Gillian: Welcome to Asset TV. I’m Gillian Kemmerer. 2017 has been a standout year across most asset classes, so what is left to accomplish in 2018? With Tax Reform on the table, a new Fed Chair and a Brexit timeline ticking, next year may prove to be even more interesting for global markets. Today we have assembled a panel of experts across a wide range of perspectives to share their outlook for next year. Welcome to our final Masterclass of the year, A Look Ahead. Thank you all so much for joining us. So I think it makes sense, Rick, before we start looking forward into 2018, to start with 2017. Give us a little bit of background on any economic or political events that surprised you and how you thought about your portfolio as a whole.
Rick Brink: You know, I guess if I had to pick something from maybe the fixed income side of the table, I’d probably talk about the French election. You know, it seemed like that was a [inaudible] moment when, you know, the election went the way markets hoped that they would. And it opened up returns across the spectrum in Europe and so forth. But actually the way I will probably answer this is I’m more surprised by the lack of impact of political events in 2017. I think there was lots of things that we could point to, but generally speaking, the market more or less threw those to the side and kept plowing ahead and we had, as you pointed out, great returns.
Gillian: It’s interesting because I feel like so many people feels as if they’ve been wearing a hard hat all year with all the headlines. But the markets have generally been unfazed.
Rick Brink: You know, we could do an entire panel on volatility, which I think would be an exciting show and I would watch that show. But you know, when you thought volatility was incredibly low, you just had to wait for 2017 to see it really get down to this, it just, and unbelievable levels really, a lot of, you know, the last 10 years we’re going to talk a great deal about all these historic data points over the entire period. Volatility in 2017 is going to have to be part of that.
Gillian: I saw a t-shirt online that said, “I survived the market crash of December 1st, 2017 at 11:00am until 12:15.” And so I think that’s about what we saw, the most excitement we saw. And Anupam tell me a little bit about what you thought about 2017, did anything surprise you in EM?
Anupam Damani: Sure. I mean emerging market economies entered 2017 with quite a bit of trepidation, I would say, given the outcome of the US presidential elections; we had a reflationary theme in the markets, right. US treasuries had had a massive abrupt selloff; US dollar was strengthening, which is not very friendly for EM economies, especially EM debt markets. And then there were worries around trade negotiations, or renegotiations and possibly border tax adjustment. So I think these were really worrisome outcomes. Here we are ending the year with a bang. We were able to get over most of these because there was a lot of noise, but very little signal in all of them. And then like Rick pointed out, I think the political outcomes were actually quite market friendly especially for risk assets and the global buoyancy market with sweet divergence where you did see a pick up in inflationary, especially wage pressures around the world, actually worked really well for the emerging markets debt.
Gillian: Well, interestingly, I feel like the developed markets are really the ones that saw the geopolitical volatility, whereas developing, it seems like all quiet on the western front, were you surprised by that?
Anupam Damani: Yes, there was, I think you’re absolutely right. But geopolitics historically is more norm than an exception. And I think it’s really always important to keep in mind that it’s really the wider economic context that matters more than the political context. So unless the global growth trajectory gets unraveled, the markets tend to, you know, sort of fade that risk.
Gillian: Sure. Rich, talk to me a little bit about how you looked back on 2017, did anything surprise you?
Richard Familetti: Well, it’s funny because what Rick said is exactly what came to mind when I thought about this question. The surprise was the lack of surprises, you know, and I think there was a pretty good expectation that interest rates would be significantly higher. Instead we saw stable rates, that there might be at least a few market blow ups, we didn’t see any at all, or to the extent that we did, they were short lived and met with buying. And in credit markets and high yield markets, we saw just excellent returns and strong demand, both domestic and overseas.
Gillian: So generally the surprise was the lack of surprises. Do you think that’s something that could continue?
Richard Familetti:Well, it’s interesting because it’s not clear to us where the pressure points might be. What’s curious is, is that so far The Fed’s gotten away with raising rates at least slowly. And I think the fact that market participants understand the direction of rates and the pace at which the change will happen has kept markets from reacting negatively; let’s say to The Fed changes.
Gillian: So perhaps one will hope that Powell will continue to telegraph the way Janet Yellen did.
Richard Familetti: It seems that he would.
Gillian: Danton, you come from the global equities perspective, so tell us a little bit about how you characterize 2017?
Danton Goei: Sure, Gillian. As you know, we are bottoms up investors. And so we spend most of our time looking at companies and industries. However, looking back at 2017 one of the, you know, I’d kind of echo what Anupam said was the rerating of the emerging markets was a big surprise. I mean I guess it shouldn’t have been if you look at the entering the year, the previous four years were really tough, right. The Emerging Markets Index was down 18% cumulatively over these previous four years. So actually it was a good set up in the sense that they were cheap, right. And so we were set up that way and we expected them to do well, but not so quickly, so 2017 was a really strong year. I mean Brazil was up 16%. India was up 25. China was a standout at 47% in terms of the Stock Market Index. Yet when you look back at the previous five years they’ve still underperformed the developed markets, Emerging Market Index is up only 20% over five years. And that’s relative to a global market that’s up 68, and to a US market that’s doubled, so over a 100%. So we still think that there’s opportunity there but that’s been really the, I think, the surprise is just that how quickly those emerging markets rerated.
Gillian: Now, you referenced China’s standout year, are you surprised by the kind of continued bearish headlines that always seem to be following China, no matter it’s performance?
Danton Goei: I think that’s, you know, generally reassuring, I guess, in the sense that the valuations are still attractive, the economy is still strong, yet investor sentiment, you know, obviously has gotten better since the market has had a
good 2017. But you’re right there’s a lot of people that are still very skeptical sitting on the sidelines.
Gillian: So we’ll take that as a good leading indicator for now.
Danton Goei: I think so.
Gillian: So let’s, before we move on to 2018, I want to take one last look at 2017 and specifically I want to know what you learned this year and if it’s anything that you can take into next year as you begin to prepare your portfolio management or construction. So I’ll start with you, Anupam, anything that characterized 2017 that you’re going to take into next year?
Anupam Damani: So I would say given the global backdrop, remains actually quite favorable going into 2018, just like it was in 2017. I think it’s fair to say, and the resiliency of the emerging markets debt asset class, I think it’s fair to say, you know, dips should be still bought into 2018. So any volatility that presents itself, which leads to any sort of a market selloff, should be bought into.
Gillian: Okay. So volatility and we might just see the comeback. Danton, what about you?
Danton Goei: Yeah, I guess so similarly, I mean we have been investors sort of overweight in emerging markets for quite a while now, yet we still see opportunity there even though a number of the names have done well. I would just say though that selectivity obviously is key there, especially in emerging markets which is sort of an amorphous class, right, it has everything from China maybe at one end and India, Brazil, Russia. I mean they don’t really have that much in common actually as countries or economies. So really being selective in terms of the geographies and also the companies I think matters a lot.
Gillian: I heard it said recently that the term the BRICs was more a good marketing move than anything else, not necessarily a good classification of a very diverse set of countries. Okay. Rich, coming to you, what are some of the stories that you’ll take from 2017 and really put forward in 2017 as lessons learned?
Richard Familetti: Well, two things I’d say. One is I think there was a broad consensus that interest rates would be higher. And they weren’t, they were flat to lower. And so I think we relearned the lesson that trying to predict the direction of interest rates is a mistake, focus on fundamentals. Focus on where, you know, you can get bottom up selection. And then I think the other lesson is as the market does better investors become more complacent and don’t learn complacency, be wary of becoming more complacent, especially in a market where we would expect continued buying of dips. And so we need to be careful not to get over-complacent about trends that might be working against the market in the, you know, the intermediate term.
Gillian: So focus on fundamentals?
Anupam Damani: Yeah, that’s a great point, Rich. I would echo that, not only for investors but also for policymakers when money is easy and capital flows are going into emerging markets debt, policymakers can get very relaxed and not continue on the same path of reform. And so I think it holds true for both investors and policymakers. And again, to your point, selection will always remain key.
Gillian: So there’s been a lot of reform but there’s still plenty to go?
Anupam Damani: Yes.
Rick Brink: That’s the undercurrent that I have found, my 2018 is that if you talk to investors across the United States, really all over the world, but in 2017 as we went through all of this strength, everyone is afraid to get off the train too early. But no one wants to be in the wreck. And so there’s one finger on the buy button, one finger on the sell button and everyone’s aware of valuations, they’re aware of a good growth inflation environment. But there’s also this notion of how do I marry the two? I can, in theory if I’m a financial advisor somewhere I can get fired for not participating enough. But I’m certainly going to get fired if I participate too much and markets go down. So I’d say 2018 for me or the 2017 lesson into 2018 is finding a way to sort of calibrate the dials so that there’s participation in the market. But there’s this embedded defense, because we might want to, you know, all of us are talking about it, investors might want to sort of put that away in their back pocket. But it’s a funny thing about downturns; they don’t send a Christmas card. And so having that sort of built into the portfolio, almost at a structural level is probably one of the most important conversations and obviously introducing credit choices.
Gillian: Well, Rick, actually I’m going to stay with you for a second because now I want to move ahead and think about 2018. So when you look at it from a bird’s eye view and I know you come from that portfolio construction standpoint. What is the capital markets environment you’re looking out on?
Rick Brink: So yeah, so I alluded to that just a moment ago. So first, I mean obviously we continue to be pretty constructive on growth globally. We’re about the same number as what it’s going to end up this year. Inflation, about the same number in 2018 as it was last year. Markets generally should continue to benefit from an environment where investors want to be invested, where there aren’t a lot of available choices. Look, if I, you know, my background in fixed income, I guess I would probably say that we think of this period where markets have done so well as a great beta trade. And the drop in rates around the developed world, certainly in the United States had almost four effects on assets. The first of which is that if you’re going to remove uncertainty from a market you’re going to maximize the valuation. You’re taking certainties of premium away. If you drop interest rates you’re going to maximize present values. If you drop interest rates you’re going to create the great net margin gains from capital refi across the US corporate space and create the greatest net margin boom in 50 years. And lastly, what exists now is if you drop rates you’re going to bring Tina to the party, there is no alternative. And so if I look at earnings yields in equity markets across the developed world and I compare it to the bond yields across that world, that gap is still generally supportive. So I’d say from a capital markets perspective still generally constructive, but we’ll probably talk about this in a little bit. We have to not go to sleep on The Fed. Don’t go to sleep on Central Bank policy.
Gillian: So keep an eye on Powell. And even though he might be a continuation of Yellen, it doesn’t mean that it’s going to be frictionless?
Rick Brink: Look, I think that one of the things that … we’re in agreement also that Powell is an extension of Yellen and all of that stuff. The thing that, you know, this is the thing to watch, it’s not necessarily the base call, but it’s the call to account for is if The Fed starts to come to the notion that maybe they’re behind the curve, if we think maybe The Fed doesn’t really care about another 20% equity market. And I don’t know that that’s necessarily true. And so the market’s thinking a couple of hikes, The Fed’s talking about a few. We think you could see as many as four. You have balance sheet reduction next year. And so imagine if all of a sudden in a meeting where you didn’t expect that The Fed, in order to try to throw a little bit of caution into the markets, actually tightened. Now, again, it’s not the base call. But that’s probably the thing that I would keep an eye on is how Central Banks are going to continue to react if markets continue to run up and throw caution to the wind and everything else.
Gillian: Go ahead.
Anupam Damani: And I would just note on that, that it’s not only The Fed. It may very well, 2018 may very well be the year for ECB and bund yields is something that we need to watch, which may be something that actually puts the US treasury yields up with them, so you know, talking about, yeah.
Richard Familetti: Yeah, rates and the shape of, yeah, that’s right. Yeah, rates and the shape of the yield curve are going to dictate the outcome this year, this year coming up, and probably into 2019. Whatever happens with the shape of the yield curve, really mid late 2018 is where you’ll start to see interesting things happen, maybe two years out. But the level of rates drives so much right now in terms of asset prices. I mean think about cap rates on commercial real estate. So cap rates on commercial real estate now are so low and tied so aggressively to the level of the 10 year note that any significant move in treasuries higher is going to have a negative impact on asset values. So that’s not necessarily something that plays out in the short term. In fact I’d say that The Fed raising short term rates actually has a positive impact on longer term rates right now. We’ve seen that, right. But that also means that as we go from a 2% 2 year note to a 3% 2 year note, that suddenly if the 10 year’s at 3 or lower inversion, that’s when you start to think about whether or not asset values could come under pressure.
Gillian: Now, Rich, I know that there’s a general expectation of a flattening of the yield curve, are you worried about an inversion?
Richard Familetti: Well, I guess the question becomes when we get to a point of flatness, of absolute flatness or possibly inversion, what will The Fed do, will they slow down? Will they just continue down that path? I think that the answer lies in the inflation rate, at least in the United States and probably in Europe as well, to the extent that inflation remains benign, I think that an inverted curve can persist for a little while before it really has any significant pain. But to the extent that inflation starts to pick up and so you have a bearish flattening or bearish inversion in rates, that’s probably a dangerous sign.
Gillian: Now, Danton, speaking from the global equities perspective, at the beginning of 2017 a lot of people were coming in and saying to me, “Europe looks cheap”, etc. Europe’s slowly caught up to the rest of the world. Obviously we’re talking about the ECB trailing The Fed. How are you thinking about the global picture in capital markets?
Danton Goei: Well, we think that still equities in general do look attractive, especially relative to fixed income. I mean if you think about today’s 10 year government bond at 2.4%. Then it translated into sort of the equity’s PE that would be 40 times plus. And so on that relative basis of course it looks attractive. What is interesting also, and what’s driving that of course inflation rates. And so we’re also following that very closely. What I found very interesting in this past year was inflation remains subdued here in the United States. And actually in some of the emerging markets actually fell. In India it fell meaningfully, in Brazil. And these are, you know, high inflation countries where actually the rates came under control. That was part of the driver of why some of these markets did well. So I think that’s interesting, but following why that happened, and then going forward, I mean if you look at the Untied States here with, what, 4.1% unemployment rate, The Fed balance sheets sort of ballooning. There are concerns for long term, you know, as we put our sort of three/five year hat on, you have to sort of really be wary of that of course. And like Rich was saying and that’ll drive really interest rates, that’ll drive, sorry, equity returns in terms of what happens to interest rates and how fast they rise over time.
Gillian: I’ll start with you on this and then I’m going to move to Anupam. But obviously we saw a great performance in all emerging market currencies. I think all of them were up on the year. When we divorce the currency story, do the fundamentals still look strong in equities or do the currencies really provide that extra tailwind this year?
Danton Goei: I think the fundamentals look pretty strong overall, if you look at the economies, you know, emerging markets, even the US obviously and developed markets and Europe generally all look very strong. The economic growth is good, unemployment has been falling. And inflation, as we spoke about has remained subdued. So the set up is overall relatively favorable, at least for the next sort of year or two.
Gillian: Okay. Now, Anupam, coming to you, similar question, obviously you think a lot about local currency versus dollar. How do you look at the capital markets going into 2018, particularly for emerging market debt?
Anupam Damani: So we think a lot of the global drivers that anchored the asset class in 2017 stay in place into 2018, but valuations are more compressed. And so I think it generally means you need to be a lot more nimble. And the markets will be a lot more fragile to any exogenous or endogenous shocks. And we do have a heavy political calendar in EM. Coming into 2018 all the way into 2019 some of the very large economies from Brazil, Mexico, Egypt, Ukraine and then into 19, India, Indonesia are going to elections. And so for us that’s very important to see the political outcomes of these elections, if they, you know, can sustain the structural reform or the fiscal consolidation, right. So the growth is there, which is providing a tailwind. And that’s a nice sort of backdrop for these policymakers to maintain social cohesion, but still embark on this or continue on this structural reform path. So on the currency piece what I would say is the sweet divergence that we saw between growth and inflation, especially in EM, the thing is that you have these new breed of EM central bankers who are extremely orthodox. You are seeing inflation actually going down and yet they continue to be extremely cautious in lowering policy rates, right. So you have real rates actually in these economies which are very high. And one of the measures that we look at is volatility adjusted carry that some of these local currency bonds provide. And in many markets that looks very attractive, even going into 2018. So we continue to like the local currency segment of emerging markets debt going into 2018. But also there’s, you know, good pockets within the EM corporate space and the EM sovereign space, especially in frontier markets.
Gillian: I’m going to come back to the politics in a second. But Gerome Powell, before he became Fed Chair said that he generally believed emerging markets were better insulated than ever to deal with the wind down of Quantitative Easing. Do you think that’s true?
Anupam Damani: Absolutely, that’s very much true. The 2013, you know, the late Taper Tantrum that we saw and the following oil price crash that we saw actually kicking and screaming, but a lot of policymakers did their job and actually started their program of fiscal consolidation or adjustment. And so as a result you are in a better place in EM, and from a macroeconomic fundamental perspective, but also external balances, you know, are quite sound. And so you’re coming into a market where capital is flowing into emerging markets. But emerging market economies are in less need of that capital. And so that’s a positive backdrop.
Rick Brink: You could almost of think of the offset of the developed market Central Banks and what we think of as the beta traded markets, and then emerging markets’ reaction to that. So 2013, you know, a lot of money, rates fall in developed markets, it goes in search of other opportunities, it finds its way to emerging markets. And then you get to 2013 and the Taper Tantrum announcement and there’s some challenges for emerging markets and maybe some weaknesses and balance sheets get revealed from lots of money coming and getting more debt issued. But then they firm up, right. And so then you come out of that other side and you’ve got this great fundamental technical valuation case in emerging markets debt and equities, where you’ve got good growth and proven growth, Anupam talked about that. You have the lower inflation, you have the real yield differential that’s attractive that plays out over a period of time that allows for emerging markets with a low inflation to good real yields to stay neutral to potentially ease, which creates some of the opportunities in markets. The technical case is that a lot of folks under-allocated them, when the difficulties happened in emerging markets they went heavily into developed markets. And so there’s an under-allocation across the investment world to emerging markets. So you can argue there’s something there too.
And as Danton can talk about price to book, other valuations in emerging markets relative to the developed markets continue to be attractive. So maybe it’s a little more expensive relative to history. But again if I put a pound for pound to the United States and Europe I still have that opportunity and so all of that is floating. But there’s also the things to watch, the idiosyncratic side of it is also watched, Fed rates in the US, dollar and how that maybe ripples through into hard currency debt. But we would also agree in opportunities in local currency EM that you see are idiosyncratically making good choices.
Gillian: So this actually leads up perfectly to a discussion of the politics, which Anupam already alluded to. But, Rich, I’m going to start with you. We have a heavy political calendar around the world but we also have a heavy legislative calendar here in the United States. What are you keeping an eye on in 2018?
Richard Familetti: Sure. So I think the final version of the Tax Bill will be very important to corporate balance sheets. What’s interesting is that there’s some restrictions on the amount of leverage a company can carry and still deduct interest. That’s a great way to encourage companies to cut the amount of debt in their balance sheet and have a little bit more balance. I think it’s somewhat dangerous for some high yield companies, at least short term, that maybe depend on cash flows from being able to write off interest to deferred taxes. But all in all, I think the domestic Tax Bill and the legislative look is pretty positive for credit markets and probably for asset markets in general in the US.
Gillian: Excellent. Danton, what are some of the political elements that you’re keeping an eye on around the world?
Danton Goei: Sure. Yeah, the US Tax Reform obviously is going to be a big driver. We own a number of multinationals, seeing what’s going to happen with them is maybe even more complex than with the US companies. And there we’ll have to really see what the bill ends up and what it looks like when it passes. Some of the regulatory issues that we’re looking at are of course in Europe, what’s happening with the US tech companies and the regulatory oversight there, how that’ll impact these large US multinational corporations. Also here back home, something that’s not really in the spotlight now, but there’s change in net neutrality, whether that will have a big impact, whether actually the broadband providers will act on it and look for other ways to have a second revenue stream by being a sort of a toll booth, whether it actually happens or not, that’ll be very interesting in seeing the impact on those markets as well.
Gillian: Yeah, very interesting point. Rick, when you look at out across the legislative calendar what are you keeping an eye on?
Rick Brink: Well, I mean, I could sort of go out on guard and talk about, Bank of Japan, confirming Kuroda or not, China staying the course and how it continues to balance the growth in debt and their forward plan. But I’ve got to go with US taxes, I mean you have to go with what happens with US taxes because the ripple effects, with all the details set to be figured out, the impact on municipal debt, the impact on home affordability in multiple states depending upon what comes out, that’s going to be a huge driver. And obviously you see how markets react to it, the minute we whisper about it happening or not happening, that continues to be a big, big driver. And it’s something that a lot of the US market is sort of almost counting on. If the beta trade was an exogenous monetary policy shock, this is an exogenous fiscal policy shock. And so, you know, I have to go with US tax as the big one.
Richard Familetti: Yeah, it’s certainly going to have an impact on corporate finance looking forward in the United States. I mean the way companies organize their balance sheets, it’s definitely going to change if this bill becomes law.
Rick Brink: And think about by the way, if you do get a tax cut then there’s the other side of the discussion which is well, now some other people have more money. And if you do see rates start to rise then people sitting on the sidelines maybe because of zero or negative rates, maybe I start to play rates. And so do I now go to invest in that market? Does IG get more attractive because you do get cut debt? So with a lesser amount of IG debt you now have an opportunity to invest. And Danton mentioned the multiple on treasuries. And so if you play that same game with triple-B rated corporates in the US you have a multiple of about 24. And so if you get rates moving up and you get some tax cuts and maybe IG spreads become attractive. Maybe that becomes a trade for investors when you take that all together.
Gillian: And, Anupam you already mentioned that you’ve got a busy calendar going into next year. Is there any particular election or regulation in emerging markets that you’re keeping an eye on?
Anupam Damani: So we’re outside of the US Tax Bill which has relevance for global markets in general because of how it moves possibly the US treasury market or the US dollar may have ripple effects. But starting in a week’s time is the South Africa ANC election, which is very key, given the amount of state capture and fiscal discretion by the authorities that we have seen there. And the outcome of it may actually be, very well be an inflection point for a better medium and long term outlook for South Africa. So that’s something that we are really watching. And it could be a big story going into 2018. Likewise I think Mexico; Nafta negotiations start heating up into 1Q. So that’s something we have an eye on, our base case remains that the core principals will be maintained. But the risk is not insignificant of it being completely taken away. And so does that then have any implications for the Mexican presidential elections that are coming in, where the leftist candidate is in the lead? So that’s again something that we are watching for. The fortunate thing in Mexico is the institutionalization of reforms and policy credibility is so high that I think markets will, you know, use that volatility or any selloff to actually look to add to some of the Mexican assets at that time.
Gillian: And this actually reminds me, Danton, coming back to you, we saw obviously the Peoples Party Congress in China this year. Are there any major geopolitical or legislative events in China that you’re keeping an eye on?
Danton Goei: Yeah. I mean the long term reform of the economy there is really a thing that’s been, you know, a big driver over the last decade and whether that’s going to be continued over the next several years. So what we’re talking about there is really the form of the financial sector and the state owned enterprises, right, and to the extent that people worry about China and it’s usually around the financial system and the increase in debt there. And the majority of the debt is at the state owned enterprise level. And so whether those companies can be reformed over time and the banking system can be reformed, really interesting. You know, the words that are coming out of the congress are sort of promising and optimistic. And we’ll see whether actually the follow through happens.
Anupam Damani: And just on Danton’s point on China what I would add is the one thing that may be a game changer for China is if it gets added to the Global Bond Indices, especially Emerging Market Debt Indices. That is something we are watching for, the Chinese authorities have been gradually addressing, and there’s concerns of entering the local bond market there. And the yields are beginning to look attractive there. So I think that may very well be, you know, something [inaudible].
Danton Goei: And you bring up a great point, I mean, you know, it’s happened already, in a small way in the equities market. And so some of the local shares have been added and so that’s probably a trend that’s going to happen over the next several years, and it should be positive.
Gillian: Okay. So now that we have gotten a good sense of your macro outlook around the world. I want to start moving into where are the opportunities that you’re seeing moving into 2018. So actually I’m going to start with you, Rich, give me a little sense of what worked for you last year and what you’re really excited about going into 2018?
Richard Familetti: It turns out that they are both the same thing. We still see plenty of opportunities in structured credit and structured finance. The wave from 2008 still hasn’t completely receded in the sense that the credit quality in structured finance is still very strong. There’s structures, the new issues that are being produced still have very high credit quality and are not over-levered. So we got great performance last year from structured credit, from asset backed securities, CMBS and CLOs. And we expect this year to be the same that will still be a focus area for us. We haven’t seen any significant deterioration in credit quality.
Gillian: Yeah. And I know there were some concerns generally about the corporate credit market potentially with credit quality, but structured overall looks good?
Richard Familetti: Well, I think with corporate credit quality, we’re at a high point in leverage. And that’s important. But there are any number of items including the Tax Bill that we’ve already spoken about that are pressing against that. That and I think the revenue growth and margins still being pretty stable have helped make corporate credit risk not as bad as it immediately appears.
Gillian: And any particular sectors or is it more of a bottom up approach, deal by deal?
Richard Familetti: For us it’s bottom up. I think as far as sectors go, the things that we’re careful about are anywhere where we see levering M&A, so that’s consumer products, possibly pharmaceuticals, DMT. We wouldn’t be surprised to see some M&A that’s transformative, not just for companies but also for their balance sheets.
Gillian: Great, thank you. Now, Rick, when you look out sort of across the landscape of opportunities, even from a portfolio construction perspective, what worked in 2017 and what do you think is going to work in 2018?
Rick Brink: Well, what worked in 2017 was not being balanced and not being cautious for the most part. And I would say 2018 is not supposed to be that kind of a year. I get asked a lot about income generation. And first, I would completely echo the area within structured credit, just the notion, by the way, generally that if you’re trying to squeeze more water out of a washcloth, broadly within private credit, compensation for liquidity premiums, you know, capturing of time is something that I think investors should be looking at broadly as they invest. But from a structural perspective, we’re big fans of credit barbells which is something that doesn’t come up at cocktail parties very often, it probably should.
Gillian: Unless Tina’s there.
Rick Brink: Unless Tina’s there, she would talk about credit the barbells too; we can’t get her to stop talking about them. So a credit barbell is the idea that you balance high grade securities with low grade or below investment grade. And over time that’s an incredibly efficient structure, the combination of pro cyclical and counter cyclical income. So much of the world is short on developed market duration. It’s become almost a standard part of a portfolio. And I know there’s an expectation of rates rising, obviously curve shape is a big part of that discussion. But when I talk to folks today, you know, I almost try to talk them back into adding thoughtful duration, with sort of balancing the two. I think the opportunity in 2018 is to be purposefully diversified, to sort of embed structural benefits into a portfolio. So if I talk about a credit barbell, we’re generally constructive on high yield. But if I was to create a risk balanced barbell, which risk balance would put it about 60 something percent treasuries, the amount of yield that I can pull from a volatility adjusted risk balanced barbell versus high yield gets you about 85% of that yield. But if we do get some kind of a difficulty in markets, the drawdowns are a fraction. And so again back to that idea of embedding defense in portfolios, if I can get most of the yield or most of the return of an asset with a much bigger defense embedded, that’s something I’m going to go after. So I know there are more specific areas to invest in, but structurally that’s probably what I [inaudible].
Richard Familetti: That makes so much sense. I mean you could take that as far as you want to. You could use high yield debt and long treasury strips. I mean that is a trade that makes so much sense. You get all or most of the income that you would get from risk assets in fixed income markets. But you get the protection of long strips that come if you do get pressure on the markets. That barbell, either that or super high quality corporates makes a great deal of sense. And we have seen clients ask about that and we’ve been moving in that direction ourselves.
Gillian: Now, obviously you already alluded to this, there’s the potential for four rate hikes next year. But the market’s pricing in approximately two, if we get to mid year and we see there’s still a divergence between market expectation and what The Fed is saying, how do you start to reorient?
Rick Brink: Well, I mean, the first is do you think it’s … I mean where do we find ourselves from a fundamental view at the middle of the year? Is there a reason why that there’s still a disconnect? But as we’ve gotten in little glimpses when the market has to come … so, look, for a long time The Fed had to come around to the market’s way of thinking. So it’s a relatively new thing that the market’s going, “Wait a second, maybe we’re not sort of driving the bus here.” If we get into the middle of next year and The Fed is dealing with, and Central Banks in general, but The Fed in particular is dealing with stronger markets, growth continues to be good, inflation continues to be sort of there, but maybe Phillips curve isn’t necessarily dead. So if you start to see a little bit of that showing up in the … and again, Fed language is going to have a lot to do with it, but you know, if we get to mid year and things look pretty good and Fed language starts to drift in a particular way, markets have to sort of adjust to that reality.
Gillian: Okay. So I’m going to move over to our investing globetrotters. So, Danton, I’m going to come to you. When you look out across the world what do you like in 2018?
Danton Goei: Well, a lot of is the themes that worked well in 2017. And when we do our investing, we are, like I mentioned in the beginning, bottoms up investors. But we also have these long term themes that help guide us in terms of our research. And these are multi year, multi decade themes. And so one of them is the rise of the online consumer, we all know that obviously in our daily habits. But investing on a global basis is even more important. If you think about three-quarters of all online purchases are outside the US. So of course, means that Amazon worked very well for our portfolio this year. But also names like Alibaba or JD.com did very well last year. And we believe are still set up for a strong 2018 in the sense that China has now become the largest ecommerce market in the world, you know, 15% of retail sales are online over there. In fact they’ve basically leapfrogged the physical retail space, just like, you know, people have leapfrogged fixed line phones to mobile. They have leapfrogged, they don’t … they haven’t built, so the T,J. Maxx’s and the Targets and the wholefoods, but gone directly to online over there. So that’s a strong area of focus, so the rise of online consumer.
A second area that’s a long term trend is also related, is this rise of the global travel or the global traveler. If you’re in emerging markets and you become middle class, one of the first things that you focus on is your ability to travel, both for business and leisure. And that has big repercussions in terms of investment opportunities. We have looked at the aerospace market for example, and found the, you know, one of the areas, the greatest value add is in jet engines. So obviously you can invest in Boeing or Airbus or other areas. But jet engines is a beautiful oligopoly of companies, in fact there’s only three or four companies that dominate the space there. And once you’re on the wing there, you are on there for 15/20 years. And it’s 15/20 years of service and parts revenue. And there are companies like Safran, which is a French aerospace manufacturer that has a JV with GE. GE and Safran together control 75% of the narrow body market. So these are the Boeing 737s and Airbus A320s that have the workforces of airlines across the world. They have 75% of that market. The other 25% is owned by Pratt Whitney, which is owned by UTX and we’re also investors in that. So both UTX we think, which is United Technologies and Safran are really well set up for the next sort of decade. Right now they’re under a pressure point we think, because they’re introducing new jet engines, which when you first roll them out are less profitable than the old ones, just because you don’t have the scale and you also don’t have the maintenance revenue. But if you look out two or three years you can really see a long stream of strong revenue.
Also in this space is an airline called Indigo, which is the leading airline in India. India’s a really fascinating market; obviously it’s a huge country, 1.3 billion people. There are only 440 commercial aircraft in the entire country. And so the demand is huge there. This airline controls 42% of the market over there and growing, very low operating costs, big procurement advantage relative to their competitors. So we think that’s another example, I guess, where selectivity matters. You can invest in lots of airlines across the world. But this one in particular is really well situated in a growing market with a dominant market position and very well run. And the last theme I will just mention that’s driving our investment portfolio is this idea of the global education, the knowledge industry has become more and more important across the world, whether you’re in EMs or in developed markets. And if you look at a country like China there, where you’ve got 200 million K through 12 students, there you have a really big opportunity because the top 40 universities there, the acceptance rate is 2.2%, 2.2, that’s 1 in 50 gets accepted. So parents are willing to spend a lot of money on their children to get them into university. So we think companies like New Oriental Education or TAL Education also very well situated and we take advantage of that.
Gillian: Excellent. So keeping an eye on that rising middle class, how technology is playing into it and they’re changing tastes and preferences as they continue to acquire wealth. Excellent, Anupam, tell me a little bit about what you like in 2018?
Anupam Damani: So 2017 we saw a lot of indiscriminate buying of high yield names and just generally whatever you bought went up. So a lot of the low hanging fruit, so to speak, has been plucked, so a lot more work will need to be done going into 2018. So we like, as Rick mentioned, we always like to hold a diversified portfolio. Be very vigilant around right sizing the position, especially if it comes with not as much liquidity. And I think it’s important to remember in times when the tide goes away you want to have that, the exit doors are small. But we do like, so we also prefer the credit barbell where we like some very sound countries like India and Indonesia and Peru and even Russia where the government has done a phenomenal job in shoring up macro stability. The policy credibility is there. I think over time the growth is going to be a big driver in these economies. So we like a lot of corporate names both in all of these economies, but we also like the real yield, like I said, it’s a low volatility, real yield carry that you can continue to harvest on. And it has lower correlation to the wider market in terms of when the markets are very volatile. On the other side of the credit barbell we like a lot of frontier names such as Ukraine, Egypt, Mongolia, now, they seem like very next generation, policies still evolving. But I think what they all have in common is an IMF backed program which provides liquidity support along with providing a policy anchor for the next few years. And we think some of the work that has been done by the governments in these, behind this IMF program, some of the fruits still haven’t been, you know, plucked. And I think you will continue to see improvements in these economies, so we like that as well.
Gillian: Excellent. So if there’s anything that we’ve touched on here, you know, I think generally speaking many of you are pulling your themes from 2017 forward, maybe making some slight adjustments based on politics. But I have to know, is there anything when you look out in 2018 you say, “Absolutely not, I’m not going to touch it with a 10 foot pole”, Rick?
Rick Brink: I don’t know that there’s a space. I’m trying to think is there an entire area of markets that I wouldn’t touch? And I guess the answer is going to be no because at a high level, idiosyncratically there are opportunities throughout much of the world. So I think themes in terms of underweights, things that we have sort of tried to stay generally away from, it didn’t necessarily work particularly well in all cases in 2017. But it’s in triple-C space, are there areas where, again, your bang for your buck and the amount of risk that you’re taking on, it’s just that compensation for risk. So I don’t think there’s a part of the market I’d just be running and hiding from. But I do think it is really a name by name story.
Gillian: Okay, Danton, anything that you’re staying away from?
Danton Goei: Well, I think this low rate environment has created some distortions in the equity markets. And I’m specifically thinking of the dividend yielding stocks.
Rick Brink: Oh, shoot, I’m in dividend yields, right, I mean why not?
Danton Goei: No, I’m not saying that.
Rick Brink: Right, so dividend yields.
Danton Goei: Some of these companies that are trading at 25 times or more low growth and the only reason they’re there now is because they’re offering a 3 or 4% dividend yield, right. Now, if you’re only counting that dividend, obviously, you know, 3% dividend, it’s going to take, you know, mathematically, 33 years to get paid back. It’s not a great bet, especially if they’re spending a large percentage of their earnings in terms of their payout. So we think that area, and that includes consumer staples, utilities, so telcos, some MLPs. That is an area to, you know, to be wary of.
Richard Familetti: But there’s been some correction there, right. So MLPs and BDCs both are really income oriented for income oriented investors. We’ve seen prices there drop pretty aggressively, maybe they have more to go. But it gets right to your point that that theme is spreading out through, you know, to other sectors of the market.
Danton Goei: You know, I think so. I think what you’re starting to see in MLPs could also happen in some of these other, you know, telcos and utilities and consumer staples.
Gillian: And correct me if I’m wrong, but this repatriation could make this an interesting story too, because that cash that’s coming over, a lot of people are expecting it to be invested in productivity. But it might just go straight back into the hands of shareholders.
Richard Familetti: Yeah, that’s for sure.
Rick Brink: Yeah. But I think we’re expecting the other.
Danton Goei: You know, I mean I think that going back to our US tax discussion, that’s an interesting point too, whether companies are actually going to hold onto those profits as well or they’ll be competed away by capitalism in terms of, you know, having to lower prices. And maybe ultimately the consumer benefits, but the companies’ profits might not rise significantly in the long term.
Rick Brink: I would, let me just say, I think that’s a terrific point. I mean obviously not all dividend payers as Rich points out are evil. But for a long time investors have really, for the most part, trusted corporations only to return capital. And so you’re seeing a lot of, you know, sort of weird things happening underneath the surface. And if you look at a lot of dividend yielders, for example, payout ratios have sort of been jumping up. And so to continue to meet that payout, it’s less about the earnings generated, and more about the share that they’re paying out. That’s not obviously what you want to look for. You want to look for, again, a dividend growth. So one of the things we do say is that we think, you know, dividend growers or dividends tomorrow are cheaper on the whole than dividends today.
Gillian: Anupam, anything in emerging markets that you don’t like right now?
Anupam Damani: Well, EM is really not a monolithic asset class. There’s so much diversity within EM that you always have idiosyncratic risk everywhere popping up and those are the best times too, if you have a team that’s doing bottom up work and actually play into those. But anywhere where valuations look extremely compressed and there’s complacency setting in by the countries or policymakers, or we see money going in just purely because everyone’s like you said, it’s trying to squeeze out the last bit of it. I think we feel better off to just take our chips off and wait for better opportunities.
Gillian: Know when to hold them, know when to fold them.
Rick Brinks: I think one area that’s interesting on a long term basis is this risk of technological obsolesce. And we’ve seen a lot of that, some of these technologies, whether it’s artificial intelligence or autonomous vehicles, online commerce, you know, electric vehicles, are really going to have a big impact on some of these, already have and obviously retail is going to be impacted. But some of these interestingly, are really going to transform over the next several years and that’s something to follow.
Richard Familetti: Yeah, what’s the impact on electric utilities in the United States to the improvement in battery capabilities? I mean that’s something to pay attention to over the next, you know, probably 5 or 10 years.
Gillian: So this has been a really interesting discussion. I’m actually really upset to cut it short at this part of it. But I want to give you each an opportunity to share with us how investors can really use whatever solutions you’re bringing to the table and fit them into a larger portfolio in 2018. So, Danton, I’ll start with you.
Danton Goei: Sure. So we run three funds that are focused on the global and national space, the Davis Global Fund, the Davis International Fund and the Davis Select Worldwide ETF. We recently launched earlier this year an ETF. And so they have all outperformed recent periods and also over their lives, 11 and 13 years for the funds. And the reason why we think that is, is because if you look at the index, the comparator out there, the MSCI [inaudible] Index, has nearly 2500 names in there. So that is a massive number of names. Obviously they’re not 2500 good companies in the world or in…
Gillian: If only.
Danton Goei: Right, exactly. And also if you look under the hood, what’s in there, it’s chockfull of government run state owned enterprises, financial institutions, utilities. So a lot of them you really would not want in your portfolio in the first place. But if you’re investing in an index, that’s what you own. And so we think that a really enactive long term, sort of bonds up very focused, are funds really only have 40/50 names in the portfolio, very focused long term bonds up approach can really add a lot of value over time. And we don’t think that just indexing on that basis, with that many companies makes a lot of sense. You know, there’s no selectivity in that process and we think that matters a lot.
Gillian: Yeah, it’s a good point. A lot of people saw the performance of international last year and want to get in. But it’s not about just getting in broadly; it’s about finding your opportunities. Rich, tell me a little bit about Ryan Labs?
Richard Familetti: Sure. So we have two focuses, when we say this, we have a great team of portfolio managers and analysts that work together. And we are very proud of the fact that we have outperformed the aggregate benchmark, core fixed income benchmark for 15 years in a row. We have been very consistent in terms of our excess returns. And so if you want a consistent excess return fixed income strategy, that’s us. And then the other thing is our solutions business, which is really focused on pension funds and risk pools where you want liability driven investing and hedging your liabilities. There we provide good total return management overlaid on a solution that works for your pension fund.
Gillian: Anupam, how should investors think about Nuveen’s emerging market solutions?
Anupam Damani: [0:49:47] Yeah. So we run an emerging markets debt fund which is actually a blended strategy. What we mean by that is we find the most compelling opportunities within the hard currency, which is US dollar denominated sovereign corporate, and then the local currency markets, you know. And these three segments of the wider emerging markets debt tend to have very distinct risk return profiles and volatility associated with it. But we blend it because we have a very experienced team, deep bench that has been doing this for a long time. So rather than an investor trying to figure out which is the best place in the market we provide that blend. And so I would say in this market this portfolio fits very well into a larger portfolio because you should take comfort in the global backdrop which is favorable, you know, embrace the diversity of emerging market debt issuers. And I would say own the really nice high income and low correlation to wider asset classes through this portfolio.
Gillian: Excellent. And, Rick, last but not least, tell us about your approach and how it fits into a broader portfolio.
Rick Brinks: Well, I mean obviously AllianceBernstein have a lot of portfolios that I could sort of choose from, very fortunate in that respect. But since I was on this fixed income theme I would say that, you know, there are so many question marks around the fixed income allocation and income and so forth that I always think in terms of the spectrum. And where can you find better betas or, you know, more efficient building blocks? And where can you combine things a little bit better? And so if I start with the classic 60/40 offset, and this is my own route showing as a former global fixed income guy, I’m a big believer in global hedged currency fixed income as an alternative to domestic, or as a complement I should say, to domestic fixed income, because historically it’s about a 90 up 70 down versus domestic. And I know it’s sort of like going through and using the wrenches to tweak. But it’s about trying to squeeze a little bit more again, from a portfolio.
And so I would favor in a core level adding in some element of international hedge fixed income with your domestic. As you move up, the most efficient income structure, I mentioned the credit barbell. So the AB Income Portfolio is the one that is available in the United States, we’re believers in barbells all over the world. But this is the one that I talk a lot about to investors today in terms of adding into their portfolio, almost as a core of their income generation. You step up one more into high yield and there’s opportunities in high yield. But I think if there’s one thing clear from everybody on this panel, the last thing you want to do is limit yourself to one narrow part of the world today. And so we tend to be big believers in global multi sector portfolios. And so our high income portfolio has 50 something countries in it. It’s sort of the way you have to go about your business today. And then the last element is many investors want income, but income is low and so the thing that they’re hanging their hat on is the potential for growth. And so I want income, but how do I get the growth element? And so I would throw finally into that mix the All Market Income portfolio, which is a combination of income beta, is classic income betas in income and growth. I think all of those up the spectrum, I think give investors an opportunity to use it differently in a portfolio, but create a better structure.
Gillian: So we’ve come to the end of our discussion. I want to give you each an opportunity to summarize, if there’s one thing that an advisor or an investor should take away and think about in 2018 after watching this program, what would it be and Anupam, I’ll start with you?
Anupam Damani: Yeah, that growth is still the biggest driver of returns for emerging markets debt, unlike most people thinking it’s the US treasuries, because if it’s happening within the backdrop of stronger growth, it’s really growth. And so emerging markets is a diversified asset class then tons of idiosyncratic stories. So really you have the potential to own not only a high income but also to have potential appreciation through local currencies or just credit spreads tightening.
Gillian: Excellent, so keep an eye on growth. Danton, what about you?
Danton Goei: You know, when I just mentioned about selectivity being very important, I would say the other thing though is, you know, I think the idea of investing on a global basis is finally here. You know, I grew up abroad so I have that view for a long time now. And I feel like the US market is slowly shifting that way and investing more on a global basis and international equities being a larger part of portfolios. And I think that’s warranted now and long term should be very positive for returns.
Gillian: Excellent. So go global in your portfolio, Rick.
Rick Brinks: I think that for the last x number of years because of Central Bank activity it’s been about this incredible great rising tide without a lot of turbulence in the water. It’s becoming more about the boats. I mean that’s the thing that I think everyone watching this should sort of take away is this has been an unbelievable free ride, a baby boomer, peak age baby boomer entered their peak earning years in 1981 and they were treated to 20 years of 18% returns in the US market, 15% 60/40, nice work if you can get it. And then you go into the tech bubble up to the financial crisis and that baby boomer is now 54 to 60 something years old and they experience an S&P down 3.6% for about 8 years. Then they get on the back end of that and they enter this QE period where they’re back to 18% returns. I think it would be well served for investors to sort of keep in mind that 18% waves generally are starting to recede and the choices that we make globally, finding the individual investments, that is extremely important for investors. And then be mindful of the traps behind the scenes. We were collectively going after parts of the market with a lot of rotation; we have to be careful because crowding is starting to become more volatile than it’s been in the past. And Anupam remarked on liquidity a little bit, that is you have to be aware of the fact that there are a lot of folks camped out investments and if liquidity disappears in a difficult market and they are crowded trades, that’s probably the biggest trap as opposed to, you know, general views about markets and what we see. And so be very selective; be very careful about block buying in 2018 and 2019.
Gillian: So we can’t just rely on the rising tide?
Rick Brinks: Riding tide, maybe for another year sort of, but, you know.
Gillian: And, Rich, last but not least.
Richard Familetti: Well, two things, one positive, one sort of negative or a concern. The positive is although asset values have been rising over the last few years, there’s certainly opportunities in the international markets. And we have not gotten to the point where asset values are so overstretched that it has become obvious. No, so we’re not at 40 PE on the S&P and such. So asset values are not at a point where we’re in a mania and you’re overstretched and it’s time to sell. On the other side, the subject that we’ve talked about a little bit and that’s income. And the thing I think of there is volatility and shorting volatility and volatility strategies. We can speak at all about that. But the VIX has been below 10 for quite a while now. And there are a number of strategies out there, esoteric or otherwise that focus on creating income, by shorting options, and using that as an income strategy, rather than bonds or some safer investments to really enhance income, that’s to be really taken care, be careful with.
Gillian: Well, thank you all so much for taking the time to share your outlook. We look forward to having you next year to see what’s going on in 2019. Thank you. And thank you for tuning in. From our studios in New York I’m Gillian Kemmerer and this was the Outlook 2018 Masterclass.