Investment Roundtable: Looking Back at a Challenging 2018
Looking Back at a Challenging 2018
A Roundtable Discussion
ID: Joseph Graham, CFA
Joseph Graham: Welcome to the latest Lord Abbett investment roundtable. My name is Joseph Graham. I lead the investment strategists group here at Lord Abbett. Today I'm joined by a number of our senior investment professionals, portfolio managers who bring a wealth of expertise in the capital markets and in their individual domains of expertise, which we will talk about.
ID: Kewjin Yuoh
Partner and Portfolio Manager
Kewjin Yuoh: Kewjin Yuoh, partner and portfolio manager in taxable fixed income.
ID: Dan Solender, CFA
Partner and Director of Tax-Free Fixed income
Daniel Solender: Dan Solender, partner and director of tax free fixed income.
ID: Leah Traub, Ph.D.
Partner and Portfolio Manager
Leah Traub: Leah Traub, partner and portfolio manager in taxable fixed income.
ID: Giulio Martini
Partner, Director of Strategic Asset Allocation
Giulio Martini: Giulio Martini, partner and head of global asset allocation.
ID: Thomas O'Halloran, J.D., CFA
Partner and Portfolio Manager
Tom O'Halloran: Tom O'Halloran, partner and manager of growth equities.
Graham: So let's start with year-end review. It's certainly been an interesting year. We've seen a number of bouts of volatility. The latest [came] in the last six weeks, where we've had a number of [market] leaders over the year turn over. Giulio, we'll start with you, what's behind this latest market weakness? And do you think it's warranted?
Martini: Well, I feel like we've always had two strands in current politics with respect to how they affect growth and the economy and the markets. The first strand was the [U.S.] tax cut and tax reform package, along with deregulation. That was growth positive, and positive for corporate earnings. And then the second part of the agenda, which had to do with trade and immigration restrictions, was always clearly going to be negative for the market, and negative for growth and earnings.
And I think we've turned around to focus more on that second part right now. And looking forward, as we've seen a few signs of slowdown in the global economy, it's coincided with that uncertainty - about the negative part of these economic policies that I think have really started to worry investors about how this all could come together and develop over the next year or so.
Graham: And that would make sense. The turmoil seemed to start in emerging markets over the early summer [of 2018]. So it would make sense that it would be trade-related. It seems to have somewhat abated there and then spread into other sectors. Tom, growth stocks in particular, do you think-- do you think trade's behind a lot of the weakness there and a lot of the rotation? Or do you think it's something else?
O'Halloran: I don't know what the culprit is at this point. I think it's the Fed reducing the balance sheet, raising interest rates to a greater degree than it is the trade issues. But they're both at work here, in bringing about the corrective phase that we find ourselves in right now. The growth stocks were leaders for 21 months or so. Often when they go that long, [growth stocks] go through a corrective phase for some period of time. And that's clearly what's happening. The leadership of the equity markets has changed from the FAANG stocks to many of the defensive stocks [for example], utilities, and consumer staples.
So we are currently in a corrective phase. I think the Fed is the main culprit, but we really don't know the culprit yet. And all of problems and risk to the market [that] were discussed at the last time we got together? They finally came to matter [at yearend].
Graham: How about the locus of the problem, emerging markets? Do you think there a tough road ahead for them with the strengthening dollar? Do you think the volatility continues?
Traub: I definitely do agree that it started with the emerging markets. And I think it was a combination, echoing what Tom said, with the Fed raising rates, reducing liquidity. And then, also, some of the trade talk [moving] back into the forefront. We [also started] seeing some slowdown in China. And that was affecting the emerging markets. It also affected commodities, which [in turn] affected the emerging markets.
And then we saw the dollar really start strengthening; it was really about April [when we] started seeing that take off, [extending] into the summer. We've seen a little bit of a reprieve now. As things have moved away from emerging markets and broadened out.
I do think the volatility is still going to be with us. We don't have resolution on the trade front, especially as it relates to China. And that is really the key tension that we have. I don't think [we will] get a quick or a full resolution. We may get little deals here and there, but I think this [will] ebb and flow, and be with us for a while.
I think the emerging markets are going to be at the whim of the [U.S.] dollar in some respects. And therefore the pace of Fed hikes and what the Fed [ultimately] ends up doing. So I think volatility is definitely here to stay. But I do think valuations have moved to reflect that volatility, so that there may be chances for it to come back a little bit, as we've seen. That may continue. And then, we may see some reversal.
Graham: Surely there are other things that have contributed to some of the weakness. One I can think of is the amount of debt [the United States has] put on at a federal level, and probably at a state level as well. Dan, can you give us a picture of what the fiscal situation looks like?
Solender: The municipal bond market this year has had a few different parts. And in a year where it's been slightly negative, one component is Fed activity, economic growth, and the impact on interest rates. The other is the tax bill from last year. And all of it has had an impact on the fiscal situation. On the Fed side, obviously the Fed has raised rates. Rates have gone up.
That's gotten retail investors very concerned about rising rates, which has made them reduce demand for the longer end of the market [and move] into the shorter end of the market. That has meant a steepening yield curve on the municipal bond side, which has been surprising a lot of [people]. When you go out there and talk to people, they all think we're following the taxable market, where the yield curve's been flattening. But we've actually been steepening this year, primarily because of the supply and demand dynamics with retail investors being concerned about rates.
On the other side, the tax bill had a big impact because it pushed a lot of our supply into December of last year. So we've had a really slow first half of the year for supply. That's picked up a little bit in the in the second half, but [it's] still on the lighter side. Even though we've had a good fiscal situation, with revenues being strong and state economies doing well, the states and municipalities have been holding back a little bit on borrowing, which has been a positive so far.
But another impact from the tax bill [is the] steepening yield curve, because retail investors are not wanting to go out [to longer maturities]. And typically institutional investors - banks and insurance companies - have been investing in the longer end of the market. But the tax bill lowered the corporate tax rate, [and] lowered banks' and insurers' demand for longer bonds. And that's [resulted in] less demand on the longer side.
So fiscally, things are doing pretty well. States are performing well. Credit quality is doing well. But we've had a steepening yield curve that's led to the investment-grade market being slightly negative for the year. The lower quality market [has been] positive for the year.
Graham: Kew, from a taxable fixed income perspective, do you see any other contributors to the weakness this year?
Yuoh: Sitting here, there is a sense of deja vu from the last time we gathered. Then, things were weakening a little bit. And we were talking about the flattening yield curve. And the narrative in the markets at that time seemed to be the yield curve is flattening. If we [were to] get an inversion [of the curve, many believed that] recession happens and risk assets should be priced wider. And that's what everyone was concerned about.
When we were last here, we talked about [the notion that] âthis time it's most likely different.â The yield curve is actually flatter now than it was when we last met. And that narrative is completely gone. So what's the narrative now? And does it make sense? Does it justify what's happened? We came into the third quarter believing that this time it was different, that the flat yield curve was okay. And in the third quarter, risk assets seemed to agree with us.
Risk assets did well. The fundamentals of the economy were the backdrop. And all of a sudden, we hit the fourth quarter and the narrative became âwe can't handle rising rates. The Fed's going too fast. It's going to be too much. Higher rates are going to be a problem. And that seemed to be one of the main narratives for all the weakness that we had. But I would disagree with that.
How is that so different from what we've been experiencing the last few years in terms of the Fed raising rates 25 basis points every quarter and the expectation that they're going to continue to do so, especially with fundamentals so strong? And [with] inflation so tame, they have the room to do this. I would point to one thing.
When the Fed came out in their September meeting and removed [the word] "accommodative" from their [post-FOMC meeting] statement, they started to point towards data dependency mattering more. I think that should have signaled to the markets that we are due for higher volatility because of higher uncertainty. And when you have higher uncertainty, you should have higher risk premiums.
But I completely agree with Leah that the weakness that we've seen thus far has offset that correction that [came] from higher uncertainty. And the fundamentals of the economyâand I'm sure we'll get to it laterâremain quite robust.
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A basis point is one one-hundredth of a percentage point.
ECB refers to the European Central Bank.
FAANG is a popular acronym for five high-performing technology stocks: Facebook, Amazon, Apple, Netflix, and Google [now Alphabet, Inc.].)
Fed refers to the U.S. Federal Reserve.
Risk asset is describes any financial security or instrument that is not a risk-free asset (i.e. a high-quality government bond). Risk assets generally encompass equities, commodities, property, and all areas of fixed income apart from high-quality sovereign bonds.
Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond's market price. Spread is the difference in yield between two different investments.
Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.
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