2018 Midyear Outlook: A Roundtable Discussion
Lord Abbett's Investment Perspectives
2018: The Midyear Outlook
A Roundtable Discussion
Joseph Graham: Good morning and welcome to Lord Abbett's 2018 Midyear Outlook. My name is Joe Graham. I lead our investment strategist group here at Lord Abbett. I'm joined today around the table by leaders within our investment department. And now I'll turn it over to them to give them a chance to introduce themselves.
Kewjin Yuoh: Well, this is Kewjin Yuoh. I'm a portfolio manager for taxable fixed income.
Giulio Martini: Hi, I'm Giulio Martini. I'm the director of global asset allocation at Lord Abbett, and my team manages the multi-asset portfolios.
Robert Lee: My name is Robert Lee. I am the chief investment officer.
Daniel Solender: Hello. My name is Dan Solender. I'm director of the tax-free fixed income group.
Tom O'Halloran: Hi, I'm Tom O'Halloran. I manage our micro, small and large cap growth funds here.
Graham: Looking at the first half of the year, we saw a return to more normalized volatility in both the fixed income and equity markets. So the first question, and I'll direct this at you, Rob. Do you think now is a good time to take risk? What do you think of the return to volatility? How do you see the second half of the year?
Lee: Sure. So I'll address it in the following way. I would say good professional investors generally do not think just in the base case, what's going to happen in the next six months. The world is nuanced and complicated. We tend to think in probabilistic, expected value scenario-based way.
So one key thing to focus on is monetary policy. Is the Fed [U.S. Federal Reserve] ahead of the curve, behind the curve on inflation? Is it taking the punch bowl away from the party too quickly? One key issue.
Second key issue is fiscal policy. We had big tax law changes that affected both the individual side and the corporate side. There are open questions on the effect of that. The first I would mention is, usually when you get fiscal stimulus, it happens during a recession or economic weakness.
This time it's been pro-cyclical. That is to say, the labor markets are tighter. The economy is growing. It's an open question as to whether that will lead to inflation and whether the effects will be short-term and/or longer term. A lot to be said there. And then the third thing I would point to very relevant for the next six months is trade policy.
So everything from withdrawing from the Trans-Pacific Partnership to the N.A.F.T.A. negotiations to Brexit and the trade negotiations in Europe and the issues and trade negotiations between the U.S. and China. All of those I think are going to be with us over the next six months.
Graham: So to just address the first one, do you think the Fed is behind the curve or ahead of the curve? And how do you think the market is seeing that? And is the market right?
Lee: So if you look at the shape of the yield curve, the yield curve has obviously been flattening. Historically that has some predictive value, not perfect, for weakening in the economy. The Fed hikes too quickly, that tends to impede economic activity. So the shape of the yield curve, the flattening of the yield curve is at least one warning flag I would say. If you look at risk markets, if you look at credit spreads in various fixed income sectors, if you look at the stock market overall, I would say risk markets tend to be more comfortable with the pace of Fed tightening.
Martini: Joe, I would just maybe try and add a little color to that by saying, you know, it's very much appreciated by investors that we've had an excellent economic environment with good growth globally, with synchronized global growth that's led to a situation where company earnings have grown very rapidly and exceeded investors' expectations for how much they would increase by.
And all this has happened in an environment of low inflation, which is also of course good for the markets. And so we've seen a couple of years through January of 2018 of very strong equity returns, of tightened credit spreads, and of asset prices just rising. I think the question that investors may be asking themselves is whether this is as good as it gets or whether there's something better yet to come.
Graham: It's a good point, Giulio, and maybe this is a good time to ask Tom, our growth equity specialist, what do you see from company earnings? Do you see this recent acceleration continuing, expanding? How do you see it?
O'Halloran: Company earnings are fantastic. I don't think they're going to get a lot better, in terms of growth rates, but they're fantastic. And I see healthy earnings growth continuing. Interest rates are very low. The world is awash in money. The U.S. government is getting out, in the sense it is deregulating and lowering taxes. That's a good thing. So I'm very bullish on equities for the rest of the year, for the next seven years.
I think over the next seven years we're going to go a lot higher. And the main reason I'm bullish is because the technology revolution is in full bloom, and it's creating tremendous growth opportunities for companies across many different industries.
Graham: Okay, thank you. Another point that was interesting Rob in your commentary is the flattening curve and what impact that may have, what that may signal for markets going forward. Maybe Kew, you might be a good person to comment on this. Do you see the flattening yield curve as an indicator that a recession is coming? Or is it not so clear-cut?
Yuoh: I would say it's not so clear-cut right now. I think a lot of comments have been made that have been very interesting. Regarding monetary policy, I think you have to look at the fact that, as far as what's happening to the yield curve, this is what's supposed to happen. When the Fed tightens, the yield curve is supposed to flatten, right. If you look at historical relationships you've been reading in the news and people have been talking about inversion and how good an indicator that is of a coming recession with somewhere around a six-month to 24-month lag, I think if you look at the yield curve right now, you can ask a lot of questions as to why it's happening.
Because we're at a place where we have just come from an incredible monetary policy experiment, right? Quantitative easing was something that's never been tried obviously, and you could point to the fact that in a normal cycle you point to fiscal policy and you point to housing as your usual recovery drivers in a cycle. And that's what we're getting now. We've got strong housing technicals. We've got fiscal stimulus. What if we are at kind of a return to a normal business cycle?
People have been saying that we're kind of in the sixth, seventh, eighth inning of the cycle for four or five years now. Right? But this domestic expansion can continue. Leading indicators are an upward trend. Hard economic indicators for the U.S. are very stable, but valuations are full. Right? It's exactly what Rob said. Risk valuations reflect the current environment, and the question is, can we kind of have even better performance in the years ahead because of domestic strength, domestic fundamentals, strong equity market?
Solender: It might be worth contrasting what's going on in the municipal bond side with what we're talking about on taxable side, because when talking about the shape of the yield curve, we're actually not seeing a flattening of the yield curve in the municipal bond market right now.
And that is really a little bit of a difference. Our [municipal bond] rates after 10 years, we've actually seen a steepening of the yield curve. It's kind of flattening a little bit beyond that. And the main reason for that is that we're a retail-dominated market, unlike a lot of other markets. If you look at Federal Reserve data, about two thirds of the bonds are owned by investors, either through managed products or in brokers' accounts.
And investors are very risk averse right now. They keep asking the question about why rates are rising, if they're going to rise, what we're going to do about rates rising. Not realizing that they've been rising for two years now and we've been in a bear market for a while. But they're very risk averse. They're going short in the retail market in a big way, and what that's doing is pushing down on short-term rates. We don't have a lot of supply on the short end. There's excess demand. So our yield curve is actually steepening, which is a different dynamic from what we're seeing in other markets.
Martini: So, you know, the Fed has raised interest rates seven times, right, since the bottom in 2015. But what it's also done more recently is allowed the securities that it took on its balance sheet in very large quantities to roll off as they mature.
And I think one of the things that investors are concerned about is, how is the market going to absorb that? Is that going to be a smooth process or does it inevitably involve some volatility, some changes in risk appetite that make it difficult to absorb that would then reverberate back onto asset prices? So I think when you assess the risk environment as Kew's pointing out, you know, the change in Fed policy is one of those factors that, you know, you have to add in on top of earnings, low inflation and all the other things that matter in the environment. And it's difficult to assess that, because we've never been through anything like this before.
Lee: Right. Let me pick up on that, on the inflation question for a second. Effects the shape of the yield curve, Fed policy, monetary policy and fiscal policy and trade policy are all tied into this. It's one of the most important questions for investors. So I agree with Giulio. So far we've had very contained, pretty stable inflation and inflation expectations within a pretty reasonable range. So, so far, so good.
The one thing I would add though is, investors shouldn't get complacent here. At the risk of stating the obvious, we're in an interesting place with monetary policy. We ballooned a balance sheet from less than a trillion to about $4.5 trillion, and now the Fed is reducing the balance sheet. So this is an experiment that hasn't really been tested in the U.S. in a long time, maybe ever.
The same thing with the Fed hikes. We've had Fed hike periods, but juxtaposed with fiscal stimulus, the tax law changes, which I think are meaningful and substantive, the combination of those two, the pro-cyclical fiscal policy make things an open question.
Graham: Now one thing that's been mentioned is investors at least in the fixed income markets have been kind of running to safety. Tom, in the equity markets, have you seen a similar phenomenon? I know we've had a return to volatility around the same time that the Fed is hiking rates. Do you see that flight to safety or is it different in the equity markets?
O'Halloran: I don't see that. I think we had the flight to safety between 2008 to 2016. We had a massive bubble in low volatility stocks, because people lost half their money twice in ten years in the stock market, and they just threw up their hands and said "no mas." So I see very broad leadership in the equity markets. It's spreading to small caps now. That's a good thing. And, as I said earlier, the tech revolution is in full bloom creating tremendous growth opportunities in many different areas.
Graham: Rob, at the outset, you mentioned in your three important points for investors to consider in the second half of 2018, tax policy is the second one. This I think is an interesting question for Dan. Dan, how has tax policy affected the municipal bond market, specifically the exemption or the limit on S.A.L.T. deductions, itemizations?
Solender: Sure. The tax policy had a tremendous impact on the municipal bond market this year. We can break it down into a supply and demand perspective. On the supply side are new issue supplies where new bonds come into the market, down about 20% year to date. A lot of it has to do with what was changed in the tax bill where in the past, municipalities and issuers were able to refinance bonds in advance of their call dates. They're not allowed to do that anymore because of their tax bill. So that was about 25% to 30% of last year's issuance, and typically it's around that amount. That can't be issued anymore in the market. They have to wait until their call date.
A second thing on the supply side is that a lot of supply was pushed into December of last year, anticipating what could happen in the tax bill. So we had a record month in December, and then the first quarter was very slow for us. So supply is very low, slowly picking up but still behind the pace of previous years.
On the demand side, as you mentioned, there's a retail component to it with the changes in the tax laws. This cap on state and local taxes is a big deal, because there are not as many exemptions for investors anymore. There's a cap on the taxes. There's smaller amount of mortgages now. For municipal bond, the tax interest wasn't affected. So we're seeing a tremendous demand from individual investors for municipals that has been large for a while, but it's been increasing.
So overall, it's had a big impact on our market. It's going to keep investors interested. States like California and New York with the high tax rates, the demand is really strong from individuals. And this tax bill has really just increased the benefit as municipal bond issuers. We talked about the economy. Revenues are very strong across the country too. We've seen states across the country. I think California a few years ago was being compared to Greece, and now they're so strong, they're trying to figure out what to do with their surplus revenue. So, there are a lot of things that have been very positive from the tax bill.
Graham: Let's talk about the dangers. Trade policy is one that you mentioned, Rob. Does anyone disagree at the table with Rob's assessment? Or think that trade policy might be something to worry about?
Martini: No, I agree that trade policy is something to worry about. And it's something to worry about because there have been very few trade wars historically, and so there's not a script for how this is going to play out. You know, I think if we did go into a situation where reciprocal tariffs were put on between the U.S. and China, the U.S. and the E.U., the U.S., Canada, Mexico and other trading partners, that we would see an impact on global economic growth that was negative.
But it wouldn't be devastating because of the direct effect of trade. It would maybe slow down global economic growth by two or three-tenths of a percent or something like that from what looks to be a pretty strong year right now.
Solender: But from the domestic side, one of the things we have to look at on the municipal bond side is the global impact and there's individual community impact. And one of the things we have to watch, and it's not determined where this is going to impact right now, but certain communities or states around the country could see an impact.
Big manufacturing states could see an impact. We could see impact from ports, what's coming in and out of ports on the different coasts of the country.
So on a credit research side, there's a lot to check, and that's why there is this need to follow so many different credits on municipal bond side. Because macro wise it might not have a big impact, but micro wise it could.
Yuoh: Yeah, I would just add that the markets have been reacting to, as Giulio mentioned, the uncertainty, right. There could be healthy debate about what the endgame is for this administration with regard to trade policy and protectionism. And so without knowing what that endgame is, without knowing how we get there, you have to have risk premium for that uncertainty.
So fundamental economic growth impact wise, we're not talking about large numbers, but it's that unknown that causes valuations to be where they are. The whole question for us is, at what point does that become more certain? Do we continue to take investments within risk assets because we believe fundamentally over the intermediate to longer term that risk will compensate?
Lee: So I think the base case is pragmatism will prevail. Cooler heads will prevail with lots of noise and volatility and thus opportunity. But the second thing I would add is, one needs to take a step back as well and look at the broader, longer-term issues.
Martini: And I would say there are just other uncertainties brewing even in the short-term. When you look at it, you know, this could really be a September to remember if it all really adds up. Because what you've got going on in September is basically, you know, the debt ceiling issue is going to come to a fore. Congress is going to have to increase the debt ceiling. There could be another government shutdown or a very tough negotiation around that. We've got the Mueller investigation that's going to come to some conclusion, you know, before the campaign in November. We've got the Brexit negotiations, which really have to be wrapped up by September, early October, because the deadline is March when the final decision has to be made.
Graham: Let's look at the flip side of that coin. The positive growth that some of those policies have enabled. Tom, can you point to a few examples within the U.S. economy of where there's outsized growth?
O'Halloran: It's just abundant in so many areas. The tech revolution is only about 60 years old. I think it'll go for another couple of centuries. It's the revolution of the brain. In 2010, $1,000 of computing power bought you the equivalent of one mouse brain. In 2023, it will buy you the equivalent of one human brain. And in 2050, it will buy you the equivalent of all human brains.
So the processing gains that are ahead are gargantuan, offering great growth opportunities for companies that are participating in that. Cloud computing is an important new architecture. When I started in the business in 1988, my computer plugged into the wall and connected to nothing else. Now we're all connected. We carry the computer around in our pocket.
We are now engaged in a new architecture in tech called Cloud computing, which is taking all of the content, putting it on a plane for software to work its magic. It's providing great growth opportunities. We have social networks where billions of people tune in every day that all of this enables. In medicine, we're conquering disease. It took $3 billion to map the first human genome.
Now we do it for under $1,000. There have only been 300,000 genomes mapped. I believe there will be a billion mapped at some point. So that provides great opportunities for companies that are making those machines to do that and for the biotech industry, which I argue the modern-day biotech industry is only ten years old. Because only recently did they have the capacity to really understand disease that the genome enabled.
And then, let's not forget the consumer. That's where 70% of the spending is. The consumer experience is just getting vastly better. We have a big, giant company that gets everything to us cheaper and more conveniently. We can get our hot meal tonight at the snap of a finger through delivery services.
Yuoh: You know, it's interesting. Tom brings up the consumer. And if you look at consumer sentiment, consumer confidence, I think consumer confidence yesterday came in at a slightly lower level than expected. But still we're at higher levels than we were before the Great Recession. Right?
The consumer confidence sentiments are at all-time highs. And if you think about what Tom and Giulio are talking about, it really at least to me points to the bifurcation that we have to manage for when it comes to growth. The U.S. is in this very strong environment with the consumer, all leading indicators continuing to trend upward. And then you make the segue to trade policy and its potential impact in terms of global growth, right? The EM [emerging markets] weakness that we've seen, the China uncertainty going forward, whatever that may be.
And so again as investors when we look at risk assets, how will risk assets perform or how can they perform in an environment where you have divergent paths fundamentally for the U.S. and the world, right? And can valuations do better from here in that environment, right? I think that's a question that we have to answer to position our portfolios correctly.
If you look at current valuations, it's already reflected some of that. High-yield debt is doing well. Investment grade corporates have weakened over the last few months, and that shift has been pretty dramatic. If you look at commercial mortgage-backed securities and asset-backed securities, commercial mortgage-backed securities focused on domestic real estate, asset-backed securities focused on the consumer. They've done very well this year, right? And so paying attention to that and thinking about the scenarios where how those relationships will change over the next six months to a year will be very important.
Solender: You know, I really enjoy hear Tom and Kew talk about their markets. I love the upside of the growth markets Tom's looking at. When you think about how they carry over to municipal bond side, 'cause it is a big impact for us, and hearing the things he's talking about when the economy's doing well, when these companies are doing well.
You look at the impact on the economy doing so well and a lot of the business that's coming from that. You look at transportation. Oil prices are on the lower side. You know, toll roads booming in terms of demand. Airports doing phenomenally compared to where they are now versus years ago. So a lot of things are doing very well in the country, and when the growth sector's doing well, when risk is doing well, a lot of that carries over to make municipal bond credit quality to be very strong.
Martini: You know, when I listen to Tom, what it all adds up to for me is low inflation and very little inflation pressure that's building.
And if there really is a lack of inflation or a lack of inflation pressure, then the kind of excess demand that's led to the end of periods of economic growth historically is, you know, well off into the future, right?
I also think the other thing that's led to the end of periods of economic growth are financial market excesses when you tend to see a very large mis-valuation in parts of the market.
If I look now, I don't see anything like that kind of financial market on a huge scale that's really threatening the environment.
Graham: All right, well, thank you all for being here. Thank you all for watching. I hope you learned something. I certainly did. And hopefully you can join us again in six months, as we look forward to 2019.
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2018 Midyear Outlook
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