Portfolio managers Rob Lovelace and David Hoag, and economist Darrell Spence share their thoughts on the outlook for global equities, fixed income and economies as they look ahead to 2018. Moderator Will McKenna addresses possible implications of these themes for Capital Group portfolios.
American Funds video transcript: “2018 Outlook: Markets and Economies”
Will McKenna: Hello, and welcome to Capital Group's 2018 Outlook event. I'm Will McKenna, vice president with Capital Group, and I'm delighted that you're joining us today to hear from our veteran team of portfolio managers and economists. Now, they're going to offer their views on today's equity and bond markets, as well as the continuing global economic recovery. Now, as many of you already know, this event is available for continuing education credit, and we will have links at the end of this presentation, as well as in our podcast show notes, so that you can connect to the form you'll need to complete in order to earn your C.E. credit. Joining me today are Capital Group portfolio managers Rob Lovelace and David Hoag, and economist Darrell Spence. Rob is an equity portfolio manager with 31 years of investment experience and has responsibilities on a number of our global investment strategies. David is a fixed income portfolio manager with 29 years of experience and manages on some of our largest bond funds. Darrell is our U.S. economist, with 24 years of experience. Gentlemen, thanks for being with us today. Rob, we often start with you at these events. What are you seeing shaping up for 2018? Rob Lovelace: Well, it has been an extraordinary period. I think all of us will touch on that in terms of strength of the markets and continuing economic expansion — and I think Darrell will probably touch on it — but I think it's the first global expansion coordinated between the different economies that we've had certainly in a decade or so. And that's really been, I think, what's been driving the markets. The U.S. has been at the forefront of the recovery, really, since the great recession. And the market has really outpaced the others, in part because it started early, but also because — I think — of the strong underpinning of the internet and technology companies that we have here. The comparable country to that is actually China, which is why I like to break China out of the emerging markets group now, because it is the second-largest economy. And as they free up their capital markets, and people get more access to the stock market there, it really will have a status similar to Japan's going forward as a standalone country. And everyone's been worried about China. China was the one that did well even through the crisis. And so we've all been talking about a hard landing in China and what's that going to mean, but again, China has had this strong tech and internet sector that's kept the market going and, in fact, probably helped the economy in a way that's allowed them to maybe even avoid a soft landing. So China and the U.S. have been the two big drivers, I think, for similar reasons, with sort of the 1.0 economy doing OK, but the 2.0 economy — that link to technology and the internet — really being a key driver. Europe's caught in between. For lots of reasons, they did not have as strong a tech and internet — at least in terms of public companies — sector to rely on, and they were later in terms of putting the quantitative easing in. So Europe's finally catching up now. And also, from a geography standpoint, about half the revenue of companies based in Europe comes from the U.S. and China. So a big part of what's happening in Europe's recovery is, in fact, the feedback loop that's coming from those two economies. Japan is on its own kind of march here. As we know, Abenomics and other aspects are trying to learn from what has been accomplished in the U.S. and in Europe, and it does look like it's working, at least in terms of eliminating the deflationary side of things. The Japanese market has recovered the least compared with the others. It's been a long time since we've talked about Japan as a value market. It was that in the 1960s, and waiting 50 years, we're finally back to Japan actually offering some of the most value, if they can actually get back on a continuous growth path. Will McKenna: That's great. This time last year, there was quite a pronounced valuation gap between some of the international and emerging markets and the U.S. Clearly, that's narrowed considerably during 2017. But we've gotten two questions from our audience, which I think are related to this, that I thought I would give to you, Rob. And those are, essentially, on valuations. Number one, is the U.S. now overvalued, and is it ripe for a correction? And then secondly, our audience is saying, have they missed the rally . . . Rob Lovelace: Right. Will McKenna: . . . in international and emerging markets? So if you would take those two sides of that coin. Rob Lovelace: I think 2017 is a great example of the conundrum of the U.S. markets, because valuations are relatively high compared to history — so sort of mid-20s on a price/earnings basis looking backward, but looking forward, it actually drops to the high teens. So the conundrum comes with fairly high valuations but strong earnings growth underneath it, particularly supported by these technology and internet companies, but also in consumer and other areas. So this last year, I think we had double-digit earnings growth in general for the S&P; it might've even been close to 15%. The market ended up going up 25% because of this confidence that some of this will continue. And I don't know what the specific outlook is, but it doesn't feel like we're on the brink of a recession in the U.S. So without an economic slowdown, it's this interesting challenge. And the market's doing a fairly good job of recognizing companies that are producing those earnings or are likely to produce those earnings — especially on a predictable basis — and giving them higher multiples. And those that are less predictable — or, in fact, have misses — are being punished quite dramatically. So the market is doing what it needs to do in terms of sorting it out. And so generally, people are upset that they missed the market; they're worried that it's too high to get in. And that's probably a sign that the market has further to go, because we haven't kicked into that greed phase yet, where everyone knows they have to be in the market and they're going to just plunge in no matter what. But we're definitely in that latter chapter, where people are moving from, "I can't understand why the markets are so calm and they seem complacent" into the "I better figure out how to be in the market, because I'm worried it's actually going to continue for a long period of time." The key company drivers are what we, I think, bring to the party here, which is, we're able to get in and look at those stocks. So even in a correction, especially if it's a valuation correction, there are likely to be companies that do well because they are economically doing well. Will McKenna: Right. And when you think about, I guess, Europe, Japan, emerging markets, are these longer cycles? How much farther would someone like that have to run once they get going? Rob Lovelace: It's definitely helped to have the U.S. doing as well as it is. And if there isn't a recession, that is a key piece to helping Europe and emerging markets continue to do well. With China and the U.S. doing well, that is even further strength to an emerging markets scenario. So this is why we have the synchronization that we have right now around the world that is very supportive of markets. And I think people looking at the U.S. and the valuations here have thought about, "Well, maybe I should be in Europe; maybe I should be in other places." As we know from the new geography, though, that's kind of a false construct. In other words, actually investing in expansion in Europe is extremely difficult to do, because there are very few companies that only do business in Europe anymore. Because of the structure of Europe for a long time, those companies that are good have figured out how to do business mainly in the U.S., but also in other parts of emerging markets and the world. So it's very hard to sort of rifle-shoot where you want to invest. Probably the best dividing line would be U.S. and non-U.S. Even that's gotten a bit blurry. I think about 35% of the revenues in the S&P come from outside the U.S., and it's probably equivalent on the other side. So it's always going to be a bit gray. But I think the U.S., at more than 50% of the world market cap, is probably in one camp. And if you think of Europe, China, the rest of emerging markets, Japan together in a block, that's probably a better way to think about it. And that's going to be affected by currency; that's going to be affected by interest rates. But really, rifle-shooting individual countries at this stage is pretty hard to do. Will McKenna: So important, probably, to have some flexibility, as investors think about size, style, domicile and the old divisions, and have a little bit broader view across some of those categories. David, let's bring you into the conversation. A lot has been happening in fixed income markets in 2017, and of course the Fed's been raising rates. We've seen the beginnings of an unwinding of the various quantitative easing programs; we'll have a new Fed chairman here soon. Give us your outlook for bond markets as we head into 2018. David Hoag: Sure. So generally, just a few broad themes throughout my portfolios. One is a low-for-longer theme, so while interest rates may slowly drift up, the terminal rate for rates during this cycle I believe to be fairly low. So that's one big theme. And part of what underlies that is [that] fixed income in the United States is still relatively attractive, both globally and locally. So, relative to other developed markets around the world — Japanese 10-year interest rates at effectively zero, German interest rates extremely low, around 40 basis points — 2.4% on a 10-year Treasury is relatively attractive. And then, more within the United States, if you look at, say, 3-year Treasury rates, we are almost three times higher than the recent low. And so there is actually a little bit of income opportunity back within fixed income. So I think we need to get used to fairly low interest rates. The fixed income markets are generally attractive. There are some areas where valuations are a little stretched surrounding credit, so that would be high-yield and investment-grade corporate bonds and mortgages are all fairly stretched in terms of valuations. Will McKenna: And that's the search for yield, that — David Hoag: It's the search for yield, absolutely. As interest rates are low around the world, a lot of investors both within the U.S. and outside the U.S. are looking to our markets as being attractive and really push down the amount one gets paid to take on extra risk, be it through owning companies or through volatility, which is a big component of owning mortgages. Will McKenna: And is it fair to say, even with the Fed raising rates here, those low rates around the rest of the world will serve as an anchor to keep our rates lower for longer, as you put it? David Hoag: Yeah, I think so. And so what we've seen during this hiking cycle is the front end of the yield curve — shorter term interest rates — moving up in coordination with what the Fed is doing. The longer end of the yield curve has remained fairly low. And so what's happened over the past year is the yield curve has effectively flattened. And I think that's due to two reasons. One is that need for yield, so buying pressure maintains in the fixed income markets globally. And it's also a view that the Fed won't be able to do as many hikes as a typical cycle would permit. And so the longer end of the yield curve remains anchored in anticipation of a fairly short Fed-hiking cycle. Will McKenna: Let me follow up with a couple of questions from our audience on this topic, David, and really about what do you see as the path of rate rises from here, and do we have a different view, perhaps, [than] consensus on how many . . . David Hoag: Right. Will McKenna: . . . and how high. And then, what does that mean? Is that good for bonds? Bad for bonds? Give us some of that “so what” context. David Hoag: Sure. Sure. So I'll brush up a little close to bond math here but not get too close. We can actually disentangle what is projected within the markets in terms of what the Fed will do. And it's a case of normalizing policy. At this point, I actually don't see the Fed trying to do what you would historically see at this phase, which is tapping on the brakes. They're still getting to a normalized position, and so this gets them a little closer to that view. And they're doing this in conjunction with tapering their balance sheet. So they have two sets of brakes that they're using, and they're trying to use them very carefully. So that's currently embedded in the markets. For next year, there are one and a half hikes priced into the math of fixed income, and I think that's a fair amount of hikes projected. If anything, they may have to do the full two hikes. So I think, maybe slightly mispriced for next year. And so what leads you to want to do is have a little less interest rate exposure in your portfolios. It's not a meaningful difference, but it's a nuance. And then in the out years, in '19, there's still a half of a hike suggested in the bond math. So I think that's a fair trajectory that gets us to relatively normalized rates, given the fundamentals of this economy, of the terminal Fed rates for this cycle. Will McKenna: Quick follow-up on the quantitative easing. We haven't seen this movie before. Safe to say, it's still important to look not just to what the Fed is doing — it sounds like it's going to be a relatively slow, drawn-out process — but also what the global central banks — the ECB, the Bank of Japan — are doing. A little context on that for our audience? David Hoag: Yeah. We've seen small pieces of this movie, perhaps, if we go way back. I don't think we've seen it at this scale, but it's intriguing to look at some of the graphs of when the various central banks have entered into the QE business. And when you start stacking them together, it becomes this very interesting line of growth of balance sheets of central banks around the world. So we do think the U.S. is first — we're beginning the tapering now — and it has not been particularly disruptive. Europe probably comes next. I'm afraid Japan, it could be quite a while before they're really ready to unwind their QE program. And so, again, we're going to be looking for that as a catalyst a year out to see how orderly we can do this unwind of massive balance sheets. So I think we've got very smart folks in the central banks who understand that this can't be a disorderly process, and they will be very quick to unwind their tapering if it becomes disruptive. So I think it's going to be a very careful, deliberate process. Will McKenna: Got it. Darrell, let's bring you into the conversation. Six months ago, we did this at midyear, and you were talking about a global synchronized recovery at that time. Where are we now, and what's your outlook as we head into 2018? Darrell Spence: Yeah, if anything, I think the recovery has become more synchronized over the past six months. As one example, if you look at all of the different countries that report purchasing managers' indices on a monthly basis — and there's over 30 of them — over 95% of them show that their economies are in expansion mode. And to Rob's comment earlier, we haven't seen synchronization at this level since 2005, 2006, really at the peak of the last cycle. So recovery is broad, and you're seeing it even in places like Japan, where growth and inflation have been notoriously low for a long, long period of time. But growth in Japan has been above potential. Inflation, we think, may hit 1% this year, which doesn't sound like much but for Japan is a pretty heroic level of inflation. As you look across Europe, growth there has also been well above expectations, well above potential. It has certainly benefited from the recovery that's been going on in the U.S. and in China; a weak euro has certainly helped. But what we're seeing now is an investment cycle getting underway within Europe. That should make their recovery more self-sustaining; lead to better job and income growth; and again, reduce their reliance on occurrences in the rest of the world and allow them to have a more self-sustaining recovery. Will McKenna: So capex and things like that? Darrell Spence: Absolutely. Capex, which leads to domestic demand, better employment growth; wages are picking up slightly — typical cyclical acceleration-type stuff. China may be a little bit the other direction. They're coming off a pretty healthy growth rate as it is. We see some fiscal and monetary policies being implemented to try to tap the brakes on that economy a little bit. But there are some offsets in the form of very positive consumer fundamentals, and again, a very positive external demand, which is very important for China's growth. So a bit of a slowdown in 2018, but nothing approaching what we saw in 2015–16, when there was a lot of concern about a hard landing. This is kind of the story of China: Things get too fast, they tap the brakes; they get too slow, they hit the accelerator. And that's what we think we're seeing — nothing more, nothing less right now. And then, of course, there's the U.S. It's been a good economy for a while now — probably the furthest along in terms of economic recoveries — but we still think has a ways to go. Growth likely to remain above potential; unemployment rate likely to continue to drop. Inflation — we think this is probably where you're likely to see it first. In fact, some of the resource utilization measures that we look at suggest inflation could hit, if not exceed, the Fed's unofficial 2% target by the end of 2018. So that is something that we're watching pretty closely. And we think the central bank will continue to tighten gradually. I think two to three rate increases in 2018 is probably a reasonable assumption unless, again, growth or inflation really do something different than what is our base forecast. So again, when you add all this together, you're looking around the world, you've got good growth. You've got moderately rising inflation, but probably not rising fast enough to be disruptive to that growth. You have central banks that will be responding, but responding, again, very gradually. This is a pretty rosy scenario. It's a great one for profit outlook, or a great one for profits, too. So we tend to think risk assets will be pretty well-supported in 2018. Will McKenna: That’s great. One of the questions we got from the audience, and you've heard this one before: How long can this go, this U.S. recovery? And you guys have done a nice job, I think, saying, "Recoveries don't die of old age," and offering your perspective on that. I think last time we talked, you said U.S. GDP had reached 112% of its prior peak, and 125% is kind of the average over time. Maybe it's a question of where are we today along that? And then I know you've made the point, really you and team are trying to look for imbalances that may be growing. And so where are we today, and are you seeing any imbalances start to come up in the economy? Darrell Spence: Sure. Well, let's start with the average that a lot of people point to when they get concerned about whether or not this expansion is about to come to an end, and that is the length of the expansion. On average in the post-war period, expansions have lasted 60 months, and we're now over 100. So it has definitely been longer than your average expansion, but if we're going to talk about averages, let me give you — and you alluded to this — a different way to think about it. On average, the economy has expanded to 123% of its prior peak before rolling over into a recession, and right now we're at 114% of the prior peak — which is really a complicated way of saying growth has been slower in this expansion than it has been in past expansions. But the reason that's important is because we think recessions are caused by excesses and imbalances that build up in the system that ultimately need to be corrected. When you have slower growth, those things tend to take a lot longer to build up in the system. And as we look across — at least in the U.S. — the landscape, pockets here and there of little things, but nothing systemic, or no big imbalances that we think are of a significant size and nature that would push the U.S. economy into a recession, certainly within the next 12 to 18 months. Will McKenna: Got it. Rob, we've talked a little bit about emerging markets. I believe you started your career there 30 years ago, traveling in places like Mexico and other parts of the world for Capital Group. It's been your view, I believe, that you can't paint all emerging markets with the same brush. Would love to hear more about how you and the team are thinking about that. It's not homogeneous. How are we thinking about that, and perhaps are there some pockets where we're excited, we're finding some opportunities that we find very compelling? Rob Lovelace: Let me start with the structure of emerging markets and sort of the challenge we all face, and then I'll talk about specific areas that I'm excited about. Emerging markets: created in the mid-1980s. It was in the middle of a debt crisis, and really, it was the World Bank's concept to create a pool of money to bring equity to offset that debt challenge. And they used an amazingly simple ratio, which [was] per capita GDP, to define what was an emerging market and what wasn't. So it was easy to get your head around. A lot of people were resistant to it at first, because they weren't sure that just because a country was poor was a good way to decide if it was going to be a good investment. But what the World Bank and the IFC — a division of the World Bank — saw was deleveraging was going to bring economic health back. And so it was, in some ways, the most indebted countries that were making the reforms that they needed to sort of set the path for growth. I tell this ancient story because if you look at that time, I think there were only two countries in all of Latin America that were an emerging market, because the others didn't have stock markets that anyone could access. And now China is by far the largest component. And so comparing what was happening in the '80s and '90s to today is sort of meaningless, because China and Russia are two of the bigger components, and they weren't even a twinkle in anyone's eye back when this whole thing began. So not only are the countries different, not only are the regions different, but the history. So when anyone looks at emerging markets are relatively expensive or . . . it doesn't really mean anything, because really, we're looking at a structure that's been changing over time. And in that spirit, I just want to remind everyone that China, if it doesn't come out of the emerging markets, will so dominate everything else in emerging markets that it would be even larger than the U.S. is now, of the world, that effectively, emerging markets funds will become China funds when you add in Taiwan, when you think about Hong Kong, when you think about Korea and their influence in the rest of southeast Asia, let alone other parts of the world. So my hunch is China's going to break out, much the way Japan has, and the end of the story will probably be China going into the World Index. So, just putting that out there to get people's head around it. If you take China out, which I think you should — China is exciting and I'll come back to it in a second — but if you think of what real emerging markets is, which is ex-China, India's probably the most exciting area where we're finding a lot of great opportunities. It's another one of these large countries that's making the reforms that are super exciting, that are helping the companies, and they're just beginning their cycle. And a little bit like the rest of the world, they've been kind of squeezed out of the internet game by the Chinese, who do a lot of their internet. But the Indians do have a lot of activity in technology, certainly on the software side, and others. So I think it's one of those countries that's got a lot of that entrepreneurial, spirit, and the powers are just being unleashed there. Latin America's coming back from a tough period. [I’m] certainly excited about places like Argentina, Brazil, when it gets through all of its political mess maybe once again. It went from sleeping giant to awakening giant back to sleeping giant. We'll see if it starts to wake up again. But in all of these countries, even when times were tough, there were great companies that we have found that we continue to invest in, sort of through thick and thin. And in some ways, they're better run, because they know how to work in a hyper-inflationary environment. Now they're learning how to operate in a low-inflationary, or even threatening-deflationary environment. So these are often very well-run companies, certainly the multinational ones that we tend to focus on in our portfolios. Will McKenna: I know one of the things you've written about is this idea of a new breed of those kinds of companies. Rob Lovelace: Right. Will McKenna: And we've seen this shift from, call it, either manufacturer- or commodities-driven companies to more idea-based companies — certainly the Chinese internet companies, some of the Indian banks. Where are some areas where we're finding particular opportunity or themes that we're excited about? Rob Lovelace: Yeah, two of our funds — most of our funds look at this — but two of our funds, New Perspective Fund® and New World Fund®, which I'm involved in, look at these changing trade patterns and thinking about companies that work across borders, so I'm particularly focused in this area. And I think with the changing view toward trade agreements and a sense that globalization is slowing down there, I think there's been concern about these companies and how well they will do. But we have so much going on, actually, in the digital area. And if you look at digital trade — which you actually can measure in bits and bytes that are moving across the world — but also, as I mentioned, the companies in the U.S. sort of dominate the internet space in most of Latin America and most of Europe. Will McKenna: Europe, yeah. Rob Lovelace: And the Chinese dominate Asia, and to an extent, even into India. So we've kind of divided the world up. There are some Russian champions. There's Mercado Libre and a few others in Latin America. So there are others that are out there. But this area is moving along at a rapid pace. And we may start to see — and we're hearing some inklings of it — governments starting to think about how we, how they, manage this or control it or . . . There are lots of pieces to this, right, that are certainly in the press right now that we need to be aware of. So I don't think they get to grow forever. But it is amazing, actually, how far these companies have gone since they were conceived. And it's real cash flow that they're getting. So we're seeing a lot of areas like that that we like. You asked specifically about India and what we like there. We do like the banks. So that's back to more of a 1.0, but that's because the economy there had been struggling. A lot of the industrial companies had been struggling, and the private banks in particular are positioned, we think, to catch that recovery cycle. But all around that, we have companies involved in consumer products that are competing with the big multinationals and doing a better job in India, maybe, than some of the Procter & Gambles and Unilever, so they're able to take market share there. So there is sort of a localization trend that's going on in some of these markets that we're excited about as well. Will McKenna: Got it. Just a quick follow-up. Our audience was curious, as they often are, about your own personal investing style. Maybe you can describe your approach there in the environment that we're in today — both the opportunities you're looking at, but also, what are the risks that you're concerned about and trying to avoid? Rob Lovelace: We live in a world that's become increasingly short term in focus, from trading during the day to trading in the minute to trading in the nanosecond. And all of the reports that are out there are constantly pushing us shorter and shorter term, trying to predict the next quarterly earnings, the next news announcement, the next drug approval. Whatever it is, that's where everyone's competing now for an information advantage. And so one of the things that I try to do in my portfolio — and I'm well-supported by the philosophy here at Capital — is to try to take a longer term view, to get out of that short-term noise and try and find investments that will be durable over time, where we can go in and ask questions about, really, what the plans are that haven't been crystallized or announced in the market, or who has the processes and teams that we think will do well through an entire economic cycle or deal with that surprise announcement that no one expected to come. So that's what I'm looking for in my portfolio. I try to have a multiyear look. In fact, my turnover would suggest that I have an average holding period of seven years. I've got some stocks that I've held for more than 20 years. Now there are some things that end up being shorter term, either because they do well quickly or because the thesis changed, so I don't want to imply that it's all that seven-year average, but it gives a sense of what I'm really looking for. And the consumer companies and some of these internet companies are obviously sort of the wheelhouse for me, because these branded companies — well-run, working in multiple countries, strong accounting and branding discipline — those tend to be great places for us to look, or certainly for me to look. And also, when you think about companies that have a particular technology — and I guess in this case I'd look at the pharmaceuticals, the ability to create a drug that will change the way we do cancer, the sort of customized treatments that some of these companies are coming up with — oftentimes they get acquired. And we continue to stay invested in them because we know it's going to be so important for multiyears and certainly life-changing, and getting more valuable as it goes through from concept to proving to distribution. Will McKenna: Great. Very, very helpful. Good insights. David, back to you. You mentioned in your opening comments some caution around credit. And I think our portfolio strategy group, PSG, and the fixed income team has been quite cautious on corporate credit, high-yield. Can you tell us why, and how we and our audience should be thinking about that? David Hoag: Sure. So it's probably much less to do with fundamentals than valuation. So I think today we've talked about fundamentals, economy-wide, being fairly good and supportive for companies' balance sheets, income statement, profits. So that part we are less worried about. However, as improvement has happened over the last few years, we've seen companies, at the margin, doing less deleveraging than they've done in the past. So in a bondholder's perfect world, all of these benefits of a rising economy would go to paying down debt and improving their ratings. Companies have toggled over the last few years to spreading the wealth of either increased dividends, share buybacks, some capital expenditures. While the fundamentals look good, few of the benefits are being pushed over to fixed income holders. So fundamentals, good. Valuations, though, are suggesting that things remain very good. And so that's where we probably bring into question whether or not it's an appropriate asset class for some of our funds. And so in many cases where we have the ability to own quite a bit of either investment-grade or corporate debt, we've taken that signal down in the portfolios, just because valuations are stretched. Will McKenna: So spreads are very tight, and — David Hoag: Spreads are low, very low. So you're not compensated much to take on more risk. And so this is an environment where we think upgrading makes sense. It doesn't cost you much to upgrade, because you're not forgoing much extra income by owning these securities. And so we'll wait for valuations to normalize before we start to go back into some of those markets. Will McKenna: One of the things I've heard you and some of your colleagues talk about is investors may not realize how much risk is in their core bond portfolios. Can you talk about that? Are you seeing that, and what guidance might you offer our audience around that topic? David Hoag: Sure. Yeah, so I think what we've seen is a bit of scope creep around fixed income. So with interest rates generally being low, people are trying to squeeze a little bit more out of fixed income. And so a very normal, natural thing to do is to take more credit risk and get a little more yield in your portfolio. Again, that's what I think is driving down valuations — or up valuations, depending on which side of the equation you're on — and have really made that a sought-after marketplace. One thing that we talk a lot about within our group in fixed income is to provide bond funds that act like bond funds. And what that means is — particularly at this point in the cycle, and these valuations — having a portfolio that will do very well in case there is some kind of disruption. And really, one of those core attributes that fixed income can provide you is stability and low equity correlations. And so we think this is a time to really be upgrading your portfolio, and not fall prey to that scope creep, as tempting as it is to go out and get a little more yield by taking a lot more risk. We think it's ill-advised to do so at this point. Will McKenna: It's this idea, if you get declines in equity markets, you want those bonds to not be correlated with that, but to hold up. David Hoag: Yeah. I think, in very simple terms, if you have an asset allocation of 60/40 — 60 stocks, 40 bonds — you don't want it to trade like 70/30 when the stock market sells off. You want that 40% of fixed income to really be a 40%, to provide that protection that you're looking for in your portfolio. And so we are conscious of that every day and remind ourselves that that's our role. Our primary role at this point is to provide that stability. Will McKenna: Maybe all three of you could address this topic. We've had remarkably tame equity markets. It's been a long time since we've seen significant pullbacks and corrections, although a look at history might indicate maybe we shouldn't get too used to that, as these things move in different kinds of cycles. Darrell, what's your view on that as we look at, U.S. markets? And maybe we can hear from you, Rob, as well, as you think about equity markets and what our expectations should be around volatility. Darrell Spence: Yeah, I think one thing to keep in mind is that bear markets are probably less common than most people believe that they are. If you look at the percent of the time either a market is in a downturn or even an economy is in a recession, it's generally one-third or less, depending on how you define the metric and what you're looking at. So they happen, but they're not super frequent events. I think the biggest concern right now for the U.S. equity market, that was alluded to earlier, is valuation. But I also think that you can't always look at valuations in a vacuum. Are P/E ratios higher than they have been historically? Absolutely. But you need to look at them in the context of where interest rates are, which is why the interest rate outlook is so important — at least in my opinion — for the equity market outlook. If we do think rates, particularly at the long end, are likely to remain fairly well-behaved, then I think these types of multiples are sustainable. The market has done very well over the past 12 months, but when you look at the valuation, it really hasn't changed much because it's all been based on better earnings growth. The other thing, too, is not all bear markets are created equal. Some are short. Some are long. Some are not very severe. Some are obviously very severe. But what we have found is that the ones that tend to be the most severe and last the longest tend to be, not surprisingly, associated with recessions. So when we think about these excesses, imbalances that we talked about earlier — and we don't really see them developing in the economy — if I had to make a guess, if there was some market weakness over the next 12 months or so, based on how we see the economic landscape evolving, I would suggest it would be more of an opportunity than a risk of a big bear market that would normally be associated with a recession. Will McKenna: How do you think about it, Rob? Are you positioning for higher volatilily in the future, or are you thinking there may be corrections which are kind of a natural part of the markets here that you want to take advantage of? What's your view on where we are in volatility? Rob Lovelace: There are lots of different ways to measure volatility. And I think if you just look at the simple one, number of days with the market down a percent or 2% or 3%, we're at an unusually quiet — I think it might even be a record — year we're headed toward this year. But if you look back over the last 10 or more years, you'll actually see that this is not an uncommon pattern, and it usually isn't a sharp spike back. In other words, you would expect volatility to increase from here in terms of daily activity. But without an outlook for a recession, it probably means that to the extent we have a correction — which is down only 10% — that's more likely than actually seeing a bear market, which is down 20%. I was just in Asia, obviously getting a lot of questions as an American there about, “Why is everyone so complacent?” That was literally the term. “Why is everyone so complacent? Why are the markets so calm?” And I said, "You know, there's nobody I'm talking to that's complacent. Everybody's nervous." And so that's the interesting part of this, right, is how nervous everyone is, how obsessed everyone is with it. And yet we're not seeing that type of volatility in the market. So my sense is, everyone wants there to be a correction so that they can buy it. So to me, that speaks to probably an increase in volatility, but not able to ever get to a bear market, the same reason interest rates probably can't spike up substantially without inflation or something underlying it: because there's so much demand right now for people trying to find income. The most vulnerable stocks are probably those that people are buying just for the dividend and that may not be as supported by the fundamentals. And this why, interestingly, some of the higher P/E stocks may actually turn out to be better. Because they're not being bought for yield, everyone's nervous about them, but the underlying fundamentals are so good — Will McKenna: Meaning the FANGs? Rob Lovelace: Yeah, exactly, the FANGs and some of the other technology-related, and maybe even some of the drug stocks — that everyone's holding them so tenuously, waiting for this correction, and they'll probably get sold off hard. But everyone I know is waiting with some type of cash or in their asset allocation — whatever they're doing — to get back into the equity markets once we clean up this lack of volatility, and we're back off to the races. So it feels more like that period of buying the dips that we had for so long, and [this] generation doesn't believe that anymore, because that isn't what we've had for a decade. So maybe the old-timers have an advantage here. Will McKenna: It does seem like a very ambivalent bull market that we're in. Rob Lovelace: I've always called it the most hated bull market that I've seen in my career, just because all the way along, everyone wanted it to end. Will McKenna: And the more it goes up, the more hated it seems to be. Rob Lovelace: Yeah, yeah. Will McKenna: I think the right follow-up for you — and I'm sure our audience wouldn't be surprised to learn that Capital Group is talking about this being a stock-picker's market, probably not a shock for them — but given where we are in the cycle, I have heard several of your colleagues on the equity team talk about, more than ever, this seems like an opportunity to differentiate yourself by not following the crowd and finding things that may hold up better, should such a decline come to pass. What's your own view on that? Rob Lovelace: We've been looking at companies with the best fundamentals, and that's driven us into the FANGs, into the larger tech and other stocks. And that's been good, because that actually has been where the market has been driven for a long time. And we certainly aren't of a mind to abandon them, especially those that have strong growth and earnings. But it does feel like a time where we should be looking more toward the mid-cap companies that are less recognized. So we're trying to really branch out and find companies either outside of the United States that maybe aren't . . . certainly wouldn't be in the U.S. index, anyway, but oftentimes they have large exposure to the U.S. economy. So if we continue in the economy to do well here, then this is a good way to get exposure to it or find some of these smaller mid[-cap] companies that are doing quite well, that may be acquired or maybe will combine with another company and grow. So that's where we're seeing a lot of the opportunities right now. Will McKenna: Great. Let’s shift gears and take a look at some of the implications, the portfolio implications, that we've drawn from this broad outlook and some of the general movements within our mutual funds. It's important to note that our equity funds are built using bottom-up security selection — really, based on fundamental research. They're not managed from a top-down asset allocation standpoint. However, when we look at that bottom-up process, we do see some themes emerging in terms of some of the regional shifts in those portfolios, and you're going to see that very clearly in the chart on the screen. Here you can see some of the regional shifts in exposure across our equity and multi-asset funds. For legal and compliance reasons, I need to mention right now that the American Funds are not available outside the U.S. Now these shifts are relatively modest, just representing any moves over 1% in the portfolios over the last six months. And what you're going to see is that generally, as we've been talking about valuations in the U.S. and outside the U.S., generally, our exposure to the U.S. has decreased. I believe nine funds — nine out of our 18 equity and multi-asset funds — have decreased exposure to the U.S., while only one has increased its exposure. Europe: It's almost an opposite picture. And again, Rob made this point earlier, that a lot of those European companies are, of course, doing business outside of Europe. But as it relates to Europe, eight funds have increased their exposure to Europe, especially in our growth-and-income strategies, while three have decreased their exposure to Europe. And when we look at Japan, it's relatively flat or neutral either way. And then finally, when we look at emerging markets, we see that six of the funds have higher exposures to emerging markets, whereas no funds have decreased their exposure to emerging markets. So that's a look at some of the changes that've been happening when we take that bottom-up view, looking through our equity and multi-asset funds. Let's now move on to fixed income. And David, I know we've got the Portfolio Strategy Group, who meet on a regular basis through the years. Maybe you give a quick thumbnail overview of that group and what you do. But we have some suggestions, recommendations, that come out of that team that we'll take a look at. So maybe first, what is the PSG? What do you do? And then we can look at the way you’re positioning portfolios based on that. David Hoag: Sure. Yeah, the Portfolio Strategy Group, or PSG, is a group that meets three times a year. And it's all of our fixed income group, so approximately 140 folks will come and sit in one large room and have two days of discussion. The first day is really focused on what the research inputs are suggesting, and it begins with folks like Darrell and others helping paint the macroeconomic view across the world. And then we move into the sub-sectors and we look at what we're seeing and hearing from [the] investment-grade corporate world — so, high-quality companies, what we're seeing out of high-yield, what mortgage markets are signaling. Will McKenna: Right. And do you want to walk us through the dials that we’ve been using for some time, to illustrate our position? David Hoag: Yeah. And so you'll see some stylistic dials on the graphic, and I'll just walk through each one of them here. U.S. rates: It's gently pushing short, and so that's a view that the Fed will continue to move interest rates up, perhaps slightly faster than the market is projecting. But it's a very minor signal. It's not blinking, "Extreme short; be worried about increases in interest rates." But what's really a lot more important on this is the second point, which is curve. So inasmuch as you take interest rate risk, really focus it in on the five-year part of the Treasury curve. We really don't love short interest rates, because we think the Fed will be increasing rates. We're a bit worried about long-term interest rates. The term premium, or the amount of extra risk you get paid by simply extending your maturities, is very low, and so we don't think you're being compensated much to move out the yield curve. So have a very slight underweight to duration overall, but when you do it, do it in the five-year part of the curve. The next dial are TIPs. That's a view on fundamentals for inflation and valuations, and so I think we've spoken earlier that we think inflation will drift up throughout the cycle for many good, fundamental reasons. And valuations: While [we're] anticipating some updraft in inflation, we still think there's a valuation wedge there, where that's an attractive asset class, so own them where you can. And then to a few of the underweights here, down below. Credit: I outlined earlier why we're shorter credit than we've been in the past, or underweight credit. We just don't think the valuations suggest taking much incremental risk there, and that's a read-through to both high-yield and investment-grade corporate bonds. Mortgage-backed securities: We are recommending an underweight there, and a lot of that has to do with the volatility discussion that we had. Mortgage bonds are effectively a risk-free bond with an option attached to it. And options are driven . . . one of the key components in valuation is volatility. And as volatility has come down, we think that option is mispriced. And when/if volatility comes back into the marketplace, we think there's scope for mortgages to underperform. So again, we'll wait for our opportunity in mortgages. And then, really no signal with non-U.S. bonds, or non-U.S. FX, at this point. Will McKenna: Got it. Well finally, let's take a look at some of the asset allocation themes within Capital Group’s 13 model portfolios. And these are the model portfolios that are overseen by our Portfolio Oversight Committee, which is a group of seven very senior-level, very experienced investment professionals who help determine, really, strategic allocations to a set of underlying funds. And so again, this is not a top-down asset allocation process, but rather a strategic allocation. And then the underlying funds are the ones that have the flexibility to run their own investment decisions at the fund level. So broadly, as you look at this graph, the idea here is to maintain essentially a core allocation to U.S. equities, but really to consider adding incrementally more exposure to international and emerging markets equities, given some of the relatively attractive valuations that we've discussed here outside of the U.S. And in fixed income, as David said, the idea is to ensure that your core bond portfolios are positioned for some rising volatility, with limited exposure to lower quality credit, as well as an emphasis on income, capital preservation and inflation protection. Well, that's all the time we have today. I want to thank our guests for their insights on today's presentation. We hope you’ve found this valuable, and we look forward to working with you throughout 2018. Now, to get C.E. credit for this event, please follow the link on the bottom right of the screen on your presentation, or if you're listening to this podcast, it should be in our show notes. 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