MASTERCLASS: State of the Economy

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  • 59 mins 53 secs
As investors enter a new decade, they'll be keeping a close eye on monetary policy, the growth of the global economy, and much more. In this Masterclass, four experts weigh recession risks, outline opportunities in gold, and share their outlooks for 2020.

  • Dirk Hofschire, CFA Senior Vice President Asset Allocation Research Team, Fidelity Investment
  • Jeffrey Schulze, Investment Strategist at Clearbridge Investments
  • Juan Carlos Artigas, Director of Investment Research at the World Gold Council
  • Edward Rosenberg, Senior Vice President and Head of Exchange Traded Funds at American Century
 

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MASTERCLASS

Jenna Dagenhart: Welcome to Asset TV. This is your 2020 Outlook Masterclass. As we head into the new year, investors have a lot to consider. We'll cover monetary policy, the state of the global economy and some of the biggest market drivers of the record bull run. Here to help us look ahead by also looking back, we have four expert panelists; Dirk Hofschire, Senior Vice President, Asset Allocation Research Team at Fidelity Investments; Juan Carlos Artigas, Director of Investment Research at the World Gold Council; Ed Rosenberg, Senior Vice President and Head of Exchange Traded Funds at American Century Investments; and Jeff Schulze, Investment Strategists at ClearBridge Investments. Thank you so much for joining us.

Jeffrey Schulze: Thank you for having us.

Juan Carlos Artigas: Good to be here.

Dirk Hofschire: Thank you for having us.

Edward Rosenberg: Thanks for having us.

Jenna Dagenhart: And it's hard to believe that 2020 is upon us. But Dirk, I wonder what's your take on the major economies and where are we headed?

Dirk Hofschire: Yeah, it is sort of weird to think about 2020. So futuristic sounding, right, that we're going to forecast 2020, but it is right here and upon us. I think the thing about where we're going next year, you really have to think a little bit about what's been going on this year and the markets have been terrific, great year for asset prices across the board. The global economy hasn't been great though, so it's almost been in spite of the global economy or the global economy kind of held up just well enough to keep things moving along. But as we look at the end of the year here, we really had a year where the US economy kind of lost some steam throughout the year, even though it's been probably the world's best performer. The rest of the world started the year kind of with manufacturing slump, trade recession and whatnot and hasn't gotten a whole lot better.

So, when I think about where we are today, it's very late cycle, kind of mature, global US economy. It's not falling off a cliff, so things are kind of going to be all right as we start 2020, but I'm having a hard time finding that real positive catalyst that gives a lot of excitement about V-shaped global recovery next year.

Jenna Dagenhart: And we've seen a lot of money pouring into safe haven assets like gold, despite these record highs. Juan Carlos, do you want to elaborate on that for us?

Juan Carlos Artigas: Yeah. Look, I agree with Dirk. If you look at the asset classes in general, you have seen positive performance in pretty much all of them. However, it hasn't been without volatility. So, the stock market, it's pretty high, but at the same time, it has had serious retracement. The level of uncertainty amongst investors I think is pretty high and the fact that stock markets continue to go up while many other assets, including, for example, gold, have been looked after this year, is giving you a sense that investors are nervous, are nervous about the environment, the uncertainty, the fact that many of the issues that the market is facing, whether it is fundamentally from an economic growth perspective or just from a geopolitical tension perspective, issues haven't been resolved, they have been postponed. So, any of the things that we have been talking about since January, we continue to talk about them.

It's trade wars and Brexit and this and that and they continue to be themes. Every time we seem to be reaching a new deadline, the deadline is postponed, right. So, point being, gold, to your initial question, has been actually a very good performing asset, not necessarily at the same level that stocks, but exactly it has worked well in periods when the stock market was pulling down, which is one of the periods that usually investors use gold for protection.

Jenna Dagenhart: So this is a little bit different.

Juan Carlos Artigas: Correct.

Jenna Dagenhart: And Ed, what do you think the big market drivers have been this year?

Edward Rosenberg: I mean, if you look at this year, right, no matter what we talk about, growth has been slowing. So, Dirk said it, the earnings for the companies are slowing down, GDP is getting lower. But what's interesting is the market reacts to two things lately, react to the FED whenever they do anything. And the question really is, is what is the FED trying to do? It feels like in this presidential run, we'll have. They're trying to just keep this market going. What does that mean for 2020? Is that something you can keep doing? You keep propping it up by using rates and other things to do that. And then every time we get close, right, we get a China deal, "We're almost there," market goes up. Then, "Nope, we're not there yet." Market goes down. I think those are the two factors that create immediacy for the volatility. But long-term, are people really taking into account what's really happening? Are people spending more money? Are the companies actually growing their earnings? Are they cutting workforce? What are they doing?

I don't think what we're seeing is what we saw this year, is those factors didn't cause any issues, the market just went up, right. There was some volatility. But in the end, it's a question of how does all of what we're doing this year really impact next year? Specifically, because the US economy could change dramatically just as an outlook with the presidential election? What does that mean at the end of the year and how do people forecast that in and what goes into it?

Jenna Dagenhart: So these trade headlines taking markets on a bit of a roller coaster ride.

Edward Rosenberg: Very much so. And what's interesting about this year is nothing seems to be able to stop the growth, with the exception of the... There's going to be negative, right. The China trade deal's never going to happen, it's just like it's going to happen. It's going to happen, right. It's almost like, "I want to buy this new car, but I don't have the money, so I'll wait another month. I'm going to buy this new car," I get excited and then I don't do it again. That just seems to be going along and the question is when do we all pay the price for all of what's happening when we realize that maybe there won't be a China deal or there won't be a deal we like and what does that mean for our economy as a whole? And quite frankly, what happens when the dollar starts to weaken, right? It's been pretty high levels throughout the year and what does that mean as we go forward?

Jenna Dagenhart: And I wonder, Jeff, what's your bull case? What's your bear case, as we've been discussing? It's been quite a long bull run.

Jeffrey Schulze: Yeah, so I think we touched on a little bit of the bear case. The bear case is certainly that we're going to go into a recession in 2020. I think a lot of that may be to the lagged effects of FED tightening. So, when the FED tightens or cuts rates, usually it takes about 12 or 18 months for that to filter through into economic activity. It's the key reason why the FED never gets a recession right because when they start to see the data deteriorating, they may cut rates, but that's not going to be a quick enough turnaround to save the actual economy.

If you look at manufacturing PMI when it's decelerated and you've had FED tightening, on average, it's bottomed out a 40.5 level and the most recent manufacturing print that we got was a 48, which means that there's going to be more slowness in that sector. We think that there's going to be a recession scare sometime in the first quarter. Also, if you look at profit margins, broadly speaking, for the US economy, we look at NIPA profit margins, there were revised down by $200 billion in July, which is a huge revision outside of a recession. This disproportionately hurts small and micro- cap businesses. So, if those businesses are starting to feel those pain, maybe they start to cut back the hours of their employees. And when that doesn't maintain their margins, eventually they'll lead to layoffs and a recession will ensue.

But the bull case is the one that the markets are clearly pricing at this point, that the FED and global central banks have engineered a soft landing similar to 1995, and investors are not positioned to be taking advantage of this. So, if you look at flows over the course of this year, about $850 billion is going into bond and money market funds and $200 billion has come out of global equity funds. The net difference between the two is over a trillion dollars, which is the largest on record. So, I believe if a soft landing is successfully engineered, that you'll have a little bit of FOMO, or fear of missing out, that money will make its way back into the equity markets and it will have a really good year in 2020.

Also, I think you could get some valuation expansion from here. If you look at every bull market top going back to 1946, heading into a recession, there's been 11 of them. On average, the trailing PE multiple has been 27% higher or at a premium versus its previous five years. And today, the PE level of the market is actually at a discount versus the last five years, so I do believe we could get a little bit of multiple expansion. And just to get to that 27% premium level, that would be PE multiples go up about five or six turns. So, the bull case is really that this soft landing is successfully engineered, flows come back into equity markets and you get multiple expansion.

Jenna Dagenhart: And I wonder, you mentioned the inflows into bonds for example, what do you make of the price of gold that we've seen rising in 2019? How does that fit into your bull case, bear case?

Jeffrey Schulze: I think it's just a sign that the FED has cut rates. They've given us an opportunity for economic growth to reaccelerate, for inflation to accelerate from here and gold is going to the natural beneficiary of that trade.

Jenna Dagenhart: Anything you'd like to add on that one Carlos?

Juan Carlos Artigas: Yeah. No, absolutely. In fact, opportunity costs or of holding gold is one of the drivers. The FED is one of the indicators. Of course, gold is a global asset, so you also need to be looking at what is happening around the world. We're talking about the very low interest rates that we are seeing here in the US. But in Europe, they are trading with negative yields. If you actually look at the real yield curve around the world, about 70% of so of developed markets are in that is trading with negative real rates, so that, of course, is diminishing or reducing the opportunity costs of owning gold and making it attractive. But it's not only that, it's of course combined with the environment that we are seeing, kind of like the fundamental perspective of seeing gold as a hedge to risks that are piling up from different perspectives, right, whether it is from people that may see stock valuation as high, especially at the level of rates, or people that may see geopolitics or other risks combining as we were discussing before. Those two things, I think, are combining, producing this year's performance or supporting this year's performance.

Jeffrey Schulze: It's interesting if you look at a chart of gold overlaid with the amount of negative interest rate bonds in the world, over the last five years, they're mirror images of one another. So if you continue to see more and more bonds globally trade at a negative interest rate, I would think that would be bullish for the price of gold.

Juan Carlos Artigas: Yeah, correct. And actually, we included that particular chart in one of our latest reports, so I completely agree. I'm glad that you flagged it.

Jenna Dagenhart: I'm glad that you bring up monetary policy too and the FED because it's difficult to talk about 2019 and where we're headed without talking the FED. So, moving down the line, I mean Dirk, what do you make of the FED and this U turn that we've seen this year? I mean, this point in 2018, the FED was hiking and now we've seen three cuts, so here we are.

Dirk Hofschire: Yeah. Pretty dramatic really. I think when you go back and think about it, it was a little bit odd from the standpoint that, yes, the markets had a lot of volatility in the last year, certainly the global data was coming in weak. But when you look at the US economy, when you look at the growth metrics, inflation metrics, there really wasn't anything that changed in the data that the FED was seeing that, to me, would have led a traditional FED to do a complete about face, going from that tightening to easing. To me, they've lost a little bit of their center of gravity when you think about this going forward in terms of what they're looking for. And remember, they also told us at the end of last year that the balance sheet was nothing to see. They were tightening the balance sheet, allowing the reserves to run off and then you had a lot of volatility in the repo markets this year and they've had to now expand that.

So, I think as you look now, I think the FED is a little bit purposely behind the curve. I think they're being very reactive at this point and waiting to see where the market tilts them, perhaps where the next big inflection point in the economy is, but they clearly had a message here recently that they're not going to do anything else for the time being and we'll see where it goes. So personally, I think then it's just the outlook on the economy. I think if it gets significantly worse in the US, the next move will definitely be easing, but we may have a few months here where not much gets done.

More generally, beyond even the FED, you mentioned negative interest rates and broadly policy outside the US. I think what we are starting to see though at a really high level is the limits of monetary policy hitting. I mean, the FED can cut interest rates a few more times so we're in a better place than Europe and Japan, but I think you are seeing for the first time in the cycle, some of these policy makers saying, "Going even more negative isn't going to help that much." Even the Federal Reserve saying, "Maybe we don't want to go all the way to zero right away until we actually see a bigger problem in the economy," because they know there's maybe not as much upside to the economy through the next monetary easing. I think fiscal is going to be where we're eventually going to get, but we'll see if it's 2020 or not.

Jenna Dagenhart: Yeah. How effective is monetary policy when you get below zero into that negative territory?

Dirk Hofschire: To me, it's actually counterproductive. I mean, first of all, it's just strange, right? I mean, what does it mean to have a negative interest rate? You're paying someone to borrow. I mean, it's just topsy-turvy and if we can't figure that out just from a human being kind of standpoint, then banks can't figure it out either, insurance companies, others, so the basic structure motivating how you lend and borrow almost doesn't make any sense in that world. It's been terrible for banks. It's actually terrible in countries that have bad demographics because these are savers. People that are living off of pensions or need to earn money from fixed income and now they're getting nothing, so I think it's hurting consumption. I  

Again, I think you're seeing the very early innings of people starting to recognize this, but the problem is there doesn't seem to be a great alternative on the horizon. Because now that you've gone negative, if you overnight and go positive in some of these countries, that's going to be very disruption. So, I think you're caught between a rock and a hard place, but you're going to have to find some other policy ways to get the economies going if they're not able to with this.

Jeffrey Schulze: And one thing that I might add is that I do think that the US probably has enough ammunition to get through the next recession, right. If you cut rates to zero, it's about 175 basis points from here. If you look at the last seven recessions, on average, it's taken them about 7.5 percentage points of cuts to get you through that rough patch. They can bring back QE. The balance sheet of the FED is about one fifth the size of the Japanese. It's less than half the size of what you have over in Europe, so they certainly will bring back QE with steroids. You could bring into the fray forward guidance, where they may say, "We're not going to raise rates for one or two years," which will help ease financial conditions.

But after you run out of those three policy choices, even though policy makers have said that they wouldn't do negative interest rates because of a lot of the things were mentioned previously, negative interest policy where the regions that it was instituted did a very good job of depreciating the currency in that region. So, when you run out of monetary bullets, I think that would be a topic of discussion if it's one of these more deeper recessions. But given the lack of accesses that we see right now, I think the next recession's probably going to be a shallow one, economically speaking.

Jenna Dagenhart: Ed, what are your thoughts?

Edward Rosenberg: I mean, here's the hard part, right. Who is the FED working for? Right. Is it working for the economy or the administration? We talked about a stark turnaround with what occurred, from tightening to easing, and that seemed to be more of peer pressure from what was going on around, and did the economy actually need it or was it something that they wanted to do? So, I think to the point of how many bullets are left that they can use, right... They've been signaling, as Dirk said, that they're not going to do anything for a little while. The question is, is what will make them do something going forward? And I actually don't know what that is, right. When you read where we are, why did they tighten and then ease? It didn't make a lot of sense, right. The data was the same. Did they need to tighten? Maybe. Did they need to ease? Maybe. Again, they could have stood patent and then see where they were. We're just a little below where we started. But in reality, the question becomes what's the next FED move and where's that going to go?

And honestly, from where we're sitting, it's just I don't see much happening for a while, until we figure out where this economy is going, right. Is it true that all the growth is slowing, and all the signals say that, and something needs to get done over time? Do we go into a recession or do these markets just continue the tail end of this growth cycle. By the way, we've all been saying it's the tail end for a while, so it's kind of hard to say where the tail end is going to end. When are we going to get to that end? But, in reality, it's a question of where does the growth take us? I mean, we've been an unprecedented bull market and just growth and people are benefiting from that. But even if you look at numbers like unemployment, right, the lowest unemployment numbers in a while, but how much are people employed? Is it low paying jobs? Is it minimum wage jobs? Is it part-time jobs? A lot of that feeds into it.

For me, looking at what the FED's going to do, I think they're going to do nothing for a while and just see how this playing field plays out. And then, hopefully react correctly when it comes forward.

Dirk Hofschire: I thought it was interesting, you said, "Who is the FED working for?" I do think we're in a place that we think of politicization of the FED or political influences maybe coming from the White House now, but there's this other element too that the Federal Reserve's getting blamed in some ways by propping up asset prices with QE and all the things that you mentioned a second ago. Helping asset markets, helping rich people, wealthy, all the things that are contributing to the stark inequality that we see and going back to that drawing board again and doing all those things again I think is really going to put them in the crosshairs for this public angst about who is the Federal Reserve working for?

Edward Rosenberg: Oh yeah.

Dirk Hofschire: I think there's going to be reluctance for them to want to do all of the extraordinary things and that's why I go back to other things are going to have to happen. There’re possible fiscal elements to this, but there's other parts of it potentially beyond monetary policy.

Edward Rosenberg: Yeah. The one thing I will say is though from QE, I know the federal government raked in a lot of money, right. They benefited themselves from it. The question is would they do something like that again if they saw some benefit from doing something like that? That's the question too, so it really comes down what is the FED trying to accomplish and who are they really trying to benefit? The hard part is, in the last 10 years, that question is probably more muddled than it's ever been, right. Is it political? Is it in house? Is it for the people? That's the hardest part when you look at the FED and where they are now and going forward.

Juan Carlos Artigas: And maybe the other thing too to think about is we cannot see the US in isolation, right. I mean, the FED is going to be doing what they need to do or feel they need to do with respect to something later that is happening, but it also matters in terms of whether the recession happens or is shallow or how the recovery happens in terms of what else is happening in the world, right. I think that part of the anxiety from global investors or investors around the world is not just what is happening in the US and what the FED is doing, which, of course, influences markets quite a bit, especially in the short term, but again, more broadly, how are we going to get out of these perhaps more complex economical and geopolitical situation where growth is no longer as coordinated as it was in previous decades, right. And I think that, again, this is important and perhaps bringing back the conversation in the context of gold, one of the benefits of gold is that it's a truly global market, right.

So, oftentimes when we talk to investors or when investors in the US are thinking about gold, they think about it in the context of, again, the US economy and so on and so forth, but it is really important to understand that there's still quite a lot of demand coming from Indian consumers and investors and Chinese and European and central banks, right, around the world, so it's not only perhaps the performance of asset classes like gold or like stocks or like bonds or anything else in the context only of US performance, but truly global performance and how that coordinates.

Jenna Dagenhart: And what about in the context of inflation as well because that's... The FED is chasing that 2% inflation target?

Juan Carlos Artigas: Correct. I think that there's a huge debate and you guys were talking about it before, what is inflation? Is it asset price inflation or is it just like CPI inflation? There's a big debate. I think that in general, for example, investors tend to use gold as a hedge against really high inflation. It's not about whether inflation increased a little bit or not, it's about in general, you have something [inaudible 00:20:50] to inflation and where you are expecting things to be not as steady as before. That is not only about goods, it's also about the stock market. Again, when the stock market starts to increase quite a bit and there's nervousness about whether there's going to be pullbacks and so on and so forth, investors may be using assets like gold and safe havens to hedge against some of those risks.

Interesting enough though, another way in which investors have used gold that gets past, is to hedge against deflation. People sometimes are very confused when somebody says, "Well, gold is a good inflation hedge and a deflation hedge." The essence of this is to understand that these are two high risks and gold is generally a good broad, systemic risk hedge. So, when you have deflation, cash is going to perform very well, but many other asset classes are not and gold still performs well, even if it doesn't necessarily... It's kind of like, again, equivalent to using cash in that environment and you can see that happening in Japan or you could have seen that happening in decades past as history tells us.

Jenna Dagenhart: Anyone else have thoughts on the FED's inflation target or how it ties into what Juan Carlos was just saying?

Jeffrey Schulze: There's been some chatter from the FED that they're going to move to an average inflation targeting regime and an average of 2%. So, since they've undershot for roughly the last 10 years... In fact, over the last 10 years, there's only been six months of that time frame where they were above their 2% core PCE target. If they move to an average of 2% inflation target, that would allow inflation to overshoot as you get later in the economic cycle. If they do that, obviously I think that's going to help boost inflation expectations that the FED is a little bit more committed to generating inflation and going to be a little bit more looser from a monetary policy perspective.

Jenna Dagenhart: I think Ed made a great point too when you said, "I don't know what would cause the FED to change its course." It's certainly signaled a pause and address some of those investor concerns about would you hike again, or would you change direction? At the last press conference, the FED addressed those concerns. So, does anyone have thoughts on what could make the FED change course?

Jeffrey Schulze: I do. I think that if you do have a genuine recession scare, which again was our base case in the first or second quarter of next year, that the FED will give an insurance cut or two more than what they've had already, so our expectation is that you're going to get at least another cut sometime in the beginning part of that year, but it's going to have be predicated on the deterioration of the data a lot further than what we've seen here recently.

Jenna Dagenhart: And how does this all tie into the strength of the US dollar too and how does that impact commodities and gold?

Juan Carlos Artigas: As we were discussing before, I think that generally speaking, actions by the FED tend to have quite a bit of influence in short term performance of asset classes, especially when they are changing their position, right, and we've been talking about this before. They were tightening for a while and then suddenly, they went on hold. That changed in direction. The market still tries to figure out what the FED next move is and reprise its expectation. So generally speaking, if you look at the level of or changes in expectations relative to what the FED is going to do, you can see how the gold price is going to react from that, right. So if some investors expect the FED to cut rates much more, then you are going to see gold price general increase and vice versa. It definitely has an effect, especially in the short term. But more importantly, it is truly the combination of the other factors, right. It's not just the FED, but what the FED is trying to signal, relative to the rest of the economy, how does it feel fundamentally that truly determines the performance of gold in the long-term.

Jenna Dagenhart: And looking at some of the fundamentals as well, Dirk, I wonder, where do you see strength and weakness in regional economic data?

Dirk Hofschire: Yeah, so when I look around the world, I wish I had real pound the table, "This region looks great," or, "Developed markets look better than emerging markets," or had some really dramatic conviction on that. I think what we're seeing is, right now, it's becoming an unsynchronized environment. I mean, you can look around the world and see places in Europe that actually kind of look okay to me cyclically, like France and then Germany actually looks like it might actually be tipping into recession. You go to Asia and India has really lost a lot of momentum. South Korea might be perking up. Latin America, Mexico, tons of head winds. Brazil might finally coming out of an economic downturn. So, I see the world perhaps being more unsynchronized than it's been in years.

In some ways though, and this gets back to your question about the dollar, I feel like it's a pretty good time to think about international versus the US, not so much because I know for sure that there's going to be this big turn right away. The US economy is still doing better. The FED keeping rates higher than a lot of other places in the world gives the dollar some ballast, but I think the next big step, when you think about US basically outperforming for 10 years and the dollar being strong from a decade, I think the next step at some point or another is going to be a rotation back to international and a weaker dollar. And maybe it's this year, but I don't think it's too early certainly to think about that rebalancing. If you've let the portfolio drift or you think that the US is always going to outperform, I actually think it's a pretty good time to be thinking about international.

Jenna Dagenhart: And what do you make of consumer strength, consumer demand right now?

Dirk Hofschire: In the US? Yeah, so to me, its late cycle environment means you're in expansion. And usually in the late cycle, the consumer does very well because the labor markets are very tight. The problem with that is that it's not a forecasting device at all because it always happens in late cycle and then at some point, other leading indicators lead you to a downturn in the consumer area. So, I'm more focused on the business side of things because clearly we know the unemployment rate is very low, consumer spending's been holding up, but that labor market, the flip side of it is rising wages, which crimps profit margins and we already talked about how profit growth has come down materially and is basically going to finish this year, 2019, zero to 2%. The market expects nine to 10% next year, so how do we get that?

To me, we're going to have to see the economy accelerate. It's hard to have such a strong labor market underpinning the consumer and yet get profit growth to really come back significantly, unless we get the whole global economy reaccelerating and that's the part again that I'm not worried about the US consumer ending the party necessarily in and of itself, it's more the businesses potentially pulling back as they feel those profits under pressure.

Jenna Dagenhart: Juan Carlos, do you think the US consumer will hold up as well?

Juan Carlos Artigas: Yeah. I mean, I think that I agree with Dirk's perspective on the US. Again, I think that in particular, when it comes to gold, you also need to think outside of the US, right. And your question is really relevant because oftentimes, gold is seen primarily as an investment or as an asset that only performs well in periods of high risk, but the reality is that there is this other side of gold, the dual nature of gold that is not only about investment, but also consumption. In fact, about 50% or so of annual demand goes to jewelry and jewelry around the world. I mean, primarily in India, China that are some of the largest and strongest markets, but also the US and Europe and various other parts in the world. Technology. Gold is an integral part of technology complications, some devices, computers and so on.

There is this procyclical side that is very relevant, especially for long-term performance of gold, while the countercyclical flight to quality aspect tends to drive prices more evidently for some investors. Long story short, in this particular environment, what we have seen is some softness in the consumer demand side of gold, in particular, because the increase in the price of gold, the volatility and uncertainty are keeping some of the consumers perhaps looking carefully when they can go in.

Now, at the same time, we do think that there have been or there are many structural reforms in place that will happen, especially in emerging markets that, again, will make this softness more of a shorter phenomenon. But again, I think it is really relevant to understand that when it comes to gold, you should only look at the investment side, flight to quality flows, but also how the consumers are reacting in those environments.

Jeffrey Schulze: One thing I'll mention about the consumer is that it's a source of strength in our Recession Risk Dashboard that we have at ClearBridge. A group of 12 variables that have done an excellent job of being able to foreshadow an upcoming recession. And right now, it's a 50/50 probability of a recession. If you think about each of those variables, green is good, yellow is caution and red is bad. And right now, we have six green, three yellow and three red signals. But most importantly, the overall dashboard is flashing a yellow signal. But if you look underneath the surface, all four of the consumer variables are green and I firmly believe that they are going to hold the fate of this economic cycle. If they can continue spending and they don't retrench, this will be a slowdown like 1995 or 1998/ But if they do start to get a little bit more worried about the labor market, start to pull back their spending because of an escalation of trade wars, that ultimately would sow the seeds for recession next year.

Now, if you look at the dashboard over history, it's done a really good job of being able to identify a recession, but there's a key difference between a red signal and a yellow signal. So, the dashboard has had eight red signals in its history, going back to 1960. Seven out of eight of those are recessionary so it's a much more powerful signal. You've had three periods where the dashboard turned yellow. Something happened and economic growth reaccelerated and it went back to green. Those false positives were 1995, '98 and then 2016. Now, ultimately, we think all of those would have been a recession, but the FED recognized weakness in each one of those instances, gave liquidity to the markets and caused the economy to reaccelerate. So, if you think about the point of where we are today, the FED has clearly gotten the message. They've cut rates three times. They're doing quantitative easing. And we can debate whether it's quantitative easing or not, but it does liquidity to the system, but it does give us a fighting shot of avoiding a recession next year.

The one thing I really want to hammer home here is that usually when you've had a yellow signal on the dashboard, between the sixth and nine month timeframe of it turning yellow, usually the data accelerates or decelerates and we turned yellow in July of this year, which makes the first quarter of 2020 the make or break moment for this cycle.

Jenna Dagenhart: We shall see. And on this conversation of the state of the economy, global growth affects corporations and I wonder with that, what do you think about these semi-transparent, actively managed ETFs and do you think they'll be a game changer?

Edward Rosenberg: They could be, right, because they can offer strategies that you just can't have today in the ETF world, right. So if you look at the ETF world, your basic index and your transparent active, but nobody's putting their true best IP forth in a product to allow the investor to come forth and potentially have a strategy that can adopt to a market cycle in an active form in a concentrated format, so these can be game changers because it gives the investors new tools that only exist in a mutual fund format. And to be honest, a lot of people may not like the mutual fund format anymore, they're looking for other vehicles. They may prefer the ETF because it potentially could be more tax efficient. By going to something like that, you're offering up tools to investors across the board that really want this ETF or want this structure, that will get something new, I'll say to play with in their portfolio or to add to their portfolio that can really bring forth, whether it's mine firm or any of the firms up here, the best idea in something that will allow them to add in a flavor that they've never had before, right.

It's simple as ice cream, right. You have vanilla, chocolate. All of a sudden, they want pistachio. If it's not available, they're not going to buy it. But if it's available and they want it, when they want it, they can use it to help with that.

Jenna Dagenhart: Are you saying now we have pistachio?

Juan Carlos Artigas: Maybe. You said we'll make it easy; things people can relate to.

Jenna Dagenhart: And building off of that, there have been a lot of headlines about these semi-transparent, non-transparent ETFs this year, all the regulatory-

Edward Rosenberg: I mean, there have. Just a few minutes before we started filming, so it'll be timely on this, the new structures, the proxy basket structure, got their go ahead, right. They were noticed last month. They got their go ahead about 20 minutes before we started filming, so that brings forth a whole new set of semi-transparent to go along with the active share structure that was already approved. So middle of next year, you could see five or six different structure types in the marketplace that will allow different strategies, potentially in each one, to bring forth products for people to use.

Jenna Dagenhart: Any other economic indicators that you're especially watching right now?

Jeffrey Schulze: One thing I'll just throw out there is that on the dashboard, one of the indicators is jobless claims. Whenever you see a year over year rise in jobless claims of 12%, it's always been recession area and you've always been three months away from that recession, so it has a very high hit rate and it has a very high degree of precision, of telling you when that recession is coming. If you look at jobless claims, we've been in a range between 210,000 per week, all the way up to 240. The most recently couple weeks, the jobless claims have gone right back to the bottom of that range, which is a good sign that we're not on the doorstep of a recession quite yet. But if you do start to see that turn to yellow and eventually red, the alarm bells will be going off at ClearBridge that the economic cycle's over.

Juan Carlos Artigas: In terms of indicators, actually one of the things that we tend to look at from a stock market perspective, I mean, people think about variations and Cap EG and so on, one of the things that we do is look at the ratio of valuation in particular relative to the level of interest rates, so not just where you are in terms of PE valuations for the stock market alone historically, but how much has that been driven by monetary policy, which goes back to the conversation we were having before. Is this related to asset price inflation or fundamentals? And I think that's an interesting perspective. We have been reaching really record highs, things that we haven't seen in a really, really long time, right. So, it talks about the fact that potentially there might be some sectors where there's opportunities, but it's also the fact that to some degree this movement, in particular in the stock market, may be driven more by monetary policy rather than fundamentals.

Going back to the point of that's one of the reasons why you can see why investors maintain hedges in their portfolios to capitalize on some of those high record prices we've seen in the stock market, but not necessarily let go of their hedge or their protection in case something goes wary.

Dirk Hofschire: I think the basket of things that I'm looking at right now has a lot to do with credit conditions, financial conditions because this is what happens really, really late in the financial cycle and the business cycle. eventually things start to tighten and that's what sow the seeds of recession when you pull back on the credit, the loan, et cetera. We haven't seen that in large part because of the Federal Reserve making the about face that we talked about before, but you can see just on the fringes in a few areas some issues.

If you look at the lowest rated quality in the high yield market, those CCC rated bonds, the spreads have really gone up quite a bit, higher than were even a year ago when we were having all that volatility. You've seen banks start to tighten credit a little bit for commercial and industrial loans. You've seen in the private equity markets as well, huge write downs on a lot of those investments and that's showing up in some of these new IPO’s that we've had over the past year. A lot of those newly IPO's companies have been selling off fairly dramatically, even as the rest of the market has gone up. So, I'm watching the credit side because if the Federal Reserve is relatively accommodative, that's great. That question is can they keep transmitting that extra bout of easing into the system? Are we reaching some sort of a breaking point at the end of the cycle people just don't want to extend that much more private equity or credit into this system just because the fundamentals just aren't there to support it? We'll see.

Jeffrey Schulze: One of the things that we're concerned with now is that credit spreads may not have the information value that they've traditionally had in previous cycles because of negative interest rate policies that are pursued by regions like Japan and Europe. The reason why we say is if you look at the fourth quarter selloff of last year, equities actually led that selloff by about a week and spreads started to blowout afterwards. We think because of this thirst for yield, that may be distorting the amount of lead time that you get from spreads. But to your point, there are areas like CCC's, lending standards that are starting to tighten up that could be signaling are the canaries of the coal mine this time around.

Dirk Hofschire: I agree with that premise completely, which makes me a little bit more concerned because what it should be doing then is tamping down the volatility in all of those things across the board. So why are you seeing pockets of it get worse? It's more just respecting the market signal. We'll see how it plays out, but it is interesting to watch at a time the FED has fully shifted the easing and sort of everything has done fine. You've got these little pockets of concern.

Juan Carlos Artigas: Yeah. And another one that probably people are not so wary, you can look at the skew in the options market for gold, in particular, and people right now are paying high premiums for protection in terms of the gold price ripping up again. So, the point is that people are buying options to ensure that if there is a pullback in the, for example, in the stock market, they are able to benefit from the potential increase in price and that skew has been increasing to some record levels, especially in recent months.

Jenna Dagenhart: And are you seeing anything in the ETF space along these lines?

Edward Rosenberg: I mean, what you've seen in the ETF space this year is people are flying into fixed income as we talked about earlier with mutual funds, 50% of all flows have gone into fixed income and all of it's been investment grade. It's kind of fascinating to see where the money is going, but I think as people are paying attention that. It's funny what people react to, right. We're paying to attention signals. But if you look at a lot of other people, right, if you look at the traditional financial advisor, they don't know most of these signals. They don't have the modes that any of us would have. They're paying attention to the landscape they can see and hear about, whether it's the trade wars, right, the FED doing some cutting. It could be as simple as who wins the Democratic nomination and do they think they can win and does that individual who can win cause a positive or negative for the market in their minds? I think what you're going to see is people shifting on those aspect first because it's the advisors who are going to react.

The institutions go by numbers, but the advisor is going to react to what they can see and what they can feel. I think those are the things that you're going see that could drive change faster than even some of these signals that we talk about.

Jenna Dagenhart: Talking about head winds and tail winds, there's been a lot of focus on the global slowdown. I wonder, Dirk, building off of that, what's happening and what's your outlook for the US?

Dirk Hofschire: The US economy just sort of in general? Yeah. So, I think we touched on it a fair amount. I think it feels like a late cycle environment. I think you can tick all the boxes of things that have gotten us to the mature phase and now it just really is a question of what leads us either to reaccelerate or it leads us down. I think when you go back to the consumer, all eyes are on the consumer. And yes, that's the biggest part of the economy, but you have to think about why will the consumer slow spending? Get worried about the labor market. Why worry about the labor market? Because businesses start paring back. I really think the battleground for next year is all about this profit of growth forecast. So double digit profit growth, if we get it next year, it means the global economy reaccelerated and I'm being way to cautious. But if that's what's really priced into consensus exceptions right now and we're sitting at zero to 2% growth here, I think the market's likely going to be disappointed at some point because it's just really hard for businesses to get that kind of profitability this late in the cycle without a big boost in growth so.

I think the US will be okay. But I think what happens with businesses, they've already cut back on Cap X, the big question here now is do they turn the labor markets, stop hiring, maybe even get to a point in the next few months where they think about laying people off. If so, this thing moves very rapidly to the downside. I don't know if that's going to happen. This late cycle has been long. The mid cycle was ridiculously long. This whole cycle has taken over a decade. So, we easily could muddle through 12 months, another 18, 24, but the upside, downside risk to me for the US economy just isn't what it was because I think everyone recognizes the US has been the best economy in the world for a long time. They see the consumer numbers, see the job numbers and maybe aren't paying quite as much attention to the underlying business dynamics, which just aren't really quite as strong as they've been.

Jeffrey Schulze: One of our saving graces, though to your point, if margins are going to continue to deteriorate, is if you look NFIB Survey, which is the premier small business survey, one of the biggest issues facing small business owners is finding qualified labor, so they may hold on to that marginal employee much longer than they traditionally would, even in light of margin deterioration because if you let that employee go, the economic growth reaccelerates, you're going to have a very hard time filling that role, but that could be one kind of silver lining that could keep us going and get us through this slow patch.

Jenna Dagenhart: An Ed, what's your outlook?

Edward Rosenberg: So, I mean, I think if you look at next year, it's going to be... Well, I start with interesting is the phrase I'll use, right. I'm not expecting double digit returns in the market. I think it's going to be relatively flat to a minimalistic growth year. I think could the government or anyone do things to push that? Sure. If we had a trade deal tomorrow that was beneficial in our favor for every country that we're "arguing" with or pushing, that could be very beneficial to the US companies, the US consumer and the economy as a whole. I don't really see that happening. It's possible, right. What I think we're going to get with is deals that slowly come in that end up with not really helping that much. I mean, they don't hurt, but it's not really helping. I think in this late cycle, as everyone's talking about, is we need help more than something that's just going to keep the status quo, so I don't see next year as growth.

I think you'll get periods of volatility, right. Whether there's a China deal or not, that will create volatility in the market. I think truthfully, as we get towards the end of the year, the uncertainty around the election and obviously we have an impeachment cycle starting now, does that do anything to spur or hurt next year? I have no idea from that perspective, but it's something to watch out for. If you look at the US, when's the last time we were in this type of political cycle where it was really crazy. It's been a long time, right. It's hard to measure what that means for the economy and because we're in it, do things happen that normally wouldn't happen? When we got back to trade deals or other things to try to spur pressure on the FED to cut rates before they should? That's a hard thing to say. I think the outlook you're going to see is a relatively flat to zero market next year, without single digit growth at best.

Jenna Dagenhart: There's been a lot of news.

Edward Rosenberg: Yes and it's not going to stop.

Jeffrey Schulze: One thing I'll say about political risks is I do believe that will keep business uncertainty high, right. The trade wars, even if you get a truce, depending on how that truce plays out, if tariffs can come back into the fray immediately, that keeps that uncertainty. Obviously, we don't know who the Democratic nominee is and what the implications are on the market, so I don't think business confidence is coming back. But if you look at the last 20 presidential election cycles, the year leading up to that presidential election, the markets have been positive 18 out of 20 times, so you have a hit rate of about 90% and your average one year return has been 9.7%. So, the market does a really good job of not shifting through the political noise and focusing on the economy. Traditionally, you'll see the market move about six months prior to the actual election.

Edward Rosenberg: One thing that's interesting about the elections, if you look at them, is it almost doesn't matter who wins the President, it's the Senate and the House. When they're on the same page, actually markets do worse, right, because people are uncertain about what they're going to do. When the House and the Senate are different, it actually propels the market because they know nothing is going to get done. That's the fascinating part about the election. It's almost not about who wins the presidency, but which way do the House and Senate end up before year end. I think that's the fascinating part.

Jeffrey Schulze: Markets don't hate bad news, they don't hate good news, they just hate uncertainty.

Edward Rosenberg: Yes.

Jeffrey Schulze: But right now, I think the basis case that's being priced into the markets right now is for a split Congress, which would be best case scenario.

Edward Rosenberg: Yeah, there also, by the way, is some random stat out there that markets do well that end in the year number five, which I'm not sure why.

Juan Carlos Artigas: Yeah, which perhaps this speaks to some of the correlation versus causation thing. I think that they need put into consideration a few other fundamentals as well as just perhaps the historical perspective.

Jenna Dagenhart: Mm-hmm (affirmative).

Dirk Hofschire: Yeah. When I think about the political and the geopolitical context right now, I think we're in a regime shift that's much longer term in nature, so I take all the historical data with a bit of grain of salt because I think what we're seeing now is we've lived most of our adult lifetimes in a world that became more tightly knit, more integrative, facilitated more trade, cross board of flows, had very little political risk in places like the US and Europe, et cetera, and we're clearly moving away from that. Part of that is the US is kind of in a relative decline and China's rising, so you've got that element of geopolitical rivalry. Part of it is just kind of a backlash against some of the things that globalization of the modern economy has stood for, again inequality, job insecurity, all of those.

You've got hints of populism; you've got hints of geopolitical risk. I think this is very, very different backdrop than we've had for a long time, so I agree with your point about uncertainty. The thing I worry about is what we're going to wake up here three, four years from now is look back and realize we never got out of the uncertainty because it was, first of all, some trade negotiations with China and then it was the 2020 election and then it's the next thing. What you realize is it's not just one administration, it's not just one issue, it's monetary policies, everything that we've talked about. The range of outcomes from a policy and political standpoint are much, much broader than they've been for the last 30 years and that's going to be the tough part, I think, for businesses and others to get past that uncertainty because when you don't know for sure what the rules of the road are going to be one year from now, five years from now. It's easy to imagine both parties in Congress taking a tougher regulatory stance against big technology companies, for example.

We don't necessarily have to have an outlier political event for the uncertainty to continue. That I think leads to some opportunities, gold might be one of them as a way to hedge those outcomes that you were talking about in the extreme, but it's going to be different. It's going to lead to some different challenges I think in terms of the way we analyze the world and the way we think about things.

Edward Rosenberg: Well, the other question I would ask too is if you think about the environment, we're in, geopolitical and everything else, but it's an information age and every day, information gets to us faster. It's not just us, it's the consumers, it's everybody. I joke that the phone that I use is, what, 50 times more powerful than the computer I took to college and I can get information at any point, anytime, anywhere and how many people have a phone that may not have that never had computers in their house or never had internet, where you can get a phone and find information on exactly what you want to know that can guide your decisions. I think that can make cycles even shorter or longer or more aggressive, is really what I'm thinking because information, people are going to react differently.

If you tell one person one thing and they react, right, because you're telling everybody with the same message. Back in the '60s when they were delivering news and you're watching three channels or four, it meant one thing. But now, you've got millions of people consuming information from millions of sources that tell you different things and everybody's going to react differently. I think that's the hard part to predict, how everyone comes forward and reacts to the news, whether it's geopolitical news in the US or whether we're doing some trade, whatever it is, it creates a different environment that maybe none of us have experienced yet.

Jenna Dagenhart: A new flavor of informational efficiency.

Edward Rosenberg: Absolutely. I don't know what flavor we'll go to, maybe we'll mix them.

Jenna Dagenhart: Great. And any other flavors on the horizon for ETFs as we look ahead to 2020 and beyond?

Edward Rosenberg: I mean, I think what you're going to see in the ETF landscape is the industry's going to continue to evolve, right. Semi-transparent is the latest step and we talk about mutual funds starting way back in... I think it was the '30s actually, so they've been around for a long time. Other investment vehicles I guess has been around for a long time, but ETFs themselves are only, what, going to be 27 next year for in the US, 29 worldwide. That's not very old. I think you're always going to see innovation there and continued expansion.

ETFs just crossed 6 trillion worldwide. It's about four and a half in the US. If you look at assets in the US, four and a half trillion compared to about 16, 17 trillion for mutual fund assets, I think what you're going to see, I won't give a time period on this, but a flip of that. I think you're going to see the ETF assets be where the mutual funds are and then the mutual fund assets will be where the ETFs are today.

Juan Carlos Artigas: If I can add to what Ed is saying about ETFs, I mean, in particular in the gold market, you've seen an explosion of the use of gold backed ETFs, in particular to get access to gold. If you look back about 10, 15 years, there were just a handful and most of them were at least primarily in the US and some in Canada. By now, we track about 80 gold backed ETFs around the world. Many of those, for example, in Europe and different jurisdictions, collectively with about $110 billion in assets. And this year alone, we've seen inflows in there of eight to nine billion, right. I think it's a combination of two trends, the combination of gold as a way to hedge some of the uncertainty, in combination of the lower opportunity costs related to the FED, but also from the expansion shelf of uses of ETFs, not only in the US, but truly around the world. Even in Asia, you are seeing also a pickup in that market, right. So, I think that that has been revolutionary as a way of access, any market right. Even if you can access gold in many, many ways, there are some interesting stats related to gold-backed ETFs in particular.

Edward Rosenberg: Sorry, I'll add to that. But if you think of ETFs, what they've done is they have brought institutional access in different forms to the retail space, right, whether it was single country where you couldn't buy a mutual fund, whether it's a commodity like gold, whether it's an institutional strategy, like factor investing, a lot of this wasn't available to the retail client and I think the evolution is the ETFs just continue to bring forth these types of strategies or processes to the retail space and that's not going to stop. It's expanded the use of different, whether it's gold as commodity or anything else, into different areas. There's a ton of retail investors that buy products now that they never would have had access to 10 years ago and I think that's just going to continue to go forward.

Jenna Dagenhart: And in closing, I want to get your final thoughts on where we're headed. We've talked a lot about uncertainties, geopolitics, upcoming election. Jeff, I'm going to start with you. What do you think the key opportunities and risks are moving forward?

Jeffrey Schulze: I think we've covered the risks pretty good on the panel here. Obviously, trade wars continuing to escalate that we don't get a truce next week. You do start to see that affect consumer confidence, business confidence and ultimately causes a recession. One of the reasons why we are pretty optimistic about trade is that if you look at every post World War II president that went for reelection, there were only three that didn't get reelected; H. W. Bush, Carter and Ford. Those are the only three presidents that had a recession within two years of the election and they're the only three presidents that had a material rise of the unemployment rate the year of the election. So, I think the Trump administration is quite aware of that trend and I think that does bring them to the table and at least, not necessarily get them a comprehensive deal, but at least have a trade truce and not have it escalate further from here.

From an opportunity standpoint though, we do believe that biopharmaceutical and healthcare, broadly speaking, looks attractive. Earnings revisions have been very positive in that group. They've held up really well. But also, if you look at biopharmaceuticals specifically, there was only two times since the 1990s where biopharma traded at a cheaper valuation than the overall market, that was the early 1990s with Hillary Care and was at the 2008 when Obama Care was coming out. Political risks were clouding the sector, but once you got through those tough periods, biopharmaceutical rerated higher. I think we will likely see that situation as we make it through the upcoming election cycle.

Jenna Dagenhart: Juan Carlos, key trends that you're watching.

Juan Carlos Artigas: Yeah. For gold in particular for next year, I'm going to highlight four things. The first one is that market uncertainty and combined with lower and low interest rates are likely to support investment [inaudible 00:55:19] for gold, well supported. That's one. The second one we also actually expect central banks to continue buying gold as part of their foreign reserves. We have seen a very strong buying from central banks in recent years and even if next year is not as high as this year or the previous year, the trend continues and that is important. The third aspect is that because people are trying to figure out what the FED and other central banks and how these different geopolitical or economic risks are going to be resolved, we may see high price volatility as much as we've seen this year. Again, it's not record highs, but it has increased relative to, for example, 2018, so we may continue to see something like that.

And then finally, we may see a little bit of softness in consumer demand for gold in the short term, but as I was saying before, we do believe that some of the structural reforms happening, in particular in India and China, will be supportive of much longer term trends.

Jenna Dagenhart: Dirk, in a nutshell, where do we go from here?

Dirk Hofschire: Well, I think the big picture is this late cycle, this mature business cycle, is just not as great of a backdrop as it was earlier in the cycle, so we've got a situation where the odds in terms of things going wrong are probably a little higher than going really, really right. Just think about that from a risk construct and then you put the absolute valuations in the market in just about every asset class are pretty stretched, it's hard for me to find kind of pound the table opportunities this year, even though we could muddle through.

I think I am shifting to think about the next few years and some of these really long running trends, like the US beating international or growth beating value, maybe we're going to start to see that rotation. It could come in 2020, maybe it doesn't. I can't predict the exact catalyst, but I think some of these relative valuation areas that have opened up, some possibilities where you a potential break in the momentum at some point, could be interesting opportunities to diversify or re-bounce back to those places.

Jenna Dagenhart: Ed, any final thoughts the new year?

Edward Rosenberg: Some simple trends in ETFs is I always joke where the money's not going is where it should be going, right. International is place it's not going because with the continued dollar strength, it's been underperforming. I think, this is a guess, but I think you'll see next year, does the dollar maintain its strength? I can't imagine it stays at these levels forever and it won't forever, but even in the near term, it has to come down a little bit, which will benefit the international market. But realistically, I think what you're going to see is the advent of a heavier rotation into we'll call it risk adverse products, whether it's equities that are low dollar dividend, whether it's US or non-US. I think you're going to see the search for yield will continue, right. More people are retiring, more people need more consistent yield and I think those are the trends that are going to continue. Those are going to lead to more, I won't say a flight to safety, but more of a search for just a little less risky assets as we go forward because I don't.

Again, I don't think next year's what we call a growth year. Although, then again, I didn't think this year would be either, but I don't think it's going to be a growth year, I think it's going to be a year into that '94 where nothing happened and it wasn't very exciting, that's how I'll put it.

Jenna Dagenhart: Well, thank you so much for all of your insights gentlemen. We'll have to have you back in 2020.

Jeffrey Schulze: Thank you so much for having us.

Dirk Hofschire: Thank you.

Juan Carlos Artigas: Thank you.

Edward Rosenberg: Thank you.

Jenna Dagenhart: And thank you for watching. I was joined by Dirk Hofschire, Senior Vice President, Asset Allocation Research Team at Fidelity Investments; Juan Carlos Artigas, Director of Investment Research at the World Gold Council; Ed Rosenberg, Senior Vice President and Head of Exchange Traded Funds at American Century Investments; and Jeff Schulze, Investment Strategists at ClearBridge Investments. From our studios in New York, I'm Jenna Dagenhart.