MASTERCLASS: Liability Driven Investing - October 2019
October 7, 2019
Richard Brink: Hello everyone. Welcome to Asset TV. This Masterclass is a review of the first quarter capital markets outlook with my colleagues from Alliance Bernstein, Walt Czaicki, senior investment strategist for equities, Douglas Peebles, CIO of Fixed Income, and Eric Winograd, chief US economist, and I'm Rick Brink, market strategist. This Masterclass is a capital markets outlook. So, let's get started. Probably fair to begin at the beginning. So, Eric, let's talk a little bit about how everyone felt coming in the year.
Eric Winograd: Yeah, I think that coming into the beginning part of this year, there was a lot of nervousness in the global financial markets, and you can see that in the poor performance that we saw in equity markets in particular last year, and with good reason. There were a lot of things to worry about. We were worried about the possibility of Europe falling into a recession, there were concerns about the Chinese growth outlook for sure and concerns that the Federal Reserve here in the United States was being a little bit tinier, that they weren't really listening to the signals from financial markets and weren't as concerned about the apparent slowing and the in the US economy as perhaps market participants were. So, there were a lot of things to worry about coming into the year.
Richard Brink: And despite that, from a market's perspective, sort of the contra indicator or sentiment as it were, how did markets do, Doug?
Douglas Peebles: Well, I think we do have to look back to the fourth quarter to start a little recap. The fourth quarter was a disaster. Interest rates went higher, so bonds ... particularly credit markets did poorly. The equity markets did quite poorly. And as Eric mentioned, the Fed was very hawkish in their commentary. So, everybody thought we were going to have a continuation of that into the new year. And then very early into the new year, the Fed came out and really reversed course in their January commentary. And so, the markets did a complete about face, and equity markets obviously did very, very well.
Douglas Peebles: The odd part in the fixed income markets is we had a situation where both interest rates rallied. So, we had a falling of interest rates and spreads also narrowed. And so, we had an outperformance of what we call both the risk mitigating assets like treasuries and the return seeking assets like high yield. So, it was all around a really good market for the first quarter for return seeking and risk mitigating investors.
Richard Brink: And while for equity it's not just a good first quarter, but a record first quarter.
Walt Czaicki: It feels good to have positive returns across the board in this quarter. Certainly, it has given mean reversion to a whole new meaning. As Doug said, when you look back and you contrast that to what happened in the fourth quarter coming out of the gate this year, this is the best equity returns in terms of first quarter. It is by the S&P data that we've seen since 1998. That's quite a feat. And coming into this year, a number of the advisors that I was speaking to articulate a number of the concerns that Eric, that you laid out, but I would add to that too, is just fears in terms of the knock on effects in terms of the Federal Reserve's fear of over cooking this by tightening too much.
Walt Czaicki: What does that mean for multinational companies in terms of their earnings via a stronger US dollar relative to other currencies? So that's something we're going to talk about a little later in terms of earnings revisions, but that was another key concern that advisors had. Couple that with the fact that, is this bull market going to die of old age? And that's not our view, but that was another concern a lot of advisers had top of mind.
Richard Brink: Well, and importantly, I think the thing that really matters as well is that it wasn't really a growth story in the first quarter. It was a good pop in valuations.
Walt Czaicki: It was. If you dissect the returns, it was a real mirror image, because last year it was effectively a bull market earnings, but a bear market in PEs in particular, when you look at what happened in the fourth quarter. To your point, when you look at that, if you decompose those returns year to date, it has been PE multiple expansion. While earnings growths we're still positive this year, and that's our expectation, that rate of growth is not going to be anywhere near what we saw last year. So, a lot of it is just a byproduct of a turn on Fed policy and other central banks, and we've saw valuations pop to the upside.
Richard Brink: And Eric, how did macro sentiment develop through quarter? So clearly, it had to start to improve to get somewhere here.
Eric Winograd: Yeah, that's right. And I think Walton and Doug have both touched on this. I think the biggest event in the first quarter was the feds turn to recognizing that financial markets were a little bit more nervous or even a lot more nervous about the economic slowdown than the central bank was, and that perhaps they had underestimated the sensitivity of financial markets to not pass moves in interest rates necessarily, but expectations about future moves. And so, the Fed in January, as Doug said, took a step back from its plans to tighten and has now indicated that they're not likely to do so for at least this year and perhaps well into next year.
Eric Winograd: On our forecast, in fact, they aren't going to raise rates in either 2019 or 2020. And what that has done is without necessarily altering the near-term growth profile, it has significantly altered the balance of risks around that. If the biggest risk coming into the year was that the Fed was going to overtighten and slow the economy too much, well that risk has been removed. You combine that with some reasonable news on some of the other risk issues, the delay of any resolution to Brexit, but the absence of a disorderly Brexit at the very least, signs that China is starting to stabilize.
Eric Winograd: And what we've seen, while it was a record first quarter, it's served in large part to reverse what happened in the fourth quarter. And so, you saw the risk mount last year and then decline this year in equity markets and risk assets in general fall last quarter and rise this quarter. And in a lot of ways we're sort of back to it to where we started a couple quarters ago, which is this environment of a gradual slowdown, but sentiment around that being much more positive than it was a few months ago.
Richard Brink: Some of the drivers of the pessimism when we came into the quarter, the expectation earnings would be really weak in fact, coming in at about zero, that's come down. Earnings estimates have come down, in fact.
Walt Czaicki: They have. But we've seen so far, a bit of a disconnect. And this was something we were alluding to earlier, while earnings revisions not only here in the US on the S&P, but if we look globally, we've seen that they've declined as the global economic growth is moderated in a meaningful way. But the markets have yet to recognize that. So, when we look at valuations now in terms of the US market, if you look at price to earnings multiples, we're about back to average if you look over a longer time series. But if you look at other measures such as price to sales, that would suggest that we are at valuation levels that aren't necessarily cheap.
Walt Czaicki: So obviously, you have to look at a mix of things when you're assessing companies. It's included in an equity portfolio, but the evaluation environment is such to where we've had this recovery, earnings as you suggested are not giving you that level of support, so the need to be discerning and in the portfolio allocation as far as what you're exposed to, in terms of the attributes of the companies. At this stage in the economic cycle, we think is especially critical. Always important, but now without that earning support, it becomes even more vital.
Douglas Peebles: Yeah. I would just add a few things that, first of all, what we've witnessed so far in the first quarter of 2019, the Chinese authorities have clearly initiated a rapid increase in credit growth. So, Eric mentioned that the markets have become a little bit more optimistic, that China's not on an inevitable slow down. And so, I think that's important. And then in the United States, there is really ... we talked one stage about the Fed. There was actually a two-step that the Fed did. So, the first thing they did was indicate that rates weren't going to go up anymore. And then the second thing that we saw more recently was they've indicated that not only are rate's not going to go up the way that the market had previously thought, but they're also going to end their balance sheet shrinkage earlier than the markets had previously thought. I think that's a big deal.
Douglas Peebles: Eric will no doubt talk later about the fairly large change in inflation policy by the Fed. But again, the other thing that we don't really talk that much about, that 2018 saw enormous tax cuts in the United States. And while that was very beneficial to earnings in the first quarter for US companies, it shouldn't be that big of a surprise that that's not going to be ... the delta on that is not going to be the same as it was in 18 in 2019.
Eric Winograd: And that's a big part of the reason that we're not concerned about the economic slowdown that we expect this year. Growth on a year on year basis was about 3% in 2019. It'll probably be about 2% this year. But the real difference isn't the underlying rate of activity in the economy. It has to do with the tax cuts and deficits spending at the federal level. Remember that government spending net is part of GDP, and so when you get a 1% fiscal stimulus, which we got last year, growth goes up by a percent and when that goes away, it goes back down to 2%. And I think that that shouldn't be cause for alarm.
Eric Winograd: 2% is still a reasonable rate of growth for our economy given its size and given some of the longer-term trends, particularly on the demographic side, the point to slower growth in the future. 2% isn't bad. But I think that in the fourth quarter, there was concerned that the slow down ... and even early in the first quarter, there was concerned that this slowdown might be more profound than that. I think that the data we've seen over the first quarter are consistent so with this sort of gradual slow down, rather than something more alarming. And I think that that combined with the policy innovations that we've seen has let the financial markets take a step back, breathe a little bit and take a more clear-eyed assessment of the situation.
Walt Czaicki: I want to add to something that Doug said. I completely agree, because if we'd look at the tail tailwind, if we had, in terms of corporate tax cuts, that is beginning to fade. And we've done some work where we've looked at corporate earnings, we've looked at S&P 500 earnings relative to sales in cashflow for your average S&P 500 company. The beneficiary, that tailwind of those tax cuts drove ... you can buy some share buybacks in there as well, but that's not going away. But to your point, that tax cut is starting to fade, there was a delta of 3X. In other words, corporate earnings growth was at three times the level that that we're seeing cashflow and sales.
Walt Czaicki: Typically, cashflow and earnings tend to track each other a little closer. That that can't be continued. And when you look at that valuation support and in this alphabet soup that is our business, many people were using the acronym TINA, there is no alternative. I think that with the Fed on hold, and we saw rates somewhat lower, that also gave some lift of the markets that people were willing to go further out on the risk curve. But it's interesting, if you look at the stocks that have really rallied, it's been these companies with higher volatility, tend to be more higher beta in companies with the balance sheet strength that we think is going to be important, not so much though stocks have rallied those ... in other words, having not the best balance sheets. We don't think that's sustainable, if we continue to see this moderation in growth.
Richard Brink: And we talked about the Fed, we talked about China. Those aren't the only countries that either backed away from tightening or added some stimulus into markets. And so that leads US into maybe a little chat about global trade, which is another obviously an important element in the economy in the world and what people are talking about.
Eric Winograd: From a US perspective, I think that the trade war has had a minimal economic impact. The US is into very open economy, and so when we talk about the risks to the US economy, that isn't front of mind. But for the global economy, it very much is. There are large economies in the world, China foremost among them, but many of the other large emerging markets also ... and Europe for that matter, that are very exposed to global trade. And so, the trade war may not have disrupted the US, but it has disrupted some of these other economies around the world.
Eric Winograd: And one of the things from a global perspective that has been encouraging in the first quarter is that it appears that the pressure toward additional sanctions, that the likelihood of additional trade actions has gone down. We don't have any special insight into whether there will be a deal between the US and China, but the rhetoric seems to have cooled a little bit. It appears that they are moving in a constructive direction. And here again, it allows the market to assess the risk based on what we know now without worrying that things will get too much worse. And you combine that with the actions from Chinese authorities to provide credit into stabilized growth, and the market can breathe a little bit easier about developments in China.
Eric Winograd: And importantly, we've seen in some of the Chinese data science that it is actually bouncing a little bit. So, you combine all those things and the trade dispute is still relevant but is not as much of a risk now as it may have appeared from a global perspective a few months ago.
Douglas Peebles: I think when you look at the growth dynamic globally, and we look at the change in the growth trend of exports around the world, it basically has collapsed though. It's big enough to be alarming when you look at the chart of how much it has fallen. And I think the other thing that we've learned is ... we always knew this. And Eric mentioned the importance of China in that whole dynamic, but you can look at certain parts of Europe like Germany and the Netherlands as levered to that play.
Douglas Peebles: And so the growth slowdown that we've seen largely because of this trade dynamic in those two particular countries has been pretty, pretty darn strong. So, when we look at ... and I think pretty soon Eric is going to start talking about this new Fed mantra. When we look at the how is the market reacted to the most recent Fed discussion points, they're acting like the Fed is really concerned about US growth. And I think that if the Fed is concerned about any growth ... correct me if I'm wrong, Eric, I think they're concerned about German growth and Chinese growth much more so than they're concerned about US growth.
Eric Winograd: I think that's right. You're exactly right to point out the impact of the trade policy disputes on Germany in particular and in Europe as a whole. I don't want to give the impression that all the risks we were worried about early in the year have faded. The risk of Europe falling into a recession is still very real. We don't expect it, but the European economy looks quite poor right now. And if you look at the reasons why it looks so poor, I think that trade policy has a lot to do with it.
Eric Winograd: Germany is very exposed to global trade and exposed to Chinese trade in particular. And the data, they have yet to turn in a meaningful way, the central bank in Europe has stepped back from any plans to tighten and has made clear that they don't plan to. But in contrast to the Fed, they don't really have a lot of tools at their disposal to ease further. And so, if I were to worry about one part of the world falling into a recession, it would be Europe. It wouldn't be the United States.
Douglas Peebles: Yeah, totally agree with that. And there is some rhetoric that if the administration gets a deal done with China, then ... okay. So the in their mind ... and I'm not saying this is accurate, but I think that the way it's portrayed is, well, we took care of the Mexican Canadian thing, now we've [crosstalk 00:15:13] taken care of the Chinese thing, that next in line is we have to go to Europe and then eventually Japan. And so, I think that's still in the back of the market's mind as it relates to what's going on in Europe right now.
Eric Winograd: And I will tell you that if the US does pivot meaningfully toward a trade war with Europe and it doesn't get resolved very, very quickly, the downside risks around the European economy are significant, and there isn't a whole lot of room to move there. They're already growing very slowly. It wouldn't take much in terms of a hot to trade war if you will, to push things in a disruptive direction. It's not our base case and we certainly hope that it doesn't happen, but it is something that we're continuing to monitor pretty closely.
Walt Czaicki: Yeah. I know this is very macro centric, but from what we're hearing on the equity side of the things, this is up and down the cap structure, large cap managers as well as small cap. One common characteristic that we're hearing from US managements is it's hard to find people in terms of jobs, to get people to take roles and find quality people to take these jobs. Because as you've mentioned before, jobless claims numbers are at historic lows. That's been very consistent.
Walt Czaicki: All the more reason that we talked about that earnings not being sustainable in terms of year over year growth, looking at things such as a company's profitability be it return on assets or other measures, we think now is that much more critical because if they are having a hard time, if we don't start to see some wage pressure and it's not centric to one industry from what we're hearing from managements, that has implications for profit margins. So, you have to look at the underlying quality of that company's balance sheet as well as their level of profitability that we just defined beyond just the accounting earnings, which can be very ephemeral.
Richard Brink: So that's a nice move into probably something that a lot of folks watching this video hear a lot. How do you react to the term late cycle or later in the cycle that we hear so much of?
Eric Winograd: Yeah, you do hear it a lot because people are accustomed to this framework where you have a business cycle that defines the entirety of the economy. And I think we've had cycles where that's been true, but I'm not sure that's true for this cycle. What I see when I look at the economy is the different parts of that are in different places. Some are late cycle, some are earlier in the cycle, and it's not as useful to characterize it all in one place. And just to be a little more explicit about that, Walt mentioned the labor market and the wages are going up and initial claims for unemployment insurance are at record lows, the unemployment rate is really low. The labor market does look late cycle. It looks a little too tight, it looks fully mature relative to the expansion.
Eric Winograd: We look at growth, and it's decelerating to 2%, but it's not looking either like a blow off top or the collapse that would signal the end of a cycle. So, I'm not sure whether you would call that late cycle mid cycle or where that would fit. And then when we look at inflation, well, one of the classic signs of being late cycle is inflation picking up, and we're not seeing that at all. So, this framework of a business cycle that defines the whole economy, I'm just not sure it's really useful at this moment in time.
Richard Brink: Well, I appreciate the segue by the way, because Doug's very excited about talking about the Fed. And it is a big deal. So, as we talk about inflation, what is this change that Doug alluded to?
Eric Winograd: So the Fed has a dual mandate. They're targeting full employment, which they have largely reached, and price stability, which means inflation of around 2%. The problem the Fed faces is that they haven't generated inflation of around 2% this cycle, they've generated inflation below 2%. If you look at their preferred measure of inflation over the past decade, it's averaged less than a percent and a half. It's average around 1.4%, which is by the standards of these things a long way from 2%. That missing inflation, if you will, is about 6% over the course of this expansion. If the Fed had hit its target, the price level would be 6% higher.
Eric Winograd: The concern that they have is the reason that you have a target is so that expectations center around it. And it's important that they center around it, which means that that target should be the average rate, but it shouldn't be a ceiling. It's supposed to be the average, and it's been treated as a ceiling. And so, what the Fed wants to do is to shift inflation expectations higher to reflect 2% being an average rather than the top. The challenge, of course, is that the way generally you get inflation expectations higher to get inflation higher, and the way you get inflation higher to get inflation expectations higher. So, there's this sort of circular thing that they're struggling to break through.
Eric Winograd: What they've done this year is become a lot more explicit about the idea of 2% being an average. It's something that they started toward a few years ago by describing the target as symmetric, that didn't do the trick. So now we're saying average. And several members of the FMC have given speeches recently where they talk explicitly about what that means. And what it means is because we know inflation will be low in bad economic environments, that it will be below the target, mathematically, if you want it to average 2%, it has to be above 2% during good economic times.
Eric Winograd: So when we translate that back to near term policy, which I think is where financial markets are, what's the implication? Well, the implication is the Fed wants inflation above 2% and historically, markets have reacted to the idea of inflation going above 2% by pricing rate hikes, saying the Fed is going to raise rates. Well, the Fed is now telling you, Okay, you don't have to price rate hikes even if inflation goes above 2%. And by the way, it's not even above 2% now. And so, if they're targeting inflation above 2% during an expansion, we think that they have room to let the economy run for at least two more years before inflation gets to the point that they should be thinking about for their rate hikes.
Eric Winograd: We think that they're going to make this transition even more explicit over the course of the year. They have a working group chaired by Vice Chair Clarida that's studying the issue. They're having a conference to talk about it in June, and they'll come to a resolution and describe the new policy framework early next year. We're pretty confident that that framework will include an average inflation target, and that the implication of that is that they won't need to raise rates even if inflation gets up above 2% here in the next what, 12, 18 months.
Douglas Peebles: Look, I-
Eric Winograd: That's a big deal.
Douglas Peebles: That's a big deal. We keep saying it's a big deal. I have it written right there. [crosstalk 00:21:20].
Richard Brink: I'll write it down too.
Walt Czaicki: [inaudible 00:21:22].
Douglas Peebles: I would say that first of all, I can't let it go without saying that we have had inflation. The Fed has been successful in stimulating some inflation, it's just been in asset prices. It hasn't been in the traditional measure of what the Fed is targeting, but we have had inflation. I think the second point is Eric is spot on with inflation expectations. And if you look what happened to Japan a couple of decades ago, inflation expectations fell flat as a stone and they never were able ... despite a very aggressive Bank of Japan, they were never able to get inflation expectations off the floor.
Douglas Peebles: And more recently, we've seen the European inflation expectations fall down to the 1.2, 1.3% level. And that's where a Central Bank who doesn't talk about symmetry, they only talk about 2% or below is their inflation target. And I think that the Fed has seen these two instances where demographics and debt have provided a backdrop for lower inflation to begin with, and then it got baked into the cake, and the Fed wisely is changing their mind and saying, "Listen, we need to make sure that we don't let those inflation expectations get in a downward spiral," because there's an upward spiral and there's a downward spiral.
Eric Winograd: And you're right to bring the Japanese experience into this because one of the push backs that I get and that others get when you talk about this idea of intentionally having inflation above your target, the pushback you get is, "How can you say inflation is a good thing? Don't you remember the 1970s and how terrible they were?" And that's right. But from a central banking perspective, we know how to cure the problem when inflation gets too high.
Douglas Peebles: That's right.
Eric Winograd: It's not pleasant, and it's painful, and it causes a recession, but you can stop inflation by raising rates enough to slow the economy. What we don't know as part of the Japanese experience is how to fix the problem when inflation and inflation expectations are persistently too low. How do you break a deflationary spiral? And no one's come up with a great answer yet. And so, the best way to break it is to avoid it all together. And if that means moving inflation and inflation expectations higher, then that's what you're supposed to do.
Eric Winograd: And when you think about it from that perspective, the surprising thing isn't really that the Fed is doing it now, it's that they think to do it a few years ago. That they didn't do it sooner when we first started to talk about this in the aftermath of the crisis. But look, better late than never. We think this is the right thing for the Fed to do, and we expect them to become much more explicit about it as the months roll on here.
Douglas Peebles: The strange thing is that the asset markets are not acting as if what we just talked about is occurring. The asset markets are acting like, Wow, the Fed came out. They're going to shrink their balance sheet faster. They're inevitably going to cut interest rates because growth is such a big problem. And our take is the fit is not doing this because of US growth. They're doing this because of US inflation. And that's a very different reaction function that the market should have if we end up being right about that thesis.
Douglas Peebles: The yield curve should be steepening. The market's pricing in Fed rate cuts, we don't believe the Fed is actually going to cut interest rates unless we're wrong about the economy, and yet we're going to run into a situation. Let's think about this. We still are at record low unemployment rates, and average hourly earnings are somewhere around 3%. And we are going to have a situation where sometime in the not too distant future, their choice of inflation, the core PCE is going to print that two four or two five, and the market's going to be like, "Wow, they got a raise rates." And the Fed is going to be like, "We're not raising rates even though inflation is at two four or two five. And I just think that the yield curve is going to steepen a lot when that happens.
Douglas Peebles: I think the equity market reaction is not terribly surprising given the fact that the bond market's taking the Fed and saying, "They're going to be cutting rates." So, the Tina trade is back on in the equity space, and maybe that we've priced in earnings expectations that are too low relative to what our belief is for the economy. So anyway, I think that there's the potential to make a fairly big play in the marketplace here. Because I think the Fed's policy is a very good one for asset prices, I would say that of all the different asset prices, the one that it's probably not the greatest play for is those risk mitigating assets. And yet they've rallied very, very strongly in anticipation that the Fed is concerned about growth, and now we're cutting interest rates.
Eric Winograd: It's interesting because to your point about risk mitigating assets, treasuries are acting as though we have a growth problem-
Douglas Peebles: That's just not correct.
Eric Winograd: ... rather than an inflation problem, and I don't think we do. If you look at the Fed's own forecasts for growth, they haven't come down by nearly enough to justify the sort of change in their own expectation of interest rates that we've seen.
Douglas Peebles: That's right.
Eric Winograd: And I think that makes clear this isn't a growth issue, it's an inflation issue, and it's leading the Fed toward this reflationary policy, which should be good for riskier assets, equities in particular, because what it's a recipe for is higher [crosstalk 00:26:43] nominal growth, and revenues or nominal.
Douglas Peebles: That's right.
Richard Brink: That's the thing that I think ... you mentioned this a moment ago, but I want to go back to it. This notion of a disconnect between the Fed's belief on what it sees and what the market thinks. Because if there's one truth that we've had for the last handful of years, is when the market and the Fed disagree and the market has to come around to the Fed's way of thinking, markets eat themselves. So, it might be good for growth assets, but by the same token, there's this adjustment that the market might have to make to that reality.
Douglas Peebles: Yeah. I think there's no doubt. And by the way, the first quarter saw both risk mitigating assets in return seeking assets do fabulously well. That usually doesn't repeat itself two quarters in a row.
Walt Czaicki: When you look at sectors for the first quarter, to your point, the top two sectors in the S&P were tech in rates. Something has to give, right?
Douglas Peebles: That's very good.
Eric Winograd: And look, where I think the market may be off base in pricing the Fed in the near term, and Doug pointed this out, the market seems to expect that the Fed will cut rates. We don't expect that. They cut rates when you have a growth problem, not an inflation problem. And if they become concerned about the growth outlook, then we can talk about rate cuts. In the meantime, I think the recipe is more for a curve steepening on the other end of things where we're talking about higher inflation expectations over time as the market has to absorb the idea of the Fed acting more reflationary.
Eric Winograd: And from an equity market and a risk market perspective, there could be some adjustment that has to be done when the market realizes that the Fed isn't particularly close to cutting rates either. I would argue that that's a fairly minor adjustment relative to some of the ones we've seen in the past. The market isn't pricing aggressive rate cuts at this stage and it's not pricing them in the near term, so there's a little bit of wiggle room there. But there definitely could be some friction as the market comes around to the idea that the recipe here is leaving rates unchanged for a really long time, rather than cutting rates to try to boost growth. It's not a growth issue, it's an inflation issue.
Richard Brink: And so if we put this all together, is it fair enough to just simply say we think moderation in terms of economic activity and moderation terms of returns, positive, but not spectacular?
Douglas Peebles: Yes. I think that that's fair. I would say that if we are in a period of lower nominal growth globally ... so we've been talking a lot about the Fed, but let's not forget about the conversation that we had a few moments back about what's going on in Europe. So, Europe has a growth and an inflation problem. So, I think that that third of the world, so to speak, in terms of growth is hardly going to be adding a lot in terms of nominal growth. And I think when you think about asset returns over time, they have to be highly correlated to nominal GDP growth.
Douglas Peebles: And I think that we've had a time period, largely because of the quantitative easing cycle where asset prices have run quite a bit ahead of growth. So, we're not like these real worry warts around the growth cycle, even though it's not particularly a dynamic every place in the world, but we've already had ... Walt just talked about some of the valuations. We've had returns that have far outpaced the growth. So, I think there's got to be a catch up for that.
Eric Winograd: It's not going too far out on a limb. When you say something like, "Well, we don't expect the second quarter to be another record [inaudible 00:30:00]. [crosstalk 00:30:00]. Yeah. So yeah, that's moderation.
Walt Czaicki: Can we just analyze this? I'd be so happy, and so on would everyone else. But no, I would agree, especially if the Fed continues to let inflation breathe higher above that 2%, what was a hard target. If you look what possibly could be the churn, as I mentioned, the first quarter what's done well in terms of stock attributes have been companies with not the best balance sheets, higher beta, higher volatility, and if people come to the expectation that, oh my goodness, the Fed is probably going to let this breathe a little more and they're not going to be cutting rates anytime soon, some stocks with those types of characteristics could be vulnerable, especially if you see borrowing costs continue to rise.
Richard Brink: Okay. So, let's take the other side of the trade then. So, we've got moderate growth, maybe moderate asset returns. Let's talk about tail risks then. You actually alluded to debt and demographics. So, let's do an around the horn here on the things that could really upset the markets over time. Not necessarily tomorrow of course, but-
Douglas Peebles: Why don't you go first? You pick one, don't take- [crosstalk 00:31:02].
Eric Winograd: Yeah, I only get to pick one.
Douglas Peebles:... take all of them.
Eric Winograd: Look, the thing that worries me the most is the continued rise in populism globally. I think it links a lot of the issues together that we are talking about that we think of as risk issues, whether it's immigration policy and the associated political dysfunction, whether it's trade policy, things like Brexit are all very closely linked to this populist idea that the existing system doesn't represent all of the people, or at least many of the people don't feel that they are represented by that system. You end up with populist outcomes when that happens, and that can be right wing, left wing. We're not expressing a preference. Just observing that when you have rising populism in an economy, it tends to lead over time, to more negative economic outcomes.
Eric Winograd: It leads to volatile policymaking, it leads to institutional erosion, the weakening of things like checks and balances, the weakening of central bank independence. All of those things lead to increased volatility. And when you talk to business leaders, the thing that they tell you more than anything else is the hardest thing for them to plan around his unpredictability. If they know the rules of the road, they may or may not like those rules, but they can arrange their businesses, they can organize their businesses, they can structure their activities to cope with whatever that environment is, as long as they know what it is. And in populist moments, it's very hard to know what that moment is or what the rules of the road are going to be. So that alone can impede economic growth and lead to more negative economic-
Douglas Peebles: I would say that we also ... oftentimes, the notion of populism, people think that the pendulum is swinging very far to the left. But there's probably just as many examples of populism swing. And so, the financial sector is a perfect example. We had the financial crisis, Dodd Frank and Volcker were both implemented. The Democrats were in control of that implementation, and it was a very hawkish reading of those two rules in particular. And then the Republicans came in to sit in both the White House and Congress, and the rules weren't changed. But the interpretation of those two rules were changed quite dramatically.
Douglas Peebles: And so you saw the pendulum on the financial swing from left to right on the regulatory framework. Who knows what's going to happen next time? You could still have Volcker in place and Dodd Frank in place and the pendulum swings back over to the other side. So that's a huge, huge dynamic for risk takers in the real economy sense to have to deal with.
Richard Brink: It's funny, as you talked about that the current administration and some policy, it's probably a nice segue then to talk about debt. And as you mentioned, we had supercharged markets for a long time and as you also pointed out, it wasn't growth. It was net margin gains, valuations and so forth. And one of the things that runs along with that is you power pretty big buildup in debt. You want to talk about this sort of debt fixed income?
Douglas Peebles: And I think debt and demographics go together. Since the financial crisis, we've had about 70 trillion dollars in debt issued globally in dollar terms since that crisis. That's about a 70% growth rate of debt in the last decade. It's just off the charts. And so, there are some areas that make up the bulk of that. China is the largest country in terms of debt growth. Government's is quite large, but in terms of percentage increase, the corporate spaces where it's been most pronounced.
Douglas Peebles: And so when we were talking about cycles earlier, I was thinking about, well ... Eric gave a lot of examples why maybe the economic cycle is not terribly old, and so maybe we're not so late cycle in the economic cycle. It's hard to say that in aggregate the credit cycle is not very late. We are very late. With the low interest rates that we've had, the notion of corporations issuing cheap debt to buy back their equity as has been a very popular theme. I am very happy that within the corporate bond space, we have had certain industries that have gone into recession.
Douglas Peebles: I think 2016 was clearly a recession for the energy space. I think with the Amazon effect; we've seen retail largely be in a recessionary environment for a long period of time. So, while I think the aggregate debt dynamics are very scary on the corporate space, I think the fact that we've had these rolling industrial setbacks is actually more healthy than not. And then the one that frankly scares me the most is the government debt cycle. And it scares me the most, not because the US treasury is going to default on their debt. They're not going to default on their debt.
Douglas Peebles: But if we're running $1 trillion budget deficit for an economy that's at full employment, what happens in the next recession? Where do we get the thrust from a policy response? We basically have very close to 0% real interest rates. And so yes, from a nominal sense, certainly the Fed can cut interest rates more. I think its Eric's view, and I totally agree with this, that QE is a policy tool in the toolbox forever. But on the fiscal side, what are we going to do? Run $3 trillion budget deficits in order to boost the economy? I just don't think that that's a terribly healthy situation. I don't think it's something that we have to worry about for a while.
Douglas Peebles: But in the back of my mind, when I think about that debt level and the demographics ... working age population growth is now, in our opinion, going to be negative for the next 25 years in the developed markets. It retards growth, because per capita growth might be okay, but in aggregate it's not so okay. And the debt levels need to be paid back by a smaller workforce. And so, I think that that is ... it just leans in the direction of greater tax on that.
Eric Winograd: And I think it's exactly right to link those two things together. When we talk about the debt, a lot of people talk about it as the source of an imminent crisis. And as you said, look, we don't believe the government is going to default on the debt, but whether they pay the debt back or simply roll it over, those are expenditures they're going to have to make that could otherwise be made on something more productive. Rolling over debt is not productive. Building roads and sewers and technology, that's productive. Rolling over the debt is just rolling over the debt. And so, it does necessarily slow future growth.
Eric Winograd: And in an environment where demographics already pointing into slower growth ... when we look out 10, 15, 20, 25 years, ... I said earlier that 2% seems like a pretty good rate of growth. 25 years ago, that would have been thought of as a terrible rate of growth. 25 years from now, people are going to think 2% sounds really, really good. The potential growth rate in the economy is falling because the population growth rate is falling, because of the debt burden, because productivity is declining for a whole host of reasons. But 2% is about the best we can hope for on a sustainable basis.
Douglas Peebles: And the United States is at the top of the list.
Eric Winograd: And we're at the top. We're the high achievers.
Walt Czaicki: Yeah. I would say on the equities side, Doug made a point that in coming out of the credit crisis, companies levered up their balance sheets pretty meaningfully because they could. You had very low interest rates, you had cheap money to do this and [inaudible 00:38:43] bought back shares. What that's left is a byproduct of that. As an equity investor, you always want to make sure your company has a good balance sheet. That's always a good thing. But if we're right and we're in this moderating phase of economic growth, we're late cycle, that becomes even more important, especially as I mentioned before, if borrowing costs go higher.
Walt Czaicki: There's a bit of an irony in this. With the stocks that have responded best, people really haven't paid as close attention because you can always refinance the debt, you had low rates, you could buy back shares that looked optically from an earning standpoint. Why? That's great. Let's bid those stocks up. Here's the irony, but it's some good news. The companies with the stronger balance sheets are actually trading at a discount to those who don't have strong balance sheets as a byproduct of that.
Walt Czaicki: So the market is getting this upside down, effectively, and there's not much ... Eric would tell you there's no such thing as a free lunch, but this is pretty close. And we've observed something very similar for companies who generate a high degree of free cash flow. We look at the metrics of companies who have the highest free cashflow yield who are actually trading at a discount for their long-term average. That's a good thing, and that's what we're trying to take advantage of, especially in this late cycle environment. Those are always good attributes, but the good news as I said is, they're on sale, and we're taking advantage of that.
Richard Brink: That's probably a good segue. I think it's really important for viewers of this video to understand that we're setting up something where growth is lower for a long time. That's going to be around for a while. Where that is looking, you can almost call that the late, late cycle, that this could be around for some time. And that doesn't mean that portfolios still don't have to be built. And the the issue of potentially populism or other government policies as well as the debt, that's also not going away anytime soon. And so, this idea of how do you build a portfolio, maybe we're saying it about now and we're actually maybe giving you a teaser for what this is going to look like, and Walt, you alluded to that. So, let's stay with this. So how do I think about an equity portfolio in this new world order?
Walt Czaicki: I think it comes down to three things. You want to focus on profitability. And again, we talked about this earlier, we're not talking about accounting earnings. There's a lot of ways you could make an accounting earnings number look really nice. And a lot of that as we talked about with the tax cuts fading somewhat, some of that is going to be a femoral. You can't count on that. So you have to look at the companies with a high return on asset, which is effectively a measure is how good is management utilizing their current assets in generating profits? And the higher, the better. And you want [inaudible 00:41:13] up.
Walt Czaicki: So first, high ROA, second strong balance sheet. If we are right that were moderating in this economic cycle in terms of its growth, borrowing costs are going up, you want these companies to be self-funding largely. You don't want them to have to rely on capital markets to go out to borrow to grow their business. That can be problematic. And if we go from moderation to contraction at some point, that becomes all the more crucial. So, you what a strong balance sheet to write out any unexpected storms. So that's number two.
Walt Czaicki: The third thing is companies who generate a lot of free cash. Think about it. For the advisors who are out there who have clients that are liquid, they know that those clients have options. Having options as a CFO or the CEO, the CEO of a company is a good thing. You have dry powder, you can buy back shares if you think it's appropriate, you can pay down debt, you can make an accretive acquisition to improve your competitive position when you come out of that downturn. So, having that optionality or that free cash is critical. It's those three things, strong balance sheet, high free cash flow and companies with a high return on asset or have strong level of profitability.
Richard Brink: Thanks Walt. And then switching over to the fixed income side of the ledger, what are some of the things that anyone watching this and needs to know about the fixed income side?
Douglas Peebles: Well, I think the first thing is that advisors and their clients are so deathly afraid of rising interest rates that when we talk about the tail risk, there are now very few assets that provide that risk mitigating relief, if you will, that flight to quality trade. And I still think from a long-term point of view, we sit here, and we talk, well, we think the curve is going to steep and we think ... you want to be a little bit underweight; you have duration bogey. That doesn't mean that you have zero duration. And I think what is important about the risk mitigating asset is when does it work. It usually works in times when the high yield market and the equity markets are really struggling. And so, the first thing is don't be afraid of duration.
Douglas Peebles: I think that in today's market, after the rally ... now, the high yield rally that we saw in the first quarter and two weeks ... so now we're in the middle of April. It has been robust. So, we came into the year and we said to people, "Look, after the sell off and high yield, the high yield market was yielding seven and a half. If you fast forward three years or five years, you can pretty certain that your annualized return over the next three or five years is going to be somewhere around that seven and a half percent. And I think that that's a pretty darn good return for an economy that's growing at 2%, and after a very, very long bull run in financial assets.
Douglas Peebles: And so we are recommending our clients that that's what you should look at. It's had that 9% return in less than four months. And so we're not saying that you have to get out of all of those assets because the backdrop that we have now with an expectation that growth is stronger than the market things and a Fed that is going to be more docile than the market is currently pricing in, we think that's pretty good environment for return fixed income assets like high yield. But it's probably better to blend those two asset classes, those risk mitigating and the return seeking together in order to give yourself a hedge if we do have an unexpected downturn.
Douglas Peebles: If the Chinese trade talks don't go well, if we decide to have a two front war that we're going to both go after China and Europe at the same time, you can create environments that are not so healthy for global growth. So, while I don't think anybody's going to get rich in a bank deposit or a three-month CD, I think what you can do is say, "Let me get some higher yielding assets. Let me get some risk mitigating assets." We know that they're negatively correlated. If you mix them together, you can actually have a fairly healthy exposure to income without having too much either default risk or too much interest rate risk in your portfolio.
Walt Czaicki: And I'd say not only in fixed income, but even on equities. If you go with a capable long shot or equity hedge manager that can mitigate some of that risk, then as Doug said, it gives you that lower correlation. I think the key thing is not only is it beneficial for the portfolio, but for people who are concerned about where the markets may go, if they know that that portion of the portfolio is doing its job by playing defense, it keeps them committed to a well thought out investment strategy. For advisers, often the thing that I hear as most frustrating is their clients will abandon a well thought out investment strategy at exactly the wrong time.
Douglas Peebles: Well, we saw that in the fourth quarter. The redemptions were enormous in the fourth quarter across the board not prior to the sell off, but during and at the end of the selloff. And then the subscriptions came in hand over fist in the first quarter, again, not on the first day of the first quarter, but after the returns had already been pretty powerful. So, if you do this long shot, you're not putting yourself in a position to act rationally when it's unlikely that you're going to act rationally. The same way with our credit barbell is that we will do the rebalancing for the client, so that when one asset does as well, we will sell that asset and rebalance into the asset that's under performed. And that is truly the only free lunch that we get in the financial markets is that rebalancing.
Richard Brink: Well, bang for your buck, just to pointed out, shows up in all of those. Walt's discussion about quality of balance sheets, persistent growers, free cashflow generation, low levels of debt, the use of beta reduction inside of equity hedge strategies. And I'll add the ingredient of high yield as an equity de-risk. That's what you alluded to as well. And then efficient income with the blending. Again, the free lunch of diversification. So that's something that I think viewers should take away too is that the persistent theme that we have is that notion of getting access or participation within market returns, but with a healthy level of defense, again, against the backdrop of everything all of you have talked about through all of this.
Richard Brink: I want to wrap with just final thoughts. If we go around the horn, what would you say is most important to you to share with people watching this that we haven't already talked about? What would you add into the mix?
Eric Winograd: I'll start. The thing that we haven't talked about that I think particularly investment advisors need to be aware of on behalf of their clients, taxes are gonna go up. One of the natural outgrowths of populism is that you get pressure for redistribution, the corporate share of GDP is higher than it's been in generations, there is going to be pressured to redistribute away from the corporate and away from the profit sector and away from the wealthy and back to the worker, if you will, to go back to a distribution that more closely resembles what we had 10 years ago or 15 years ago. So, it's re-re-distribution. We've re-distributed up, now we're going to redistribute back down.
Eric Winograd: That's particularly true when you look at the debt load. The way that government can service that debt is eventually going to be through higher tax [inaudible 00:48:28]. It's an inevitability. You always get redistribution with populism. You have to get tax revenue in order to pay off debts. And with a lower growth world, which is necessary, or which is an inevitable consequence of demographics, there's only so many ways you can do all that. And so, it may not happen this year, it may not happen next year. Obviously, it depends on the political cycle, but over time, taxes are going to go up, and it may come through higher tax rates, it may come through reduced deductions.
Eric Winograd: I think a lot of people who paid their taxes this week and live in high tax metropolitan areas probably felt that through the loss of the state and local tax exemption. But one way or another, taxes are going up, re-re-distribution is going to happen, and I think clients need to be, and investors need to be prepared for that because it could take a lot of different forms, but it's going to happen.
Douglas Peebles: And so municipal bonds for those clients who pay taxes in the United States is a good answer to that, particularly in the risk mitigating bucket. I still think if we couch the next six to 12 months, I still think the change in that Fed policy is the most important thing. Something that we haven't talked about which it gets a lot of press is the notion of the triple B, the size of the triple B market in the corporate credit market. And I'm not overly concerned about the size of the triple B space. That's within the context of being very concerned about there's too much corporate debt, but I don't think you can isolate that and say, "Oh, those triple C's, that's where we're really worried."
Douglas Peebles: If I ran you a chart that showed high yield spreads and triple B spreads over time, if you are a statistician, you wouldn't be able to distinguish the difference between those two. And so, I think you should be worried about corporate debt, but I don't think that there's any specific nature of the B market today that should make you more worried than you've been in the past. That's typical bond guy's response. Yes, you should be worried. Don't be so worried about the thing that everybody else is worried about.
Walt Czaicki: And Rick, I would just add the attributes that I talked about, namely high profitability, strong balance sheets, high free cash flow. That applies to growth versus value or any approach, and one that we didn't talk about is international. That's a lot of questions I get from advisors is when is international going to [inaudible 00:50:53]. Say for 2016 and a few other episodes, it's been all S&P all the time. It will have its day, clearly. But one of the things that we would say is ... another thing that's been a bit of a headwind is when you look at the underlying indexes in terms of ... if you look at the S&P 500, if you look at the EFI index, if you looked at the EM equity index, the composition, there's some pretty stark differences. Namely, if you look at how cyclical international is versus US, the international indices are more cyclical.
Walt Czaicki: So we did a brief experiment. We said if we take materials, industrials, energies in financials, those four sectors, which arguably are very cyclical, boom bust, if you will. If you look at the S&P, that's only 30% of the S&P 500 index. For the emerging market equity index, it goes to 45%. For the EFI, it goes up to 47%. Again, it doesn't mean it's an investible asset class. It will have its day in the sun, but within moderating economic growth environment, that's been another headwind to that asset class. Because if you think of the S&P as 30% in those cyclical sectors, what are you left with? You're left with defense, staples, utilities, and rates, and growth, tech and discretionary.
Walt Czaicki: So that's been one of the causes in terms of this delta, if you will, between performances and those indices. But we would still say we're finding opportunities because when we look at valuations ... I know it's hard. We counsel people. Be patient. It will have its day in the sun. We're at 20-year lows in terms of international stocks versus US in terms of valuation. So clearly, there's opportunity, but what we're emphasizing is focused on those companies as you noted, Rick, that have that enduring and persistent growth. Secondly, who have high quality. And we really define that as somebody with a real strong competitive advantage.
Walt Czaicki: Stability, don't go too far out in terms of the risky stocks. Keep your beta fairly low. And what we say price. Don't pay too much up for it obviously from a valuation standpoint. But what we're talking about specifically is avoid some of those crowded trades that can happen. Because people say, "Well, if I'm going to go international, I'll go in an area like consumer staples." But what we found is that sector is not as defensive as Doug, when you and I were growing up in the business because your barriers to entry are low.
Walt Czaicki: Just ask Gillette about Harry's Shave Club. They could undermine in terms of the amount of money you spend into that brand. And consumer preferences in terms of food, habits are changing. They're not as defensive as you think. In some cases, they get bid up very high. We're trying to avoid some of those crowded trades. But we're finding opportunities, but as with all things, you need to be selective.
Douglas Peebles: One thing we haven't talked about is the currencies, and largely because they've been fairly docile. Emerging market currencies have underperformed quite a bit, but the majors really haven't moved all that much. One of the things that we would expect is for that trend to continue. Now, famous last words when you predict no volatility in currency markets there. So, let me talk a little bit about that. I think it would be bad news for financial assets everything else being equal if the dollar were to rally a lot, because the notion of that is a symbol of declining dollar liquidity, so less dollars available, particularly off shore and therefore the price of the dollar goes up.
Douglas Peebles: Now, if the US wasn't running this enormous trade deficit, we would probably be more likely to be predicting a higher US dollar, because US growth is stronger and US interest rates are the highest in the world now, in the developed world. And technically, which matters a lot in foreign exchange, we are at some important resistance levels for the dollar. We don't expect the dollar to go through those resistance levels, but I think if it did, it would give me some caution that either one, we're wrong on this Fed call. I don't think that we're wrong on this Fed call. At some point, Eric and I are going to be having real conversations about, Okay, now the market has caught up with our Fed call. Will it work? And so-
Eric Winograd: Which is the next question.
Douglas Peebles: That is the next question [crosstalk 00:55:08].
Eric Winograd: With any policy act, the first question is will they do it, and the second question is will it work? We're not quite at the point of having to answer that second question yet, but we're doing work on that now because it is a multi-trillion-dollar question.
Douglas Peebles: That's right.
Eric Winograd: And it is to a degree, uncharted waters. It's a change in the reaction function of the biggest central bank in the world, the most important central bank in the world. How that plays out has the potential to shape global financial markets for a long time.
Douglas Peebles: Well, I would say that the last time the Fed did something potentially as big as this is when they did QA.
Eric Winograd: And look what that did [crosstalk 00:55:42].
Douglas Peebles: And look what that did. It was an enormous impact on markets. But I think specifically to currencies, I think the collective wisdom of the market is saying, "Well, the Fed is going to let inflation run hot at times," and the next question is answered in the positive that, yes, it will work, I think the dollar is going to do a lot better under that environment. And then we can argue about that because you never know when something might seem so clear, other people think the opposite way on that. And so, I would think that oddly enough, that that situation might actually call into question some of these valuations at the stretch levels that Walt had mentioned earlier. So, we'll have to keep an eye on that as well.
Richard Brink: Well, gentlemen, thank you for the final thoughts. Thank you for your overall comments. I think we've covered a ton of ground for everyone here. I think there's definitely something here for everyone to help with their portfolios. I would like to thank my friends first and foremost, and my colleagues from Alliance Bernstein, Walt Czaicki, Douglas Peebles and Eric Winograd. Again, I'm Rick Brink. Thank you for joining Asset TV. This has been The CMO Masterclass.