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Equity Perspectives

Do you have the right portfolio now for the next cycle? 

 

In Brief:

  • It looks like investors can finally put the worst financial calamity of this young century behind them. If so, it’s well worth examining what this means to their asset allocations.
  • Extrapolating the trends of the last secular economic cycle in determining asset allocation could be a big mistake.
  • Consider looking at ways to benefit should inflation exceed expectations. The most obvious assets are economically sensitive equities.
  • A combination that we favor in both the United States and overseas is to focus on dividend-paying companies, and small- and mid-cap stocks, as they tend to have high operating leverage to increasing growth and pricing trends.
  • Now may be a good time to increase one’s allocation to overseas markets, where there appears to be an overly negative view of the impact of political turmoil.

 

It seems a long time since the investment world was debating the provocative 2008 research of Carmen Reinhart and Kenneth Rogoff (which later, in 2011, was turned into a book titled, This Time Is Different: Eight Centuries of Financial Folly). One of their many findings was that bursting credit bubbles are starkly different from cyclical recessions in terms of economic ramifications, and that ensuing policy prescriptions typically lead to subpar economic growth for roughly 10 years. Well, we’re almost 10 years past the mortgage credit bubble, and given some of the changes we’ve seen in market behavior and leadership this year, it begs the question, “are we finally leaving the crisis behind?”

It does appear that market participants are beginning to look beyond their fixation with inflation, unemployment, and bank capital levels. Of course, this could be premature, given the volatility being introduced into the political process here and abroad that exacerbates uncertainty in the markets. But whether it’s this year, next year, or in a few years, indications are growing that we’ve turned the corner on the worst financial calamity of this young century. If so, it’s well worth examining what this means to an investor’s asset allocation. The most important reason is that the final quantitative easing-induced interest-rate dénouement just may have coincided with the end of the 36-year secular economic cycle—which also saw inflation squeezed out of the system and nothing but lower and lower interest rates for that entire cycle.  If this is the case, extrapolating the trends of the last 36 years is probably the most irresponsible mistake one can make when determining the asset allocation of his or her portfolio.

One of the notable aspects of the world economy since the onset of our cycle in 1980 has been the surge in the most productive, highest earning, and highest spending cohort of people—those aged 35–55. This growth was both absolute—fueled by economic liberalization and the opening up of large emerging markets—and relative. The surge not only helped economic growth globally but also helped, via productivity, to keep prices in check. At the beginning of 1980, the number of people in this productive group was at a low, relative to those both younger and older. (See Chart 1.) This ratio (called the dependency ratio) is now peaking in the large economic powers, and will begin to reverse, and for some time to come. But we can still reap the benefits of the economic liberalization that has occurred, and there should be numerous countries newly entering their phase of rapid development. Our point is that many of these secular drivers are shifting, and that it happens to coincide with the shorter-term changes in politics and policy that mark the current era in which we are living. Such fundamental change, therefore, necessitates a reassessment of one’s portfolio, since what worked in the past likely will not work as well going forward.

 

Chart 1.  Don’t Count on the Last 36 Years Repeating Itself—Productivity Likely to Decline
Productivity ratio (for ages 35–54 years versus 0-24 years and >65 years), 1950–2050E

Source: Deutsche Bank, UN Population Division.

 

Capital markets already are reacting to this change in drivers, anticipating new policies to spur growth globally, along with fiscal and regulatory reforms. This is a stark contrast to previous policy (QE and negative interest rates from 2008 to 2016). The expectation is that capital market participants will decisively leave behind any deflation fears; hence, interest rates and inflation should move higher over time, back toward their historical ranges. We can see these expectations in the consensus economic forecasts for the G20 countries in Table 1. Nominal GDP growth (real GDP plus inflation) is expected to improve, to roughly 6% growth over the next two years, as both inflation and real growth inch higher.

 

Table 1. G20 Consensus Forecasts Point to Reflation

Source: Bloomberg.
Nominal GDP is gross domestic product (GDP) evaluated at current market prices, GDP being the monetary value of all the finished goods and services produced within a country's borders in a specific time period. The main difference between nominal and real values is that real values are adjusted for inflation, while nominal values are not.
Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

 

Asset allocation, we believe, is about finding market asymmetries—that is, areas where the consensus may be wrong and the cost of exposure is low, thus the investment opportunity is mispriced and tilted in your favor. One such asymmetry is in those tame expectations for inflation. If we are in a different era—one in which we have reached the limits of cheap labor propelling productivity and deflation globally—then it may be worth looking at ways to benefit should inflation exceed expectations. In that regard, it’s interesting to note that Chinese producer price inflation (PPI) is back in positive territory—for the first time since 2011. As manufacturer to the world, what does Chinese PPI mean for global inflation?

If once the asset to own for the unprecedented deflationary run we’ve had was U.S. long-term Treasuries, then one should be looking away from them and instead toward assets that stand to benefit from a return of inflation, even modest inflation.  The most obvious assets are economically sensitive equities—and, indeed, we’ve begun to see a turn in asset flows that reflect this in the U.S. market. (See Chart 2.)  A combination that we favor in both the United States and overseas is to focus on dividend-paying companies, given dividends grow with inflation over the medium term, and small- and mid-cap stocks, as they tend to have high operating leverage to increasing growth and pricing trends.

 

Chart 2. Fund Flows into Developed Market Bond and Equities, 2011–16

Source: BlackRock Investment Institute and EPFR Global. Data as of November 30, 2016.
Notes: The lines show cumulative bond and equity fund flows since January 2011.  Bernanke’s tapering speech is when the Fed Chair Ben Bernanke flagged the gradual end of bond purchases.
For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Small-cap and mid-cap company stocks tend to be more volatile and can be less liquid than large-cap company stocks. Due to market volatility, the market may not perform in a similar manner in the future. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

 

Another ideal hedge, in our opinion, would be an asset that is positively correlated with inflation, negatively correlated with higher interest rates, and that has relatively low annual volatility. While most investors think of commodities and Treasury inflation-protected securities as useful inflation hedges, they don’t offer the best trade-off for the three attributes listed above. But a combination of inflation index forward contracts and a short-maturity income fund helps provide  the best combination of positive inflation correlation, negative interest-rate correlation, and low annualized volatility. Our inflation-focused strategy uses such an approach.

An opportunity also might arise from the consensus expectations for both a strong dollar (propelled by higher U.S. interest rates) and political turmoil in Europe, which consequently would create disappointing growth dynamics overseas. The combination of these two consensus views has, lately, kept most U.S. investors from looking at overseas investment opportunities. (For a glimpse of price and valuation differences, see Chart 3.) The strong dollar has been a headwind for international equity strategies over the last five years.  After such a lengthy run, we would caution that the two-way risk is perhaps more real than expected by the market. The factors strengthening the dollar are all well known: rate support, safety, and strong relative economic growth. But with dollar bulls already positioned, a mercantilist president who may want a lower dollar, which is overvalued on a purchasing power-parity basis, the consensus is set up for another asymmetry to exploit.

 

Chart 3. Cheaper Stock Prices Abroad May Attract More Investor Attention 
MSCI USA Index versus MSCI World ex-USA Indexes and price/earnings ratios, 2008–2016

Source: Bloomberg.

 

Combine the U.S. dollar headwinds turning to tailwinds and the excessive pessimism on European and Asian growth prospects, then one can make a strong case for increasing one’s allocation to overseas markets, where there appears to be an overly negative view of the impact of political turmoil. Typically, the impact from political surprises is short-lived, because the course of the economic cycle eventually reasserts itself. That cycle lately has been characterized by stimulatory, low interest-rate policies, increasing fiscal expansion, lower unemployment, and positive economic surprises in the majority of countries. Recently, however, most of the economic indicators from overseas have been exceeding expectations, and we see numerous leading indicators pointing toward a broadening of growth around the world, not a weakening. In fact, more than 90% of the world’s manufacturing purchasing manager indexes are above 50, meaning they are in expansion territory. 

So, whether or not we’re at an inflection point is open to debate, but it does appear we have moved past the dire effects of the financial crisis of 2008–09. The upcoming and unavoidable decrease in the dependency ratio within the world’s largest economies coupled with the changing political environment should ensure that the past trends will begin to fade and that new ones will assert themselves. These in turn likely will shape the upcoming decades, just as they did from 1980 onward. There also should be created very different opportunities within the investment world than what we have witnessed over the last few decades, and, ultimately, these will change the ideas of how one’s portfolio should look.  If your portfolio reflects the trends of the last 36 years, it may be time to start leaning toward a different world dynamic.

 

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The MSCI USA Total Return Index is designed to measure the performance of the large and mid cap segments of the US market. With 630 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US.

The MSCI World ex USA Total Return Index captures large and mid cap representation across 22 of 23 developed markets countries*—excluding the United States. With 1,022 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The G20 (or G-20 or Group of Twenty) is an international forum for the governments and central bank governors from 20 major economies.

Gross domestic product (GDP):  The monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

The Consumer Price Index (CPI) measures the price changes f or each item in a predetermined basket of goods and services, and the inputs are weighted according to their importance to consumers.

TIPS (Treasury Inflation-Protected Securities) are U.S. Treasury securities indexed to inflation in order to protect investors from the negative effects of inflation. The principal of a TIP is adjusted according to the CPI-U. With a rise in the index, or inflation, the principal increases. With a fall in the index, or deflation, the principal decreases. Though the rate is fixed and paid semi-annually, interest payments vary because the rate is applied to the adjusted principal. Specifically, the amount of each interest payment is determined by multiplying the adjusted principal by one-half the interest rate. Upon maturity, TIPS pay the original or adjusted principal amount, whichever is greater. Because TIPS are adjusted for inflation, a change in real interest rates (but not nominal interest rates) will affect the value of TIPS. When real interest rates rise, the value of TIPS will decline, and when real interest rates fall, the value of TIPS will rise.

Asset allocation does not guarantee a profit or protect against loss in declining markets.

Risks to Consider: Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing, including those related to currency fluctuations and foreign, political, and economic events. The securities markets of emerging countries tend to be less liquid, especially subject to greater price volatility, have a smaller market capitalization, have less government regulation and may not be subject to as extensive and frequent accounting, financial and other reporting requirements as securities issued in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions. No investing strategy can overcome all market volatility or guarantee future results.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The G20 (or G-20 or Group of Twenty) is an international forum for the governments and central bank governors from 20 major economies.

Gross domestic product (GDP):  The monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

The Consumer Price Index (CPI) measures the price changes f or each item in a predetermined basket of goods and services, and the inputs are weighted according to their importance to consumers.

TIPS (Treasury Inflation-Protected Securities) are U.S. Treasury securities indexed to inflation in order to protect investors from the negative effects of inflation. The principal of a TIP is adjusted according to the CPI-U. With a rise in the index, or inflation, the principal increases. With a fall in the index, or deflation, the principal decreases. Though the rate is fixed and paid semi-annually, interest payments vary because the rate is applied to the adjusted principal. Specifically, the amount of each interest payment is determined by multiplying the adjusted principal by one-half the interest rate. Upon maturity, TIPS pay the original or adjusted principal amount, whichever is greater. Because TIPS are adjusted for inflation, a change in real interest rates (but not nominal interest rates) will affect the value of TIPS. When real interest rates rise, the value of TIPS will decline, and when real interest rates fall, the value of TIPS will rise.

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