The future of ESG investing
May 3, 2021
Capital Group video transcript: “2020 Outlook”
Will McKenna: Hello and welcome to Capital Group's 2020 Outlook. I'm your host, Will McKenna, and today I'm joined by Rob Lovelace, Darrell Spence and Margaret Steinbach, three of our investment veterans who are going to help us make sense of the market and economic environment as we head into 2020. And there's plenty to make sense of, I think, next year.
I also want to extend a warm welcome to those of you in the audience. I know we literally have thousands of advisors on this event. I want to thank you for joining us. And I also want to thank many of you for sending in so many thoughtful questions in advance, and I literally have page after page of those great questions here. And as we look through your questions, we saw four or five key themes emerge.
Number one, we're entering a pivotal election year. So what are the implications going to be for markets and investors? Number two, we do see slowing growth in the global economy, although the U.S. continues to do pretty well. Do we see any signs of recession on the horizon in 2020, whether in the U.S. or elsewhere around the world in places like Germany. And of course we'll get into that with Darrell.
Number three, international markets have lagged the U.S. in eight of the last 10 years. Now, this has been a recurring theme. I know, Rob, you'll help us tackle this question. When do we see that turning around? And maybe more importantly, what's the right way to think about investing in international today? Because I think some things have changed, and you've got some perspective for us there.
Finally, Margaret, you know, rates in the U.S. around the world are going lower for even longer. How low can they go? And we got quite a few questions about negative rates. What are the implications? Could they ever show up in the U.S.? So, I think, a good question for all of us to dig into.
And finally, what does all of that mean for client portfolios in 2020? So, excited to dig into this. Safe to say we're going to cover all those kinds of questions and more with this program.
Now before we get started, let me cover just a couple of housekeeping items. As you all know, this event is available for CE credit if you have a CFP or a CIMA designation. Now to get your credit, you need to stick with us for at least 50 minutes. So stick with us until the end of the webinar. And we need you to pay attention because at the end of that time, we're going to give you a short quiz that you'll need to pass in order to earn your credit. You're going to find that CE credit quiz down in the additional resources tab of this webinar, and it should be pretty easy to find. There's a link there marked CE credit. And please allow us up to 10 business days to process your credit for you.
I should say this event is being prerecorded, and that's so that we can qualify for CE credit. And meanwhile, if you do experience any technical problems, just let us know in the Q&A window on your screen.
So now let me formally introduce our speakers, starting with Rob Lovelace. Rob is an equity portfolio manager with 33 years of investment experience, and he is responsible for a number of our global investment strategies. And Rob is also vice chairman of the Capital Group Companies. Welcome, Rob.
Rob Lovelace: Thank you.
Will McKenna: Darrell Spence, many of you know Darrell. He's our U.S. economist. He's been in the business for 26 years. And he will be addressing the U.S. and global economic outlook, and also providing the exact date of the next recession.
Margaret Steinbach is a fixed income investment director with 12 years of industry experience and a first-time guest on this webinar. Welcome, Margaret.
Margaret Steinbach: Thank you for having me.
Will McKenna: I understand your husband is also in the fixed income business, and you guys are writing a children's book. Tell us a little bit about the title of that book.
Margaret Steinbach: Yeah. So we thought “Goodnight, Bond Math” would be a good title for that one, and it would ensure that our two-year-old son falls asleep quickly at night.
Will McKenna: OK. So folks, look out for that in the next year sometime, “Goodnight, Bond Math.”
Great to have you all with us. Happy holidays. A ton of things to discuss. So let's go ahead and jump right in.
Rob, I thought I would start with you, and you know, no shortage of interesting things happening in the world. I know you just got back from China. I want to get to that in a minute. But we often — and this has become a bit of a custom for us, you're a global equity investor — we usually start these by asking you to take us on a tour of the world. Talk about your outlook for 2020 across the major markets around the world.
Rob Lovelace: You know, I'm happy to do that, but it is important to remember that the world has changed. And while it is important to focus on the different constituent parts, correlations between the U.S. and international markets went up substantially, really starting in the mid-2000s — accelerated by the great financial crisis — and they've stayed high ever since. And so I think, through the conversation, we'll pivot more to a conversation around how the world is actually one big investment pool, as opposed to the traditional model that, frankly, most of us grew up with, which was thinking U.S. and non-U.S. You even framed the question that way. And I think lots of asset allocation structures are set up in this sort of U.S./non-U.S. and getting that number right. It may still be fair in the fixed income world because of currencies and other things, but I think in the equity world, with the integration of companies and these high correlations, we've really moved into a different era.
So with that in mind, I guess what I'd highlight is, most of the economies are being affected by the same thing relative to interest rates and monetary policy and coordination and other things that others will touch on. And really, the giant debate that the equity markets are wrestling with and have been for a decade around the globe is inflation versus deflation. Every country I go to has some aspect of it.
Just in Asia, as you highlighted, I was in Japan. Japan is 30 years into this debate. And so a lot of countries now, and investors, are looking to Japan to see if there are lessons learned. We did some things differently, which I think has been one of the things that's helped the U.S. And the U.S. has also benefited from the fact that most, if not all, of the internet companies are basically here. Obviously, there's a big group that's in China, but they function mainly in a Chinese internet. And there's a fair amount in Russia, but they operate in a Russian internet. So the rest of the world's internet is really driven by companies that are predominantly in the U.S. And it's led to this interesting situation where the U.S. markets have done so much better over the last decade — as you highlighted, eight of the last 10 years in any given year. But really, if you look at the compounding number, it's really spectacular.
But if you look at the spread in the price/earnings ratio, it's actually not that great. Which tells you that there's been value being created mainly by these tech and internet companies — also by some of the pharmaceutical companies — that have really allowed the U.S. equity markets to do so much better.
So when you go around the world, as we used to, and you go to a place like Europe, what you find is those European companies that have done well are the ones that diversified out of Europe and are doing business in the U.S. or are doing business in China or other emerging markets. And when you get to Asia and you look at which companies are doing well, they tend to be the ones that are focused on doing business in China or doing business in the United States. So this is part of where this broad correlation comes in across the world. And you're left with the economic discussion that we need to get into.
The two big engines that are doing fine right now are China and the United States. And that's why all the questions end up there. Japan, as I said, has been trapped for 30 years. Europe is pretty much trapped in a similar situation for at least a decade. And the big question is, are we destined for 20 more years in the developed world of what Japan has had of this kind of lower for a lot longer? Or are we going back to the world that most of us [as] investors grew up in, which is some inflation and a lot more volatility in interest rates.
So I think that's the big debate that we need to talk about today.
Will McKenna: So in a way, thinking much more on a global frame rather than in these regional pockets, and we'll dig into that much more when we get into equity markets in more detail. And as you point out, the U.S. and China are the drivers. In some ways Europe is kind of stuck in the middle of this trade skirmish, but we'll come back to that. That's a great start.
Darrell, why don't you pick it up and talk a little bit about the economic outlook. Let's start with the U.S. I want to hold off on the R word, recession; we got plenty of questions about that. But just start with the U.S. What's your outlook for the U.S. economy in 2020?
Darrell Spence: We think we're going to get a bit of a re-acceleration. And maybe a different way to phrase the inflation/deflation debate is — even though you said you didn’t want to get into it — recession or no recession. And I think we're starting to get the answer to that.
But what we've had in the U.S. economy for a while is what we've been calling this tale of two economies. You have kind of a weak industrial sector because of the trade war, because of the inventory stocking that proceeded the trade war, while at the same time you have a really, really healthy domestic economy, which is largely the U.S. consumer. And so you look at the growth of those two areas of the U.S., and they've diverged pretty dramatically. It's very similar to what we saw back in 2015 and 2016. And at the end of that episode, essentially the industrial sector recovered, and we think that is likely to be the case this time around.
So as we move through the remainder of 2019 and into 2020, we think some of these fears will be moving out of the markets, and you're starting to see that, I think, perhaps with some of the bond yield movements and equity price movements that we've seen over the past couple of weeks. But a lot of that is predicated on no further escalation in the trade war. And we seem to have found some type of truce here, and we don't think you need to go backwards. Tariffs don't need to come off to continue to have a more optimistic outlook in 2020. But you probably can't have much more of an escalation either. And again, we think we’ve found some type of truce, but it's kind of day to day when it comes to this type of stuff. So that's the one caveat in all that, I would say.
Will McKenna: You mentioned a pickup, again, in manufacturing. What do you think will help drive that?
Darrell Spence: Well, one would be a truce in the trade war, for sure. The two areas that have caused the manufacturing sector weakness are exports — and we're starting to see some indication that those are rebounding — and the other had been the inventory stocking that occurred in anticipation of the trade war. And when you look at, say, inventory sales ratios across the manufacturing sector, they're starting to come down. So a simple turn in those two things, we think, will lead to better activity and better output. But again, that assumes no further escalation in the trade war, too
Will McKenna: Any signs of recession on the horizon? Or you and the team don't see that, certainly in 2020, and maybe it's pushed out a ways?
Darrell Spence: We don’t. I mean, there's always a chance you get some type of shock that, by definition, you almost can't see coming. But keep in mind that recessions aren't just about the amount of time that's gone by or how long the economy has been in an expansion. They're about excesses and imbalances that built up in the system that ultimately need to be corrected. And we do actually see some late-cycle excesses and imbalances building up. A lot of it is concentrated in corporate debt and leveraged loans.
But even then, just because you have a lot of excesses and imbalances building up doesn't mean they have to cause a recession. You need some type of catalyst that ultimately causes those things to be a problem. And then the excesses are the accelerant that ultimately push the economy into a recession. And historically — and we think this time around, too — the most likely catalyst is tighter monetary policy. And in fact, over the course of 2019, we’ve moved in the opposite direction.
So even though these risk areas are still out there, until we probably get meaningfully tighter monetary policy and tighter liquidity conditions — or essentially a reversal of the conditions that have allowed this debt and this leverage to build up — there's probably not a reason that it has to unwind anytime soon. So our best guess — and guess is the word I would emphasize there — is probably sometime late 2021 would be the most likely time frame, again, assuming that the Fed eventually gets back into the tightening game. But that could be a while.
Will McKenna: That's a good segue to Margaret. One quick follow up. I saw you speak recently at a Barron's conference, and you mentioned a couple of things. One was this idea that corporate debt — and we'll get into that, Margaret, in terms of the growth in the triple-B part of the market — may not be the catalyst. It might be more of an accelerant once things get going.
Darrell Spence: Right.
Will McKenna: You also mentioned that there's a sense that recessions that emerge from the corporate sector tend to be a little less severe than those that emerge from banks or housing or ... Say a little bit about that before we transition to Margaret.
Darrell Spence: Yeah. I think one of the biggest concerns that investors have is when we do — inevitably, most likely — get into a recession, that it is going to be 2007–2009 all over again. And you know, it's really hard to determine how bad these things will be in advance. But our read of history is that recessions that originate within the corporate sector tend to be less severe than those that originate within the household sector, or certainly involve the banking system. And even though we're talking about a fairly significant amount of debt, a lot of that debt is actually held outside of the banking system. So if there is an issue with it, we don't think it will impact bank balance sheets like the housing bubble did when it blew up in the global financial crisis.
So again, that's a read of history. I mean, an example of a recession originating in the business sector or the corporate sector would be the internet bubble. A lot of over-investment, ultimately, that had to be unwinded. But in terms of its impact on the consumer and the overall financial system, it wasn't that large and the recession ended up being pretty mild.
Will McKenna: OK, great. Margaret, let's transition to a view from bond land. How's the bond market outlook shaping up for 2020?
Margaret Steinbach: Yeah. So I think it'll be an interesting year ahead. So we've seen heightened levels of policy uncertainty, both geopolitical and trade policy, and I would expect that uncertainty to remain heightened going into next year. We'll get clarity on the direction of the economy, so we'll find out in the coming months whether or not this is what we would classify as a late-cycle slowdown or if it's the beginning of a more protracted downturn.
And what we’ve heard from the Fed is that they're done cutting. We think there's a high bar to further cuts from here. So the bond market is pricing in about 30 basis points of additional cuts from here. But I think what the market's actually pricing is some probability that we do enter a more protracted downturn and the Fed has to cut to zero, and some probability that we come out of this and the Fed does nothing. Now, we think there's a high bar to the Fed cutting from here, but we think that there's an even higher bar that the Fed continues to hike this cycle. We think there's not enough momentum in the economy. We think inflation is unlikely to rise to a point where the Fed feels that they need to hike from here.
And what's interesting is that they're really reevaluating the tools that they use to target inflation. So we expect to get an announcement from the Fed next year in regard to that. So they're going to probably be using some kind of an average inflation target, which really means that they're going to be easier for longer.
So we've been talking about lower for longer interest rates for years. And so now, when I go out and speak to advisors, I'm not just saying lower for longer. I'm saying lower for longer and longer and longer.
Will McKenna: Lots of “longers.”
Margaret Steinbach: Yes.
Will McKenna: And give us a sense of, you know, is that years? Is it many years? At what point does our team see them having to come back to hiking?
Margaret Steinbach: Again, I think there's a really high bar for the Fed to hike this cycle, barring a significant pickup in inflation, and I'm talking sustained inflation above 2.5%. So the Fed's preferred measure of inflation, core PCE [personal consumption expenditure], today is about 1.7%. So we're a pretty long way away from that.
If you look at the forward market, it's pricing lower rates for a very long time. So as of this morning, it's suggesting that the 10-year yield will be at 2.5% in 10 years' time.
Will McKenna: That’s pretty low.
Margaret Steinbach: So …
Will McKenna: That gives you a sense of timing.
Margaret Steinbach: Yes, exactly.
Will McKenna: That's great. Darrell, I know I want to dig into the equity markets in more detail with Rob after this, but one of the things that you mentioned at that Barron's conference which really struck me — and [I] would love for you to share with our audience — is, [it’s] good to remember that the cuts that we've seen this year in 2019, it takes a while for those to flow through the system. I don't know if that's six months, nine months, whatever the case may be. But say a little bit more about that, and when might those cuts really start filtering into the economy?
Darrell Spence: Yeah. I mean, monetary policy works with a lag essentially, and what that lag is can vary cycle to cycle, but let's call it six to 18 months as a range. And that would suggest we would start to see more of the impact of it as we exit 2019 and head into the first half of 2020. You're already starting to see it in a recovery in the housing market with sales and construction activity picking up. And you would start to see it again in some other areas, particularly if the uncertainty surrounding the trade war starts to be reduced because that will encourage firms to maybe ramp up their capital expenditures a little bit, and low rates can certainly help with that as well.
But I'm in agreement with the Fed staying on hold for a long period of time. If anybody wants to head into the holiday season with some cocktail party trivia, here's one: If you look back over the past 25 years, the amount of time that core PCE inflation has been at or above 2%, which is the Fed's unofficial target, is 25%. So they have an inflation target that is really actually pretty difficult to hit, and they've kind of put themselves on record as not really doing anything until they actually hit that. So I think Margaret's spot-on, at least from our economic point of view, that there's a pretty high hurdle for them to raise rates, given that it's just very difficult to get inflation rates at that level to start with.
Will McKenna: That's pretty great. Those of you in our audience, if you're multitasking, I would pay attention right now because that will probably end up on the quiz. So, 25% of inflation has been above the 2% target.
Rob, back to you. You referenced some of this in the way the world is changing for equity investors. But one of our initial audience questions that I thought I'd pose to you is, here we are in the U.S. — U.S. markets are at or near all-time highs. How long can this continue? Do you see this heading into 2020? What's your perspective on the U.S. markets?
Rob Lovelace: On market levels, it’s interesting when I talk to some of our younger associates, because they're nervous because the equity market is hitting all-time highs. As a 34-year veteran, I have to say I've seen a lot of all-time highs in the market. The equity market has this bad habit of going up over long periods of time. In fact, that's the core of what we all do for our investors. It's kind of premised on the fact that equity markets over time will be positive. Without that, we wouldn't have the money for people's retirement and other needs, so that's the good news. So I kind of celebrate every time we hit an all-new high — and especially in this case, when it’s really pretty linked to underlying earnings. There has been some multiple expansion that we've seen across the world, but it has really been driven by underlying earnings.
I think what's getting everyone’s attention right now is there definitely has been a bit of a rollover on margins. So corporate profit margins were expanding post-great financial crisis, in part because I think people were planning for a slower economy and slower revenues that actually didn't come. And with the general technology implementation that's come across, that's made companies more efficient, at least on a cost basis. So margins have been steadily increasing, and that's really peaked in the last year or two.
So with the slowdown, I think, people have extrapolated from that slowdown in margins and then concerns about a recession. Are we, therefore, in for some type of a correction in the market? And I think that would be a very logical thing in the world that most of us grew up in, in the ‘70s, ‘80s, ‘90s and 2000s. The challenge right now is with interest rates as low as they are, it’s very hard to see alternatives to equities. And again, having been in Japan recently and looking at their 30-year experience … and there, it’s not a total analogy because they were able to invest outside of Japan in other equity markets.
The challenge we have now is that there's kind of only one market. It’s all one market, and so you can't move as easily from one place to the other. So there is no free lunch anywhere in the world, at least in the equity markets. That's a bit of where I think that homogeneity comes from. And so that search for companies that can continue to grow the top-line, or more impressively, actually expand margins during this period gives them a value that's higher today than maybe it was in the past. And this is what's allowing, I think, those companies to have and sustain high multiples. And if you look over, again, long scopes of history, when interest rates have been this low for sustained periods, P/Es do tend to be high.
So in some ways, what's remarkable is how moderate the price/earnings ratios are, because we have enough of these fast-growing companies so that the ratio is pulled up by very high multiples for a handful of companies that are very big and growing fast, that are generally in the internet or health care area. But they really are growing their businesses. So they're actually growing into those multiples in a way that wasn't true in the late ‘90s with the internet companies where, I think, at that stage the internet stocks were 25% of the S&P — or 25% of the U.S. market — and only 5% of the earnings. Today they're 25% of the U.S. market and 25% of the earnings.
Will McKenna: So the earnings are supported.
Rob Lovelace: So the earnings are there.
Will McKenna: Yeah.
Rob Lovelace: I mean, it’s just a very different world. So markets are hitting all-time highs, multiples are high, margins are rolling over, so there's a whole bear case that we've all built. And we've said it multiple times: This has been the most hated bull market ever. I don't know that we have a measurement of that for “ever,” but I'm going to go with it.
Will McKenna: Right. It feels that way to us.
Rob Lovelace: Yeah, and this is really big. And it will continue to be that because everyone knows — because they learned these lessons in the ‘70s, ‘80s, ‘90s, 2000s — they know all the lessons. They know all the things to look for; the flags are up. We should be concerned. And even if it does happen, even if there's a recession, it can't be a very extended bear market in equities because there's nowhere else to get the returns that you need. And it’s going to continue to be driven toward particular securities that either pay high dividends or that are able to grow their top, and better yet, bottom lines.
Will McKenna: That's great. So some of the FAANGs, for example like a Google and Alphabet that have the kind of earnings that might support their P/E, or some of the so-called defensive stocks that pay those steady dividends, are the ones that people are focused on.
Rob Lovelace: I think it’s across different sectors of the market. But certainly in technology. But a lot of the software-as-a-service companies are also creating value right now. There are areas in health care — mainly bio-tech, but some others — that are doing that, so all through the tech food chain. But it’s not every company. You can't really do this by sector. It is absolutely a stock-picking environment, and a lot of times it’s been recognized, and so everyone looks around and says, “Well, everyone already knows that this is going to be growing. I have to look somewhere else to find value." And this is that question [of] value versus growth.
Will McKenna: Right.
Rob Lovelace: But in this environment, actually the most valuable thing is a company that’s growing its top-line. And if they're actually even expanding or maintaining margins through that, that's an incredibly valuable and hard to do thing in an environment that isn't expanding. And so I think we've created another false debate of growth versus value because people think value has to be these sort of ugly companies that aren't growing. I think the rare commodity is that company that's actually able to grow in this tough environment.
Will McKenna: Right. I think that leads us into a great way to think about companies in the international sphere. You brought up a little bit of this earlier.
For those of you in our audience, Rob and his colleague David Polak recently authored a great piece of content, I think, called "The Guide to International Investing" that gets into this in quite a bit of detail. I know a couple of the charts that you helped develop — some of your favorites are this whole theme that if you think all the best stocks are in the U.S., think again. There's almost this conundrum of eight out of the last 10 years the U.S. market did better, but this year 45 of the top 50 stocks were outside the U.S. How can that be?
And then I know you also focus a lot on the composition of the index in the U.S. versus outside, and the fact that those indexes kind of mask what's really happening underneath. Talk a little bit more about that whole concept and help our audience understand how should they be thinking about that in today's world?
Rob Lovelace: Well, I don't know if "Guide to International Investing" is as compelling as "Goodnight, Bond Math" …
Margaret Steinbach: Fair.
Rob Lovelace: … but it is a good read and has some interesting slides in it. No, I think the conundrum that you highlight really well is the conversation usually starts with how impressive what's going on in the U.S. is. The companies that are here that are really unique, particularly in the tech space, somewhat in the biotech and/or health care areas in particular, and those are the ones really driving growth. And the U.S. has done better eight of the last 10 years. The compounding since the great financial crisis has really been remarkable. So why would you invest anywhere else? Thirty percent of the revenue of U.S. companies comes from outside the U.S. Why wouldn't we just consider the S&P a great global fund to invest in?
And I think maybe that's the first piece that begins to show you the flaw in the logic, which is: OK, 30% of the revenue comes from outside the U.S., but that's a really badly constructed global strategy. Right?
Will McKenna: Right.
Rob Lovelace: I mean, wouldn't you rather buy the best companies than just say, “Oh, great. I'm getting some U.S. companies that do business outside the U.S.” And a lot of that non-U.S. exposure actually comes from supply chain as opposed to it being the Coca-Colas or others that really have real revenue outside of the U.S. So why don’t we look for the best companies around the world? And again, we've got a slide that shows over the last 10 years, a majority of the stocks in any given year that did better were based outside the U.S. And a lot of times, it's because they do business in the U.S. So a lot of the consumer products companies, a lot of the luxury companies and other companies that have done well are domiciled outside the U.S.
So the great thing that we've noticed is we don't care as much about ZIP code anymore. Where a company gets its mail is not a good proxy anymore for where they do business. You really need to get in on the fundamentals and think about where companies are doing business. And some of the best businesses to get exposure to growth in China are domiciled in Europe. Some of them are domiciled in the U.S. And some of the ways to get at things that are happening in the U.S. are actually domiciled outside of the U.S.
So you really want to just focus on the best companies, wherever they're based. Because of this construct that we've had for so long of U.S. versus non-U.S., we tend to have regression-to-the-mean kind of an approach and think, "Well, the U.S. has done well, so non-U.S. necessarily will catch up.” I have a hard time arguing that, because the difference in the multiples — forward P/E of about 17 in the U.S. and maybe 13 and change outside the U.S. — is mostly explained by structural differences in the index.
Outside the U.S., the index is dominated by financials and commodities and materials companies, mainly oil companies. The U.S. is dominated by the internet, technology and health care.
Will McKenna: So, old economy outside and new economy inside of the U.S.?
Rob Lovelace: Right, and when you correct for those two, the multiples are actually pretty similar. So what it tells you is that actually, everyone's doing their job. And when you have a fast-growing company like ASML that's based in Europe, guess what? It trades at the same multiple as the other technology equipment providers. So you have to change the mindset of U.S. versus non-U.S. to find the best companies wherever they're based. Make sure you're finding someone that's doing that analysis, because why would I limit my universe to one third of the companies arbitrarily because they happen to have decided to be domiciled in the U.S.? Why not invest in great companies that happen to be based in Japan, that happen to be based in China, that happen to be based in Germany? And this is why the conversation around what's happening with the German economy or what do I think of Brexit almost becomes moot. It's not what matters anymore. What matters is where the companies are doing business, what business lines that they're in, and are they able to grow in this tough environment.
And we're finding as many or more opportunities outside the U.S. than the U.S., even though I think overall, the U.S. market will be one of the best markets going forward. So that's a conundrum, but the reality of it is, if you can find those great stocks based outside the U.S., you'll do even better than the U.S. market.
Will McKenna: That’s great perspective. Give us a little flavor. You mentioned ASML and some of those top industries, company examples within those. You guys have talked about luxury in Europe. You guys have talked about certain areas in Japan and automation. You’ve talked about health care in some places. TSMC — you know, semis — and others. Give us a sense of those best industries and leaders there.
Rob Lovelace: Well, I think there are two categories. I think there are those industries now where you have logical pairings. One of the other things that's happened over the last 10 years, maybe longer, is there's been a lot of consolidation in almost every industry. And so you're now down to a few players. And interestingly, there's usually one in the U.S. and one outside the U.S. So Intel and TSMC, Boeing and Airbus — you have all these different pairings.
Will McKenna: Nike and Adidas.
Rob Lovelace: Nike and Adidas, right. And so what's interesting is, again, you could say, “I'm just going to arbitrarily say we should buy the one in the U.S. because the U.S. market's going to be better.” But in fact, Airbus has done better than Boeing, even before the recent issues. Adidas has recently done better than Nike. You have to look at each of these and know what's driving each of the companies.
Will McKenna: That's great.
So let’s turn to you, Margaret. Thank you, Rob, great perspective. Our audience really wanted to understand within the bond market what do we see as relatively attractive as you look out to 2020, whether that's Treasuries, corporates, high-yield, mortgages, EM debt. How are we thinking about those different areas?
Margaret Steinbach: Sure. So I would say it’s hard to argue that anything is really cheap today. And so it’s a matter of what's relatively cheap. And we're finding the higher quality areas of the bond market more attractive today, so Treasuries, agency mortgages. We really see corporate valuations as being pretty full.
So if you look at investment-grade corporate debt spreads, they're at about 105 basis points today. I feel like at high-yield spreads, they’re at about 390 today. And that's very close to territory where, on a go-forward basis over the next two years, corporates tend to underperform Treasuries. And so it’s not necessarily an outlook on the economic environment, but at this point in the economic cycle, and in the market cycle, looking at valuations, we think it makes sense to be a bit higher quality.
Will McKenna: And I know we've been using the phrase “focus on upgrading your core portfolio.” Is that equivalent to what you’re talking about? Stay focused on that higher quality —
Margaret Steinbach: Yes.
Will McKenna: — at this point in the cycle?
Margaret Steinbach: Yes, that’s right.
Will McKenna: Muni bonds.
Margaret Steinbach: Yeah.
Will McKenna: More or less attractive or appealing following the tax cuts? How are you thinking about that?
Margaret Steinbach: Sure. So there’s a lot of volatility around tax reform and questions about whether or not munis would lose their tax benefit. And with cutting tax rates for individuals, would munis still be attractive? And once the dust settled, what came to light is that munis actually became more attractive for many investors. So for corporations that buy munis because they have a lower tax rate, munis became less attractive for them on the margin. But even though tax rates came down, for a lot of individuals effective tax rates went up, especially for those of us who live in California or New York [after] getting rid of a lot of the deductions.
And so munis continue to be attractive today. If you look at relative valuations compared to taxable markets, I think the breakeven tax rate is around 20–25% today, so anyone who pays 20–25% in taxes or more actually benefits from owning munis compared to taxable bonds. So still attractive for a lot of investors.
Will McKenna: Spreads in high yield have been very tight — you have to be very selective there — but we talk about emerging markets debt as an interesting, pehaps, alternative to getting that kind of enhanced income as long as you’re comfortable with some volatility. But tell us about emerging markets bonds and how we’re thinking about that.
Margaret Steinbach: Absolutely. It’s a really compelling sector. Structurally speaking, it’s high quality — I think more so than maybe the market perception is. So over half of the emerging market debt universe is rated investment grade today. The sector over the last 15 years has produced strong risk-adjusted returns compared to high-yield bonds, compared to equity markets, emerging market equities. What I’ve found is that individual investors tend to be a bit more comfortable with emerging market equities, but actually emerging market debt has produced stronger risk-adjusted returns over the last 15 years. And then, looking at a landscape where nothing is really cheap, emerging market debt offers pretty reasonable valuations today.
So the yield is about 6.5% if we're looking at a blend of half dollar, half local currency. And so that's looking particularly attractive to us.
Will McKenna: Probably just a newer, less familiar asset class for folks.
Margaret Steinbach: I think that’s right.
Will McKenna: I mean, there's a difference between equities and bonds there.
Shall we dive into the deep end of the pool with negative rates? Maybe, Margaret, just frame this up for us. How should we be thinking about this phenomenon? I know the number behind negative debt is a very large one; it has a “T” in front of it. How should we be thinking about it?
Margaret Steinbach: I would describe negative rates as an experimental policy. It’s really a crazy idea. It’s certainly not something that we all read about when were coming up through school. I think it will probably be in future textbooks for our children and our children's children. But this is a brand new concept that's come into the markets in the last few years.
There's about $15 trillion of negative-yielding debt today, and this is because central banks around the globe, including the European Central Bank and the Bank of Japan, have embarked on negative policy rates as a way to try and stimulate growth in their economies. Now we could talk about whether or not it’s been helpful to growth. I think the jury is still out. But as a result — and the fact that we continue to be in a pretty muted-growth, low-inflation environment across the world — that's also suppressing long-term rates as well.
Will McKenna: It’s kind of an anchor on the U.S. rates and other long-term rates.
Margaret Steinbach: Yes, that’s right.
Will McKenna: Let’s pivot now to trade and the global trade outlook. And as we're doing that, I might remind our audience we're probably not quite at but we're approaching the 50-minute mark. And just a reminder that your CE quiz will be there for you when we do cross that threshold.
Rob, why don't you start us out. You were just in China. [I’d] be curious to hear what the mood is like over there around this topic. But also, how do you think this is going to play out? And then, maybe, are you thinking about doing things differently in your portfolios as a result?
Rob Lovelace: Yeah, no, we really do have to pay attention to this. Being in Hong Kong, in particular, was a pretty stark reminder that the world has changed. Hong Kong, everyone knew, had changed since 1997. I think until the current regime in China, what Hong Kong was hoping for was that China would become more like Hong Kong. And with the way the reforms were going, it looked like that's where it was. But President Xi has definitely taken China in a different direction, and so now it’s very clear to Hong Kong that those rivers flowing together the way that they had hoped is not happening. And that's where you're seeing the tension come from.
And I think we really do need to step back from the trade war and realize this is a broader conflict. It’s happening on multiple fronts. Clearly there's tension in the internet area that most of us don't see every day, but it’s happening. And lots of other areas in which we see tension. The only consensus in Washington right now is around a hard line on China. You could literally take the extremes from both ends of the political spectrum and, not how we should achieve it, but they’re in alignment on that.
Will McKenna: Right.
Rob Lovelace: That’s something to take note of. So we're in that challenging transition of the rise of an economic power. China is the second largest economy. It will be, if it isn't already, the second largest market. And so it’s very interesting for us as investors to try to figure out, “Should I invest in this, or is this tension something that should scare me away?” And it’s partly why we're looking at a whole array of things to invest in, because there are some goods in companies that China can't replicate, and those seem like great places to be. They're having a hard time manufacturing planes, for example, and they wouldn't want only one supplier in Airbus, so Boeing is a very valuable company to them. One day it won't be, but it looks like a decade or more before they can really get into volume and commercial.
Will McKenna: And the growth in planes there, the demand is sky high.
Rob Lovelace: Exactly. So we have to understand that the trade negotiations are the piece of a much bigger puzzle. It's a very political puzzle, and we're only seeing slight parts of it. So again, the market is going to be overly focused on it. Both bond and equity markets are super-focused on “Are the tariffs in or are the tariffs out?” But I think the signaling of that is masking this much broader and more important trend that's going on of a major transition happening around the world. And right now, the two sides aren't talking. They're not even using the same language in terms of what that transition really means, and that's something that is going to, I think, dominate conversations for a while going forward.
So we may get respite in the short term in the trade negotiations for either U.S. political reasons, because we're coming into Christmas — and why would we want all the consumer goods to be taxed, because that might hurt someone politically — and/or an election period. But the reality is, whoever’s elected, it's going to have a big impact on the U.S. I think it's going to have very little impact on our approach to China —
Will McKenna: Right.
Rob Lovelace: — which is going to be hard line going forward.
Will McKenna: And you look at a lot of companies, obviously. Are the multinationals taking a lot of actions to adjust?What are you seeing out there in your travels with companies, and who is positioning themselves well to adapt to this new situation?
Rob Lovelace: Yeah, I mean, this is what makes the multinationals such interesting bellwethers to watch, because they are very adept at moving. So with the change in Hong Kong that we've already seen — and it looks unlikely that China's going to allow as many Chinese tourists to go there — so the luxury goods companies have already begun to adjust. Most of them already have stores in other Chinese cities or Singapore, Korea and other places that the Chinese tourists are now going. So for some of them, actually, they're not seeing any change in their top line because it’s just shifted to other stores. But I just think it's a signal that there'll be a hollowing out in Hong Kong going forward from a business standpoint. And what we're seeing broadly, to your question, in terms of changes are most companies that have manufacturing in China are trying to figure out other options.
Will McKenna: Right.
Rob Lovelace: But Vietnam, Malaysia, Thailand, even Latin America can only take a very limited amount of it. The scale of what's happening in China is so huge. So that's a multiyear, if not multi-decade, change. But you're seeing it happening. And those are the kind of trends that we try to identify and get ahead of in the investments that we're making, because it will lead to build-up in other places.
Will McKenna: So you can't turn on a dime, but somebody's benefiting from this.
Rob Lovelace: Right.
Will McKenna: And I don't know if you're starting to see that yet in the economic data in some of those other countries, but I know you guys try to measure or quantify what are the impacts of this in tariffs and so on.
Darrell, how are you seeing this unfold? And you mentioned some of the potential mini-deals that may happen for political reasons, but how is the economics team looking at this?
Darrell Spence: Yeah. I think to the extent anybody is benefiting from it, it's very, very incremental and over a long period of time. Whereas those who are being hurt by it, it's much more immediate, at least from a U.S. perspective.
We talked about the difficulty with exporters right now. Global trade is actually starting to fall, even though the global economy is not in a recession. And a lot of that just simply has to do with the impact that this is having on global trade, but a lot of the higher prices haven't really been flowing through to the U.S. consumer.
If you look at broad measures of inflation, you barely see them blipping. We addressed that earlier. There are some isolated things, like washing machines, where you've seen more significant price increases. But for the most part, the people who are really bearing the brunt of this are the producers themselves. So if you're on the Chinese side, there's a couple of things you can do. You can hope for a currency depreciation, which we've gotten a little of; that offsets some of the higher tariffs, and you can just take it in your margins. And a lot of Chinese companies, it seems like, are doing that. So that's where the damage is occurring.
I guess from a macro perspective, this seems pretty manageable, again, given where we've gotten to and assuming we can stay here. I guess where we'd start to worry is the more unquantifiable stuff. If you get in the world of embargoes, boycotts, firms on either side of the ocean physically can't get the products that they need to produce the goods that they sell. I mean, that's how companies go out of business, and that's how this thing could really become much more economically damaging. But for now, it seems to be pretty manageable, and a lot of the pressure is being put on the corporates. It's not flowing through to the end consumer, at least in the U.S.
Rob Lovelace: Can I just add one …
Will McKenna: Please, yeah. Please.
Rob Lovelace: … important additional trivia fact to this? I think global trade actually peaked four or five years ago — so, long before this process. And this is just an acceleration of that in terms of physical goods. But one of the things that we've focused on is that actually, it's hard to track it per se, but digital trade — in other words the movement of information across borders — has increased and continues to rise. So it's another one where a lot of the indicators and a lot of what people think about is moving cars from continent to continent, but actually the integration in the digital world is increasing. And you may not see it in terms of shipped goods, but it could actually be manifest in terms of delivery of product in country, the benefits of which, though, flow to a U.S. company, which has set up the chassis on which that transaction happened.
Will McKenna: The way we measure trade has not caught up with some of the realities of how it's done, and it ties into that international story the way we measure those indexes.
And Margaret, incredibly, monetary policy … I know we have a chart — I should mention to our audience, some of the slides you're seeing on the screen come from this report, which is also available in your additional resources there — just a picture of all the countries that have been cutting rates, and some just admittedly in response to the amount of policy and trade uncertainty out there. How is this affecting monetary policy as the team thinks about it?
Margaret Steinbach: Sure, yeah. So trade policy uncertainty certainly has fed through to the industrial side of the economy, which Darrell described earlier: this tale of two economies. And it's a large reason that we've seen global central banks easing policy, including here in the U.S.
Now that we've gotten a little bit of clarity or a little bit of respite, the Fed is done cutting for now. But I would expect if we see a re-emergence in this uncertainty going into next year, they could cut further. It’s certainly a very fluid situation. And as Rob mentioned, sentiment seems to change day to day, depending on the headlines.
Will McKenna: Right.
Margaret Steinbach: And so, I think a big takeaway for us as investors is to stay focused on the big picture, the long term. Stay invested.
Will McKenna: That's a very good segue. I wanted to now dig into election years and markets and investing — a topic we got a lot of questions on, very much on our clients' minds. And I think a lot of the audience's questions had to do with — or what I read into them was — “Help us help our clients understand that they can stay invested and don't have to be so uncertain.”
I know, Rob, you've talked about — we went back and looked at the data — and in these fourth years, you do see a real decline in people investing in mutual funds and a real acceleration in money going to money markets. And you've talked about that idea of “It's not that people redeem money; it’s just they stopped buying mutual funds.”
Rob Lovelace: Right.
Will McKenna: So we see that coming through the data. And one other chart I'd bring to folks' attention before we get into this dialogue:
At the beginning of this report, we looked at, I think, all the election years going back to the 1930s, or call it 22 cycles. And what we found so interesting was when you compare that election year to all the other years, you see this real volatile period in the primary season, so call it January through May, where the election years [have] very sideways, choppy markets, while the rest of the years do fine. But then, at the end of that kind of uncertain primary period, here we go. We get back on track. And often those election years from that point forward did better than other years.
So I saw that as, really, a roadmap for what we ought to expect for 2020, and to help stay the course amid that volatility. But Darrell, as we think — historically speaking, overall — has it really made much of a difference whether a Republican or a Democrat wins the White House as it relates to investors?
Darrell Spence: Well, you can make data say whatever you want it to say, as you know. And I'm sure you'll start to see it over the next year that the stock market historically has done better when Democrats have been in office versus Republicans. But that doesn't mean necessarily — and I don't mean this as a political statement — that Democrats are better for the stock market. There are —
Will McKenna: It’s not that it’s causal.
Darrell Spence: It’s not causal. Exactly.
Will McKenna: It might be —
Darrell Spence: There are millions of things …
Will McKenna: Right.
Darrell Spence: ... that determine the course of both economies and stock markets. And even when you look at those averages, there's great variation underneath those averages that you need to be cognizant [of] as well. So even though one number may be bigger than the other, that doesn't mean that it's any more consistent.
So in my mind, presidents and administrations get far too much credit or blame for the state of the economy — and ultimately the state of the markets — simply because, like I said before, there are far too many different variables that determine where the economy is going to go. And there's actually very little influence ultimately that a president can have. Probably the biggest ones would be tax changes like we saw, but those tend to be temporary, tend to be one-time boosts or headwinds to an economy. And then the economy comes back to do what the fundamentals suggest it was going to do anyway.
And so looking out over four years, our outlook is that the next year or so will start to see an improvement in growth. What it's going to look like at the end of the next four-year presidential cycle, frankly, I have no idea. But that's what's going to determine what the market does, not necessarily whether it's a Democrat or a Republican in the office.
Will McKenna: Yeah, well said.
Rob, as you think about investing through this kind of period, does this change anything for you? Are you thinking differently about it? I mean, clearly, certain areas — for example, in this cycle, health care stocks and the focus on pricing — are very much in the news. And you see some pressure there. Maybe those are good opportunities for long-term investors like us. But are you looking past the horizon on this, or how are you approaching this inside your own portfolios?
Rob Lovelace: Well, I think you summed it up well at the beginning. And I think this cycle will be particularly pronounced in terms of that uncertainty during the primaries in particular, and maybe throughout, because we have a few candidates in the democratic pool that have a pretty fundamentally different view of how the economy should be shaped.
Will McKenna: Right.
Rob Lovelace: And so that uncertainty that would come if those candidates are the ones chosen — their real different visions for how the economy and the government is going to interact with the economy — leads to uncertainty. And uncertainty always pushes people out of equities and into more conservative investments. I think that's why this primary period will be particularly pronounced because we may not have a lot of centrist voices.
And so if you have extremes, that tends to get people worried. Depending on who the candidate ends up being on the democratic side — I think we're pretty clear on where the republican policies are, there's not going to be a lot of course change, I don't think — so that will be what determines whether we're off to the races once we have a candidate, because we have sort of a centrist; however pro-market they are will determine it. But we have candidates that are pretty challenging to the structure of a lot of the capital markets that we need to pay attention to. So I think that makes it a little bit different.
What am I doing? I turn over my portfolio about 10% a year. I'm trying to take the long-term view. I think the advantage that we have at Capital Group is really taking that longer term view. And so I tend to look for opportunities that are presented, particularly in the health care and other areas where there's always a fear of regulation coming in. But the reality is, those companies with good drugs that actually are helping people, and better yet, maybe even cures — so permanently helping people — will be able to get into the market, and they will get paid for it.
So when everything becomes a concern because the new policy's going to come in — it's going to destroy a sector — that's usually overblown. And those present those opportunities, so I try to always turn it into a buying opportunity. But on the margin, I think, even our pharmaceutical and drug analysts have been saying let's be really specific about the companies we want to own through this period because it's proven every election cycle to be one of the choppiest sectors.
Will McKenna: It really has.
Rob Lovelace: And then, I think, to the extent that the capital markets in some of the financials companies would also be ones to watch in this cycle, depending on what happens with the democratic candidate.
Will McKenna: Right. I want to come back to that long-term view in one second. But let me mention to our audience, just a reminder about the CE credit quiz. You should be able to find that. I would also mention that if you prefer to take your CE credit quiz at a later date, you're going to get an email from us the day after this airs. And so that email should include the very same quiz.
I want to get all three of you on a closing statement speed round, but let me pick on you for one second, Rob, because one of my note cards here — it's probably buried — but it just said, “innovation” at the top of it. And you saying you turn your portfolio over 10%, so you basically have a 10-year horizon. You think about the last 10, we've had a number of great innovations — probably the smartphone in our pocket being at the top of that list — but some true game-changing innovations in pharmaceuticals, health care and other places.
Rob Lovelace: Right.
Will McKenna: Let's take a step back away from all the uncertainty and clouds that we've been talking about. I would love to get your views on what are you and the team thinking about and seeing out there in terms of innovation over that longer term that we might be excited about watching closely, really anticipating, over that long horizon.
Rob Lovelace: Yeah, it's interesting. I'm actually going to start on the opposite side of that a little bit because one of the concerns that always has to come up when you're investing in internet stocks is what's that next platform. Because as we moved from desktop to mobile, that had a big change on who the winners and losers are. And so what's interesting right now is actually how few challengers there are coming up in the internet space.
You're not hearing about new social media platforms. There is software-as-a-service, the SaaS stuff, but that's where the innovation seems to be. But it's not really challenging the Googles and Alphabet … Amazon — like that all seems to have calmed down a bit. So, interestingly, there's a lot of runway there. And I think for a while people were thinking of virtual reality as maybe that new platform. But from what I can tell, the goggles are still too big and heavy …
Will McKenna: It seems a little —
Rob Lovelace: ... and people ... you know, a Ready Player One world is just not here yet. And I think the real leap is probably quantum computing, but the technology is a decade out. So you’ll probably hear it talked about more. That is a game-changer. The winners and losers will be completely different. All of the current encryption is rendered vulnerable by these computers. So talk about a game-changer, right?
So all the governments are going to need to upgrade; everyone's going to need to think about how they upgrade to these hyper-fast computing capabilities. So you're going to hear about that for a long time before it actually becomes a thing.
Will McKenna: Kind of like we’ve done with AI?
Rob Lovelace: Well, yeah. Exactly. Although AI comes in … I mean this sort of arrives one day — there's a destination — whereas AI keeps evolving and developing. And blockchain is in there, too. But again, I'm not sure I've seen that thing, in terms of the technology world, where I'm clear.
In terms of innovation in health care, we're just beginning now to see these customized therapeutics to your genome, to your specific areas where they're actually identifying the mechanics of how things work and being able to really get at it. The costs are crazy high right now. But the exciting thing is, as with many things, I think the first computers were unbelievably expensive …
Will McKenna: Right.
Rob Lovelace: … and we got better at them. And then they figured out how to do them in more efficient ways. Right now the issue on the personalized medicine is the turnaround times are too long, and the costs are too high. And they're getting better at both.
Will McKenna: Right, right. That's fantastic. What I'd love to do is maybe come down the line here, and if each of you would please summarize your thoughts — your outlook for 2020 — leave our audience with a couple of key takeaways? Darrell, if you don't mind, I'll start with you.
Darrell Spence: Yeah, I would say be relatively constructive on the outlook. Obviously, geopolitics is a risk — very difficult to predict those types of things — but we do think it will likely settle out in the short term, acknowledging some of the long-term issues that are going to be around for a while.
So that's a fairly constructive market outlook. But there's no doubt in our minds that we are late cycle, particularly in the U.S. And as we talked about earlier, there are excesses and imbalances building that we need to be wary of and to start preparing, at some point, for how we might want to act when those things start to become bigger issues, and particularly when they go from being tailwinds, to activity, to ultimately being headwinds.
Will McKenna: That’s great.
Margaret, your thoughts on bond markets in 2020 and a couple of key takeaways.
Margaret Steinbach: Sure. So I think we've covered the potential for heightened policy uncertainty and how that can lead to higher volatility and maybe a better buying opportunity, particularly in corporate bond spreads in the fixed income universe, which we mentioned earlier have been very tight.
I think in terms of portfolio construction, we're really recommending a balance between interest rate risk and credit risk, and then, based on relative valuations there, maybe skewing it to taking a bit more interest rate risk than credit risk — again, hoping ... expecting a better buying opportunity. In this type of a late-cycle environment, you really want, we think, for the bulk of your fixed income allocation to come from the core universe. And from there you can get a good balance of interest rate and credit risk.
Will McKenna: Great. So if a typical 60/40, if that 40 is bonds, call it 30% should be core …
Margaret Steinbach: Yeah.
Will McKenna: … something like that?
Margaret Steinbach: Yep.
Will McKenna: Not core-plus in disguise, which is... maybe a different topic, but …
Margaret Steinbach: Sure. And there's a role for core-plus in a portfolio certainly, but those higher total returns come at a cost. And, that's —
Will McKenna: Keep those in the margins.
Margaret Steinbach: Yes, exactly.
Will McKenna: OK, great. Good advice.
And for you, sir: 2020 outlook and key takeaways for the audience.
Rob Lovelace: Well, I think my key takeaway to everyone who's managing money right now: Make 2020 the year in which you create a new framework for how to invest globally. Move away from the U.S./non-U.S. construct and think about, really, how to invest in the best companies wherever they're based. That old structure served us well for 40 or 50 years; it's time to trade it in.
In terms of my specific outlook for the year, I think equity markets will be higher by year-end, having had a real rollercoaster ride as we get through all the political … trade ... I mean, everyone is so focused on these things, and everyone's so ready to sell the equity markets, I just can't imagine that we don't have some real swoons during the year. But once we have clarity on whoever that president is going to be, I think we'll be off to the races because equity's the place to be in this low interest rate environment. The good companies will have continued to do well, and people will finally at least have certainty about where we're headed.
Will McKenna: That's great. And picking up on two things there, I think, number one, a good part of our job here at Capital Group is [to] help you all in the audience help your clients during this period. So expect to hear a lot from us to give you the perspective you're going to need to keep them staying the course.
And then secondly, Rob, we talked about your bond allocation — so let's say the 60 equity in the 60/40, instead of doing the classic 40 U.S./20 non-U.S. — think about putting some global strategies in there.
Rob Lovelace: It can swing it for you.
Will McKenna: It can swing it for you. And have that flexibility. It's a good time to have flexibility rather than be constrained —
Rob Lovelace: Right.
Will McKenna: — in this kind of a market, right?
Well, that’s all the time we have today. I want to thank you all so much, Rob, Margaret and Darrell, for your insights into the financial markets and economies around the world.
We really hope you in the audience found this discussion helpful, and we look forward to working with you in 2020.
And once again, webinar participants, don't forget to take the CE credit quiz if you are looking for credit for CFP and CIMA. You can do that now. And you can do it after you receive our follow-up email in the next day or so.
So thanks again. Happy holidays. And enjoy the rest of your day.
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