1Q:2019 Capital Markets Outlook

Perhaps the best way to summarize 2018, is the continued strength in developed markets, labor performance and the consumption it would allow, against fears of global trade, trade policy and tightening financial conditions. And you can see that play out in U.S. equity markets throughout the year giving way between strengthened markets and fears of trade or rates until we get to the end of the third quarter where both of those came to a head. Worries around U.S. and China, particularly the meeting in Buenos Aires in the fourth quarter and also Jay Powell’s comments leading to a strong sell off and creating a negative year in most risk assets in the world.

And that negativity carried over in U.S. markets into 2019: pricing and no rate increases, no earnings growth, and anemic economic growth. And indeed we had two very confusing economic reports to start the year with very weak manufacturing PMI data and very strong payrolls report. We believe the truth is somewhere in the middle as labor growth will still be strong but moderate, toward trend, economic activity will stabilize, and will start to look classically ‘late cycle’. Take a look at this stylized market clock over here. If you’re on the left side things are usually pretty good. And as we move through the years you can see that strength and growth contained inflation. But as we move past midnight assets become more challenged. How challenged this year will depend on several things.

The first of which of those two things I was just talking about. Both manufacturing PMI or economic activity, and payrolls could soften a bit because we’ve been running above trend in both. But if we get down below 50 in manufacturing ISM or if we approach 100,000 in the market clearing rate and payrolls, markets are going to question economic strength within the developed markets in the United States, in particular.

Outside of the US in China, of course, lots of questions around growth. China had a weak PMI number of its own but they’re offsetting that with a significant amount of fiscal stimulus so probably the bigger thing to think about in the first quarter, of course, is U.S. / China trade negotiations, and inside the US the biggest story will ultimately be about tightening financial conditions continuing. The market thinks no rate increases the Fed says two but they’ll be data dependent. And they also say they’re going to continue to reduce the balance sheet by about six hundred billion dollars this year which means the market has to absorb that debt and they’ll have to absorb it at the same time that lots of new debt is coming out on the back of trillion - trillion plus dollar deficits in the United States.

And outside of the public sector corporate debt has been growing strongly for about a decade, and much of that debt is coming due and will have to be refinanced. And that maturity wall, while manageable, will produce winners and losers which will affect our fixed income portfolios. What should I do in my fixed income portfolio? What should I think about? Three things in my mind: One - don’t fear duration, lots of worries about rising rates and high-grade bonds, of all the things in your portfolio that can hurt you, the math typically doesn’t allow for that to be one of them.

Secondly from an income perspective we still think a credit barbell is a really efficient structure, combining high grade and high yield to produce a solid yield, but also good downside protection. By the way speaking of yield, high yield spreads widened out in the fourth quarter meaningfully, so much so, that in the United States we enter the year with expected equity returns over the next five years lower than high yield. Translation: consider selling some of your equities and derisking into high yield to produce better drawdown and potentially higher, if not equivalent, returns.

And speaking of which, within the equity portfolio, also remember we’re late cycle so factors that matter here are going to be persistency and quality of growth, free cash flow, yield generation and the star of this presentation, debt. Leverage has become a big topic. It was last year and will be as we go forward, between low and high levered companies. And speaking of reversals of fortune within markets, we’ve enjoyed a very long period of strong performance and low volatility, and that has changed. That means one last consideration is to dust off an old strategy, hedged equities. Why? Because they take lower market risk, replace that with idiosyncratic market exposure, and that allows them to both participate in markets but defend if things sell off. The reality is that’s something we should be trying to build into our overall portfolio.

We have the largest retiring developed-world demographic in world history, and we have to tread very carefully to protect retirement portfolios across the globe over the coming years. As a result our entire portfolio should be looking to participate and defend.

And that negativity carried over in U.S. markets into 2019: pricing and no rate increases, no earnings growth, and anemic economic growth. And indeed we had two very confusing economic reports to start the year with very weak manufacturing PMI data and very strong payrolls report. We believe the truth is somewhere in the middle as labor growth will still be strong but moderate, toward trend, economic activity will stabilize, and will start to look classically ‘late cycle’. Take a look at this stylized market clock over here. If you’re on the left side things are usually pretty good. And as we move through the years you can see that strength and growth contained inflation. But as we move past midnight assets become more challenged. How challenged this year will depend on several things.

The first of which of those two things I was just talking about. Both manufacturing PMI or economic activity, and payrolls could soften a bit because we’ve been running above trend in both. But if we get down below 50 in manufacturing ISM or if we approach 100,000 in the market clearing rate and payrolls, markets are going to question economic strength within the developed markets in the United States, in particular.

Outside of the US in China, of course, lots of questions around growth. China had a weak PMI number of its own but they’re offsetting that with a significant amount of fiscal stimulus so probably the bigger thing to think about in the first quarter, of course, is U.S. / China trade negotiations, and inside the US the biggest story will ultimately be about tightening financial conditions continuing. The market thinks no rate increases the Fed says two but they’ll be data dependent. And they also say they’re going to continue to reduce the balance sheet by about six hundred billion dollars this year which means the market has to absorb that debt and they’ll have to absorb it at the same time that lots of new debt is coming out on the back of trillion - trillion plus dollar deficits in the United States.

And outside of the public sector corporate debt has been growing strongly for about a decade, and much of that debt is coming due and will have to be refinanced. And that maturity wall, while manageable, will produce winners and losers which will affect our fixed income portfolios. What should I do in my fixed income portfolio? What should I think about? Three things in my mind: One - don’t fear duration, lots of worries about rising rates and high-grade bonds, of all the things in your portfolio that can hurt you, the math typically doesn’t allow for that to be one of them.

Secondly from an income perspective we still think a credit barbell is a really efficient structure, combining high grade and high yield to produce a solid yield, but also good downside protection. By the way speaking of yield, high yield spreads widened out in the fourth quarter meaningfully, so much so, that in the United States we enter the year with expected equity returns over the next five years lower than high yield. Translation: consider selling some of your equities and derisking into high yield to produce better drawdown and potentially higher, if not equivalent, returns.

And speaking of which, within the equity portfolio, also remember we’re late cycle so factors that matter here are going to be persistency and quality of growth, free cash flow, yield generation and the star of this presentation, debt. Leverage has become a big topic. It was last year and will be as we go forward, between low and high levered companies. And speaking of reversals of fortune within markets, we’ve enjoyed a very long period of strong performance and low volatility, and that has changed. That means one last consideration is to dust off an old strategy, hedged equities. Why? Because they take lower market risk, replace that with idiosyncratic market exposure, and that allows them to both participate in markets but defend if things sell off. The reality is that’s something we should be trying to build into our overall portfolio.

We have the largest retiring developed-world demographic in world history, and we have to tread very carefully to protect retirement portfolios across the globe over the coming years. As a result our entire portfolio should be looking to participate and defend.