This video was filmed April 30, 2019

In brief: 

Market outlook

  • We continue to see the global economy on a glide path to slower, trend-like growth. Inflation remains low and disinflation is creeping back into the market narrative.

  • The biggest adjustment for markets this year has been the Fed’s abrupt pivot away from tightening. We’re simply not seeing levels of inflation globally that would warrant tighter monetary policy in developed markets. That’s creating a “Goldilocks” environment of sorts for risk assets as well as for core bonds.

  • While we believe we are past the worst of the emotional riot that began last year due to investors fearing recession, risks remain. Market expectations about future Fed policy may shift, higher oil prices may challenge consumption, and ongoing trade policy developments can further increase market risks—as they are currently.

Portfolios

  • We remain well diversified and cyclically positioned, but with lower risk exposure relative to this time last year. We’ve ridden through the past six months with an unemotional focus on fundamentals.

  • All of our equity overweight—and more—is in the U.S. equity market because we believe it has the strongest growth potential. Generally, we see value in select subsectors of technology, energy and healthcare.

  • We’ve exited most of our extended credit positions. Credit market returns should now principally be driven by coupons, so we prefer to have that risk budget allocated to U.S. stocks within multi-asset portfolios.

  • We want to make sure portfolios always have appropriate shock absorbers and that we are diversifying risk. That is exactly how we are currently positioned. 

Bashfully bullish is how I would characterize market sentiment. When I’m asked what I think makes a good investor, I usually say that it’s someone that starts each day an optimist. You have to be excited about finding the next smart investment. That said, you also have to be a skeptic to challenge each investment idea thoroughly, without hubris. You can’t be a cynic, because a cynic never invests. 

A large part of the challenge facing investors today stems from the fact that markets have bounced back so quickly from last year’s emotional sell-off. Had markets not bounced back so quickly this year, negative sentiment would have hung over markets far longer. 

An important point worth repeating is to recall that global equity markets saw almost $108 billion in outflows in the fourth-quarter of last year according to EPFR Global. December alone saw some $105 billion in outflows (Figure 1). Data continues to show equity outflows this year. Current investor positioning may create technical support for risk assets ahead.

A bar chart shows flows into and out of global equity funds from December 2015 through March 2019. The chart highlights a significant outflow in December 2018 of $105 billion, and continues to show outflows through March 2019.

With large amounts of cash sidelined, there are deep pockets able to buy market dips. That may mean markets can see shallower pullbacks. “FOMO,” or the fear of missing out, is beginning to quietly creep into the market narrative. While supportive of risk assets, it’s also something to be wary of. It’s been a painful rally for anyone that sold equities late last year. The “pain trade” for investors is for markets to move higher. 

Leaning in

The pace of the recent market bounce-back helps reinforce the fact that December was an overreaction to fear mongering about impending recession. Imminent recession was never our base case or reflected in our portfolio positioning. We didn’t run away from markets late last year. We leaned in, adding to equities in late December and early January. 

I view the quick recovery that markets experienced as a retracement from an overdone fourth-quarter sell-off. We’ve just recently seen new equity market highs in the U.S. I continue to give bulls the benefit of the doubt, but return expectations need to be lowered. Investors should also expect higher market volatility ahead. 

Where markets are going from here and how we get there are two different things. I believe risk assets have some room to run, but the best returns for this year are likely behind us. Markets clawed their way back to where they were in late September. It’s been quite a ride. 

Over the next year, mid-single digit returns for equity markets and low-single digits for fixed income seem about right. While we maintain an overweight to equities, we have recently trimmed back the size of that overweight. All of our equity overweight is in the U.S. and then some. I want to be a buyer on market weakness and a seller into market strength. That’s exactly what we’ve been doing. 

Powell’s policy pivot

The biggest adjustment for markets this year has been the Fed’s abrupt pivot away from tightening. The Fed rightfully hit pause, recognizing that December’s rate hike may have been one too many for the current macro environment. Growth is slowing and inflation isn’t a threat to the U.S. or global economy (Figure 2).

A line graph shows a comparison of the U.S. Markit Manufacturing Purchasing Managers Index with the U.S. Core Personal Consumption Expenditures Price Index. Both indices have trended down since the end of 2018, indicating that U.S. growth is slowing.

The Fed was tapping on the policy brakes with a little too much force. It has taken its foot off the brake, for the moment. Its policy pivot wasn’t meant to signal that rate hikes are over. It was a change in the pace of hikes and an admission that it had over-stepped in policy tightening. 

After December’s rate hike, investors feared the Fed was on a programmatic path to raise rates. I don’t believe investors fully appreciate the significance of the policy pause that Chair Powell effected—also, the humility and facility to swiftly shift policy gears so quickly. I can’t recall a time when I’ve seen the Fed make such an immediate shift in policy, outside a major economic derailment or shock. 

Investors were expecting the Fed to raise rates this year until it nudged the economy into recession. With strong labor markets, the Fed has been anticipating inflation to rise. We are simply not seeing inflation or inflation expectations run ahead of the Fed or any major developed market central bank. That’s creating a “Goldilocks” environment of sorts for markets. 

Markets came into the fourth-quarter last year expecting two or three rate hikes from the Fed. That felt overdone. The market now seems to expect a rate cut from the Fed later this year and possibly another rate cut next year. That also feels overdone based on the trajectory of the U.S. and global economy. 

Looking at the economic data, our base case is for the Fed to remain on hold this year. If it was to move policy rates at all, I think the move would be higher and would be much later this year. Our fair-value target on 10-year U.S. Treasury yields is somewhere between 2.6% and 2.8%. We’ll see if we land there. 

The European Central Bank (ECB) is likely to ease policy further before hiking. I would say the same for the Bank of Japan (BoJ). Central banks across emerging economies are tilting to easier policy as well. For now, central bank monetary policy in aggregate leans toward easing. “Goldilocks” indeed. 

A global soft-landing

We continue to see the global economy on a glide path to slower growth. Slower economic growth is nothing unexpected. Growth continues to slow to trend. Disinflation is creeping back into the market narrative as well (Figure 3). That combination is what is keeping central banks from tightening—it’s not because they feel generous to investors.

A line graph shows the change in 2019 Bloomberg Consensus Inflation since December 1, 2018. Data shows that consensus expected Consumer Price Inflation for 2019 has declined in the U.S., Eurozone and Japan.

Trend-like growth with low inflation is supportive of markets. As that narrative becomes better recognized, I would expect risk premia to be supportive across equity and credit markets alike. In general, I would characterize equity markets globally as fairly valued and reflective of current fundamentals. The wild card for markets currently is U.S. trade policy. 

Trend growth in the U.S. is around 2%, while in Europe, it is right around 1%. That doesn’t leave a lot of room for the ECB to make a policy mistake. ECB President Mario Draghi is leaving office at the end of October. That will add uncertainty about the path of future European monetary policy. Markets are going to be watching for the announcement of Draghi’s replacement closely. 

While trend growth may be unexciting, a little boring is fine given the excitement we’ve seen over the past six months. With economic stabilization slowly returning to China—thanks to targeted stimulus—later this year, we may be reading about a global soft-landing. 

If I had to put odds on the chance of recession over the next 18 months, I would say it’s around 30-35%. Those numbers are lower than they were late last year because of recent Fed policy action. I believe the Fed’s policy pause, because it came so quickly, can help to extend the current cycle further. 

There couldn’t possibly be a better period than the past six months to emphasize why long-term money should stay invested. The portfolios we manage aren’t static, they are actively managed. From a goals-based approach to investing, making sure return and risk targets align with personal goals is essential. It can literally make the difference between staying invested and blinking at the wrong moment. To borrow an old Wall Street adage: Be right, sit tight. 

Markets feel ahead of the economic data. That’s fine, as long as we are right about the global economy stabilizing without a more meaningful rise in inflation expectations. Markets generally run ahead of economic data. They are forward-looking, while economic data is, to a large degree, backward-looking. I’m keeping a close eye this quarter on consumer as well as business confidence (Figure 4).

A line graph shows Global Business Confidence from 2010 through March 2019. Data shows confidence levels have consistently trended downward since summer 2018.

I’m also watching stock buybacks. Our Investment Bank is forecasting some $850 billion in U.S. stock buybacks this year. That should add about 2% of earnings per share growth to the S&P 500. Year to date, we’ve seen about $200 billion in announced buybacks, led by technology companies. I mentioned before that individual investors are sitting on significant cash positions. Excluding financials, U.S. companies are sitting on about $1.5 trillion in cash as well. 

Past the worst?

While I believe we are past the worst of the emotional riot that began last year due to investors fearing recession, there is a significant list of risks I am keeping a close eye on. I don’t believe any one of these risks is likely to derail the macro outlook. But they are worth watching, in particular if several were to escalate concurrently. 

Ironically, first on my list: market expectations about future Fed policy. It’s beneficial to believe the Fed is done hiking rates for this cycle. While it may be expedient, it isn’t what the Fed is saying. It has hit pause for the right reasons, but I firmly believe if the data changes and both growth and inflation accelerate, the Fed will quickly be back to tapping on the policy brakes. 

The run up this year in spot oil prices is something to monitor. We’re nowhere near prior highs, but the recent acceleration in energy prices will likely weigh on consumption. Higher energy prices may also weigh incrementally on profit margins and earnings, and raise inflation expectations. That said, energy remains one of the sectors we favor as an overweight both in the U.S. as well as in European equity markets. 

Politics, unfortunately, is going to remain part of the market narrative. Whether trade policy and tariffs, a continuation of the U.K. kicking the can down the road on Brexit, or U.S. politics ahead of 2020 elections, political theatre isn’t going away anytime soon. Policy and politics will continue to weigh on investor sentiment, as they are currently. 

Actively managing portfolios

We’ve been adding to core bonds and extending fixed income duration over the last year. Those were contrarian trades when we made them. Across multi-asset portfolios, we’ve now exited most of our extended credit positions. 

The reason we’ve been reducing extended credit isn’t because we’re worried about a looming break in credit markets. At current spread levels, I view extended credit as a carry trade—returns ahead should principally be driven by coupons, not additional spread compression. For our multi-asset portfolios, I prefer to have that risk budget allocated to U.S. stocks. On a relative basis, there is still a little room, with bumps, for equity multiples to extend a bit further. 

All of our equity overweight—and more—is in the U.S. equity market. We began to reduce exposure to developed equity markets outside of the U.S. in the second-quarter of last year. We’ve done this gradually, with discipline and without fanfare. When we’ve cut overall equity exposure, we’ve taken it from non-U.S. developed markets. When we’ve added to overall equity exposure, we’ve added to the U.S. 

We remain cyclically positioned across portfolios but have markedly pulled back risk from where we were this time last year. We’ve ridden through the past six months with an unemotional focus on fundamentals. As I mentioned in my last note, over the long term, markets are a weighing machine focused on the fundamentals. In the short term, they can be highly charged and emotional. That creates opportunity we are well positioned to take advantage of. 

Long-term money is meant to remain invested. We actively manage portfolios, calibrating the amount of risk and tracking error we take based on our fundamental view and outlook. I want to be leaning into more concentrated positions when we see a meaningful value proposition. When we don’t see those opportunities, I want to make sure portfolios have appropriate shock absorbers and that we are diversifying risk. That’s how we are currently positioned. 

Diversification is never more important than when we’re late in the cycle and markets, in general, feel fully valued. We will inevitably be presented with new investment opportunities—just as we were in late December and early January when we added to U.S. equities. That’s the optimist and the skeptic in me speaking, as we continue to actively navigate markets ahead.