July 18, 2019
Jeffrey Schulze: ClearBridge is a global equity manager with 147 billion in assets under management committed to delivering long-term results through authentic active management. ClearBridge tailors our strategies to meet three primary climate objectives in our areas of proven expertise, high active share, income solutions, and low volatility. We integrate ESG considerations into our fundamental research process across all strategies. Well, 2018 has been quite [00:00:30] a year as volatility has returned to equity markets while trade tensions with China and the just completed midterm elections have driven the geopolitical debate. As we sit down here at the end of November, despite several drawdowns, the secular bull market remains intact while our economic expansion is showing few signs of distress.
Jeffrey Schulze: I want to start off on volatility, first and foremost because that's the new thing that's been introduced to the markets in 2018. In fact, in 2017, the biggest drawdown that we saw throughout the course of the year was 3%. We've already [00:01:00] had two 10% corrections this year alone. So a key question, is volatility returning back to the market for good? I'm happy to be here today with my colleagues Margaret Vitrano, portfolio manager for the large-cap growth and all-cap growth strategies, Scott Glasser, co-chief investment officer and portfolio managers for the appreciation and dividend strategies, and Michael Testorf, CFA, portfolio manager for the international growth and global growth strategies.
Jeffrey Schulze: Scott, did you want to weigh in on whether or not volatility [00:01:30] is back for the rest of this cycle?
Scott Glasser: Sure. I think it's important to put this in historical context. You mentioned that last year there was one 3% drawdown. By historical standards, that's extremely rare. As a matter of fact, since we entered a period of ultra-low rates after the Fed took rates essentially to zero, we've been in an extended period of time, essentially since 2008, of low volatility. The effect of very [00:02:00] low interest rates, the effect of a reduction in the term premium in bonds has had the effect of muting volatility across the spectrum. Equities have seen very few drawdowns over the last 10 years. We've been in a period of abnormal volatility. I think we're returning back towards more normal volatility as interest rates start to rise, as the Fed comes out of this per of ultra-low interest rates or near-zero interest rates. [00:02:30] So I think, yes, investors should expect volatility to climb from here.
Scott Glasser: But I think it's only going back to a period of normal. The problem is we've been in a period where it's been so abnormally low that it feels like it's something more than it actually is. Now, as a portfolio manager, volatility, I think, is a good thing. It actually doesn't bother me. Volatility, from a portfolio management standpoint, gives you the opportunity to add, subtract, to do things in a portfolio [00:03:00] that you think adds value for a client over time. Every portfolio management team generally works on what we call a secondary buy list, a list of stocks that they hope to buy someday. They've done the work but maybe the valuations aren't what they want.
Scott Glasser: A lot of times, in these drawdowns, you have the opportunity to add a stock that comes down because the market as a whole comes down. It comes down for liquidity reasons, not particularly company-specific reasons. That's when you go [00:03:30] to your secondary buy list and you're able to add something. Conversely, you always have something that didn't work out the way that you expected. A lot of times you can swap those. Yes, you're swapping out of the beaten down stock but you're entering into, also, a beaten-down stock, hopefully, with better fundamental expectations going forward. Volatility to me, A, is going back to normal. It should be expected. And B, gives an opportunity for a portfolio managers to distinguish themselves and actually be more active, [00:04:00] be a little bit more active.
Jeffrey Schulze: So most investors are scared of volatility but it's an asset for an active manager?
Scott Glasser: I thrive on volatility. I love volatility.
Jeffrey Schulze: Michael, what are your thoughts? Do you think volatility is going to continue to rise from here?
Michael Testorf: Absolutely. I do believe, as Scott said, that volatility is to stay with us. On the international side, we have a few things more to worry just ... not only about the Fed. We do have the slowdown in China. We do have an Italian budget discussion. [00:04:30] We have Brexit. Let's go from the back to the front. Brexit, we have a withdrawal agreement decided by the EU 27 already. Theresa May agreed on that, too. But the real problem is to get it through the lower house. That will happen in the next weeks. It might not pass in the first run, might pass on the second run. But that is the deal the EU would offer. I think there would be no alternative to that, otherwise, we have a hard Brexit, which I personally do not believe [00:05:00] in.
Michael Testorf: Then, Italy, there is a populist government in place right now. They're on confrontational course with the EU, within the European Union about their budget proposal. Here, it looks like that we'd come to a kind of compromise. The governments have signaled that they would not be as stubborn as they have been originally. China, which is, for me, on the international side, by far the biggest issue. [00:05:30] The trade issue, hopefully, will ease up a little bit. We have the G20 meeting coming up and I hope to get some positive news on it.
Jeffrey Schulze: You mentioned trade issues. That's been a big source of volatility here recently. It shouldn't be any surprise to investors, as Donald Trump campaigned about reworking some of the trade agreements that we've had. The reality has come due here in 2018. You mentioned the G20 meeting later this week. If some sign of accord can get forged there, obviously, financial markets would like [00:06:00] that. But if there is no agreement, on January 1, the 10% tariff on the $200 billion worth of goods that went into place last month will go up to 25%. So you do have the potential for escalation. Margaret, do you think that we're going to get to some sort of resolution from a trade perspective or is it going to continue to be a headwind for companies with international exposure?
Margaret Vitran: I'm not quite as optimistic as Michael that we'll have a near-term resolution in our discussions with China. I think it's bigger and broader [00:06:30] than just what the final tariff rate is going to be. Regardless of what comes out of the next G20 meeting, I think we're in for a period of frostier relations with China. For us, as we think about the portfolio, we think about direct impacts and indirect impacts. The direct impacts are obviously higher tariffs. Most of our portfolio companies are talking about trying to pass along those higher costs to consumers. Caterpillar's talking about that. Grainger is talking about that. That just means slight [00:07:00] inflation and slight headwind to the US economy.
Margaret Vitran: What I think is more troublesome and more material, potentially longer term, is the indirect impact. That really comes through in translation impacts, the impacts of a stronger dollar, and in business confidence. The more CEOs are worried about that impact of China and those frostier relations with China, and the more that that is a deterrent to them spending, that's not great for the US economy. That's the thing that we're asking [00:07:30] our portfolio companies about.
Jeffrey Schulze: You've certainly seen CapEx come down dramatically from the face that we saw in Q1. Michael, any thoughts on trade tensions?
Michael Testorf: Well, I'm not super bullish on the G20 meeting. I just have to rephrase that a little bit. From my point, just a little bit of an improvement, a delay of the 25% to a later point, would make markets already move. Because the markets are so sensitive what the relation is between the United States and China. For us on the international [00:08:00] side, it's even more important because, when you think about it, China was a growth engine over the last 15 years for the world economy and, in particular, for the international markets. Because they were the major consumer of resources over the last 15 years. In some cases they made 50% of the entire demand for certain resources, which helps certain emerging markets but also some of the developed markets like Canada or Australia, which are very resource-driven.
Michael Testorf: Then, if you build up the entire production chain in [00:08:30] China ... I mean, you were buying goods from whatever, from Germany or Europe in general, from Japan, South Korea, and so on and so on. Therefore, the impact is much, much bigger. If you were looking at United States exports to emerging markets, it's only half what Europe would be, for example. So far, the impact were not as massive, were only a few tenths of a percentage point in terms of GDP growth. But the sentiment is the critical part. Right? Originally, we were thinking about [00:09:00] because utilization rates are relatively high by now, that people go into CapEx spending. CapEx spending actually hasn't really happened as we were originally forecasting. I think the sentiment is what brought international markets down this year, together with currency.
Jeffrey Schulze: Did you want to add something to that?
Scott Glasser: I do. I do. I think that one of the things that the markets have a hard time with is just the unknown. Right? We don't know what it's going to be, and so companies can't plan. It goes to CapEx. It comes to budgeting. [00:09:30] It goes to a lot of different parts of their business. If there's clarity on, okay, what the tariffs are and what they're not, where they're going to be, companies have a pretty good ability to reroute. Whether it be manufacturing ... There are costs involved. But they can react and then deal with it. But not knowing what it's going to be and kind of having it play out over a longer time is the difficulty for the markets to interpret. That lack of clarity, I think, is what kind of hangs over the markets more [00:10:00] than anything.
Jeffrey Schulze: I do think that there's a natural limit to how long these trade talks will continue. If you think about Donald Trump and his re-election bid in 2020, I'm sure he's willing to accept a little bit of a market volatility, maybe some economic weakness to the middle part of 2019. But as we move closer and closer to 2020, I would imagine that the risk-reward or the upside-downside of a trade deal actually comes a lot more in favor of having one rather than not. But if trade wars continue to escalate, [00:10:30] it's going to hurt the earnings picture. We've had very robust earnings here in the US because of tax cuts. But with tax cuts waning, is that going to weigh on the earnings picture in 2019? What's really going to drive growth and cash flow? Margaret, I'll start with you.
Margaret Vitran: 10:47 Well, you're right. We've been in a period of very good earnings growth and it's hard to imagine, broadly speaking, that margins are going that much higher. It's also hard to imagine that we're going to have buybacks at the same level that we've had in 2018 in 2019. [00:11:00] I'm going to take us back to CapEx because what you really need is to see revenue growth. You need the multiplier effect of companies spending and good consumers confidence and good business confidence to keep things moving in the US. I do think it's relevant to remember that tax reform ... Part of tax reform included immediate write-offs on CapEx, so that made it more attractive for companies to spend. When you think about what companies are spending on, it's not just [00:11:30] diggers and factories. It's enterprise software. It's technology. Those kinds of investments, I think will have a multiplier effect that I'm hopeful will help us in 2019.
Jeffrey Schulze: Scott, any perspective?
Scott Glasser: It's interesting. If you look at the effect of the US tax cuts and also the repatriation that happened and continues to happen, it's very consistent with what we saw in 2003 and then a couple of years later with the repatriation. Meaning that in both cases [00:12:00] they were front-loaded tax cuts, where the benefits accrued both to individuals and corporations pretty immediately. It lowered the cost of capital in different ways but still had the effect of lowering the cost of capital. You saw a six- to eight-quarter benefit and then you saw growth revert back down to what it was pre-tax cut. That's exactly what we're seeing here. So you got to bump up last year. S&P profits [00:12:30] were up mid-20s, 23, 24, 25%. You now have growth reverting back more to where it was.
Scott Glasser: We've got some trade issues, which I think is probably depressing growth a little bit more than otherwise. We talked about some of the effects of that on CapEx and spending. So you have overall S&P profit growth probably coming in right now, consensus, at 7 or 8%. The question's going to be, is that 7 or 8% kind of revert [00:13:00] down to 4 or 5% or lower. It'll still be decent growth. Don't forget, the 100 year average of S&P growth is, what, 5 or 6%, something around that number. So it'll still be good growth. It's the fact that we're coming off such a high level and the second derivative or the rate of growth is declining that, generally, markets kind of struggle with until they kind of feel comfortable with that rate.
Scott Glasser: We haven't gotten to the point where people have a better sense of, "Okay, what's the baseline going to be [00:13:30] this next year?" I think once we do that, people will be better off. I think the key's going to be, though ... When you come off higher growth years where I think most of us would argue a lot of the returns last year were based on this higher growth rate. You saw some multiple compression but you saw 25% earnings growth. What will be key this year is within a lower tax rate, what's the ability of companies to supplement [00:14:00] that growth, either with strong capital management ... It could be share buybacks. It could be dividend increases. M&A, which has continued to pick up and I think will be a important theme during 2019.
Scott Glasser: Then, you're going to have very product-specific product stories or restructurings that are going to be attractive. Growth may be lower but they'll be places where the growth will be either better or it will be supplemented by these other factors [00:14:30] that I think as portfolio managers, that is what we have to focus in on and that's what will kind of supplement the growth as we go to a lower growth environment.
Jeffrey Schulze: Yeah. I think, personally, that if we can maintain revenue growth close to where we are right now ... Revenue growth was 8% year over year in the third quarter, which has been above trend. If we can stay at 6 or 7% revenue growth, I think you can continue to see an earnings picture that hits expectations. In my opinion, it all really comes back to the consumers. If you look at total cash earnings from a consumer perspective, and that takes [00:15:00] hours of work into consideration plus wage gains, it's at 5.5% year over year, which is the highest that we've seen throughout this entire recovery.
Jeffrey Schulze: You put into effect, also, that the consumers are going to have 60 billion extra in their pockets next year versus this year because of tax cuts, and now that oil's down 25% from highs a couple of months ago, I think there's going to be some extra money floating in the consumers' pockets that they can spend and keep revenue growth above trend. But, obviously, we've had a pretty big drawdown here recently. With drawdowns, [00:15:30] it creates opportunities from a sector and an individual company level. Now, Margaret, I know that you and Peter have been talking recently about the opportunity and information technology. What are seeing in that space?
Margaret Vitran: Yeah. Well, we've been more defensively positioned in tech for a little over a year or so. But now, you have certain subsectors of tech that are down more than 2X the overall market. To Scott's point before about the volatility creating opportunity, I think the volatility is creating some opportunity in tech. I think [00:16:00] it's also worth noting that many of the other sectors in the S&P, whether it's interest rate concerns or consumers credit being at all-time lows and us worrying that it's going to get worse from here, or the housing cycle potentially winding down, or inflation, or emerging markets exposure. Tech, conveniently, doesn't have exposure to a lot of those potential headwinds so there's a little bit less vulnerability to some of the bigger issues that we're all talking about.
Jeffrey Schulze: I also think there's a misconception out there [00:16:30] that tech has been fueled on speculation like the dot-com bubble in the 2000s. In fact, if you look since the March '09 lows, 90% of information technology's returns have been driven by earnings, only 10% through PE expansion.
Margaret Vitran: The returns in those businesses are very, very good.
Jeffrey Schulze: Scott, any thoughts? Any sector that you think is attractive right now?
Scott Glasser: I see opportunities across sectors. I think it's interesting. A lot of people talk about growth versus value. The growth stocks, obviously, have been [00:17:00] driven by technology. Technology was the best sector-
Scott Glasser: -driven by technology. Technology was the best sector. Had driven returns over the last couple of years, quite honestly. I do see a bifurcation in that market. Meaning, it's not just technology. Just can't say technology. You really need to know where you're playing in technology. And so, there's a bifurcation. It's not everything in technology. Things with cloud, some internet storage. There's certain areas that are better markets [00:17:30] than others in technology. But I see opportunities across the spectrum.
Scott Glasser: I think what's happened is that you actually hear, which I find amazing, talk about recession now. A lot of cyclical companies have actually sold off as if we're going into a recession. But yet when you look at the economic data, it's not there. It doesn't ... there's no support for that argument, I would argue. Slower growth, yes. A recession, [00:18:00] no. But yet again, a lot of the cyclical companies have sold off as if we're going into recession. Those evaluations on the more value-oriented sectors reflect that. So, I think that we're just going back to that 4.2 peak GDP back to 2-3%. And those companies, which had been oversold on the downside, in sectors like industrials. In sectors like financials. I think that, again, you can go [00:18:30] through sector by sector, but there's a number of opportunities.
Scott Glasser: Let me ask you this question. I'll turn the tables on you. You've done a lot of work on the economic outlook, and that's your primary focus. You've created something called the Clear Bridge Economic Dashboard. What are you seeing in terms of the outlook economically?
Jeffrey Schulze: Well, we will have a recession. I just don't think the recession's going to come in the next 12 months. [00:19:00] I think investors have this preconceived notion that an economic cycle has an expiration date or a sell-by date, and in fact, that's usually been true here in the U.S. But even though we're in the 10th year of this expansion, there's been several expansions outside of our borders that have lasted a lot longer.
Jeffrey Schulze: So if you look at the U.K. and Canada, each of those countries had a 16-year expansion from 1992 through 2008. The Japanese had a 17-year expansion from 1975 through 1992. And the Australians are currently in their 27th year of expansion. [00:19:30] They have not had a recession since 1992. So there's not necessarily a sell-by date that you need to get out of the markets because the economy's going to roll over.
Jeffrey Schulze: But the one thing that gives us confidence that this cycle will continue to move forward is that we share similar characteristics with those cycles. First off, we have a flatter Phillips curve. What that means is, is when the unemployment rate goes down, wage growth doesn't spike up. And usually when wage growth spikes us because it's the biggest determinant of inflation, central banks tighten policy too much and end up choking off the recovery. This time around, [00:20:00] we have a little bit of flexibility where the fed can normalize and not necessarily go too far.
Jeffrey Schulze: We have stronger financial regulations because of Dodd-Frank, our banks are probably in the best shape they've been in in over the last 30 years. So it's a really good foundation for the economy to sit on. And then lastly, there's no obvious financial imbalance out there. AKA, a bubble that's going to pop and bring down the economy along with it. So because of those dynamics, we think that this is going to continue to last for the next 12 months at a minimum.
Jeffrey Schulze: And you mention this, Scott, the economic dashboard does say [00:20:30] the same exact thing. If you look at the chart in front of you, it looks across the four fault lines of the economy. It looks at the financial stresses. Usually, financial stresses will emanate in those markets before the economy rolls over. We look at inflation. The fed looks at inflation, so it's something we want to be cognizant of. Looks at consumer health. It's the biggest part of our dashboard and it's because it's the biggest part of our economy. And then lastly, we look at business activity. Business is higher. They do cap backs and that has a multiplier effect on Main Street and with the stop light analogy meaning green is good, yellow is caution, red [00:21:00] it bad. We have 11 green, one yellow and zero red, which gives us the confidence that this cycle's going to continue for at least the next 12 months. So we've talked a bit about the U.S. markets. Let's move over to the international space.
Michael Testorf: Okay, my turn again.
Jeffrey Schulze: So let's talk about earnings trends in Europe, the U.K., Japan and will valuations catch up here to the U.S.?
Michael Testorf: So, Scott you were mentioning we are coming down from very, very high level. The U.S., without any doubt was a rockstar in 2018. [00:21:30] What what we will see in 2019, and I just take EPS numbers, right? In order to be as neutral as possible. So, U.S. EPS numbers are somewhere around the eight level for 2018, potentially increasing slightly for 2020 for ten, right?
Scott Glasser: Just for clarity, those are consensus, EPS numbers?
Michael Testorf: That's right. EPS consensus numbers. Sorry, yes. So, and Europe had already several downgrades over the last quarter. In particular in the last one. The [00:22:00] ECB policy overall, the stimulus in Europe started much much later than in the U.S. So with the benefits of all this QE program is coming later in Europe and in other regions as well.
Michael Testorf: So, IBIS is forecasting for next year, actually, around 10 percent for the Eurozone and then 9 percent for the year after. UK in a little bit difficult situation because of the Brexit situation is more thinking about [00:22:30] 7. And then in 2025, Japan is a very slow growing economy anyway to start with. It's somewhere around 7 for 2019. Five for the year after. The ones which are in double digit over both series are emerging markets. So this is what IBIS is saying, and I think critical to see when this whole trend is turning is looking at revision ratios. So if we have upgrades [00:23:00] versus downgrades, and right now we're in below [inaudible 00:23:03]. We have more downgrades than upgrades. This is exactly what we talked about the sentiment issue. I mean, all of us agree on that for sure. And it looks like that we have to watch when it's bottoming out. You have had a really tough time over the last whatever few months. Could there be a bottoming out somewhere? Yeah. Perhaps. It's possible. But that would be more 2019 story, rather than the end of 2018 [00:23:30] now.
Michael Testorf: So, the second part of your question was can international markets, evaluations catch up with the U.S.? So that would be, I think kind of wishful thinking if that is going to happen. Historically, always the U.S. was leading in terms of overall evaluations. But there are also certain reasons to that. One is clearly the composition of the index like S&P 500 has much more technology in there. Much more high growth, whereas much more of the indexes worldwide... some of [00:24:00] them are actually value-oriented. Some of them are a mix of this. The other part of this is what the U.S. always had over international market. They had a much higher ROE, return on equity. So, historically, it was around 5, 6%. That's where we are currently, as well. Part of that is because it's higher gross. They have less equity as a gross environment. But the other part is actually that the U.S. really done it very smartly and leveled up the balance sheet. [00:24:30] The chair buybacks put additional debt on the balance sheet, brought equities back, reduced the equity exposure and got a higher ROE just via that measure.
Michael Testorf: So could international companies do the same? The answer is yet, it could. Because when you look at balance sheets of international companies, if you look at a 30-year-average, and you're for example, below a 30-year-average. Japan, we're on [00:25:00] historical lows. Actually, we have a lot of cash. It's sitting there and it's diluting the ROE. And with higher ROE, you get of course, higher valuations.
Michael Testorf: The other part is cash flow. U.S. companies have managed a cash flow always better than international companies. That is... working in capitol management and so on, could international companies catch up a little bit? Yes. I think that's possible, too. But will there be always a gap? Yes. [00:25:30] So, I mean, unfortunately I have to give that to U.S. here.
Scott Glasser: But you're seeing... you're seeing progress in share [inaudible 00:25:38] purchase as an example. That is something that has supported the U.S. market for a period of time that you're seeing kind of more evidence of in international markets.
Michael Testorf: The short answer is yes. Also because the international markets had a very, very deep crisis. A deep financial crisis. And they're in general, a little bit more conservative and they need a [00:26:00] little bit longer to improve and then feel comfortable to do share buy backs.
Jeffrey Schulze: And Michael you mentioned the composition of the NDCs being different, US being more growth oriented. Europe, Japan being a little more value-centric. We've actually done some work on this, and we normalize so you have the same amount of IT exposure in the U.S. versus Europe. And even when you normalize the two markets, the U.S. is trading one PE higher than Europe. So that would actually bode if you do see a turnaround in Europe, maybe some potential higher valuations, [00:26:30] broadly speaking.
Jeffrey Schulze: But one of the reasons why I think Europe and international markets could turn around is because of liquidity. Central banks still have their foot on the accelerator broad, and Scott this is a topic that you speak about quite a bit. Can you talk a little bit about liquidity? What is it? And where are we in the liquidity cycle?
Scott Glasser: Liquidity is defined in many different ways. And I believe very strongly studying financial markets that kind [00:27:00] of liquidity is the key to bull and bear markets. And that when liquidity is ample, in fact, that creates an enormous ability for asset prices to rise. It creates the NDC conditions or the background conditions for assets to rise. And then, when liquidity starts to tighten, it creates a much more difficult environment for all asset categories. And essentially that too tight liquidity [00:27:30] results in a slowing of growth, basically, ultimately bear markets and recessions. Or recessions and bear markets. Bear markets obviously being a reflection of that recession. And so, liquidity to me is incredibly important to monitor. More so, I would argue than earnings. Because earnings, again, I would argue in this evolution is earnings are kind of driven by the liquidity environment. And so liquidity is not just [00:28:00] the fed.
Scott Glasser: Liquidity is clearly, and the fed is a key component of that, the fed funds rate is a key component of that. But liquidity is a company's ability and access to capitol. And, that can be monitored through looking at spreads. Now, we have charges that look at high-yield spreads relative to the 10-year treasury. We can look at the triple B relative to again, the 10-year treasury. There are lots of ways in terms of spreads, swap spreads, [00:28:30] to look at basically how cheap is money and what's cost of money, and how available is it?
Scott Glasser: Liquidity can also be the U.S. dollar. If the U.S. dollar is higher, because so many goods around the world are priced in U.S. dollars, that's actually a high cost. And when the dollar's coming down, that provides more ample. And when it's up, that kind of provides a head wind. Again, because raw materials and oil is priced in dollars around the world.
Jeffrey Schulze: There's 11 trillion dollars in U.S. dollars and [inaudible 00:28:58] outside of our borders. So if the dollar's [00:29:00] strengthening, servicing that debt gets a lot harder.
Scott Glasser: Right. So the dollar plays a part in liquidity, energy, oil. Plays a card in liquidity. Raw materials do. Spreads do. The fed funds do. All these things kind of paint to whether the picture is easy or tight. So, I think that that's the one variable as we go forward over the next, you know 6-18 months that we really need to focus in on.
Scott Glasser: I'll give you another example of liquidity, which is the fed. The fed is actually starting to contract its balance sheet. [00:29:30] So, that's a slight negative in terms of liquidity. So when you look at the liquidity picture now, I would argue that it's tighter than it's been. We had as we talked about, ample liquidity. We're coming out of that period of kind of easy, free costless money. And we're going into a more normal environment. That is a tightening of liquidity by itself.
Scott Glasser: You know, the fed's shrinking the balance sheet. You have interest rates going up. It is not yet in both your work, and my estimation, it has not turned ... again, [00:30:00] using your analogy, the stoplight from green to red. It is maybe a little tinge of yellow. Because if you look at spreads, spreads have tightened. But they've tightened from ultra all-time tights. They've come out a little. If you look at fed funds, yes it's up from where it was. But from ultra low starting point. So, you've come off an extreme back towards a normal. It's not yet a worry, but it's something to [00:30:30] watch. Because ultimately liquidity, again I would argue, is the prime determinant of both bull and bear markets.
Jeffrey Schulze: This is the prime reason why we've seen some volatility here over the last couple months.
Scott Glasser: And I think it adds to the volatility, absolutely.
Jeffrey Schulze: Now, you mentioned the U.S. dollar being a very big component of the liquidity picture. Obviously, when the dollar strengthens, liquidity tends to tighten or go away. When the dollar weakens, liquidity gets more abundant. We've seen the dollar shrink throughout the course of this year, which is a stark contract to what we saw in 2017. What's [00:31:00] your outlook from a currency perspective? And how will that impact stock returns? Margaret, I'll turn to you.
Margaret Vitran: Well, Michael is probably more of an expert in terms of forecasting currencies. As a U.S. large cap investor, we don't spend a lot of time trying to figure out what specific currencies are going to move what way in 2019. But we do spend a lot of time trying to think about, where's our risk? How much risk do we have in Brazil between companies that have all of their revenues in Brazil and companies that make a portion of their revenues [00:31:30] in Brazil. Companies that may have that second derivative impact of changes in the Brazilian economy. So we think about it in terms of that and making sure that we have good diversification. That we don't have too much exposure to some of these markets that have good growth, but also have a lot of volatility.
Jeffrey Schulze: Sorry, Michael. Margaret put you on the spot there that you had some comments on the U.S. dollar?
Michael Testorf: For us, the currency is super super important. At the end of the day, the total return from our shareholders is a combination of the local stock markets [00:32:00] and the return on the currency. So 2017, as you said, we had a fantastic year. 2018, we have headwinds from both sides. Local stock markets, as proper currency. So the question mark is what will happen to 2019? I just want to go through a few little pieces which could determine which direction we're going. One is more a technical thing. Positioning in this whole risk of mode was clearly we go back to the U.S. dollar from [00:32:30] foreign currency into U.S. We are today in terms of long position speculative, long positions, U.S. dollar close to all time highs. If you are the contrarian view, you would be on the other side, right? You would be short the dollar at one point in time.
Jeffrey Schulze: Which is what markets were coming in to 2018?
Michael Testorf: Yeah. So, the next step would be what happens to interest rate differentials? Somewhere at the beginning of 2019, we're probably going to see the peak of interest [00:33:00] rate differentials. For example, U.S. dollar and euro. We are in different stages, as I said earlier, in terms of central bank policy. So in the U.S., the fed has finished QE already. We're in quantitative tightening mode, as you said Scott. In Europe we are still in qualitative easing mode until the end of this year. And we'll stop QE beginning January 1st. But that doesn't mean that liquidity will get tighter in Europe. It [00:33:30] will actually, the Central Bank, the ECB will continue to get enough liquidity and one, which I would expect, and two, which is a facility for the banks, which is called TLTRO. And that will be given because once it runs out, they want to make sure that there's enough liquidity in the system.
Michael Testorf: I think that would be one. From the liquidity side, I think the ECB would be easy for the whole year, 2019. We'll start the first little increase towards 2019. [00:34:00] But that is a lot of negative territory into positive-
Michael Testorf: In 2019, but that is out of negative territory and deposit into still negative territory. 2020 we will see the first time positive interest rates in Europe. That's at least what consensus here is building into the forecast course. Bank of Japan, was very easy so far and it looks like it will continue. We will still be around the zero level and liquidity is still ample. We get, we still get the green light, Jeff, on central banks internationally. China [00:34:30] press, we talk about that later, but there are back to QE from tightening. That also brought the Chinese market down because they took liquidity out of the market. Credit growth was slower, clearly slower, and is coming back with their measures they took just recently. The other part is when I look at currencies, I look at GDP differentials.
Michael Testorf: So here clearly the US was the rockstar again in 2018. [00:35:00] Going forward in 2019-2020, we're converging. The US will still leading, but the gap between US and Europe or Japan will close a little bit and emerging market, interestingly, I think could accelerate if we're not going in a totally full out blown trade war, which I do not hope for. Then the other ones are a little bit more on the current account deficit in the US, which is pretty high. The [00:35:30] US has to issue a lot of that in order to finance the tax cuts, which we have seen here in 2018 going into 2019. Could that be also slightly negative for the US dollar? So the more we go into 2019, to sum up that point is, the more we go into 2019, I could see that the US dollar starting to weaken again.
Scott Glasser: So you're saying the international countries may have more financial discipline than the US over the course of the next year?
Michael Testorf: I wouldn't call it necessarily [00:36:00] financial discipline because also ECB and the BOJ have widened their balance sheet quite dramatically.
Scott Glasser: QE on steroids.
Michael Testorf: Right. I wouldn't call it discipline per se, but for the reasons that I mentioned, I could see the US dollar somewhere in 2019 getting weaker again.
Jeffrey Schulze: I wouldn't be a surprise to me to see a dovish fed surprise. I mean if you listen to the narrative of all fed committee members, they've turned a little bit more dovish recently. They've changed their tone. [00:36:30] Then also if you look at inflation and even with four percent growth in the second quarter, we've seen peak inflation, inflation from a core PCE perspective is starting to come down, and with oil down 25 percent from the recent highs. Inflation is not going to be an issue in the near term, that allows them the breathing room to potentially take a pause in March or maybe in June, but US dollar obviously is, one of the reasons why the US has outperformed most other global markets in 2018. What makes you optimistic about the potential returns for international [00:37:00] developed markets and then also emerging markets like China as well? I'm going to start with you.
Michael Testorf: Me again. Okay, good, so let's start with positioning first of all again. Clearly, with the kind of risk of more people just [inaudible 00:37:14] sold emerging markets first, Europe second and this money went into either different [inaudible 00:37:21] classes but all of them US dollar denominated, and the only country where we have really seen inflows was Japan. Being [00:37:30] contrarian again, that will be a positive for international markets. The other part is actually valuations. I don't want to see look into in terms of absolute or absolute levels of PE's or price to books. I prefer actually because the valuations are always lower in international markets to look versus history of the respective regions. If you look backwards 30 years, you see that PE's, and it's similar to a price [00:38:00] to book and other measures, that Europe is roughly seven percent cheap over 30 year average.
Michael Testorf: The emerging markets are currently 15 percent cheap and Japan, if you were doing that exercise, is actually 45 percent cheap. That sounds like a lot for Japan, but it's because at the beginning we had extreme high multiples. We just came out of the bubble of Japan, which is lifting, lifting the overall average, so, but even if we were doing that over a shorter period of time, even Japan looks relatively cheap, so that is the [00:38:30] part of valuation. Central banks, I elaborated a little bit before, so liquidity is there for the ECB and Europe. It would be the case for Japan, and the big one for us on the international side is China. China itself has done several things over the last month, being pretty tight in 2017, going into 2018, because they wanted to [00:39:00] make sure that there is not too many of the bad loans that were restrictive.
Michael Testorf: So 2018, with the whole trade war, they started to go the other way around. They used one measure which is called the RRR, which is the reserve requirement ratio, which basically allows banks to lend more for the capital they have. They have done already 150, 100 are in the making, so we're talking about 250 basis points, which is a lot. The [inaudible 00:05:28], which is the [00:39:30] short term rate which went from five to three. We had overall financial condition ratios, which are, as is just a chart which a lot of people use, went from 75 to 90, 90 being higher, being more easy. What it does, it should lead to higher [inaudible 00:39:53] growth. It should lead to better overall growth in the economy, but in there is the banking [00:40:00] system and the banking system has to give more loans and that has not really happened to the full extent as it did in the last cycles.
Michael Testorf: We have seen first little steps, but going into 2019, the Chinese government would put a little bit more pressure on the overall banks and will enforce lending. I would expect for 2019 the overall liquidity in 2019 for China to improve again. That will be a positive and a lot of investors [00:40:30] are asking already, ah, it's not really working yet. Therefore, should we come with fixed asset investments, which we have seen in every single crisis when China was on their knees, they said, okay, let's put a lot more money into fixed assets, which are, as you know-
Scott Glasser: Bridges, roads, structure.
Michael Testorf: Another airport or whatever, right? So they're are actually quite some projects on the table, but there couldn't be executed because there was not enough liquidity in the system, there was not enough banks [00:41:00] lending to them. FII, you will see picking up in 2019 the moment liquidity comes into the system.
Michael Testorf: So from that perspective, if China is doing relatively well as they did, or hopefully better from very badly, that will also be positive for the entire international market as I discussed before, because of the [inaudible 00:41:23] dependence. Then the next part would be how do actually the different parts of the [00:41:30] economy to consumers. Consumers are doing actually fairly well everywhere in the developed world. We're talking in Europe for example, we have already shortage in terms of skilled laborers in Germany and other northern European countries. We have wage growth is around three plus percent already. Japan. We're so tight in the labor market that applicant ratio to open jobs is skyrocketing. Also, even in Japan, we see [00:42:00] wage growth, so the consumer is actually doing fairly well and was never really that leveraged over the last years. That's a good thing. Then we have the corporate sector. Corporate sector is also doing relatively well because they have not put that much debt on it.
Michael Testorf: As I said before, we're below 30 year average in Europe, and we're at rock bottom in terms of leverage, meaning actually cash in Japan. From that [00:42:30] perspective, the base is actually relatively good. What we need is clearly we need better sentiment, and sentiment, I think trade could be one. Hopefully we will postpone the kind of 25 or will reduce it a little bit, although I do agree with you, Margaret. Margaret will be on technology. The fight will continue, and that the Americans will pushed for patent [00:43:00] preservation and protection. I think that will continue for many, many years to come. What I'm talking about, which should lead to a little bit better sentiment, is the edges, that they come for certain goods, which I could agree on. I mean, that's what I would like to see.
Jeffrey Schulze: Margaret, any perspective from a multinational [inaudible 00:43:19] exposure?
Margaret Vitran: I think Michael summed it up nicely when he said it really comes down to GDP differentials because when I think about investing in China or investing in Brazil, [00:43:30] some of these emerging markets, they obviously have higher risk profiles and they're obviously more volatile, but it's hard to fight with six percent GDP growth. So even if China slows a little bit, it's still a lot better than the US. So I think, you want to be prudent in terms of managing the risk of that, but I think there are some good long term value to investing in these volatile but faster growth through the cycle kinds of markets.
Jeffrey Schulze: And one key component that Michael, you had mentioned that I think is underestimated by participants right now is Chinese [00:44:00] stimulus.
Margaret Vitran: Yes. That's absolutely true.
Jeffrey Schulze: Through both monetary and fiscal levers. Believe it or not, they've done almost 40 measures of easing throughout the course of 2018. 40. It's a big number.
Margaret Vitran: I feel better with them on my side.
Jeffrey Schulze: The last time that they did stimulus like this was 2015. It took a little bit of time for the rubber to hit the road, but of course in 2016 international markets took off and they never looked back. I could very easily see a scenario going into early next year where that stimulus starts to work its way into the system. Global growth picks [00:44:30] up and financial markets will lead higher.
Scott Glasser: I thought I heard kind of a, maybe not explicit, but implicit argument for buying international growth on my left here.
Jeffrey Schulze: I think he was making a case for it.
Scott Glasser: And it makes sense. That's what I heard at least.
Jeffrey Schulze: Well, I think we're up on time. I appreciate you all joining me in the studio here today, but I want to just leave the viewers with one key takeaway. If there's one thing that you want the viewers to think about what's likely [00:45:00] to transpire or keep in front of their mind for 2019, what is it? And Margaret, I'll start with you.
Margaret Vitran: I would say that from our view, we are in the later stages of the economic cycle, but that doesn't mean that parts of the market can't continue to march higher. When you think about your portfolio, think about diversification and think about not having all of your eggs in one basket because I think that will serve you well in a market that's probably going to remain choppy and remain volatile, but can march higher.
Jeffrey Schulze: Scott?
Scott Glasser: I would focus [00:45:30] on, in the portfolios, I think that we, again, I'd agree we're in the later stages. Per your comments. It doesn't mean that can't extend for several more years. I don't think there are any signs of a recession, a slower growth, yes, but a recession, no. I think liquidity is something, as I mentioned, we need to continue to watch, but I think it's fine right now. In fact, as you heard, global liquidity is actually becoming, it is either expansive or becoming, [00:46:00] in the case of China, more expansive, and that's helpful as well. When I think about stocks and I think about the portfolio, I think that we are in the stage where there's certain periods of time where quality oriented stocks do better and quality oriented stocks do less well.
Scott Glasser: I think we're in that former stage where quality, as you come towards the later stage, when you've got these issues, when you've got more volatility, I think there is a preference for quality. So [00:46:30] my message to investors is, is stay diversified, as Margaret said, but also kind of lean towards that quality oriented portfolio. It's not the time per se to have the pedal to the metal. It's not 2003. It's not 2009 where things are cheap across the board and everything's going up. I think there's much more separation between the good and the bad and those that are actually performing [00:47:00] and not, so everything doesn't go up per se. The market will go up but everything doesn't go up per se. That I would be leaning towards consistency of ROE's, consistency of balance sheets. I think quality of balance sheet as we are in the later stages matters more and we've seen that more recently with the correction and quality overall. My comment would be lean towards quality in terms of your both stock and portfolio selections.
Jeffrey Schulze: And know what you own.
Scott Glasser: Always.
Jeffrey Schulze: Michael.
Michael Testorf: It's always good to be third, because I don't [00:47:30] have to talk about ... Margaret, thanks for diversification. That also applies actually for Internet-
Margaret Vitran: Over to you, Michael.
Michael Testorf: Not only in terms of sectors but it could be also in terms of regions and currencies and so on. I know that a lot of investors have a bias to which, towards home. That's also understandable because the obligations are normally in US dollar, but putting a little sliver of international here and there wouldn't hurt, [00:48:00] for the reasons which I was mentioning. Scott, I do agree with you that quality is probably the main focus if we're in the later part of the cycle. I think that also helps for us on the international strategies because we have a quality focus and I think what investors have to, in these kind of volatile times, have to be very evaluation focused. What we try to do in our international strategy is that we have a very strong [00:48:30] valuation approach to growth. We're not one to overpay for growth. If stocks are coming down, gives you by opportunities, and that's what we're trying to do. I think what investors should do as well, using some of the dips in quality stocks, and focus, even if the sentiment is sometimes a little bit bad, but that's normally the time when you look at the stocks.
Jeffrey Schulze: And maybe the one key takeaway that I'll say is that this is the sixth drawdown that we've had during this expansion [00:49:00] of 10 percent or greater, so it's not the first time that we've been here, but we're historically entering into to a very good timeframe from an equity market perspective. If you look at the year following the midterm elections, going all the way back to 1950, we've had 17 of those years, 17 for 17 times, the equity markets have been positive for that one year following the elections, with your average one year return of 15 point three percent. The reason why you've seen outsize gains during this year is because you've never seen a recession start in year three of a presidential [00:49:30] cycle. 2019 is year three of Trump's presidential cycle.
Jeffrey Schulze: So just not to be too bearish. Remember that the fundamental picture is still intact. US growth is slowing, earnings will slow, but it's going to be above trend. Then you have the potential for global growth reaccelerating over the course of 2019. Well, great. I want to thank all of you for joining me here in the studio today. I'm going to thank all of you for tuning in to the 2019 outlook. Hopefully we're able to give you some perspective on what's likely to transpire over the next 12 months. [00:50:00] From ClearBridge Investments, we hope everybody has a safe and happy holiday season and New Years and we look forward to having you back here sometime soon.
Jeffrey Schulze: Please note the following. Past performance is no guarantee of future results. The opinions and views expressed in today's podcast are of the individual speakers and not intended to be a forecast of future events, a guarantee of future results or investment advice. Any statistics referenced have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments [00:50:30] nor its information providers are responsible for any damages or losses arising from any use of this information.