific goals, objectives and risk tolerances.
Asset class yields in charts herein are generally represented by indexes as follows: U.S. Real Interest Rate: yield on Bloomberg U.S. generic TIPS 10-Year index. Europe Real Interest Rate: yield on Barclays Capital Germany Inflation Linked Bonds All Maturities Index. Government Bonds: U.S. - yield-to-maturity on the Bloomberg U.S. generic government 10-year index; Europe - yield on the Bloomberg generic 10-Year German government Bund index; Asia - yield on the treasury component of the Barclays Capital Asian-Pacific Non-Japan Government Index; Latin America - yield on the JPMorgan EMBI Plus Latin Sovereign Index. Investment Grade Credit: U.S. - yield-to-worst on the Barclays Capital U.S. Corporate Investment Grade Index; Europe - yield-to-worst on the Barclays Capital Euro Corporate Investment Grade Index; Asia - yield-to-maturity on the JACI Investment Grade Index; Latin America - yield on the JPM Corporate EMBI Hybrid Blended Latin America Index. High Yield Credit: U.S. - yield-to-worst on the Barclays Capital U.S. Corporate High Yield Index; Europe - yield-to-worst on the Barclays Capital Pan-European Corporate High Yield Index; Asia - yield-to-maturity on the JACI Non-Investment Grade Corporate Index. Public equity valuations calculated as the 12-month forward earnings/price ratio of each of the following indices: U.S. - S&P 500 Index per Bloomberg estimates; Europe - MSCI Europe Index per Bloomberg estimates; Asia - MSCI Asia ex-Japan Index; Latin America - MSCI EM Latin America Index; 10-Year Treasury Bonds - Bloomberg U.S. government generic 10-year index; Investment Grade Bonds - Barclays Corporate Investment Grade Index; First Lien - first lien current yields from Credit Suisse Leveraged Loans Index; Second Lien - second lien current yields from Credit Suisse Leveraged Loans Index; High Yield Bonds - Barclays Corporate High Yield Bond Index.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
