MASTERCLASS: Midyear Outlook – June 2017

Portfolio managers Jody Jonsson and David Hoag, economist Darrell Spence and policy and communications advisor Matt Miller discuss the global outlook for financial markets, as well as the macroeconomic and political landscape, for the second half of 2017 and beyond.

  • Darrell Spence, Economist
  • Jody Jonsson, Portfolio Manager
  • David Hoag, Portfolio Manager
  • Matt Miller, Policy and Communications Advisor

  • |
  • 53 mins 32 secs
American Funds Video Transcript:
MASTERCLASS: Midyear Outlook – June 2017

Matt Miller: Hello and welcome to MASTERCLASS. I'm Matt Miller, policy and communications advisor with Capital Group. The topic of the day is our midyear outlook for the global economy, equities and fixed income markets. To discuss these issues, I'm joined by three of my Capital Group colleagues: Jody Jonsson, an equity portfolio manager with 28 years of investment industry experience; David Hoag, a fixed income portfolio manager with 29 years of experience; and Darrell Spence, our senior U.S. economist who's been doing this for 24 years. Welcome, guys. Great to have you with us for this important conversation.

Darrell, why don't we start with you? Why don't you take us on a little trip around the world? We are seeing a lot of momentum building up in the U.S., Europe, Asia and the emerging markets right now. Where are we in your view right now in the global economic recovery story?

Darrell Spence: Well, I guess when we talk about recovery, we want to talk about two separate recoveries. There's the recovery that the world is seeing since the global financial crisis. That's been going on for almost a decade now, and we expect it to continue. The other recovery is from the growth scare, or growth slowdown, that we saw at the beginning of 2016. If you recall, back then energy prices and other commodity prices had come down a lot. There was a lot of instability, or big changes in currencies that were weighing on markets. And there was legitimate fear of a hard landing in China. And all of those were creating fears of a slowdown in the markets, and some actual economic slowdown in the economies.

Most of those things have stabilized, and so we've seen this acceleration in economic activity over the past 12 to 18 months. But it's important to keep in mind that, just as we're seeing an acceleration now, at some point we will see a deceleration. That is the totally normal ebb and flow of an economy in the midst of a longer economic expansion.

So for us as investors, it's important that we don't get too carried away or extrapolate these mini-cycles in economic activity, but really focus on the longer term economic expansion in which they can occur, and the fundamentals that are driving that.

Matt Miller: Just following up on that, as you said, it's been a long expansion. At some point, does that mean the expansion dies of old age? Does it mean we're, quote unquote, due for a recession? Or is that a wrong way of thinking about it?

Darrell Spence: I'm not a big believer that time and distance are the best indicator of when a recession is likely to occur. Or as Janet Yellen said, "Expansions don't die of old age." Rather, what causes expansions to come to an end are excesses or imbalances that build up in the system that need to be corrected. They can come in a variety of forms. They can be inventory excesses like we saw back in the ‘50s and the ‘60s; they can be inflation excesses that we saw in the ‘70s and the ‘80s; and they can be financial excesses, which is what we saw with the internet bubble and the housing bubble.

As we look out at the U.S. economy in particular, we just don't see those types of excesses building that might ultimately lead to a downturn, at least within the near-term time frame. And in fact, just a statistic: On average, the U.S. economy has grown to about 125% of its prior peak before the next recession occurred. And right now the U.S. economy is 112% of its prior peak, so half of the historical average.

And the reason for that number is to suggest that the expansion has been slower than it has been historically. But that means that these imbalances and excesses are much slower to develop. So again, we've looked out. We really don't see significant ones occurring right now, and as such, we don't think there's any reason that this expansion can't go on for another one to two years — if not even beyond that time frame.

Matt Miller: And that 125% versus 112% thing — that's one potential metric for thinking there's still some room to go.

Darrell Spence: Absolutely.

Matt Miller: Jody, let me bring you into the conversation. Does that — it's not wildly optimistic, but a kind of steady-as-she-goes view of the economy — make it sound like there may be a decent outlook for global equities? How do you think about this as you think about the U.S. and European markets ahead?

Jody Jonsson: Well, I think for the U.S. we've had essentially a Goldilocks economy: not too hot, not too cold, just right. We've had enough economic growth to prolong the expansion, but we haven't had inflation really rearing its head yet. And that's been a good environment for equities. And really what we've seen is earnings growth accompanied by expanding valuation. So the U.S. is at relatively high valuations relative to its history. Valuations have gone up about twice as fast as earnings over the last eight years. So the U.S. feels like it's on the generously valued side of its own history.

Outside the U.S. I think you're starting to see more stabilization politically in many areas, particularly around Europe, and valuations in general are a bit lower. And so we’ve found more opportunities there. It’s also helped that the dollar has retreated this year. And in a weaker dollar environment non-U.S. equities, in dollar terms, tend to perform more strongly — and particularly emerging markets equities, which we've seen this year helped by their currencies.

Matt Miller: You were kind of decomposing the growth we've seen in the U.S. market between changes in earnings and changes in valuations, because that's an important way we look at how to assess where the market is. Can you say little bit more about that for folks to understand?

Jody Jonsson: Well, it's easy to say that the U.S. is expensive relative to the rest of the world. If you take the market apart sector by sector, it's not so clear. The technology sector had driven a lot of the valuation growth, the P/E expansion, in the U.S. market. If you take that aside, then if you look at industrials, consumer staples and other sectors relative to the rest of the world — the valuations are more comparable. So the U.S. as a whole is more expensive but, in part, driven because of the rapid growth in those sectors.

Outside the U.S., in particular the financial sector remains quite cheap relative to the rest of the world. And now you're finally starting to see conditions — for example, in Europe — where the banks could do better. The economic growth is picking up, inflation is no longer negative, the conditions seem ripe for the financial sector to do better there than it has over the last several years, and so you could see some catch-up there.

Matt Miller: Great. David, let me bring you into this conversation. Now with the outlook we're talking about — with continued economic growth, even if it's not gangbuster but kind steady as she goes, the Goldilocks kind of economy — with interest rates rising over time, does that means that's bad for bonds? What's the right way to think about the fixed income market in this context?

David Hoag: Sure. I'll start with a couple of ideas. One, interest rates are expected to go up, and that's already embedded into bond markets — and I'll explain that. And then secondly, U.S. interest rates are relatively attractive. Now that may not strike people as obvious, so I'll cover that one too.

So firstly, if you look at what is embedded into the bond math, the bond markets, we are expecting the Fed to increase short-term interest rates over the coming few years. The bond market is arguing the Fed may not get to their ultimate goal of around 3%, but yet we still have increases already priced into the bond market. And so that's where bond prices will move the most when they adjust to whether the Fed moves faster or slower. I believe that they will move fairly slow.

And then secondly, interest rates in the United States are relatively attractive [compared] to other developed markets. And so if you look at a 10-year Treasury in the United States relative to Japan or Europe, yields are actually quite high relative to those other developed markets. So I think that ultimately also keeps a lid on the interest rates.

Matt Miller: And in terms of just the bigger picture, historically rates are . . . People who are living on fixed incomes, or had looked traditionally maybe to interest rates, were, "Wow, how am I supposed to live on a fixed income on 2.5%?" What's the right way to think historically about where interest rates are? We're in this kind of unusual period in economic history, is that fair to say?

David Hoag: It depends on your time frame. So yeah, if you if you start the picture in the 1960s and end today, it looks low.

If you really stretch that picture out over 100 years, we're actually at the lower end of the channel, but we are not in unusual territory. And so the anomaly [was] in the 1970s with interest rates that were extremely high, 14 percent-type interest rates. The price you paid there was that inflation was extremely high. So even though you were getting a lot of yield, you weren't keeping much of that income, because inflation eroded your purchasing power.

Matt Miller: Great. Jody, let me bring you back in. You were talking about the loftier valuations, arguably, in the U.S. market, but let's dig a little deeper on Europe, because they've lagged the U.S. for a long time. How do you think about whether that's turning a corner now, and are you finding attractive opportunities there?

Jody Jonsson: We try to always go where we see the best relative value, and it's not so much a call about one region versus another but just where we're finding opportunities in individual companies.

I think in Europe, what's changed in the last few months is that the political environment seems to have stabilized. And whereas investors were painting it with a very broad brush — the brush of populism, and potentially a wave of populist government change there — the more recent elections, for example the French election, has turned out better than expected. And I think if that continues, we have a more stable backdrop in which reform can be accomplished. I think there's a great desire for reform, a great need to change some things still to make the EU and the euro project work, and I think there's sort of a collective will for that in Europe. That's a more favorable backdrop.

And when you look at some of the data around GDP, consumer confidence, PMIs [Purchasing Managers’ Index] — just general indicators of economic growth — they look quite healthy in Europe, more so than they have in a long time. So it feels like a more constructive backdrop in which to find good companies.

Matt Miller: Now Darrell, bringing in your economic perspective again — building on what Jody said, clearly this — whether it's a Macron market or some kind of sense of more stability now looking forward — there's still been this kind of backdrop of rolling crises in the euro zone in the last number of years. How do you think about where that all stands? And the arguments we hear often about “there is some inherent tension or instability with the euro and the euro zone” — where are we on this trajectory? How do you think about that?

Darrell Spence: Well, again, there's the cyclical versus longer term story. And all of the things that Jody mentioned are certainly going on a cyclical basis. There is a recovery going on in Europe. It seems very real. Europe is benefiting from very accommodative monetary policy — fiscal policies that are no longer extremely austere, which is one of the big reasons for the rolling crises that you've mentioned. And also the weak euro has been benefiting exporters, as well as better growth outside of the European region. All of those things we expect to stay in place, and that's fostering a nice increase in domestic demand growth — mostly in Germany and France, but it's now starting to spread to other parts of Europe. That, we think, continues. But longer term, there are still issues that Europe has to deal with, mostly around debt.

And so the biggest increase, probably, to this cyclical recovery that we're seeing right now is a big increase in interest rates, because it would make servicing that debt very difficult for some of the peripheral countries, but awful also for some of the large countries like Italy. We don't think that's in the cards, at least for the foreseeable future. The ECB hasn't suggested that they're going to go on an aggressive tightening path, but those numbers, over the long term, are unsustainable.

The good news, as Jody mentioned, is that there is a recognition of the issues, and there is an appetite to fix the issues. It will take time. These debt issues will flare up and cause market consternation from time to time, even in the midst of an improving economic outlook.

Matt Miller: Take us to China for a minute, just staying with you, Darrell. Early 2016 there was almost a — maybe panic is too strong a word — but tremendous anxiety about what was happening with China early in the year. Have they gotten that under control? Have they found a way to mask problems that will reappear? Where are we in the China story?

Darrell Spence: Yes and yes — to both of your questions. What they did in the face of the weakness in early 2016 was to put together a fairly aggressive stimulus package, and that got the economy to turn around. And we're still seeing the benefits of that as we move through to the middle part of 2017. They also stopped shooting themselves in the foot by making what they consider to be very technical minor currency adjustments but that the market was interpreting as precursors to a major devaluation — which we don't think the Chinese authorities ever really intended. And now they've created more stability in the currency market.

But you know, China has a lot of imbalances and issues, just like other regions of the world, that will have to be dealt with over a longer period of time.

What we do think the market underappreciates, though, is the number of tools and other things that the authorities there have to mitigate and manage through these issues. China is an economy unlike many others in a lot of ways, most significant of those being their ability to control what's going on within the country. So even though there are lots of imbalances there [and] they have lots of ability to manage those and to push the problems out into the future, it doesn't mean that they don't need to be dealt with at some point. But the market’s interpretation that there's always an imminent crisis in China probably doesn't give enough credit to the ability that the authorities have to manage through these crises, and their willingness to do so.

Matt Miller: Jody when you think about China and emerging markets, the emerging market as asset class has been one of the biggest bull stories this year. Is that something that can last? Is it a kind of flash in the pan? What's the right way to analyze that?

Jody Jonsson Well, again, it's hard to paint all emerging market countries with the same brush. I think generally they have been helped by a weaker dollar, which has meant stronger EM currencies, and so that's been a more favorable backdrop for those equity returns in U.S.-dollar terms. But it’s varied greatly. India versus Russia — let's say, in terms of the types of things that will affect that economy — Russia's been weighed down by the oil price; India's been helped by better growth than expected post-demonetization. So very different fundamentals.

I would say our investments have focused more around consumers in these markets. So in China, for example, we have a lot of investments around the internet and the whole move online in terms of both commerce and payments — everything around online commerce in China, and much less in commodity-oriented sectors, state-owned enterprises and the like. So it's again, very hard to paint them with a broad brush, but the underlying fundamental trends for the consumer are very strong in many of these markets, and that's where we've tended to focus.

Matt Miller: Just to stay with that for one second, isn't it right that on things like online payments and mobile payments, China's really leading the world? Is that correct?

Jody Jonsson: Absolutely. Applications such as WeChat are the singular application that they use for almost everything from ordering food to online chat to payments to pretty much everything. And Tencent really dominates that space.

So we've tried to look for the areas of growth in China that are independent of what the government is doing, that are not so dependent on what's happening in the financial sector or that don't depend on China's level of industrial spending or investment spending. The consumer trend in China is very strong, almost regardless of what happens to GDP growth and the political backdrop, and so that's where we've tended to focus our investments.

Matt Miller: It’s just fascinating. The reason I call it out is I think sometimes we think with a broad brush. While China, despite its enormous development in the last 30 years, still has a much lower per capita GDP than we do, and yet in some of these modes of social behavior — and thus the businesses we can help clients partner with to create value — they're really ahead of the rest of the industrial world. Is that fair to … ?

Jody Jonsson: And many of the U.S. and European companies are looking to the Chinese as examples of how to do it.

Matt Miller: Fascinating. David, back to the bond market. What are your expectations for bond market returns this year?

David Hoag: Sure. Generally speaking, your starting yield ends up being a decent proxy for your returns. And yields are relatively low, so I would say modest expectations for returns within fixed income broadly speaking. There's still a lot of room for active management to add value around extremely low interest rates.

But I think you do have to start with fairly low expectations. And the only way to increase those returns — again, generally speaking — is if the overall level of interest rates [does] fall. There's some scope for rates to come down, but not a tremendous amount. So really not emphasizing capital gains, it's really kind of your starting yield would be your best proxy for returns.

Matt Miller: And within that context, are there specific areas — whether it's Treasuries or mortgages or corporates — that you and your colleagues are focusing on?

David Hoag: Sure. Yeah, even though they aren't the highest yielding of our choices, we do like Treasury securities still, in certain maturities that we prefer.

Matt Miller: Because?

David Hoag: So we do believe that the Fed will be raising interest rates, but a little less than what the market expects. And so there's room — there's some scope — for fairly small capital gains embedded in, say, five-year Treasury securities. So we think those are attractive.

Risk premiums, generally speaking — I would argue, across financial markets — are low. So one isn't paid a tremendous amount to take more risk. And that even pertains to the Treasury curve, where we think five-year Treasury rates look fair. As you move out the Treasury curve to 30-year Treasuries, the risk premium that you would generally get paid to own longer maturities has evaporated. And so we don't think there's a lot of value there.

We think there's more value down the curve. And we still think there's some value in having some inflation protection, particularly the way it's priced in the markets today — which, in the U.S., is kind of an adjunct to a U.S. Treasury, but you capture some of the uplift in inflation if it were to occur. So those are two areas that we prefer compared to taking more risk in other areas, such as credit risk or corporate risk.

Matt Miller: The risk premium you said for the longer duration things is kind of evaporated, or gone away. What's the commonsense way for people to understand why that seems to be the case? I can imagine people scratching their heads saying, “Why is that?”

David Hoag: Yeah. So there is a lot of head-scratching going on. At the end of my head scratching, the conclusion I come to is, we have gone through a very unusual period since the global financial crisis of a tremendous amount of liquidity being applied to financial systems — be it from very low interest rates, in some cases negative interest rates, to quantitative easing, which is basically asset purchases. So . . .

Matt Miller: By the central banks globally, right?

David Hoag: By the central banks. And in my view, that has caused a lot of money to be chasing very few assets to seek as much yield as possible. And so that, to me, has compressed risk premiums to a very low level. And so then the obvious question I have to ask is, if we revert to something that looks a little more normal what happens then? And so that's what drives me to be cautious of risk premiums at this point.

Matt Miller: Great. Thanks for explaining that. So let's shift gears for a second and talk a little bit about your portfolio management approaches. Jody, let me start with you. Everybody — and we talk about this among colleagues a lot — has a somewhat different investment style. What's your investment style? How do you think about finding attractive opportunities?

Jody Jonsson: I try to find companies that have long runways for growth. And I try to find them at a time when perhaps they're out of favor due to something that’s maybe outside of their control, or something that's temporary and fixable, and then that gives us an opportunity to buy it at a discount. But I try to buy a company where I think they have a defensible business that's sort of either immune to competition or very strongly protected against it, that's self-funding, generating lots of strong cash flows, and where the value of that franchise is going to be recognized over time through the valuation in the stock. To me, that's sort of my sweet spot as an investor.

Matt Miller: Can you share a few examples — and this obviously wouldn't be making investment recommendations to buy or sell — but some examples to make more concrete the kind of approach you're talking about? What companies you're maybe excited about, or illustrations that would put flesh on that?

Jody Jonsson: Well, one of the themes I'm pursuing at the moment is trying to find companies in various sectors who are essentially the arms dealers to their industries. So one example is Taiwan Semiconductor. It doesn't really matter who wins; it just matters that the use of semiconductors in everything we have — whether it's cars, phones, tablets, the internet of things — the intensity of usage is up. The content per device is up. And ultimately, those all lead back to TSMC, because they're the leader in semiconductor manufacturing equipment, and they allow the industry to go down in scale, along Moore's Law. And so that stock continues to grow at double-digit rates, but still isn't expensive — still trades at maybe 15 times P/E — grows its dividend, produces very strong cash flows.

And so those sorts of companies, maybe in health care — companies that provide the tools for diagnostics, for example, and for doing the work of genetic testing and DNA sequencing and all that — you don't have to pick the winner necessarily, who has the best drug . . .

Matt Miller: Of the end application you mean, right?

Jody Jonsson: … but you know that everyone's going to have to use more of that equipment. So it's a way to participate in the growth without having to make the call precisely right on who wins.

Matt Miller: Very interesting. David, same general question for you. How do you think about managing, say, the U.S. core fixed income portfolios? Is it more about safety and liquidity? Are you looking to boost returns by taking on more credit risk? What's the way you think about that?

David Hoag: Yeah, so it does change throughout the cycle, my general approach. At this point, as I described earlier, risk premiums are very low, so I'm not paid much to move out the risk spectrum, including corporate high-yield type securities. So if you look at my portfolio today, it does emphasize liquidity and safety. And I think that's . . . For someone who navigates the bond markets every day, liquidity's a very important thing to consider. It's very difficult sometimes to move within the fixed income markets.

Matt Miller: And liquidity in that context just means being able to sell?

David Hoag: Buy and sell securities around the price at which you think you should. So my portfolio — the portfolios that I'm responsible for — are fairly liquid at this point, and they own a lot of Treasury securities.

So I believe there'll be some opportunities coming for me to be able to redeploy those liquid assets into things that have done poorly. But again, you have to have liquid assets ready to go, to turn those into money, to buy securities that may have traded off for some reason or another. So liquidity and safety is probably the key theme that's in my portfolios at this point.

Matt Miller: Now I've heard you and colleagues talk a lot about “bond funds that act like bond funds.”

David Hoag: Yeah.

Matt Miller: That that's kind of a mantra. What does that mean exactly? And why does it matter?

David Hoag: Yeah. Yeah so, if you . . .

Matt Miller: What else might a bond fund act like?

David Hoag: Yeah. So if you do roam the halls of our fixed income group, you will hear that comment. What it means is we believe that people own fixed income funds for a specific reason — and that is for stability and income. That's the hallmark of why one would own fixed income. And so we want to make sure we are providing that stability when it's really needed.

And typically, when folks really want that stability is if the equity markets have a difficult time. So we really want to hold up our end of the deal if equity has a hard, a difficult, episode.

And so within fixed income, you can own bonds that have expected very low-to-negative equity correlations. And you can own bonds that have very high equity correlations. High-yield corporate bonds have historically had a fairly high equity correlation; Treasury securities have had very low equity correlations. And so again, with that framework that people own fixed income for a very specific reason — to provide that stability — we want to make sure that we are delivering to that need for stability.

Matt Miller: And that's a focus of ours that might be different than some other market participants who are, what, slipping in some high yield into a bond fund …

David Hoag: Yeah.

Matt Miller: … and might surprise folks when there’s an equity downturn?

David Hoag: What we talk about internally is that we need to prevent scope creep. It is very tempting to go out and put a little more yield into your portfolio. It creates a little extra total return. In a world of very low interest rates, everyone is scrambling to get that little increment of yield. And again, that's why risk premiums have collapsed, because everybody's struggling to get that small amount of extra income.

And so that's what we're trying to avoid in our funds — is being pulled into that scope creep. And another way to frame it out is, if one has a broad asset allocation of 60% stocks, 40% bonds, you really need that 40% bonds to act like bonds. And you don't want your portfolio to trade as an 80% stocks, 20% bonds if the equity market has a difficult time. So that's what we're really focused on, is providing that pattern of results that people expect within fixed income.

Matt Miller: Now how do you think about where interest rates will hit? Obviously a big focus of the team. The Federal Reserve has raised rates this year. Do you foresee a time when rates get back to levels we think of as more normal? Or are we in a new era that's going to be longer lasting in this regard?

David Hoag: I think, generally speaking, we do need to be accustomed to fairly low interest rates. Absent spikes in inflation, the Federal Reserve, I think, will be fairly moderate in their increases over the coming years. And we'll end up at a terminal rate that will suggest that interest rates are definitely not in the context of the 1970s, but much more in the context of the very long-term history of Treasuries.

Matt Miller: And do you have any concern? We see sometimes some of the Larry Summers of the world — you know, the former Obama and Clinton advisor and others — echo this concern that if we get to another recession at some point, if the business cycle isn't ultimately repealed, that interest rates won't have risen to a point where there's room to do the normal kind of interest rate cuts without getting us back near the zero lower bound again. Is that a concern our team has?

David Hoag: It’s something we discuss. And I think the current Fed is conflicted around this point now. I think on one hand, Janet Yellen has dovish leanings, so she's inclined to do less in terms of raising interest rates. On the other hand, I think they have an interest in getting interest rates closer to normal so they have that dry powder when the time comes.

And the other thing that is probably not understood or discussed enough is they also have an interest in shrinking their balance sheet. QE inflated their balance sheet to over $4 trillion of Treasuries and mortgages — again, in light of them being interested in having that capablility back when/if a recession were to occur. At some point here they're going to have to focus on the balance sheet, and that will be their tool, as opposed to raising short-term interest rates. And so we're looking for that to occur sometime around the end of the year, for us to have more clarity as to how they're going to shrink their balance sheet.

Matt Miller: Why don't we talk a little bit about politics and the kind of political environment in which all these investment decisions are taking place. And Jody, I want to start with you. But let me just offer at least a thought.

I look at politics and policy for our team. And we are just in an unprecedented time, in my view, in terms of — how should we say it — the unusual characteristics of the current American president and the way that he's both challenging establishment behavior, but also bringing a kind of sense of behaviors himself that are unsettling the world. When we talk to officials and others across the world, there are aspects of how this administration is conducting itself that are creating anxiety and nervousness, I think, around the globe. And yet at the same time, there's an agenda potentially. If the administration can find a way to move its agenda and steer a course — because of the unusual situation of Republicans having control of Congress and the ability with 51 votes in the Senate to take some major actions — that there could be positive moves on, or at least moves on, tax reduction if not full tax reform, deregulatory actions that markets seem, in some way, to be anticipating, and may account for some of the measured optimism that we're seeing, at least in the U.S.

But Jody, talk for a minute about Europe. You mentioned this before briefly, but the Macron victory over Le Pen in France was really a . . . it doesn't get as much attention in the U.S. perhaps, but really a kind of signature event in all the recent hoopla that we've been having back and forth on the forces of populism, etc. And Macron is now being kind of embraced as this figure who may embody — especially given some question marks around U.S. leadership — a kind of new direction for Europe. Say more about what the significance of Macron's win is, and how we ought to think about that.

Jody Jonsson: Well, I think the most significant point about his win is that it was a disaster avoided. Europe has lurched from political crisis to crisis over the last several years, and financial crises around Greece, etc. And I think just the avoidance of another crisis was a huge positive.

Macron represents sort of a youthful optimism. He's very pro-Europe. He's pro-euro. He wants to work with Germany. I think he's pro-reform. There are clearly some obstacles in getting to reform in France, the unions being one. Labor reform is probably one of the most important things they need to do.

But I do think it's a really positive sign. And the avoidance of disaster around the currency, the avoidance of uncertainty . . . I think part of what Europe is suffering from is just this overhanging uncertainty of the last several years. You can make all the plans you want, but it might be undone by a political event or by the currency being under stress.

I think the U.K. is another interesting example of uncertainty right now. Brexit hasn't had a terribly negative impact on the economy to this point, but there still remains the negotiation process over the next couple of years. And my concern is just that it takes up a tremendous amount of energy on the part of the government and companies and individuals — just planning for the future and getting to some point of certainty. And that's a resource that's kind of wasted for an economy, so it probably leads to slower growth in the U.K.

That would be a risk in the U.S., I think. If we get into political wrangling, and just mired in controversy . . .

Matt Miller: Scandal or controversy.

Jody Jonsson: . . . it makes it hard for businesses to plan. It makes it hard to invest. It's hard to know what consistent policy will be going forward. And if I'm concerned about one thing with regard to politics, it's just the wasted time and energy of not knowing what the outlook looks like.

That said, if we can get to some consensus, there are some things that I think are not controversial. Corporate tax reform is not very controversial. The U.S.’s is the highest in the world. We can bring that down. We can make a much simpler tax code and make our companies more competitive without having to do any government spending to get there. So I think there are some things we could really make progress on if the noise just dies down.

Interestingly, the market seems to have gone from being very focused on the noise a few months back, right after the election, to now almost ignoring it and looking through it, and going back more to fundamentals of companies and industries rather than the politics.

Matt Miller: Darrell, how do you see the Trump-enomics era? How is it affecting your outlook for the economy? And how is it affecting markets? What's your take?

Darrell Spence: Well, generally we start with the fundamentals, and what is the economy doing outside of politics and government policy. And, as we've talked about, that looks pretty good in the U.S. and has for a while.

The way I would describe where we've gone since the election is, if you think about where an economy is going to go over a 12- to 24-month period, there's a range of outcomes, and we've called it now “the cone of uncertainty.” Prior to the election, it was a certain width of the cone, and then after the election — simply because the number of proposals that Trump had made, the size of the proposals in terms of dollar amounts that Trump had made — that cone of uncertainty had widened. The positive side had widened because things like tax reform, tax cuts, infrastructure spending could be very growth-positive. The negative side of the cone dropped because things like trade wars and the like . . .

Matt Miller: Right.

Darrell Spence: . . . are growth-negative. As we've gone through the first couple of months here, we've started to narrow the cone down. It's become very clear that it'll be more difficult than perhaps he thought — and we thought — to get some of these things done within say, a 2017 time frame. It doesn't mean that we've taken them out of the forecast completely, but we're just putting lower probabilities on those scenarios for the foreseeable future.

But I also get the sense the cone is starting to widen again, and it's not because of economic or government policy. It's because of all of the other noise — the things that you mentioned that are going on that are distracting to markets, have the potential to hit confidence, make planning more difficult and perhaps make difficulties in our relationships with other countries around the world.

So you know, in my 25 years of doing this, I think this is the most time we've ever had to spend thinking about government policies: the impact they'll have on the economy, on the markets, on companies and industries. One example is the border adjustable tax. We spent a lot of time trying to figure out who would win from that, who would lose from that, knowing all along that there was probably a relatively low probability of it being enacted.

Matt Miller: Right.

Darrell Spence: But were it enacted, we needed to be ready. We're doing that with a lot of these other policy proposals. Even though the probabilities are going down, we're still running the scenario analysis, because if they do come through, we want to be ahead of the game in knowing how it's going to impact the economy and the companies and industries we invest in.

Matt Miller: Makes sense. Jody, let's talk about the whole populist kind of movement around the world. How do you think about . . . and this is related to Brexit, related to … Even if Le Pen was defeated in a way that was reassuring to markets, the fact that she's getting close to 40% and may be back again in 2022 suggests a kind of strength of energy around dissatisfaction. Large swaths of workers and voters in advanced nations are unhappy with the trajectory of the economy, with cultural issues, with their lives. Same thing inspired Trump's own narrow win in the United States. Is this something that's going to be a feature, we think, of the landscape now for the indefinite future? Are concerns about this overstated? How do you think about it?

Jody Jonsson: I think the concern is not overstated. I think it's a very, very important issue that is going to be with us regardless of who's in power. And Matt, I think you said it very well in some of your own writings, that the benefits of globalization are very widespread and very dispersed and very small to any individual.

But the costs of globalization are heavily felt by a few people. And we've seen that in the Trump election; we've seen it in France. We see it throughout the word where income inequality magnifies those effects of globalization.

I think globalization is very hard to reverse; it's so embedded in how companies do business now, how their supply chains are located, producing where you sell. I mean, every company is more global today than it was a decade or two ago, so I don't think that reverses. But I do think, as a society, we need to give much more thought to the impact that it has on a few people. And it's a serious problem for society.

How do I think about that with regard to companies? I think, in particular, companies that are monopolistic and very profitable and who own a lot of information and have a lot of control — you know, much of the technology sector — could be at risk in terms of government regulation or taxation or policies that somehow try to get back at the effect that globalization has had on the population.

And so I think those companies need to be very careful how they operate politically, socially, their tone of voice, how they do business. Those are all things we're watching very, very closely. And we're looking for things that might come out of left field to be disruptive to that finely balanced system that we're invested in now.

Matt Miller: It’s interesting that you raise that because my own view, as I think you know, was that if Hillary Clinton had won, some of those concerns about the privacy antitrust competition policy would've been put more to the fore. Probably less likely under Trump.

Jody Jonsson: Yes.

Matt Miller: But those issues, as you say, are not going away and . . .

Jody Jonsson: We see them in Europe frequently.

Matt Miller: Yes.

Jody Jonsson: And I don't know that Europe will be that effective at solving them. But I think if they start to come out of Washington, then there will be much more traction. So it is something we watch very closely.

Matt Miller: And David, before I bring you back in . . . You know, globalization is one of the themes we hear about leading to this kind of populist surge, but the impact of technological change is, if anything, much greater . . .

Jody Jonsson: Yes.

Matt Miller: . . . in terms of the actual income impact, job impact. It gets discussed in elite circles now as the concerns about, “Is AI going to destroy the middle class somehow?” Does that affect the way you think at all about particular investments? How do you take that into account as you're factoring in these different social forces that may impact the investment climate?

Jody Jonsson: I think about it a great deal. Amazon is responsible for a lot of jobs going away in the retail sector. Amazon creates many jobs through, not only its retail operations, but Amazon web services, which is one of the most rapidly growing technology companies in the world.

Matt Miller: Yeah.

Jody Jonsson: That said, the impact is felt very severely in certain industries, and we as a society don't have a good solution to that yet. Whether it's education or training or . . . There isn't a new source of jobs that's growing as quickly as the jobs . . . some of which are being wiped out by this. So it is something I think very carefully about. And I think there are going to be important policy implications around it that we need to consider in our investment outlook.

Matt Miller: David, how do you think about all this political noise, and how it affects your world? The noise ratio versus market volatility seems high. I mean, there's a lot more noise . . .

David Hoag: Yeah.

Matt Miller: . . . than there is market disruption. Why is that?

David Hoag: Well, first of all, I . . . For me . . .

Matt Miller: It's the calm nature of fixed income?

David Hoag: Exactly. We’re just all levelheaded.

One of the most difficult things around being an investor in fixed income is using that political lens. It's a little easier for me to think about straight economics, and people making economic financial rational decisions. When you have to overlay particularly difficult or tumultuous political episodes, it's a little hard to do the hard analysis in terms of, you know, here's the unambiguous correct financial decision. Whereas a corporate management may be able to make that cold calculation, calculation within politics is much more difficult. So one can't avoid letting it influence their portfolios, but you have to be careful to not overread into your portfolios. So it is a backdrop into what we do.

You know, one thing I'm thinking about as I pull away from more near-term political turmoil — and I don't want to play my bond-vigilante card — but the deficits in the United States are fairly high. Entitlement spending will be going up. And any policies that amplify that are going to cause me concern as a bond investor, and it's going to make me a little less willing to lend money to the United States if I feel that the credit is deteriorating, i.e., they're just taking on a lot of debt to pay for all these entitlements. So actually, I have to pull back from probably a 20-year view to think about that. But from a political and societal perspective, that's something we're going to have to start to address fairly soon, or I start to get worried.

Matt Miller: Seems like you do want to play your bond vigilante card.

David Hoag: Maybe I played it gently.

Matt Miller: As we move toward wrapping up our discussion today, I want to talk a little bit about portfolio construction, and how the rubber really meets the road on all of this. Jody, I know you're a bottom-up stock picker, but you're also a member of our Portfolio Oversight Committee. What is that exactly? How does it work, and how does it help shape the direction of our investments?

Jody Jonsson: The Portfolio Oversight Committee is a group of seven experienced portfolio managers, both from equity and fixed income sides of the firm, and our job is to provide strategic asset allocation oversight. Most of our asset allocation happens in our underlying funds that are the building blocks of our multi-asset offerings. So it might be our balanced funds, our income funds, Capital Income Builder® — any fund where we have the flexibility to move between equities and bonds. But the POC provides longer term strategic direction on the asset allocation process and looks at the individual fund building blocks to make sure that they are doing what we expect them to do in different market environments.

So, in a down market environment are the bond funds acting like bond funds, as David said? Are they providing complementarity to the equity funds and not being overly correlated? And if we find that the funds aren't behaving as we expect, then we might make some tweaks in the allocation between them in those multi-fund offerings we have. We now offer 13 model portfolios that are our best thinking on asset allocation, and they're very much geared to investor outcomes. Examples of the things that POC oversees include our target date funds, our portfolio series and our retirement income series. And these are all about delivering objectives for investors at different stages of their lifecycle.

Matt Miller: Great. David how about in the fixed income world? There's something called the Portfolio Strategy Group. It's one way, I guess, that the team tries to develop a point of view that then helps shape decision-making going forward. How does that work?

David Hoag: Portfolio Strategy Group is effectively all of fixed income. We meet three times a year, all of [us] from around the world, we all meet — and include many folks from Darrell's group, our economists — to lay out the current macroeconomic view, where we think it's moving towards.

But then more importantly, on top of that we're going to have to overlay valuations. So as I described earlier, it's not enough to say the Fed's going to start raising interest rates. OK, why will they raise interest rates? How quickly? And that's where the valuation piece comes into the fundamental piece. And so we meet episodically, three times a year, to talk through the economic environment, the asset class pricing throughout all of fixed income — and come out with a view. A smaller group then will meet on a regular basis, on a weekly basis throughout the year, to update that view.

And a few themes that are coming out of that forum right now [are] to have a neutral view on interest rates . . .

Matt Miller: What does that mean?

David Hoag: So inasmuch as an investor would choose a certain maturity spectrum — so if one wants to own an intermediate bond fund, we would have a neutral duration for an intermediate type of bond fund. So it means don't be too afraid of the level of interest rates, but no need to be super bullish on interest rates. So a full complement of duration — but then we'll modify that again and say, “However, try to get as much of that interest rate exposure as you can in the five-year part of the curve.” Again, because risk premiums are so low, that that's your best risk return. So that's one piece.

We think inflation is apt to rise fairly slowly. And when you overlay that with the valuations in the U.S. TIPS market — Treasury Inflation-Protected Securities — that the valuations are reflecting that inflation may be too low moving forward, we think there's some updrift. And so that's another signal that we should own some inflation protection in portfolios where it's appropriate.

And then [we’re] shying away from some of the more equity-like risks in bond portfolios. So high yield is at a very low signal for us. So in a fund like our [The] Bond Fund of America®, which has capacity to own high yield, we've effectively dialed that down to zero.

So [it’s] just an asset class that we don't think offers a tremendous amount of value at this point. If that changes, if we do get a selloff, then we can be opportunistic owners of high yield, but right now the signal is “don't take a lot of equity-like risk in your bond portfolios.”

Matt Miller: Because it wouldn't be a bond fund acting like a bond fund.

David Hoag: Yes, that is part of it. And then also valuations. Again risk premiums, even in high yield, are very tight. And that makes sense. I mean, people are struggling to get that income, and they've really stretched themselves. And a lot of investors have reached for that extra yield and driven security prices up, yields down. We thinks it's just a poor risk return profile at this point.

Matt Miller: And so, what’s the bottom line that comes out of it in terms of your team’s point of view?

David Hoag: Sure. So yeah, there are five factors that are coming out of PSG. One is on duration, which is to have a full compliment of duration. So don't be too short, not too long. The level of interest rates [is] generally fair.

The second key metric would be on the curve. So we think five-year interest rates are a lot more attractive than 30-year interest rates because of term premiums.

We think inflation is slightly underpriced at this point.

Mortgages are slightly overpriced. As the Fed balance sheet normalizes, we think mortgages could cheapen up a little bit, and could offer value in the future, but not now.

And then high yield or credit risk, we're downplaying the role of credit risk overall in portfolios.

Matt Miller: And David, in your own portfolios what are some examples, just to get a little more granular, of the types of holdings you have there? Not to make them buy or sell recommendations, but to give folks a feel.

David Hoag: Yeah. So, even in some of these metrics that we may not love, such as mortgages, there's still some value — good value — in certain areas that our research has uncovered. And so some higher coupon mortgages that we don’t think will prepay as quickly as the market thinks. So again, even if we don't love the asset class, we're finding some idiosyncratic ideas that we do like. And in high yield, [while] we're very low in our allocation of high yield, our analysts do love some companies, and so we're able to put those into the portfolio in a very modest amount. And in fact, in Bond Fund of America, which does have the capacity to own high yield, we've taken that overall allocation extremely low. But we own a few things that our analysts are still very excited about.

Matt Miller: It's interesting because one thing you mentioned earlier that I just wanted to tease out for a second — as you think about kind of the fixed income strategy thinking — is, unlike the equity markets, on the bond side there is a point of view implicit in the math of the market, right?

David Hoag: Right.

Matt Miller: Because there is a term structure to interest rates, so we can see every day — every hour — what the one-year, five-year, 10-year, 30-year is. And so is it right then to say that one of the tasks, or challenges, or perspectives our team brings is, what's our point of view versus what is implicitly expressed in the math of the bond market every day? Do we think the market is right or wrong, and why? And is that where some analytic effort …

David Hoag: Absolutely. Every day we're doing that. One of the first things I ask when I walk in is, “What's priced for the Fed?” So, what's priced in the markets for the trajectory of the Fed? And then we have discussions around those things. And so, you know, the good news and bad news. The good news, we can actually distill the math of this and understand what's embedded, particularly in shorter term interest rates. The difficulty there, the art comes in in terms of, “Well, is that too aggressive or not aggressive enough?” So one does have to apply a bit more of that mathematical macro framework to fixed income investing, perhaps, than one might on the equity side.

Matt Miller: And then just finally on the fixed income side, how can investors use high-quality bonds to dampen volatility in an overall investment portfolio? How do you think about that?

David Hoag: Yeah, so again we think bonds can provide income and stability generally speaking in an overall set of holdings. Income is lower now than it has been due to the overall level of interest rates, but we can still be providing stability. And the way I would think about it is stability relative to a difficult equity market. So there's nothing wrong with having equity correlations within your equity portfolio, but when you own bonds, I think you own them for a reason — which is to provide stability vis-à-vis the equity markets. And so we think fixed income will continue to provide that relative stability.

Matt Miller: Fascinating discussion. We could go on for another hour I'm sure, but unfortunately our time is up. Thank you, Jody, David and Darrell. We really appreciate your insights on these important topics, and look forward to hearing from you again in the near future.

For Capital Group, I'm Matt Miller, reminding you that the most valuable asset is a long-term perspective.

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