If we are going to recap this quarter, we should talk about how we felt at the beginning of it, which is to say very pessimistic; but that didn’t stop it from being the best first quarter in many, many years. But it’s important to know where that performance came from: valuation expansion rather than growth. And those valuations expanded largely on the back of major central banks backing away from tightening. And they did so because of their countries’ ongoing exposure to deteriorating global trade. Now, the one exception amongst those central banks would be the Federal Reserve which modified its approach to inflation. Historically, across the cycle the Federal Reserve targets 2% inflation all along that period. The modification is to average 2% inflation. Why does that matter? Because typically, in a downturn, inflation is below 2%, which means the Federal Reserve can allow it to run a little hotter in expansionary periods like right now; which explains why one meeting ago the Federal Reserve was predicting perhaps two rate increases. And now it is zero, and so of course we’re going to have to watch how the market absorbs this new approach. However, something that hasn’t changed is the macroeconomic backdrop that’s powering economies and markets: labor.
Labor is still the engine. However, that engine continues to moderate and as it moderates, the expectation and what we think is going to happen is growth will moderate with it. And you can see that view showing up in global expectations, industrialized economies, in the United States specifically. The thing is though, this idea of moderating growth is not new. “Late in the cycle” is something that almost everyone talks about. Probably the more critical thing is what do you do about a world where growth is moderating, returns are expected to be quite moderate, and there’s tremendous downside risk in the world? The thing that we continue to speak to is the importance of participation and defense. Participating in a market cycle or a point in the market cycle where returns should be solid, if below average. But how do we defend against potential downturns?
On the fixed income side of the ledger, there are three tenants; they are still the same. The first is don’t get caught wrong-footed and isolating too much of your portfolio into risk assets. Create balance, so maintain your core allocation. As always, we would suggest that you globalize. One additional modification is - because of the Fed - perhaps within your U.S. high-grade fixed-income allocation, consider adding in maybe a bit of inflation protection. The second tenant: the most efficient income that we know of across the cycle and particularly now because of where yields and spreads are, is a credit barbell. The blending of high grade and high yield today you can get about 80 percent of the yield of high yield with a credit barbell. But, of course, with a fraction of the drawdown. That’s a pretty potent cocktail at this point in the cycle. But before we feel too badly for high yield: high yield is one of the stronger betas in capital markets in terms of up-down participation. One great usage of high yield as an equity de-risk. Very powerful today. Why is it so powerful? Well, we came into this quarter with high-yield yield-to-worst around the same level as what we would expect the S&P 500 returns to be over the next five years. And why should you care about that? Because the reality is whatever your starting yield-to-worst is in high yield, regardless of where we find ourselves in a cycle, over the next five years, with striking regularity that’s pretty much going to be what your average annual return is. As you can see here, whether we are at a good point in the cycle or a bad point in the cycle, if spreads are wide, if spreads are tight, regardless. We tend to see the same thing happening over and over: Your starting yield-to-worst is your return. And again, keep in mind that high yield has a fraction of the drawdowns of equities, so this would be a great way to consider de-risking your equity allocation.
But that’s not the only ingredient. There are more. Think of this as sort of a pie chart prescription. Add to high yield things like quality of growth, low volatility, low levels of debt, free cash flow generation, equity hedge strategies where you can take down some of the beta in our portfolio even further... The thing is over entire cycles all of these factors tend to do quite well, thank you very much, but they’re most famous for their performance late in a cycle. Now, because as I mentioned earlier, everyone sort of thinks we’re late cycle, you would think that these things are expensive today, but they’re not. Here are two examples: The first would be low leverage - United States or Europe: the relative valuations are actually cheap relative to history. Same thing for free-cash-flow yield generation. Perhaps one of the reasons is because we’ve been so focused on growth into the future and pushing up valuations of those stocks, we’ve forgotten the quality-balance-sheet persistent growers. Let’s not forget them.
These could be the things that allow us to walk through the rest of this cycle. And that’s probably the most important thing to consider here, is we have to make our way through the rest of this cycle where returns can be solid for some time if unspectacular. But as I mentioned before there are lots of tail risks in the world. And there is a world of baby boomers at critical stages of retirement where we need to walk them through the rest of the cycle safely. All of these factors, all of these ideas allow us to do that. We look forward to talking to you about all of these as we go forward into the future because it is so important. But for now, thank you for joining and I will see you next quarter.
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