Solutions - Putting It Together
March 25, 2019
Brian Nick: Good afternoon and thank you for joining us today for our investing outlook, 2019; Navigating market change and volatility. I'm Brian Nick, Chief Investment Strategist for Nuveen. Equity markets are now closed in the U.S. for the day. They won't reopen until Thursday as Wall Street remains dark on December 5th to honor the political, and I think it's fair to say, personal legacy of president George Herbert Walker Bush. When they do reopen markets will hold just 16 more trading sessions before we reach the new year. We're here today to share our outlook for investors in 2019.
Brian Nick: To help with that discussion I'm joined by a group of my colleagues from around Nuveen. Bob Doll, Senior Portfolio Manager and Chief Equity Strategist, Joe Higgins, Fixed Income Portfolio Manager, and John Miller head of municipals. Thanks for joining us today. We expect 2019 to be a year of change and uncertainty. That environment brings its own set of potential risks and opportunities. That leaves us all with the question; How do we navigate that uncertainty and the volatility that comes with it? As a reminder this is a live interactive session. I encourage you to ask your questions to our panel by submitting them in the field on your computer screen. Let's start with a brief recap of what 2018 looked like.
Brian Nick: Bob, let's start with you, the general environment coming into 2018, I remember sitting here last year, we were upbeat, tax bill had just been passed, what was your take on what we saw this year?
Robert Doll: I think it was a tale of lots of stories as you undoubtedly know. If I keep it simple, earnings went up more than we thought, and valuations, P/E ratios crunched more than we thought. Therefore, we have a market that's not a whole lot changed from where we were. The economy has done reasonably well. As mentioned, earnings have done very well, it's the uncertainty about what's next, as you already previewed, that's caused that multiple crunch.
Brian Nick: John, good economic performance, rising interest rates, not always the friendliest environment for bonds, how did the muni market fair?
John Miller: Actually, the muni market held up reasonably well when you consider, first of all, there was a combination of both low interest rates at the beginning of the year, plus a lot of fiscal stimulus, plus a lot of repatriation of corporate profits, when you add in the effects of that tax cut. That boosted GDP in the middle part of the year, up above 4%, and the unemployment rate below 4%, 3.7%.
John Miller: In that kind of environment, the Fed's been hawkish, and when the Fed's hawkish, bonds can be under pressure. For Municipals, they, I would say, were pretty resilient overall. Supply's down, demand held in very well, especially among retail investors. Institutional investors were a little bit softer, but retail investors held strong within the Municipal area.
John Miller: Certain pockets did better than others, but high quality, actually just turned positive for the year-to-date period on total returns, very, very close to zero. High-yield, up about 3% to 4%, so pretty resilient performance considering how hawkish the Fed was, and the fact that, as you mentioned, rates were up.
Brian Nick: Joe, what about the taxable markets? Pretty varied within the space that you cover, but what was your general take on the year?
Joseph Higgins: That's exactly right Brian, it was really a tale of bifurcated markets. We had the US economy strengthened certainly on a relative basis compared to the rest of the world, rates rose of course, creating a lot of weakness in emerging markets, in corporates, and in sovereigns. A weakness in IG corporate spreads as well, relatively surprising, as historically those spreads would narrow into rate increases, and yet, we had pockets of significant strength really through most of the year.
Joseph Higgins: Leveraged loans certainly, which do well as rates rise, and then high-yield bonds and structured products. Really a story of what market you were in, and where you were asset allocated.
Brian Nick: Just digging down a little deeper, within the asset class, you described a couple of those different sectors. What was working really well this year, if anything, and what were the places that if you had 20/20 hindsight, you would have stayed away?
Joseph Higgins: Certainly asset classes with a lot of spread component did well into the rate increases. That is high-yield bonds, fundamentals of the market remained strong, the risk of recession remained remote. In terms of having spread that could offset some of the impact of rising rates, those sectors did really, really well. Also, you had some technical's that helped out in that sector.
Joseph Higgins: Issuance was down about 20%, and that boosted the market right up really until very recently, where declines in oil prices started to hit high-yield bonds a bit. Leveraged loans did very well as having an organic hedge into rising rates. Exposures there, diversified exposures there paid off well for many core and core plus type of accounts.
Joseph Higgins: Areas that didn't do well, was again, investment grade bonds. We had the European buyers, and international buyers disappear, go on strike if you will, as hedging into or out of US dollars got very expensive. We had significant issuance that also pressured the market, and delayed again, that natural historical function where IG spreads would tighten, and delayed that.
Joseph Higgins: Structured products were a bit of a haven in the storm. Unique stories based upon, in many cases, the health of the consumer, which remain strong held up very well. That include CMBS, ABS, and the like. Mortgages didn't do so well, not a surprise with increased rate volatility.
Brian Nick: John, Joe's describing the environment for a bond investor where you have to think about credit risk, and you have to think about industry risk. How do you pull those two levers when you're managing a muni portfolio?
John Miller: Absolutely, both components are prevalent really cross all Municipals. The highest quality Municipals longer-term on the yield curve with lower coupons, those are going to be a lot more interest-rate sensitive. Switching gears, shorter duration, and lower on the credit spectrum, non-rated, etc., those are going to have a lot more credit risk. So far this year, the short duration and the high-yield have done the best.
John Miller: Now, we can talk about this later. I do think that, that's shifting, because longer duration, high quality has lagged. As I said, they just went positive for the year, but that means price decline has been almost approximately equal to the coupon that you've gotten. Now going forward though, when you look at the after-tax, after inflation yields, they actually look pretty attractive. We could see a shift, and see some longer duration, high quality performing better.
Brian Nick: Bob, the US equity market, I keep calling it the Lebron James of the global financial market, seems to come out on top, find a way every year. A little bit of a different year this year in terms of the leadership, how did you navigate through that?
Robert Doll: Yeah, with great difficulty, because if you had the same strategy all year long, you struggled as you point out. I'd start with okay earnings, up 22%, 23%. When the year's said and done, roughly a third coming from the tax bill, roughly a third from amazing revenue growth, and roughly a third from profit margin improvement, and some financial engineering, offset by an almost equal decline in P/E ratios.
Robert Doll: What's caused that? I'd say classically modestly higher interest rates and inflation from the first of the year, and then I call it the list, China, trade ...
Brian Nick: The naughty list, or the nice list?
Robert Doll: Yeah exactly, and you add to it in any particular order, Brexit and Italy and credit spreads and that complements things. We had lots of transitions this year from well, as you point out, geographically the US led again. We can come back to that when we talk about '19, but it seems like we've had passing the baton from growth to value. We have certainly had the passing of the baton, at least for now, from small stocks, which led early in the year, to big stocks, which has fared better in the back part of the year.
Robert Doll: We've had two pretty noticeable corrections, a double-digit percentage one in late January, early February, and then the one we're mired in as we speak.
Brian Nick: I'll use a point you made about where the earnings came from to ask you about 2019. You mentioned the tax cuts accounting for a third of the revenue growth, amazing revenues, some of that has to be from customers that had just been given individual tax cuts. What does the outlook look like in 2019 for the US equity market?
Robert Doll: On all three of those earnings components, worse than 2018. As you well know, part of the problem in the market here in the back part of the year, has been okay, economic and earnings growth is slowing to still reasonable levels, but how far is it going to slow? That's got the market concerned. The tax bill will have some residual positive impact.
Robert Doll: The revenue growth, undoubtedly much slower. Part of the problem there is the rise in the dollar, that creates some headwinds for revenue growth. Then profit margins, I think is the area of the biggest debate. The bulls would say, "Profit margin expansion, we could see some more next year," and yes we could. Those of us that are a little more concerned say, "Not so sure." There are creeping cost pressures, wage growth is picking up, there's some raw materials, transportation costs are moving up, interest expenses moving up. I think the margin issue is the real question mark for next year.
Brian Nick: Wages are so often used, and should be used as a sign the economy is relatively healthy when wages are growing, but not necessarily great news for corporations that are already facing higher costs.
Robert Doll: Exactly, and as you hinted, a good economy and a good stock market don't always go hand in hand. You want a good economy for earnings to be good, but be careful where it comes. Both you and Joe have alluded to, and I'll make the exclamation point, The US consumer's in very good shape. Record numbers of people working, more being added at above normal rate on the payrolls. Wage growth, starting to pick up some. Savings rate up here, rather than down here, as it usually is at this point in the cycle, so consumer's in pretty good shape.
Brian Nick: John, interest rates are up for the year, meaning all else equal, muni's have a better outlook heading into next year, than they did heading into this year. What do you see as the major drivers of how the markets likely to go?
John Miller: Sure, that's a great point, and people look at historical returns, and they say, "Well, muni's are flat, however, that means rates are higher, so forward-looking returns." Book your tax-free income at a higher level, and in fact, of course, the tax exemption has been affirmed by getting through the tax Reform Act of 2017. Municipal's still tax exempt, there are actually some bells and whistles that maybe make that tax exemption more attractive after-tax, but then also, of course, after inflation for any bond analysis.
John Miller: The yield that you can get after inflation, well, inflation at the core PCE level, it hit the Fed's target of 2% for a couple of months, and now is starting to pull back, 1.8%, the most recent release. Now oil prices are down by a third, that may create a little bit more downward pressure on inflation. That's why I think about after-tax, after inflation, total returns for muni's, look better heading into 2019.
John Miller: There are also supply and demand characteristics, and as I mentioned, has held up from the individual investor side, because their tax rates are still pretty high. Banks and insurance companies have sold down some of their Municipal portfolios, that had to be absorbed in the market in 2018. I think that's largely run its course, so perhaps we see less institutional selling pressure in 2019, more retail demand, and moderate supply from the borrowers. The technical's, just that supply and demand dynamic from muni's, also looks pretty constructive heading into 2019.
Brian Nick: Joe, your benchmark has US treasuries in it, and it has corporate bonds in it, and other types of fixed income. How are you managing risk coming into next year, as you anticipate again, a year in which rates start off higher, which perhaps give you a bit more of a cushion, but what's the outlook look like?
Joseph Higgins: Yeah, you are correct Brian, higher rates certainly are more attractive going to 2019 than we were as we entered 2018. That really calls for a more modest duration under weight across many strategies, for example. Diversification is going to remain key, it will be a volatile year most likely. You have a lot of the below investor grade asset classes, high-yield bonds for example, heavily correlated with oil, and indeed correlated certainly the lower quality tranches correlated with equity moves.
Joseph Higgins: Diversification will be key, the dollar is entering 2019 in my view, either fairly valued, or overvalued. That augurs reasonably well for EM, if and when the dollar weakens in 2019, is an unknown, but the ability to retain global leadership from a currency viewpoint, will be tested if equities, we can further or remain weak. That could lead global investors into other markets, and really pressure the dollar in some way.
Joseph Higgins: In that sense, EM looks perhaps amongst the best valued asset classes in my view on a relative basis, compared to say triple C, or lower quality high-yield bonds. Investment-grade will continue to possibly have some challenges until farm buyers reemerge, or issuance declines, creating a possible technical there. Some late stage asset classes that remain attractive are again, ABS, CMBS, bodies and buildings remains on a positive trend line with employment growth, and indeed, yet again, strong consumers augur well for performance characteristics there. Recession remains only a modest to low risk, so the ability to be in credit seems warranted. A lot is priced in as we enter the new year.
Brian Nick: It seems like, especially based on some of the market action we've seen in the last couple of days, that the risk of a recession is not necessarily high moving into next year, in fact, we don't think it's high at all. The risk of recession risk, so the second derivative of that risk, where the markets are responding to the perception that things are slowing down, that seems like it's very much a part of the market psychology, at least at the moment as we sit here today.
Brian Nick: Speaking of the US dollar, but also recession risk, we have a new Fed chair this year, who's now got about a year of a track record behind him. He's been in the news lately, he's got a couple of words of encouragement, shout out from the President himself a few times recently. What do you make of the ... Encouragement being a euphemism I think. What do you make of the job that Jerome Powell has done, and what is your outlook, as you think about how to build portfolios for what the Fed is likely to do next year?
Joseph Higgins: We've learned a lot in the last week or two, clearly as chair Powell has clarified his view around how close we are to a neutral rate. A neutral rate, as you well know, as we all know, is a broad concept, and it's a moving target. Chair Powell has recently clearly indicated that the Fed is data dependent, and it means we're all really along for a ride together in the coming months certainly, to see how strong data comes in.
Joseph Higgins: Critical data remaining, of course, the size and scope of wage gains, business capex investing, and participation rate, and financial conditions broadly defined. Whether it's sure, an equity market does feed into financial conditions, but something that would be important to the Fed, would include business lending by banks and the like. The Fed will monitor those elements.
Joseph Higgins: I think chair Powell has done, frankly, a fair job, if not a good job since he's been in the role. Being data dependent is technically neither hawkish nor dovish. Some could say it's dovish in the sense that in past cycles, the Fed might have gone on until it saw more weakness, the whites of the eyes of the weakness so to speak. This Fed is saying, "Let us see how much effect we've had to date, and let us witness it through data."
Joseph Higgins: I view it as indifferent rather than dovish per se, but I think it is not imprudent for chair Powell to take the board towards, let's see what the data continue to say. Today's a very noisy day, it's one day, it doesn't necessarily indicate what 2019 will look like. Again, yet again, back to the economy, it's strong in the US. It may even be perking up slightly out of Europe, right? And/or stabilized in China, notwithstanding tariff noise, and sentiment shifts, and the like.
Joseph Higgins: I think the Fed is taking a fair and appropriate, I don't even want to call it a pause, it may not result in a pause, but a wait-and-see attitude.
Brian Nick: It seemed like if you hadn't been following the markets at all this quarter, and had just been tracking economic data, you'd be wondering why everybody's talking about the Fed pausing. It still seems like, from their perspective, it makes sense to keep raising rates, at least in a couple of weeks when we think that they will almost certainly go in December, and then the uncertainty as you move into next year.
Brian Nick: John, when you're managing duration, obviously, the Fed policy's going to play a big role in that, whether you want to be on the short end, or the long end of the curve. What's your take on how the Fed has managed through this?
John Miller: Sure, well, agreed, I think there's been some communication, maybe uncertainty, and confusion around the communication. People have forgotten about the fact that interest rates affect the economy with a lag. They've forgotten about the fact that every meeting is a new fresh start, and it doesn't have to be locked into a specific policy, as it has been largely in 2018.
John Miller: Clarifying that, that's actually taking a lot of the future rate expectations for 2019, and putting them a lot more uncertainty around them, around when the Fed is going to take a pause. I think when the Fed is going to take the pause has become closer in time, and because when you do look at the data, albeit labor market's probably the strongest component, you also have to say, "Well, if inflation is coming down, why do they have to raise rates?"
John Miller: The other thing, is rates, using the 10 year treasury, actually hit their lows back in June 2016. Again, that affects the economy with a lag. 10 year treasury has essentially about doubled since June 2016. Therefore, mortgage rates have doubled since that time, and we're not seeing a housing recession, or anything of that nature, but some slowdown. It's a little bit tougher to sell the new homes that the home builders are constructing.
John Miller: When you start to see home prices come down, that's a third ... Owners equivalent in rent, housing prices, that's about a third of the inflationary statistics. Again, if you see oil and housing and autos with a little bit of marginal softness, then the reason to raise rates yet again, becomes maybe a little bit less compelling. In terms of managing muni portfolios, it's interesting that, as I mentioned, muni's increasingly dominated by the individual investor, less institutional, more individual.
John Miller: What have individuals been doing? Similar to the taxable side, they've really been saying, "Well, I want stories that are not related to interest rates," and therefore, shorter duration, higher-yielding has been the most popular. Therefore, the long end has not had much sponsorship, and in fact, long-term muni's are cheap, even relative to taxable. Ironically, the Municipal yield curve has steepened.
John Miller: In an environment of yield curve flattening, the Municipal yield curve has steepened, which is unusual, meaning longer-term bonds are not only cheaper on an absolute basis, but they're also cheaper on a relative basis. Should the Fed actually move to the sidelines, I mean, technically they're not there yet, but if and when that does occur, I think we can see a rally in longer term bonds.
Brian Nick: Bob, the Fed has a complicated relationship I'd say with the equity market. A little bit of a love-hate relationship at times. Sometimes they really like what Powell says, and sometimes they really don't like what Powell says. I'm struck by the fact the FOMC statement at their last meeting contained some version of the word strong six times. The Fed is clearly saying, it thinks the economy is okay in theory, although, as you pointed out, there's not a perfect correlation, this should be an okay environment for stocks. Why do the markets seem skittish with regard to the Fed?
Robert Doll: I think because the interest rates have moved up a bunch. We had zero interest rates to exaggerate, but not by much for a long time. As John just pointed out, let's use the 10 year treasury, summer of 2016, 1.4%. A year ago, 2.4%, while we're under 3%, and down from 3.25%, we're still up a bunch from where we were at the first of the year. Again, John's great point, interest rate increases operate with a long lag.
Robert Doll: I think the equity market is looking at all of that every. I think the equity market is also saying, "Really? No inflation." The unemployment rate is continuing to come down, and expectations for wage growth, 3.1%, 3.1%, 3.1%, 3.1%, as far as the eye can see. That math doesn't add up to me. If the unemployment rate keeps falling, if job growth is strong, there's no question wage rates are going to move up, which is a big counter to a lot of the other good points that have been made on inflation.
Robert Doll: I think that's what the market's concerned about. One more concern, because interest rates were so low for so long, too many people were able to borrow money that shouldn't have been able to borrow money. I think that risk is in the market now. As rates move up, back to Warren Buffett, when the tide goes out, we see who has a bathing suit on, and who doesn't, and that's part of the liquidity and the interest rate impact here.
Robert Doll: Then we could talk about housing and autos, big time interest rate sensitive sectors, this far into the cycle is amazing. Usually a couple of years in it dies, because rates have moved up. Housing and autos have been a key part of this cycle for umpteen quarters now.
Brian Nick: This cycle feels like a slinky that one of my kids has pulled apart, so it no longer ... It looks like a normal cycle, but it's just much, much longer. The things that shouldn't be working nine years in, are still working. I think I'm going to be going down your list of risks on the naughty side primarily, and asking you about trade.
Robert Doll: Yes.
Brian Nick: Probably the noisiest source of policy uncertainty that we've seen, maybe since the Fed was doing QE off and on during those years, the headline risk is just ... As opposed to the Fed, QE was often seen as a positive thing in equity markets. Trade has almost always been a negative this year, and we have, I think, more uncertainty coming out of the meeting at the G20 last week between the US and China. What was discussed? What were the terms? What are these negotiations going to look like? How long and how patient are the two sides going to be? Can the equity markets, as a whole, do okay under the grip of policy uncertainty with regards to Trump.
Robert Doll: You know how I'm going to answer that, probably not. Despite the analysis that says these tariffs as a percentage of GDP are not all that big, it's that markets hate uncertainty. When you have a dinner like Saturday night, and the US says one thing, and the Chinese say something that ... We're they really at the same dinner? The absence of specifics, the delay in the tariffs without China giving up a whole lot. Within the Trump administration already in the last few days, lots of different signals, markets are confused.
Brian Nick: The table might have been too big.
Robert Doll: Maybe that was the problem, or the food wasn't so good, I don't know what. The trade issue is a big one that sits on the table. Look, the Chinese need us, and we need the Chinese. As an American, I'm glad that they need us a little more than we need them, and I think that's why you're seeing what's going on here. We can't have a great equity market, in my view, as long as this big uncertainty prevails.
Robert Doll: Let's think about the politics, the President has to worry about the economy, and eventually, assuming reelection, and so there's only a point in time where he can continue to delay these tariffs. Eventually, he's going to have to declare victory back off his long-term objectives to give the markets and the economy more certainty.
Brian Nick: Maybe no other issue highlights the different degrees of sensitivity the equity markets have to an issue versus the economy. It's hard to see, you need a microscope to see the broad economic impact from tariffs this year, because the dollar amount, so far, has not been that great. The uncertainty combined with where it hits, the equity markets have a bigger problem than the economy.
Robert Doll: Right, and add one more point to it, remember, going back to summer time, President Trump said, using his words, "You're all screwing us." Meaning every country in the world, I'm going to rip up all these trade agreements, and then Japan, and South Korea, and Europe, and Canada, and Mexico, we come to an agreement, leaving China, the big one out there, which is where he was starting in the first place. He was sending a message to everybody, but the real message was to China.
Brian Nick: John, it seemed like the impact that trade has on the bond markets, is at least in the last couple of days, we've seen interest rates come down pretty appreciably, maybe just a risk off. How much does that factor in beyond how is the economy doing, what should interest rates be doing, but then you have this flight to safety or flight to quality every time there's a growth scare around trade?
John Miller: Sure, I mean, fundamentally speaking, you need the market for US treasuries, and China has been historically one of the big buyers, they still own over a trillion. In a sense, cooperation with China is a positive on the fundamental side. In terms of inputs, I think more so than GDP, but inputs into the supply chain of companies, and keeping their costs down, and helping keep inflation low, that's where another fundamental quality comes into place, which in theory, would be positive for treasuries.
John Miller: What's positive for treasuries, does filter through the rest of the bond markets, the spread market, corporates, muni's, and so forth. Now on the day-to-day though, the risk off mentality, that creates flight to quality, and the flight to quality certainly creates a more interest in buying treasuries in the near term. I actually think that a lot of the overall fundamentals in inflation and relative value of the US sovereign debt, relative to other sovereign debts around the country, I mean, around the globe, makes treasuries look fairly good.
John Miller:The biggest negative actually, has been the supply, i.e., the deficit and the expanding deficit from the tax cuts. With the strong dollar, finding those buyers, but those buyers have to be global. That does have to include China, I totally agree with Bob in that really, the current administration appears to be quick and easy cooperation with Canada, Mexico, Europe, create a block, and use that block to pressure China.
John Miller: I do think they are under pressure. I mean, I don't know what the final agreements going to look like, if there is an agreement, how long it takes, all of those details everybody's nervous about. Certainly the America first policy, that is the goal, because it's more than 50% of our trade deficit is with one country. That's why they're intentionally putting them under so much pressure.
Brian Nick: Joe, I'm thinking about the impact that we've seen on oil prices, and some of that is related to skittishness from China, it certainly impacts the corporate bond market, and also just EM related to skittishness from China. It certainly impacts the corporate bond market, and also just EM, which you mentioned. See, that volatility on that asset class has gone up whenever trade has made its way into the headlines. What's your outlook for ... does this get resolved? Are we looking at a world with fewer tariffs in a year, or a world where this just keeps going?
Joseph Higgins: Yeah. I think that certainly equities ... EM equities and EM debt remains very correlated to what goes on in China. To the extent China experiences a slowdown, it will impact currency and EM countries that are tied to the renminbi. It's very important. From what I've seen, I don't see any signs of the administration necessarily backing down. The benefits of Chinese imports to U.S. industries is not always obviously apparent. In some sense, U.S. automotives have remained competitive on a global stage, or domestically against global competitors by importing some amount of Chinese parts, keeping their costs down, to your point, Bob.
Joseph Higgins: The other thing is, if the administration is successful in reducing the deficit with China in a significant manner, it may just shift the supply chains elsewhere into Asia, as we all area aware. The ultimate issue for the United States to explore, which I don't think the administration has done just yet, is what are the drivers of our twin deficits?
Joseph Higgins: Some of that has to do simply with the timing ... Brian, you and I have discussed this ... of having a dramatic fiscal stimulus at the late stage of the economic cycle is going to draw dollars into the U.S. It's going to cause foreign goods deficits to naturally increase for some length of time, while that fiscal stimulus is in place. There isn't a neat solution, as we know.
Joseph Higgins: Global trade itself is 55% of world GDP. It isn't critical to the U.S. in one sense, but in the other sense, we're hearing this from many business leaders, disruption, or concern about disruption to supply chains freezes CAPEX spending. All of which is a negative for the economy.
Joseph Higgins: It has exaggerated effects on the economy, to Bob's point. Uncertainty, even if it's not a major uncertainty, can have dramatic effects on business spending. At some point, we could see corporations slow down, and ... I think this is always into the future, but hurt the consumer through layoffs or through ratcheting back their own investment plans.
Brian Nick: You mentioned the fiscal stimulus. I think that this time last year, it felt like the tax cuts were very much on the nice list. At this point, I think it's a little bit more ambiguous just what we've done with supercharging the economy the way we did in 2018, and whether we put too big of an engine in maybe too small of a car, and that's why we're seeing some of this.
Brian Nick: But when you're thinking about the fact that corporations have had significant tax cuts this year. Individuals, again, significant tax cuts ... turns out they use some of that money to buy imports, as is evidenced by the wider trade deficits that you mentioned. What's going to be the long-term impact of the tax bill that we saw last year? Are the effects going to stick with us in 2019, as far as your asset classes go?
Joseph Higgins: It will remain similar, clearly, into 2019. We will see a slowdown, however, and that should help emerging markets, as I alluded to earlier, and serve to weaken the dollar. There will be that much more emphasis on the U.S. twin deficits. The issuance of Treasury's deficit ... I think it will run about a trillion dollars next year. I don't know what your exact estimate is, Brian.
Joseph Higgins: We will start to see a little bit more hesitation. That should have the effect of raising rates a little bit, if demand should weaken. But then you also have the safe haven aspect. That's why, as a reserve currency, the ability to print in excess of your economic growth really can go on for many years before you ultimately feel those effects. But for asset classes, it makes EM feel fairly valued, for certain.
Brian Nick: John, from the standpoint of the tax reform bill, more than the reduction in the rates, we had elimination of certain deductions, which puts munis in the crosshairs, at least compares them to other sources of tax shelters that people have the option to do. Is the reaction in the muni market a year later about what you expected?
John Miller: I think it's been a little bit obscured by the hawkish surprise from the Fed, and the grinding higher interest rates through the course of the year. That's obscured a little bit of the positive news on the muni side with regard to how do munis look in terms of the new tax act?
John Miller: How do they look? Alluded to it a couple of times. For bank holding companies and insurance companies, and their muni portfolios, they've pared them back again. I think they've got them more or less where they want them, because they are not as attractive versus other asset classes, if you just got a huge tax cut. That's really more of a corporate tax cut ... for the big numbers.
John Miller:Now, that actually leaves more room for ... so how do munis serve the individual investor? That's where you've got this small tweak lower, in the top marginal bracket, from 39.6 to 37, but then you've lost a lot of stuff on the other side. You lost a lot of deductions, and you were capped out ... for upper-income households, you were capped out at $10,000 on all your local property taxes, plus your state income tax, if your state has an income tax.
John Miller: I think some people are ahead of the game, if you will, and realize that that means, "Hey, maybe I actually got a tax increase here." Others might ... I think it can sift through the market gradually over time, as people start calculating their 2018 taxes, and say, "Well, munis look good on an after-tax basis." Now, because particularly California, New York, Virginia, etc. ... New Jersey ... These high-tax states are where most of the muni bonds are issued, and there's good demand for those.
John Miller: I would say that just getting through ... Of course, to give this huge corporate tax cut, the Congress was looking for ways to pay for it. They didn't pay for it completely. But in the process of looking through ways to pay for it, munis were very carefully scrutinized and analyzed, and because of the importance to finance the U.S. infrastructure, the muni exemption came through intact.
John Miller: The utilization, the ability to spend money on different projects ... Airports were looked at. Schools. Universities, and so forth. Hospitals. These all passed muster through Congress, and were untouched in terms of the exemption itself. There's the exemption. That's intact long-term. And then there's your personal circumstance, which could have been affected by the cap of $10,000 on the state and local tax level.
Brian Nick: Bob, in addition to the exemption elimination, one of the other reform aspects of the tax bill was to restructure the corporate tax codes. Not just reduce rates, but also give corporations front-loaded incentives to invest, with the goal of unlocking potentially higher worker productivity, higher growth. Is that what we're seeing? Is that what we've seen companies undertake this year? Do you expect that impact to stay with us in 2019?
Robert Doll: To some degree. Let's start with the corporate tax rate. As you know, over the last decade-plus, where the U.S. corporate tax rate was basically unchanged, the rest of the world kept bringing their tax rate down. So this huge gap opened up, making the U.S. less competitive. Tax cut enters, that tax rate is brought down almost to the middle of where everybody else is, making the U.S. one more time competitive. That's been a huge help, and of course, a big boost to earnings this year, and to some degree next year. The incentives, then, on top of that, to say, "Okay, capital expenditures ... We need that, if we're going to get productivity." Productivity had fallen precipitously in the last decade. Some CAPEX and reinvestment in other ways has created a turn in productivity from very low, to still low levels. Back to our trade discussion, as you know, in the third quarter, CAPEX was disappointing, and corporate America said the reason is, "We just don't know." That uncertainty comes back in. It would be great if we could resolve some of these issues, because I think we would get some more capital expenditures. More importantly, productivity enhancements.
Brian Nick: Slightly different topic, but in the same ball park. We did have the 2018 midterm election. I'm thankful that we're having this discussion after that, so we don't have to prognosticate on the results. Who knows if we would have gotten anything right or wrong? But we're clearly entering a different political environment now. One in which last year's tax cut probably would have no chance of making it through the way it did. What is your outlook for the next two years? The next Congress? What's that working environment going to be like in Washington? Should I not even use the word "working?"
Robert Doll: I'm yawning, because I think that's what it's going to be. Look, to be really simple, I think what the markets wanted from a Trump Administration was, number one, a pro-growth tax bill. Check. Done. The midterm elections could do virtually nothing to that. That gets threatened if we have a new President and/or a different kind of Congress. The second thing was less regulation. Fewer newer ones, and if you can roll back a few along the way, that's great. That's almost entirely the purview of the executive branch of the government. Therefore, the legislature can't do anything to that or for that. I think the markets are saying, "Hey, we got what we wanted. Now, let's give it some time." I think the markets are expecting almost nothing. Oh, there will be bits and pieces here around all kinds of stuff we could discuss, but in terms of major new legislation, I think back to what you said, "working" environment with quotes around it.
Brian Nick: Infrastructure bill?
Robert Doll: I'm of the view that if we get one, it's because the President needs to check the box, so he can run for re-election and put the chalkboard that says, "Here, I promised all these things. Check, check, check." But if we get one, I think it's a real small one. There's just no money. Might he try to do a deal with the Democrats on that side, and Republicans either say no or reluctantly come on? That's possible. I think it's going to be small in the scheme of things. It's not going to be a trillion dollars like he talked about on the campaign trail, over ten years.
Brian Nick: So if Congress wants to make a withdrawal from the bank, it turns out the last Congress already took all the money out.
Robert Doll:Well, or the one before that, or the one before that. The one before that. Right, yeah. It gets a little bit harder every time we roll forward.
Brian Nick: John, obviously publicly-funded infrastructure could have an impact on the media market, too. Sounds like we're thinking that's not as likely, or a market-changing bill ...
John Miller: Yeah, I think it could be one of those ancillary, smaller programs that can garner some bipartisan support, and you can get something where the Democrats can declare victory and the Republicans could declare victory. We don't have the money for a huge trillion-dollar program, but around the margins, some additional incentives for public-private partnerships, for airport spending, or toll-road spending ... These sorts of things are feasible, potentially.
John Miller: We haven't seen the details of what this plan would look like. Prior to the midterm elections, there were some thumbnail sketches around an infrastructure plan, and municipal bond issuances encouraging them in terms of specific opportunity zones, and reducing the AMT, and things like that, were part of it. This new one, if it does emerge, may bode for a little bit more municipal issuance.
John Miller: Municipal issuance is actually down this year. It's not down as much as expected. It is not actually keeping pace with all the bonds that are going away. In other words, about $400 billion in bonds go away every year due to maturities and bond calls. Issuance is going to be below that. An infrastructure plan could uptick that issuance a little bit, but probably more for 2020, if it happens, because if it happens, it'll be into the year 2019 already, so could they create some incentives for 2020? Possibly.
Brian Nick: I think we should probably just take a few questions from some of the folks who have been submitting them online. Joe, this one's for you, from Galena. Are you concerned about the overall level of corporate debt? And she asked specifically about the growth of collateralized loan obligations, or CLOs.
Joseph Higgins: Yeah, it's an important question. As far as overall debt levels, generally, corporate debt has grown dramatically. Dramatically more so than consumers. The ability to service the debt remains fairly sound. Much of the fixed portion of debt has been termed out. There isn't an enormous reason to think that there will be an inability to make debt payments, even as we potentially enter a modest recession in 2020. With regard to CLOs, it's an asset class that has performed well in several cycles. It has proven its ability to weather economic and financial distress. In that sense, I think it is a tested asset class. We have had enormous growth in the marketplace. We have had a relaxation of terms. I'm sure that's the point of the question.
Joseph Higgins: But what's worth noting is many of the corporate entities that get reduced terms, covenant-lite, whatever reduced requirements, are the better ones. There isn't necessarily a reason to think that it's a bubble. Clearly, companies have taken advantage of the cheap financing to buy back stock. There will be hiccups there. There will be losses. Recovery rates will be lower than they were historically.
Joseph Higgins: Historically, you can count on between 70%, even up to 80% recoveries. We're probably talking more like 60%. But most investors understand those risks. I would say it's a market that is likely modestly overheated. The ability to credit-pick the right issuers and the right managers remains at a healthy level, and a doable level, for the right manager.
Brian Nick: John, I think this one's going to be right up your alley. What is the outlook for high-yield municipal credit?
John Miller: Sure. Thanks. Well, first of all, high-yield municipals, I think it's important to understand even while some general obligation debt might grab the headlines from time to time, pension-funding issues, and so forth, high-yield municipals are predominantly revenue bonds. They're predominantly infrastructure-oriented projects, which may have a developmental component to them ... your ramp-up component to them ... but are ultimately creating essential services and natural-type monopolies. We try to select those types of credits that we think would do well, particularly in a mild downturn, or a mild recession, if that were to occur. So that, therefore, when default rates go up in fixed-income markets broadly, they tend to go up a lot less in high-yield municipals.
John Miller: Right now, defaults are at a very low level, and state and local governments have actually benefited from the corporate repatriation of profits, and personal income tax growth, and the low unemployment. Personal income taxes, revenues, sales tax revenues, and property tax revenues are the big ones. They're up at an annualized 10% pace this year, so that's pretty strong. Upgrades have exceeded downgrades, as a result. These are some of the fundamental supports. Now, credit spreads have contracted to about 200-basis-points this year. That's the AAA municipal bond benchmark, plus 200-basis-points for high-yield. 200-basis-points, I think, overall, is fairly attractive if default rates stay low. Now, some of that spread compression has actually been some of these special stories that are CCC rated, that are even in default, or on the cusp of default, stressed credits, or distressed credits ... Puerto Rico, tobacco ... I actually think we're underweighted in those areas. We're underweighted in CCC, and Puerto Rico, and things like that.
John Miller: I think that high-yield municipals in 2019 should broaden out, and things like BB should out-perform. At 200-basis-points, you have this tailwind. Essentially, you have more yield as a tailwind to potential out-performance, but of course, credit conditions and low defaults have to hold up. I think in 2019, even with a slowdown ... maybe we have one-and-a-half percent growth might be the low end of the range of expectations, something like that ... We're trying to invest in those credits that are going to be resilient to a mild slowdown, and enhance broadening out of those sectors, beyond just Puerto Rico and tobacco, you'd think should out-perform.
Brian Nick: Bob, you're not going to believe this, but we have multiple investors who are frustrated about the performance of their international portfolio this year. Sounds familiar. Yes, it does. But I'll let Ernest take this one. What would have to happen for international equity markets to outperform?
Robert Doll: I'm going to be a simple man here. The U.S. economy and U.S. earnings have outperformed non-U.S. economies and non-U.S. earnings. Isn't it logical to think the U.S. stock market would outperform? Therefore, the switch comes when we reverse that. The argument to overweight the U.S. ... non-U.S., excuse me, largely came out of cheapness. I warn everybody who's watching or listening that we've all bought cheap things that stay cheap or get cheaper. Until the transition, where non-U.S. economies and earnings beat the U.S., I think the U.S. is likely to lead. I don't know when that transition's coming. My guess is overweighting the U.S. is long in the tooth, but I'm going to wait for the market to tell me, as opposed to try to catch the falling knife.
Brian Nick: This ... jump off for everyone who wants to answer, from Ashlynn. When will the U.S. debt and ongoing deficit spending become a problem for the markets or the broader economy? I get this question every single time I speak to any audience anywhere. I'm going to start putting it in an envelope and holding it up to my head like Johnny Carson, to predict what the questions are going to be. John, what's your take [crosstalk 01:23:26] question?
John Miller: Sure. Well, I think first of all, in my opinion, we don't really have a problem with revenues. We have a problem on the spending side of the equation. The spending side of the equation, most of that is on autopilot, because of Social Security and Medicare are going to be continuing to grow as more and more people turn 65 and start collecting benefits. On the one hand, it's concerning because the discretionary component of spending is so much smaller than the non-discretionary, but it's also solvable, because you know exactly what you have to do. You have to do what politicians don't want to do, which is do some reforms of the Social Security and Medicare systems.
John Miller: The prospect of that is doesn't appear any near-term prospect of actually doing that, but nor does the debt-crisis itself appear near-term. Many European countries are in the same boat, but just not as large of a scale. Japan is even further along in this aging process, as a demographic and aging process. Ironically, perhaps, you see the dollar strengthening. Where you really see, okay, debt is going to become like crisis proportions, would be if you see the dollar dropping, and people refusing to buy U.S. assets, including U.S. Treasuries. That doesn't appear to be a near-term issue. I mean, I think we all realize the components of how to construct a solution to it, but it's almost more in the political realm. Politicians consider it to be the third-rail at this point in time.
Brian Nick: Simple, but not easy to do. Correct? Joe, we talk all the time about Treasury issuance, keeping our eye on auctions, and obviously there's a lot more Treasuries out there today than there was a year ago. Long term, there's going to be even more, as John was saying. How does that impact how you're managing money?
Joseph Higgins: Well, it argues for a strategic long-term allocation in either non-dollar or EM entities, who might have less relative paper generation, so to speak. I think that I agree with everything John just said. I would add that the problem is solvable. I would second that it's solvable. You could also raise revenue, if you chose to, but it is a political issue, and it's probably four, six, eight, or ten years away, before these hard decisions are made. It'll probably reach a near-crisis sentiment at that point in time. I think that the U.S. Treasury market, as a critical store of global wealth, will remain intact, really, for the foreseeable future.
Robert Doll: Let me take a shot at it. First of all, agreeing with my two colleagues. The way I look at this, is Americans are surveyed on these kind of questions, as you know, and the response generally is, to the question, "Do you want Congress to fix the deficit, and the entitlements, and the debt?" The response is, "Of course, I do, but don't touch my benefits, and if you do, I'm going to boot you out of office." People say, "Why don't they do something about it?" And the answer is, "Because we're telling them not to." The questioner said, "when." None of us knows. My view is we'll try to get out of some recession, at some point ... Probably not the next one. Maybe not the one thereafter. And we'll apply normal policy tools, and it won't take. We'll have interest rates going up, and the dollar going down, as both of these gentlemen have hinted.
Robert Doll: At that point in time, I think the debt and the deficits will move from page 25 of the newspaper to page one. Then when we get surveyed, we'll say, "Yes, I want them to fix it, and here's my dollar." At which point, as John just hinted, they'll go for it. It's easy to solve, if you have the political will. Let's take Social Security. You delay the start. You lower the rate of increase. You do some means testing. You'll step on a lot of toes, but the three things I suggested, that may save as much as three trillion dollars. We can fix this. We will, but not till our backs are against the wall.
Brian Nick: We're not looking for that next year, I think it's fair to say. Let's keep going. I was on four e-mail chains this morning about the inverted yield curve, which is how you know that it was leading on all of the financial websites. Bob, the inverted yield curve, people look at it, because if you know one indicator for a recession, you probably know that one, and you're using it at all of the cocktail parties around the holidays. Could you just talk about, what is your view on how worried we should be that short-term interest rates have moved up, while long-term interest rates have moved up, but by slightly less?
Robert Doll: I'd start by saying it is definitely not a positive, but how much of a negative it is, we could have a long debate. Look, you can be technical, and say, "Well, this measure was inverted, but that one wasn't." Whether it's two-to-tens, or two-to-fives, or 90-day ... All of them come up with a different answer, which just shows you how marginal this all is. We all know that when the yield curve does what it's done, it's basically saying to the Fed, "You better be careful. You can't go too far. You'll create a big problem." I think that's the message. We'll see how the Fed reacts to all of that, post the December increase, and the language thereafter.
Robert Doll: Look, there are few things that are good, dependable lead indicators of top in the stock market and a recession. The yield curve is one of them. That's why people are paying attention to it, but I'm not going to turn around tomorrow morning and sell every stock I know just because the yield curve, at certain points, began to invert. Let's keep our eye on it, but let's not make it the only thing we look at.
Brian Nick: John, you mentioned that your yield curve is not inverted this year. It's actually become steeper. It's the last thing on your mind you have to worry about, but do you have a thought on, as a recession indicator, how ...
John Miller: Sure. Well, very interesting, you're on four e-mail chains, and I'm seeing articles that are discussing what Bob said, which is twos-to-fives inverted, but twos-to-tens did not invert. I'm amazed that there's this much press-
Brian Nick: You can always find a spot on the curve that's [crosstalk 01:29:58].
John Miller: ... this much press on the inverted yield curve. It's incredible. Very sensitive. I think what the two-year is saying that the Fed is going to ignore the data and keep raising rates no matter what. Then the fives and the tens are saying, well, if they do that, inflation is going to drop, and therefore those bond yields are going to drop. They're, of course, anticipating it. They're dropping already. I think, actually, that the Fed will back off, because the Fed is obviously sensitive to this issue, as well. If the Fed is able to back off with the data, of course, inflation and growth data that we've been talking about, then the curve will maintain a positive slope. It has been a very good recession indicator.
John Miller: Maybe people are also sensitive to it because we're the second-longest expansion in modern history, and about to become the first-longest expansion in modern history, so it's coincident with tons and tons of questions around "Well, when is the expansion going to end?" How about the inverted yield curve? Is that going to tell us that it's going to end?" All you have to do is get a little bit more dovish Fed, and the curve will steepen. That's what I think is pretty likely for 2019.
Brian Nick: Joe, you agree with that?
Joseph Higgins: I do, as a matter of fact. I think, also, that the yield curve may be reacting not just to Fed rate increases, but the ongoing roll-off of the balance sheet, which is restrictive to financial conditions. Indeed, the talk, it may not manifest, of an anti-European QE, and possible an anti-QE in Japan ... It's a global marketplace. Financial flows matter. The yield curve could also be reacting to that. But it can be changed from central bank policy shifts.
Brian Nick: All right. Well, I'll give you each one last question. Maybe 30 seconds to a minute each. We've been talking about our base case. What is it we think is going to happen? Is there something that you think could surprise, that's maybe a high probability, but not a base case event? Either for your asset class, the markets, the economic environment in 2019? I'll start with you, Joe.
Joseph Higgins: I think it's not implausible that growth elsewhere in the world surprises somewhat to the upside, and brings the dollar down, and that the world gets more balanced. I would say it's not a majority likelihood, but it's not something higher than 10% or 20%, as well. For example, in Europe, we have a lot of weakness that has come about in Germany from remodeling of auto plants, and a lot of weakness maybe cyclical rather than long-term decline out of Asia as well as Europe. It's possible.
Brian Nick: John?
John Miller: Well, I think, again, not the base case, but a possible positive surprise, as we've discussed here, is if the Fed doesn't raise rates in 2019. That would be ... They've starting to give themselves a little bit of leeway as possibly doing that, without making themselves look like they reversed themselves. That could be a linchpin to help financial markets generally, and even to extend this growth phase into another phase without tripping into another recession.
Brian Nick: Two positive surprises so far. Bob, do you want to go three-for-three?
Robert Doll: I'll do a positive and a negative, inside of 30 seconds. How's that? Positive is, consistent with what these guys have said, the economy does okay. I mean, right now, the mood in the market is the economy is dying. If the economy just does okay, it doesn't have to be great, and we have decent, above-average earnings, I think stocks worldwide will be a pretty good place to be. The other side of that is if inflation rears its ugly head. We've talked about a lot of reasons why inflation seems to be quieting down, but I come back to that labor issue. If that gets a head of steam, then the Fed is between a rock and a hard place. I don't think that's about 50%, but it's not zero.
Brian Nick: It's certainly hard to find people in the market who think the Fed is dangerously behind the curve at this point, so things being what they are, maybe that ends up being a risk that we're not appreciating at the moment. Although, I think it's fair to say everybody's in agreement that maybe the Fed is right on, or maybe even slightly ahead at this point.
Brian Nick: We're going to have to leave it there. We're getting up right against time. Bob, John, Joe, thank you so much for joining us today. Thank you to our audience for participating. I know we weren't able to get to all of your questions, so if you have a topic you'd like to discuss, you can reach out to your Nuveen relationship manager, or visit nuveen.com. You should also know there will be a replay available of this event on Nuveen's website, as well as on Asset TV. Additionally, Nuveen's full 2019 outlook, by our colleagues from across Nuveen, and representing a variety of other market sectors, will be available next week on nuveen.com. Thank you again for viewing today.