Trade Wars: Phase One Implications
January 7, 2020
Rick Brink: Hello, everyone, and welcome. My name is Rick Brink, Market Strategist for AllianceBernstein. Welcome to our 2020 Outlook. I'm joined by some close friends and colleagues, Doug Peebles, CIO of Fixed Income, Eric Winograd, Chief US Economist, and Walt Czaiki, fellow Coloradan, Senior Equity Strategist. We're going to jump in right away. We're going to start with the "if things go according to plan question." We'll call it our base case. I'll start with you, Eric. If things go according to plan the US economy in 2020 will go like this.
Eric Winograd: Thanks, Rick. Honestly, it's a more difficult question to answer than you would think because we've spent most of 2019 with different parts of the US economy sending us very different signals about the forward outlook. I know we'll come back to that and talk about it a little bit more. When we bring all the information available together, when we synthesize it, what we see is an economy that looks in a lot of respects similar to this year, but perhaps a little bit slower.
We think that there are still some significant headwinds to growth. We think that the trade picture which remains unresolved and is likely to remain unresolved is a headwind. We think the electoral cycle is something that adds to uncertainty and is likely to limit business investment. Of course, the global economy is still quite weak.
We see those factors weighing down on growth. There are some positive offsets from the consumer and from monetary policy as well. It isn't a disastrous scenario by any stretch, but we're looking for growth to be closer to 1-1/2% in 2020 rather than the roughly 2% that we're going to get this year.
Rick Brink: In terms of inflation and Fed policy generally speaking?
Eric Winograd: Inflation has been something of a mystery over the course of this cycle because it hasn't risen as much as one would expect. We think that that's likely to still be the case. It may continue to grind slightly higher. It has done so over the course of this year, but we don't see inflation moving higher in the sort of way that would require a policy response and the FOMC doesn't see that either. They've been pretty clear that their expectation is that they won't move interest rates over the course of 2020.
We disagree a little bit because our growth forecast is more pessimistic than theirs is by a little bit. We do think that the odds favor rate cuts next year, limited rate cuts, but, again, it's very difficult to forecast and very uncertain given the differing signals we're getting from the economy.
Rick Brink: If I go outside of the United States, same thing, so sort of a base thought on developed markets outside of the US in terms of economic performance?
Eric Winograd: In the US, one of the things that I mentioned as a positive support for growth is monetary policy which we think has been effective this year in stabilizing growth and stands ready to do so again next year if necessary. You contrast that with Europe and Japan where they don't really have the scope to do that and not surprisingly, we think that the growth outlook in those two countries, in those two regions, it is not as positive.
We think growth in Europe and in Japan is going to be quite a bit slower than it is in the US. There are other places where the picture looks a little bit better. We think China's growth will remain stable for example, but outside of the US, the aggregate global economy is likely to be still quite slow next year.
Rick Brink: Okay. So, against, this backdrop, if I've got moderating growth, I've got generally accommodative policy, what does fixed income look like if we play according to plan?
Doug Peebles: I'm struck by Eric's notion that they were forecasting 1-1/2% growth in the United States and we think that the US is the growth engine of the world, right? I mean, that's pretty scary. It's not surprising that the Fed is leaning in a dovish mode and our forecast is maybe even more dovish than their dot plot suggests.
Whenever I look at the fixed income markets in December, end of December, beginning of January, I always start with the basic notion that the return in each of the sector is basically going to be the yield that you get over the year, and then I sort of listen to our research teams and adjust accordingly whether or not will rates will go down a little bit so we should get some capital gains on top of that. But we're at, even though 1-1/2% growth in the United States, the 10-year Treasury at this morning was at 1.8%.
That doesn't strike us as necessarily the wrong level for the US Treasury. I think that all things being equal, your forecast is 175 for the end of next year. That's right on spot on. That would indicate you get a 1.8% return in 10-year Treasuries. I think more important than looking at the Treasury market on its own is to look at it in conjunction with the other markets.
For the calendar year 2019, risk assets did spectacularly well, and Treasury returns were really good. Now, for two asset classes that are supposed to be negatively correlated, that doesn't mean they're always in opposite directions, but 2019 showed a situation where they both did really well. If you'd asked me, "Well, where are rates going to be more specifically than just, 'Okay, what's the coupon in a generic forecast out to the end of the year.'"
I would ask you a question and say, "Okay, if the equity market is up 12% next year, I think that odds are we'll probably be north of 2% on the 10-year Treasury." That means that the economy has done either a little bit more, better than we had expected or the Fed has been more aggressive maybe in line with our expectations and importantly, the market by the shape of the yield curve builds in optimism for the future. Because one of the things that really at the heart of the matter, is earnings growth going to be strong?
I think for a while the markets can price in a forward expectations of future earnings growth finally getting strong, but if you have consecutive years of earnings growth that's not particularly strong, it's going to be hard for risk assets to do well. The base case is coupon clipping in all of the markets, and importantly, don't be afraid of that duration because if I mentioned what happens if the equity market is up? 12%. If the equity market is down 15%, I see no reason why the 10-year Treasury can't go to let's say 1-1/4.
Then, depending on the up 12 or minus 12 or somewhere in between or a little bit outside of that on the equity market, I think high-yield or return-seeking fixed income assets are going to tend in excess return space to be in the direction of where is the equity market going. I'm sure we'll circle back around to talk about the credit cycle and all of that at a later date, but we don't really see anything out of the ordinary as we move into the next year, largely because monetary policy has been so accommodative around the world and maybe not terribly effective for the economies, but certainly effective for the bond markets.
Rick Brink: So, no pressure, Walt, but as you just heard Doug talk about everything hinges on what you're going to say about what the equity market is going to do for the rest of the questions in this panel, and so all right. We've got the moderating growth story, we've got the generally accommodative central bank story, we've got the roughly coupon to coupon plus with a lot of variance based on the things that Doug talked about, and then that leads us through to the equity market.
Walt, if equities go according to plan next year, what happens?
Walt Czaiki: I always love being the anchorperson, Rick. Thank you very much.
Doug Peebles: Clean up well.
Walt Czaiki: Absolutely. I'm from St. Louis so I'm all about baseball. So, initially, if we look at equity returns in terms of those expectations, Rick, Doug had mentioned in terms of earnings growth, we'll mention that earnings expectations have come down pretty substantially. If we look globally, if we just go back to March, the five-year forward expectation on earnings growth was somewhere in the 12% range. That's been marked down to about 9% globally, in the US, it's about eight if you take it out over the cycle.
But we know we are late-cycle and we've seen this year as an example. Expectations were higher and we saw those earnings fade, but I will note that we haven't seen the expectations be marked this low. It's pretty much in line with the 30-year average where we've seen expectations not being so high so that gives us some comfort, but we do have to acknowledge that we are late cycle. We do have some of base risks, and overtime expectations start to come in.
So, if we figure mid-single-digit on earnings, roughly 2% dividend yield, and we don't want to give a whole lot of expectation in terms of P/E multiples expanding, which I'll get into in a bit later. If you look at that, you're figuring maybe mid-single-digit to maybe high-single-digit returns if we're kind of in this base case expectation with no disasters as Eric, you alluded to.
The volatility that we saw really is reassert itself about this time last year. We think that persists. Eric highlighted some of the risks. We have global slowdown. We have Brexit. We have the US election. We have a number of things that are out there that could lead to heightened volatility in the continuation of that. You take that plus moderate expectations in terms of earnings growth with no P/E multiple expansion, that's how we get at this moderate growth rate, if you will, for equities for 2020. Good but not great.
Rick Brink: This sounds pretty benign and a happy sort of slowdown in growth coupon, coupon plus, mid-single digits on equity returns with dividends getting paid and reasonable but not too spectacular earnings growth.
Walt Czaiki: Right.
Rick Brink: But the Devil is in the details, and so now we move into the variance of potential outcomes and some of the tug of wars that are going on and there are some really prominent ones particularly macroeconomically. The big one that you've been talking about for some time is sort of what the labor market is signaling versus economic activity ICSM, et cetera, so let's start there.
Eric Winograd: Yeah. The base case is, as we've said, is sort of too soft land it, right? Where things slowed down, but it isn't disastrous, and when you aggregate the economic data together that's what it looks like, but when you look at these different sectors of the economy, we get really dramatically different signals. The manufacturing sector, anything really that is externally exposed, that is vulnerable to the trade war, looks pretty bad.
Manufacturing has had a very difficult year. We've seen most surveys of manufacturing confidence, surveys of business confidence. If you ask CEOs how they think the environment is, they'll tell you it's terrible. Right? That's reflected in the hard data around manufacturing which is quite weak in the US and quite weak globally.
Then, if you ask consumers what the situation looks like, they tell you it's fine. Right? No wonder, the unemployment rate is the lowest it's been since 1970, give or take. The labor market is very, very strong right now. We see this bifurcation that's really unusual between a manufacturing sector that tells you we're headed into a recession and a consumer and a labor market that tells you the opposite.
Okay, when you average it out, you get to this sort of soft landing, but one or another of those may prevail over the course of the year, right? It could be that the manufacturing sector weakness spills over, that firms really stop hiring and start laying people off and that cascades across the supply chain and down into the broader economy and things weaken or it could be that the consumer continues to hold up that the labor market is strong that because this is now much more a service-oriented economy than a manufacturing one, that there's enough strength there to pull manufacturing back out of the hole, right?
You could get an acceleration. It's extremely difficult to forecast which of those things is right. When you think about what that means from an investment perspective, well, we've been talking about most recently that's really striking is the equity market seems to believe in the consumer and the bond market seems to believe in manufacturing, right?
So, to the point about equities and bonds both performing well this year, both markets saw what they wanted to see, right? They looked through the information and found what worked for them and ran with it. There's no guarantee that that continues into the next year. There are a lot of sources of potential volatility even aside from that gap needing to be filled, if you will, from those two needing to converge.
The electoral cycle is the foremost one, but as you go into any year, there are always going to be unexpected events and how that impacts this sort of two-speed economy is very difficult to foresee. It leads to potentially very disparate outcomes.
Rick Brink: Can we hone in a little bit more on trade then? I mean, obviously, this is something that everyone is talking about. A lot of the recovery in the market that we saw starting in early October was based or predicated largely on a phase one trade deal potential and some other things. What is that in your mind practically mean in terms of getting us out of the woods or not getting us out of the woods and the way businesses react to it and so forth?
Eric Winograd: One of the ways where I think we're different from the market consensus is that we aren't as convinced as the market appears to be that a phase one trade deal necessarily signals the end of the trade war, right? The market seems to believe that once a Phase one deal is reached, it's only a matter of time before you come up with some sort of comprehensive deal that the likelihood of tariffs being reinstated or new tariffs or additional fronts in the trade war opened would be essentially zero after a phase one deal.
I'm not convinced. We're not convinced. I think part of that is that we view the trade war not as a cause necessarily so much as it is a symptom of the underlying political dynamic, which is a global move toward populism. Anti-trade policies, restrictive trade policies, trade wars are classic populist policies. The idea that in a populist moment, which is a global phenomenon if you look you, we reference Brexit earlier, but protests and strikes in France and the protests in Hong Kong, in Chile. There are populist movements gaining momentum all around the world.
In a populist moment, we think that the trade war and the tension that underlies it is likely to be persistent, even if there is a phase one trade deal reached. I would simply recall that about a year ago that, or over the course of the last year despite there being a trade deal between the US, Mexico, and Canada, the US administration threatened to put new tariffs on Mexico anyway as a result of some non-trade related policy.
We think that this is going to be persistent. We think that from a business investment perspective, in particular, the uncertainty around that matters, right? It isn't necessarily that there is a direct impact that businesses are looking and saying, "We expect new tariffs so we're not going to invest." It's simply that they don't know, right?
If you're looking at a 5-year investment horizon or a 10-year investment horizon and you don't know what the rules of the road are going to be, it's difficult to make that decision. We've seen businesses, we've seen capex come down. We've seen it make a negative contribution to GDP growth this year, which is extremely unusual outside of a recession. In a lot of respects, it's been good for the equity market because we know what businesses have been doing with that money rather than investing it.
Walt Czaiki: Oh, yeah.
Eric Winograd: Right? They've been capital engineering and capital structure arbitraging and buybacks and dividends and shareholder-friendly things, but from a long-term growth perspective, think about what that means. That's really sort of a depressing thing when a business executive gives money back to shareholders. It's essentially saying, "Hey, look, we don't really have anything good to do with this money. We don't know what to do with it. We don't have an investment channel for it, so you take it. Maybe you've got something better to do with it."
It feels great in the short-term, but in the long-term, it limits the productive capacity of the economy. It's a reason that even beyond 202, we do expect growth to be slower going forward than it has been in the past.
Rick Brink: Yet, in theory, the US has a lesser sensitivity to trade than the rest of the world so if we just sort of hop around the horn really quickly, let's maybe hit on trades impact or general impact as it relates to Europe, specifically, Germany, a little Japan, a little China.
Eric Winograd: Yeah. Absolutely. The US is not an open economy. We talk about trade openness as exports plus imports divided by GDP, just simply how much of what is going on in your economy is going across the border? For the US, the number is in the high 20% range, which isn't really that much. China's in the mid-40s, which is more. But, again, not that much when you talk about Mexico, for example, it's close to 80%. Canada close to 80%. Germany close to 80%. If you exclude other European countries, it's still 55% for Germany.
We're talking about relatively large numbers here. Those are the countries that have really felt the most significant impact from the trade war. Some of the Asian trade powerhouses, a country like Singapore that does very little other than trade has seen GDP growth from the beginning of the trade war to now go from 4-1/2% to essentially zero, right?
We've seen large impacts around the world and that does create a headwind for growth in the US and even for non-trade exposed countries, the slower mobile growth environment does matter, but it does depend on where you sit, right? Some countries are more exposed than others. I would say also it's not a coincidence the two of the less exposed countries are the US and China and those are the ones who haven't felt any particular urgency to reach a deal because they can afford it, because they can withstand it because they have larger, more diverse economies.
Rick Brink: The other side of that then, of course, one thing we've talked a lot about is central banks around the world trying to proactively step in and form some form of an offset to what's happening with trade, but just as different countries have different sensitivities to trade, different countries have different policy effectiveness as it relates to combating some of the issues from trade, so maybe talk a little bit the other part of the equation, which is central bank effectiveness?
Eric Winograd: Yeah. This is the other reason that the US and China have been able to withstand the trade war relatively well. Both countries have policy space to maneuver. The Fed cut interest rates 75 basis points this year despite economic data still generally looking okay in an effort to offset the future impact of trade policy and certainly, that's been important for financial markets.
Walt Czaiki: Definitely.
Eric Winograd: That has eased financial conditions and allowed the economy to withstand, at least, the first phase of the trade war. Chinese authorities have also eased policy significantly. It has been effective at stabilizing growth there as it has in the US. Again, you contrast that with Europe or with Japan where policy rates are already negative, where there isn't very much more that central banks can do or, at least, not very much more they can do that will be effective, right?
Again, when you look at the forward growth trajectory, it's better to be a country that is relatively insulated from trade and that has the ability to offset it with policy. Right now, that's the US and China. That's how we end up with forecasts for the US and China that are better, relatively speaking, than what's going on in the rest of the developed world.
Rick Brink: Which is a nice natural segue to another part of the discussion on stimulus, which is fiscal, and the ability of countries to implement fiscal stimulus alongside monetary policy. But, again, there's some question marks about how quickly it could be implemented, and limitations so maybe talk a little bit about the fiscal side.
Eric Winograd: Our belief is that with monetary policy in many countries at the end of its rope, where there isn't very much more than it can do and even in a country like the United States where that, yes, the Fed could cut interest rates further, but the scope for policy easing is more limited than it has been. We think that fiscal policy will play an increasingly important role in economic policy going forward. When interest rates are at or close to zero, fiscal policy matters a lot more.
One of the things that would be very positive for global growth would be to see more fiscal stimulus and Germany, in particular, has fiscal room that they have chosen not to use. It would be very beneficial for European growth for the German government to spend more money. We don't have a high conviction view on what will happen with the fiscal policy in the US. I think ahead of an electoral cycle that is very unpredictable, it's wise not to have high conviction in very much of anything about what goes on in Washington, but there is some scope for fiscal expansion and maybe I'll turn it to Doug, because historically the restraint on fiscal expansion has been the bond market, right?
Bond market vigilantes have been the ones who have stepped in and said, "Okay. We are not willing to fund additional fiscal stimulus at the, at low levels of interest rates because we worry about inflation, because we worry about the amount of debt outstanding." Yet, even as we have seen generally accommodative fiscal policy, global interest rates have come, have become incredibly low.
The question, I guess for you, Doug, is do you see a scenario in which the market refuses to underwrite fiscal expansion? Because if the answer to that is no, then the odds are good that in this populist moment we've been discussing, we will see fiscal expansion over the course of the next few years.
Doug Peebles: Yeah. I think it makes sense to talk about the bond market vigilantes and the impact that they have on issuance. If you actually do the math of budget deficits as it relates to current and future interest rate changes, there's no relationship. Let's look at Japan. You look at Japan, they've been running five or so percent budget deficits forever. Their overall debt to GDP ratio is somewhere around 250% and their interest rates are…
I mean, the headline yesterday was, "Oh, my goodness. For a brief period of time during trading 10-year JGBs trade with a positive handle in front of them." Then, they quickly close negative again. I think that there's a notion of that extra issuance on the government side leads to lower prices and higher yields, history doesn't suggest how that happens because what the bond market really cares about is the growth outlook.
I think Japan is an example that even though the government has been running simulative fiscal policy, it hasn't been enough to get more energy into the economy. I think what's more important as it relates to the level of yields, at least for the near term. I'll come back to why maybe the United States is different in a moment, is the fact that do we believe that this is just some quick response that will get extra spending on the government side, but it doesn't lead to further potential growth in the future and lift the expectations of what is the normal growth rate of the economy up to a level that is frankly higher than where yields are today.
When I go back and talk about the US relative to let's say Japan, one of the important things is we run a current account deficit which we need, means, we need foreigners to buy the bonds in the United States, whereas Japan is very different from that. All of that debt issuance is essentially owned within Japan. It doesn't have a huge impact on the currency, the yen as it relates to Japan.
That's probably not the case for the United States. So, even if my thesis is right that I question the notion of whether more fiscal policy will either increase rates or steepen the yield curve, I think it's pretty clear that it should weaken the currency in order to entice non-US, non-dollar based investors to come in and buy Treasuries. We basically have a situation where growth is really low, monetary policy arguably is either at the end or very close to the end on its effectiveness, and now the world is looking for fiscal policy to come in, maybe we're just at a point in time where because of dead overhangs and demographics that the natural rate of growth in the currently, the developed world, but rapidly the developing world is just a lot smaller than we've had in the past.
Rick Brink: That's something that I talk quite a bit about, I think we all do is sort of structural ability of markets to grow over time based on demographics and underlining, underlying GDP potential. I do want to come back to one more straightforward thing, Eric, which is you alluded to it in your opening statement, but just coming back to just US Federal Reserve policy next year, you are a little bit different from say consensus. So, maybe just hit on that real quick.
Eric Winograd: Yeah. I do think because the growth outlook in our forecast is going to be lower than the Fed itself is forecasting. I think that the Fed will or is more likely than not to step in and cut interest rates a couple of times. Again, it's important not to have too high conviction a view now in December about what we think will happen next June, July, August, September. It's a long way away and a lot of things can happen.
But the Fed has shown, and I think correctly, almost no tolerance for slower economic growth, right? They have spoken a lot about the benefits of, the benefits that we are seeing from this now record length expansion. We're seeing people drawn into the labor force who might otherwise not get that opportunity. We've been able to do that without inflation running out of control. As long as that is the case, I think that the Fed is more likely than not to cut interest rates if growth wobbles.
Doug described a positive scenario earlier where the yield curve steepens because these growth expectations have gone up, if that happens, it may not be necessary for the Fed to cut interest rates and that would be a wonderful thing. But I think the Fed has shown a willingness to be preemptive and if the economy starts to weaken at all, unless inflation is running at a level that neither we, nor they, nor anybody else in the market seems to expect, it'll be relatively easy and painless to cut interest rates.
The cost of cutting interest rates historically has been that inflation runs too hot. I don't think that that's something that we're really worried about at this point. I don't think it's something that the Fed is worried about. If the labor market starts to weaken even a little bit, I think it's easy to step back in and prevent that from occurring, and so is it a 100% certain that they'll cut rates? Of course not, but I think it is more likely than not.
Doug Peebles: I would just add a couple of things to that. I think the first one is, Eric has appropriately said the Fed is willing to ensure that the economic situation is stable to growing and been very proactive in that. I would add to that and with a skeptical notion that the Fed is also very concerned about financial market instability. They're also reactive to events in the marketplace which could undermine the growth rate.
I would say that it's sort of unhealthy the dependence that the economy has on the asset markets as opposed to the asset markets being a reflection of the real economy. I think we sort of have the horse and the cart a little bit messed up at the moment, but I do believe what Erik had said in the past is because not only has the Fed missed their inflation target for such a long period of time, but they're also still below their inflation target and Chair Powell has come out and said, "We're basically not going to raise rates until we're above our inflation target."
I think the market feels very confident that we have an asymmetry of Fed policy in the future. I would just sort of feedback into, and this is where it's not all rainbows and butterflies. I think that we should spend a minute talking about what's going on in the repo market and there's a lot of discussion that the, there's technical forces that are forcing interest rates up in the money markets in the United States and the Fed has done some operations in which to deal with that, which so far as we're sitting here in the second week of December has been effective, but there's still an underlying concern as we move into year-end and even a broader concern about, is there something other than a technical notion going on in the repo markets that the Fed has so far solved with liquidity via short-term issuance?
Again, I think there are some things that may be at the surface are not quite as clear to market participants, that I think are, they're not raising the yellow flag yet, but they're unpacking the yellow flag in their bag and maybe starting to get, ready to start waving it.
Rick Brink: Well, if I steal the analogy and I think of financial markets is the horse and the real economy is the cart, let's talk quickly about the probability of the cart breaking because recession is obviously one of those questions, it pops up everywhere, so when you get the question, US recession potential or what are the markers you're looking for, how do you usually address it?
Eric Winograd: It's a measure I think of how quickly sentiment has turned that two or three months ago recession was the first thing that people asked, "Oh, are we going into a recession? The yield curve is really flat, the manufacturing data look terrible." Now, two or three months later, the market consensus seems to be that we're on the cusp of an economic rebound and things are looking much brighter. I have to tell you; the data haven't really changed very much along the way.
Doug Peebles: No. The stock market prices have.
Eric Winograd: Funny that, right?
Walt Czaiki: Yeah. Absolutely. That's one of the things that we have to acknowledge the risk, I've talked earlier about we're not anticipating much way of P/E multiple expansion. A big part of that, and Eric you touched on this, by some measures of financial conditions, we haven't seen them this easy since close to the tech bubble and after we had that adrenaline shot, if you will, from the corporate tax cuts that we saw in 2018.
That's something that is a gating factor in our view to P/E multiples going higher. It's not to say that opportunities aren't out there and exist, we talked about earnings being marked down so it was a contrarian. It's like, "Okay, I like that." In terms of pessimism to that level, but that's one of the gating factors that we say in terms of multiple expansion beyond just the risk that Eric and Doug are talking about.
Eric Winograd: Yeah. When we sort of combine that together, I'm a traditionalist like Doug. I believe that financial markets over time reflect what goes on in the real economy and not the other way around. When I look at recession indicators, I'm not looking at equity markets, I'm not even really looking at the yield curve. I think it's a useful guideposts, but it isn't the kind of thing that I would use analytically to forecast a recession.
What we're looking for right now is evidence that the slowdown in manufacturing is spilling over into the labor market. We look at initial jobless claims, right? Workers who are laid off had the ability to file for unemployment insurance benefits. We get statistics every week about how many have done so. If that starts to increase materially that will be a good sign that the economy is weakening. If the economy, if the rate of hiring, which has been robust all year starts to slow, then that will be a sign the businesses are pulling back, not just from capital investment but also from hiring.
It's really remarkable and has been really remarkable over the course of this year the extent to which firms have been unwilling to invest in capital expenditures, but still willing to hire people, right? If that willingness to hire people slows, then we'll start to worry much more about negative growth or about a recession. For right now, while I'm a little bit perplexed by how quickly the market has turned around and concluded that we're on the cusp of an upswing, I do share the general relaxed attitude, if you will, toward the prospect of an economic contraction in the near term. I'm not losing sleep over it.
Rick Brink: Speaking of losing sleep, can we talk about US elections? This is the, everyone wants to know, what will happen? They try to frame candidate's policies, the impact on markets, there's no shortage of news articles that speak to what would happen in other party should any candidate gain the presidency? But I think we talked a little bit about it a little differently, particularly, in terms of just its impact on general volatility and reaction in markets, so maybe we can talk about the election and how we frame that.
Eric Winograd: I will tell you, most of the time, we significantly overestimate the impact of the political cycle on the economy and on financial markets. If you look at a chart of GDP growth or if you look at a chart of the stock market and shade the different types of administration's red or blue, right? One for Democrats, one for Republicans, you can't tell the difference by looking, right? There is no reliable pattern where you can say, "Oh, markets do better under this type of administration than under that one or the economy grows more under Democrats than Republicans."
It just isn't there. I'm sure that all of you will see over the course of the next year a lot of analysis that says, "Oh, on average the market does X under Democrats and Y under Republicans and X under Democrats when there's a Republican Congress." It's going to be broken down and parsed because this is a topic that people want to hear about. None of it is really statistically significant, most of it is coincidence rather than causation.
The vast majority of the time, I would tell you, we don't really need to talk about the election nearly as much as we think we do. However, this time does seem different, and the reason I think is because in this populist moment, the breadth of the political discussion, the topics that are under discussion, and serious discussion by various candidates is much wider than historically. Right?
Over the past however many cycles you want to look at, the true difference between the economic policies of one party versus the other weren't really that great, right? But now, again, in this populist moment, we're seeing things under discussion that had not been discussed seriously for generations, whether it's monetary theory, wealth taxes on the left. Some of the very conservative policies around corporate tax cuts and it's just a very wide spectrum of potential outcomes.
It's likely that it will be more meaningful to financial markets, and there's two ways to approach it. One is sort of top-down trying to say, "Well, we think that it will do XY and Z." We're not really in a position to do that I think until we get a little bit more clarity about which candidates are likely to be competing for the election and what their actual policies will be. From a top-down macro perspective, what I think we can say is what you hinted at Rick.
We don't know how it's going to come out, but we think it's going to cause volatility, right? One way or another, the bipolar nature of the political spectrum means that we're going to go from pricing in one set of policies, and then another that are dramatically different in a way that policies have not been dramatically different in the past. That said, while we may not be able to say much from a macro perspective, I think from a sector perspective, right?
There are some trends in there, there are some things that are perhaps more meaningful. It may come out in the from a macro perspective and the overall index may not do as well, but there are certainly some sectors that are very sensitive to what's going on electorally.
Walt Czaiki: No doubt. That's that the election, Rick, is certainly part of our volatility equation, if you will, is one of the factors that we anticipate driving that. I wouldn't really add a whole lot to what Eric said in terms of trying to handicap it. We've talked about some of the risks and some of the limits that could mean in terms of P/E multiple expansion and clearly, on the sector side that does have some implications, but I'd like to just get, before I were to close out, I want to hit on a couple of things just that if they view as some positive, there's some offsetting factors to some of the risk that we acknowledge.
One, we've talked about, we've used the acronym TINA, there is no alternative, right? We've seen equity risk premiums rise. In other words, there's less competition from interest rates. Certainly, from a year ago after the Feds last tightening in that cycle, Eric, right? We've seen that, that's a nice buffer.
The other thing that we've seen is the fact that money flows, just up until recently, most of the money globally has been going in the fixed income side. You're welcome, Doug, right? We see a lot of capital flows that way where money has been flowing out of equities. In the last 20 months, there was almost $280 billion that was flowing out of equities, however, the last 6 weeks, we've seen that reverse.
We've seen a $41 billion swing back into equities. Now, most of the outflow was out of Europe versus US, but if that were to continue, that's a nice buying power that we would see for the asset class. That certainly is a positive. Our prescription is we look out, it hasn't really changed from where it was last year. In other words, focus on those companies who have that persistent level of profitability. If you're going to go to the value side, and it looks like some of the cheapest value stocks have trough on earnings, which is encouraging.
If there's going to be any degree of multiple expansion, it would probably be on the US value side and possibly on the international side. Because their valuations are certainly off of a low base and if we do have kind of a stable economy or if we were to get some upside surprise, that would be one segment where we could see some potential multiple expansion.
I know for our advisors out there those have been tough asset classes. We're not putting a stake in the ground saying, "Okay, this is the inflection point." But the risk/reward there looks to us very, very favorable given that backdrop and given the valuations that we see there.
Doug Peebles: Especially if they have a longer-term time horizon.
Walt Czaiki: Yeah. To be sure. Again, it's been very, very tough in this moderate growth environment. Doug, I know you and your team talk in terms of barbell in terms of that is a proper structure for the environment. I think we could look at that from the equity side as well, not giving up the ghost on growth. Clearly, on the sectors, we've seen in certain areas of technology. If it's software-as-a-service or some areas within the industry that we just view as too expensive, even our growth guys are fading those versus some of the other areas that may be more controversial, but we're seeing a good valuation opportunity there.
But as Doug said when you have that horizon, the barbell to us make some sense. Focus on those persistently profitable companies, but on the international side, I would say all three. If there's going to be a bias, it would be to growth on the international side. But, again, look at those companies with the balance sheet strength and the ability to generate that free cash flow to ride out some of these unexpected storms that could be emerged, especially in this late cycle.
That we have to acknowledge the risks, but when we look at the valuation opportunity, lack of competition from interest rates as I said, and if those money flows do change, that's up for a decent year in my view.
Rick Brink: The last thing that you said Walt is something that I think is digging it for just a second is that whether we're looking at capitalization or region or everything else, one thing that you and the rest of the equity group talked quite a bit about is to focus more on the characteristics, the companies represent rather than I should be international, I should be domestic, correct?
Walt Czaiki: Right. Absolutely, and some of these, some of the factors that we would acknowledge our attributes, so we'd look at or, again, the companies were that persistent profitability and the financial strength, that to us makes a lot of sense. One of the areas that's just consensus across, be it regardless of style, is the fact that some of these low volatility stocks are these, in a lot of cases, they're skewed to these bond proxies.
In our view, they're just too expensive. We look at the relative valuations of those stocks and they're skewed to the usual suspects. If it's going to be staples, utilities, and REITs, people are reaching for yield. The relative valuations are not only expensive, but we're starting to see the earnings revisions and some of those companies are starting to fade.
That high valuation plus your earnings outlook doesn't look so good where some of the cheapest value stocks, a period of trough, we would prefer the latter versus chasing these higher-yielding stocks.
Rick Brink: Yeah. This year to date in terms of ETF flows, a significant, significant amount of the net flows have been going into low volatility offerings within the ETF space so that echoes your comments.
Walt Czaiki: Indeed.
Rick Brink: All right. Let's talk about fixed income, something near and dear to my heart, of course. Walt jumped into the equity side, let's parse out fixed-income opportunities. The one that I think is really always interesting to talk about is the differing places that sectors or regions find themselves in, within the credit cycle globally so maybe talk about that.
Doug Peebles: Right. I think if you look at the notion of, okay, where our leverage ratios were, interest rate coverage, those types of things. We and the majority of the market have been talking this notion of late cycle for a long, long period of time, right? I think one of the things that keeps kicking the can down the road is that the policy response has continued to be very aggressive and even proactive in this cycle so that we enable the cycle to extend. That's no different from today.
I would say that what has been a little bit different in the past several years is we tend to have credit cycles in differing sectors along this extended credit cycle. Some, like energy, have almost come full circle twice already just in the last several years. Now, all that being said, so we can say, "Look, the two areas or the two sectors that are perhaps most influenced by what's going on in the world have been retail and energy."
It's not surprising that retail bonds and energy bonds have underperformed there other, the different sectors that they compete with, but nonetheless, I think it's still information value when we look at, okay, in 2019, BB excess returns have outperformed single B excess returns which have far outperformed CCC excess returns.
You're getting the steepening of the credit curve, which is another warning signal that maybe we are coming to an end to this. We're not calling for that, but I'm just laying out what are the markets telling us that we should be aware of to listen to. I think another thing that's maybe a little bit different in this cycle is at this stage in the light cycle, when so many people are searching for a yield, the issuance within the lowest credit quality space would have been the highest.
When there's a demand for a yield, Wall Street has a tendency to supply that demand with even worse credit quality. In this cycle, when we look at just the high-yield bond market, the portion of issuance in that CCC, that lower credit quality space has not grown. It's actually shrunk. You say to yourself, "Well, why isn't that happening?"
Well, we have a new player on the block in terms of supply and that has been the bank loan space. There has been a weakening of the credit quality of the supply in the bank loan space. There are these cross currents and Eric said at once today that maybe it's different this time, maybe it is different this time in the credit space, but there are some things that we're watching that bear a continuation of watching just like those two that I mentioned.
Another area and Walt touched on this a little bit as it relates to equities because emerging market equities have under by a lot. Emerging-market local-currency investments in the fixed-income space have also underperformed a lot. One of the things that Eric might have said at the beginning and I know his view is that if everything goes according to plan, we would expect the US dollar not to appreciate anymore.
It's maybe too much to ask for it to depreciate a lot, over the last two years, the dollar on a trade-weighted index is about 10% stronger. Again, if it's another 5% stronger in 2020, I'm not going to have wanted to make this recommendation that I'm going to make now, but from a valuation standpoint, emerging market sector looks attractive. It has underperformed for a long, long period of time and I think one of the reasons of its underperformance, it's very closely tied to the dollar.
So if all things go according to plan, the dollar has maybe peaked out for a little while and tends to go down as the Fed reduces interest rates, then I would say emerging market as a sector looks attractive as well. The last area that we think is attractive in the sector space is the securitized space. The closer that we can get tied to the US consumer, which is the strongest growth engine, perhaps the only growth engine left in the world, the more we want to be.
We still think that there's value in securities that are tied to the housing cycle, and not so much housing activity, but the price of residential real estate. That's still attractive to us. Then, if anybody wants to, we're not going to have time to do this today, but if anybody wants to get a very, very deep dive into the world of commercial mortgage-backed securities, just go to the AB Global website and look up the recent white paper we've written on the CMBS index contract.
I think what the viewpoint there is a difference of opinion that AB has as it relates to the future of malls in America and the credit quality of the loans that backed those. There’re many people who believe that because of Amazon and because of their troubles in retail that all malls in America are going to go out of business. We very much disagree with that. Again, we're not going to discuss it in great detail here, but that's another sector that we think offers value in the world of bonds.
Rick Brink: I would say that the 16-year-old me would find this quite shocking, but I found that pretty riveting. I would also recommend someone looks into that.
Walt Czaiki: I want to just pick up on stuff that Doug said. I talked a little about the rebalance, the potential rebalancing opportunity that we see in international. If currency were to moderate that, it could be a nice tailwind for that asset class on international. It's interesting, Doug, you said about the CCC space, it seems ironic you would think that would be picking up, but you haven't seen it.
I'd say as we go down to cap structure, one of the things we've seen is a fairly good pickup at IPO activity, but it's interesting to see that a number of those new issues on the equity side are trading well below their issue price. When I said it earlier, "Don't give up the ghost on growth." It's, again, focusing on those companies that have persistent profitability, especially this late in the cycle.
Rick, to your point, what are the characteristics that you look for? Growth still to us makes a lot of sense, especially if the economy moderates, you get a scarcity premium for those companies who can deliver, and we say that's where you want to stay on the growth side. On the value side, I'm making the distinction, in terms of the higher-quality cyclicals. There's lots of flavors of value. Is there lots of flavors and growth?
You combine the late cycle and, Doug, you mentioned one of the industry is retail. If you think of an industry that has been cut up in the crosshairs of disruption, you run the risks of having businesses going to be impaired, think Amazon as an example. That's not so much where we would be looking. It's those companies that have individual company level catalysts where the valuation opportunity is there on.
Doug Peebles: That's a tricky part about the indices, right? So many of the sort of passive investments are looking at these value opportunities, but are they value opportunities because of just pure valuation or is the growth outlooks so dimmed that you're really never going to be able to monetize that?
Walt Czaiki: Yeah. It value… Yeah. In this stage of the cycle, value, especially, you want to be active.
Doug Peebles: Yeah. For sure.
Rick Brink: We talked about, I mean, look, whenever we talk about equity, if I just sum it all up, it sorts of singles and doubles hitters. As you mentioned, we talked a lot about persistency of growth and quality and all of that. That's an ongoing theme that sort of finding efficiency. Obviously, a lot of those factors are great, light cycle performers. Again, late cycle, yes. It's a very long late cycle. I'm a Yankees fan. Anybody whosever watched a Yankees, Red Sox game knows you can be late innings and have another four hours left, but this idea of efficiency is important.
I know we talk about this a lot, Doug, but I almost feel like it's a public service announcement at this point. Can we talk about a barbell and what we think about a barbell at this point in the cycle for efficiency of income?
Doug Peebles: Sure. We think of a barbell as a combination of two asset classes. In one instance on the left side of the barbell is your anchor, which is what we call risk-mitigating bonds. Bonds like US Treasuries is the poster child for that. Then, on the right side of the barbell is, again, poster child would be US high-yield. Additionally, you could throw in some emerging markets or other securities that fall into the category that they're more highly correlated to the equity market than they are to the bond market.
Now, the beauty about that investment is both of the risks associated with that, you have duration risk over here and you have default risk over here. Both of those risks pay you over time, so if you have two asset classes that both pay you and they're negatively correlated, if you buy both of them, you get paid the premium for both of them and they offset each other.
To us, in today's market, that is the best place to get efficient income. There is a huge search for income, we think that's the best way to play that. Now, I go back to that notion because so many of the advisors and so many of the clients say well, "Doug, the 10-year Treasuries is 185. I'm used to it averaging five, and then, when it was low, it would get to four, and eventually, will get back to six and a half."
I think it's fair to say that for the time being those days are over. What we do is we ask yourself, "Okay, 180 on the 10-year Treasury." The first thing we talked about, if the equity market falls by 15%, not calling for that, but if that happens, do I have protection in my left side of the barbell? Because if the equity market falls by 15%, high-yield is going to underperform. It's just what happens 9/10 times.
I have to ask, and the team has to ask, "At 180, can we go to 120?" I think we can. That efficiency particularly, when people need the yield is the best way to play it in today's market. Now, if we have a situation, the equity market goes down 15%, high-yield spreads go from 330 basis points over US Treasuries to 700 basis points over US Treasuries. I'm not going to tell you the best way to get your income is through a barbell, but in the meantime just wait it out, you're going to get almost the same yield, it's an attractive yield, and then you'd be able to switch into the right side of the barbell for a full yield exposure at some time in the future.
In these markets, it is important to earn your carry, as we sit here, and to be proactively able to go and buy into the sell-offs, right? As opposed to just being long and wrong all the time, and then it eventually gets so painful that you sell it right at the wrong period of time.
Rick Brink: I mean, that's the thing we talk about with a risk balance volatility adjusted barbell is that relative to say the pure right side of the barbell like US high-yield, the compensation, the carry, the relative carry is high relative to history. The cost of hanging around and clipping a coupon is low, and at the same time, as you point out, one of the survival traits of where we are as an investor right now is probably the ability to have dry protected powders.
Doug Peebles: That's right.
Rick Brink: The barbell is one that sort of affords both right now. So, to wrap up, I'm going to uncork my Toy Story reference of 2020 and beyond. We've talked about the outlook for next year, but I know one of the things we talk a lot about are some structural realities that are present. I'll begin with the one that you've referenced a couple of times, Eric, which is populism, which we've both talked about as being something that's been brewing since the dawn of heavy globalization automation, probably 40 years ago.
That really has implications for what we're going to see beyond 2020 and into the next decade.
Eric Winograd: Yeah. We think populism is durable, right? Populism, as you say, has been steadily growing over the course in the last couple of generations and has really accelerated recently as more of our national income has found its way up the income spectrum rather than down, right? The reality is that the wealthy have gotten wealthier and the people who are not wealthy have really not seen very tangible increases in their standards of living.
Until that changes, we think populism is going to be durable on a global basis. It is a recipe for policy volatility. As we talked about earlier, it means that topics that were previously not acceptable within the political spectrum now are, and the range of political outcomes is much lighter than it has been. That volatility alone breeds uncertainty, and uncertainty is bad for growth. It makes growth less efficient.
It means that over time, you get less growth per unit of inflation, right? You should expect, and I know we've talked a lot about inflation being subdued and we do expect that in the near term. As we move beyond 2020 though, the history of populism tells you that inflation will eventually come back. There's a lot of that out there that is serviceable now because interest rates are very low. Populism is a risk to that in the long term.
It's not the kind of thing that we worry about that requires us to change the way we're thinking about investments for the next 12 to 18 months, but when you're looking at 12 to 18 years, the world could look very different indeed and if it does, it will probably be because of this populist momentum.
Doug Peebles: We talk a lot about this. We have strategic investment forums that we have. Eric and the rest of the research team do a tremendous amount of work on thinking about these longer-term trends and there's no doubt when you lay out the facts about this move towards populism, they're certainly well justified on why it's happening.
I would say that the policy responds to fix some other problems have this unintended consequence of flaming the fires of populism even though the desire of extra loose monetary policy is actually to help the people who are on the lower end of the wage scale. It's actually formatting itself in helping the upper end of the wealth scale become even wealthier. There’re these unintended consequences that are happening and there's no doubt, you think about closing down immigration, you think about no more international trade.
These things are highly inflationary in theory, and so why isn't it happening? Well, I think, number one, is so far, it's time horizon, and number two, there are some things on the other side of the ledger like demographics and extra debt levels that are hampering growth and retarding some of that policy that is trying to get growth going.
It's a very, very complicated situation, but the one thing that Walt has mentioned, and Eric has mentioned, I agree with is, it probably brings with it a lot more volatility. So, if you have this lower nominal growth environment and we believe that the cart is in the back and the horse is in the front, then we should have a situation where we're not surprised that you should be penciling in returns in your financial portfolio that may be in the next 10 years have been lower than they've been in the last 10 years.
But the other side of the bad news, I just dropped that bomb on is that, well, returns are going to be lower, but don't you worry about it, volatility is going to be heck of a lot higher so that'll make, more than make up for it.
Walt Czaiki: Rick, what we're talking about, yeah, our team is… We're small but we're slow, right? Kind of a situation but it certainly has implications for the equity market because as many people know, if we're going to be in this moderate growth phase on GDP, there's a pretty high correlation to top-line growth for businesses in terms of how that tracks GDP.
I go back to the old adage, "No top-line no bottom line." We're going to have some exceptions. We've had a good year from risk assets this year. It's not to say that we can't have some episodes where we have good years, but I completely agree with, Doug. We're in this late stage cycle, you look at some of the things that are crowding out investment that lend itself to GDP growth. That plays out, you're not going to have much in, at the line of top-line growth, which means your expectations need to be calibrated for more moderate returns in the equity space.
Rick Brink: I think in the end, what we sort of set up for next year and beyond is really this notion that in the end, the economy drives financial market performance, as you said, "No top-line no bottom line." If the growth potential of economies over time is going to be lower than the growth potential of capital markets, in theory, is going to be lower, if bond yields are lower than the returns that accrue to bonds are going to be lower, and so investors have to plan, really truly plan for the notion that that would be the state of their 60/40 allocation, but also have to look out below on the potential for a downside volatility.
I'd like to thank all of you for all of the answers to all of my questions and just for being my friends and colleagues. I'd like to thank everyone else for joining us here for this 2020 outlook for AllianceBernstein. On behalf of Doug Peebles and Eric Winograd and Walt Czaiki, I'm Rick Brink. Thanks for joining us. Have a wonderful New Year and we'll talk to you then.