there's a good chance that they may be disappointed should reality .... fiscal spending programs; small businesses tethe
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Investment Platform BREADTH OF INDEPENDENT PERSPECTIVES ACROSS ASSET CLASSES
AUM $255BN1 INVESTMENT PROFESSIONALS
FUNDAMENTAL
EQUITY
FIXED INCOME
ALTERNATIVES
$96bn 236
$120bn 146
$51bn 117
Global/EAFE U.S. Value/Core/Growth Emerging Markets Regional EM, China Socially Responsive Investing Income Strategies:
Global Investment Grade Global Non-Investment Grade Emerging Markets Opportunistic/Unconstrained Municipals Specialty Strategies:
Private Equity:
– MLP – REITs
– CLO Mezzanine – Currency – Corporate Hybrids
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Hedge Funds:
– Primaries – Multi-Manager – Co-Investments – Equity Long/Short – Secondaries – Credit Long/Short – Royalty Strategies – Event Driven – Minority stakes in alternative firms/DYAL
Alternative Credit: – Private Credit – Residential Loans – Special Situations
Global U.S. Emerging Markets Custom Beta
QUANTITATIVE
AUM and Committed Capital
Risk Premia Options Global Macro Commodities
MULTI-ASSET CLASS SOLUTIONS AND STRATEGIC PARTNERSHIPS FUNDAMENTAL
Global Relative and Absolute Return Income Focused Inflation Management Liability Aware
QUANTITATIVE
Risk Parity Global Tactical Asset Allocation
As of September 30, 2016. Firm assets under management (AUM) includes $95.7 billion in Equity assets, $119.7 billion in Fixed Income assets and $39.7 billion in Alternatives assets under management. Alternatives AUM includes AUM & Committed Capital since inception, which reflects contractual commitments to fund investments advised by NB Alternatives Advisers LLC, including those still in documentation, since inception (the oldest mandate of which was founded in 1981) (“Committed Capital”).
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SOLVING FOR 2017
Ten for 2017 2
The heads of our four investment platforms identified the key themes they anticipate will guide investment decisions in 2017. These 10 themes are summarized below and discussed in more detail in the CIO Roundtable beginning on page 5. MACRO: A SEA CHANGE FOR ECONOMIES AND MARKETS
1 2
The Rise of Nationalistic Self-Interest Continues to Upset the World Order fter political upheavals in the U.K. and U.S. during 2016, French and German voters will be A among those in 2017 to test the persistence of anti-establishment/anti-globalization trends.
Central Bank Impact Fades Global central banks appear to have reached an inflection point and will likely drive an increase in interest rates, inflation expectations and market volatility, and a stronger U.S. dollar.
FIXED INCOME: NORMALIZATION RESUMES
3 4
Real Interest Rates in the U.S. Continue to Push Higher Expectations for higher growth and inflation are likely to drive higher Treasury yields and a steeper curve, though we don’t anticipate a break from the global rate tether.
Credit Still Holds Appeal The credit cycle is mature, but it doesn’t appear ready to turn just yet; when it does, more supportive fundamentals are likely to help absorb the impact.
EQUITIES: BACK TO BASICS
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Pro-Growth Trump Administration Fuels Outperformance of U.S. Equities
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Alpha—And Active Managers Able to Generate It—May Stage a Comeback
A more business-friendly environment—characterized by lower taxes, loosened regulations and robust fiscal spending—could provide a tailwind for corporate earnings and stock markets in the U.S.
The removal of artificially low interest rates could result in individual stock performance once again being differentiated by company fundamentals, to the benefit of high-conviction, fundamental investors. 3
EMERGING MARKETS: BOTH WINNERS AND LOSERS EMERGE
7 8
Economic Orientation Counts In our view, fears that U.S. policy will drag down the entire emerging world are overblown; improved global growth should be generally supportive, though countries likely will be differentiated based on their key economic drivers—manufacturing vs. commodities vs. domestic.
China Risks Remain Significant The world’s second-largest economy faces a number of ongoing issues—from asset bubbles to currency management—that require a particularly deft touch from Beijing.
ALTERNATIVES: HELPING NARROW THE RETURN GAP
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Volatility Can Work for Investors
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Private Debt Remains Attractive
We anticipate that the difference between long-term investor needs and what can be generated from traditional sources of beta is likely to persist, highlighting the value of alternative risk premia and volatility-capture strategies.
Despite the potential re-emergence of banks as liquidity providers, it is unlikely that they will rebuild the infrastructure required to compete in similar, less-liquid credit. In addition, increased M&A activity will likely keep the private debt market well stocked with opportunities.
CLOCKWISE: Joseph V. Amato President, Chief Investment Officer—Equities Erik L. Knutzen, CFA, CAIA Chief Investment Officer—Multi-Asset Class Brad Tank Chief Investment Officer—Fixed Income Anthony D. Tutrone Global Head of Alternatives
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CIO Roundtable: NOTHING ENDURES BUT CHANGE With an eventful 2016 drawing to a close, the heads of our four investment platforms gathered together to talk about the key events of the past 12 months and how they shaped their investment themes for 2017. MACRO: A SEA CHANGE FOR ECONOMIES AND MARKETS Brad Tank: Someone I worked for a long time ago taught me that as an investor you’re often going to be wrong, but rarely should you be surprised. And I think that’s an important distinction to make following Trump’s victory. While many were wrong about the outcome of the presidential election, it really shouldn’t have come as a tremendous surprise given the populist momentum that has been building throughout the developed world. The political landscape has polarized around such issues as sovereignty, trade, globalization and immigration, with the middle and working classes feeling that they’re being squeezed by these existential forces and voting for change. Erik Knutzen: The European Union’s inability to properly address these issues has caused tension within and among the countries of the currency bloc, presenting a major risk to the future of the euro. Brexit was a big example of this over the summer, and the complicated process of the U.K.’s disentanglement from the EU will continue to play out over the next few years. Italy’s referendum on constitutional reform in early December was seemingly for all intents and purposes a referendum on Prime Minister Renzi and perhaps Italy’s future in the currency bloc. The “no” victory led Renzi to resign and presents an opportunity for antiestablishment parties like the Five Star Movement to fill the vacuum. Joe Amato: The European political calendar only gets more challenging in 2017. Dutch general elections are scheduled for mid-March, and a far-right anti-EU party holds a strong position in the polls. France will elect a new president in the spring. Current Socialist President Hollande has declined to run for re-election in the face of single-digit approval ratings, and many polls are being led by candidates from the center-right Republican Party and far-right National Front, both of whom have sought to tap into French nationalism. Germans go to the polls in the late summer/early fall to elect their chancellor; though Angela Merkel is favored to hold her position, parties on both the left
and right have made some noise at local elections of late. And now Italy will need to elect a new prime minister. Tony Tutrone: As we have seen, these campaigns can be trigger points for short-term spikes in volatility and potentially have a negative effect on the markets depending on the outcome. ELECTION RISK—THE CYCLE CONTINUES
JUNE 2016 Brexit Spanish general election OCTOBER 2016 Austrian presidential election Hungarian referendum NOVEMBER 2016 U.S. presidential election DECEMBER 2016 Italian referendum MARCH 2017 Dutch general election MAY 2017 French presidential election SEPTEMBER 2017 German federal election Source: Legal and General, November 2016.
January – June 2017 Potential U.K. general election
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Tank: While the shifting political landscape has gotten a lot of attention, a related sea change is the transition from central bankdominated markets to ones driven by supportive fiscal policy and a more activist approach to business on the part of governments. There have been signs of a peak in central bank credibility throughout 2016, but the concept was turbocharged in the U.S. with Trump’s victory and the policies that he appears to espouse. It’s likely on the precipice of being turbocharged in Japan as well given the Bank of Japan’s introduction of a zero target rate for its 10-year bonds. The shift also seems to be starting in Europe, though it’s likely to be slower and less dramatic given the bloc’s limiting factors. Amato: Another related change is the emergence of a new, more pro-business environment in the U.S., an outlook that drove the spike in domestic equity markets in the weeks after the election. Lower taxes, loosened regulations and robust fiscal spending would likely provide a tailwind for corporate earnings, helping unlock the so-called Keynesian “animal spirits” in terms of business confidence and investment. Though the market may have gotten ahead of itself given the magnitude of the post-election rally, the emergence of these business-friendly shifts could be a positive for the stock market and economic growth. Tutrone: Of course, this also means that primary responsibility for economic policy-making will shift from highly transparent and methodical central banks to legislators and governments that tend to be neither of those things. Given the euphoria with which risk markets reacted to Trump’s election and anticipated policy actions, there’s a good chance that they may be disappointed should reality fall short of their expectations. FIXED INCOME: NORMALIZATION RESUMES Tank: I think the U.S. economy will reflate beyond recent trend growth but fall short of pre-crisis levels. We anticipate GDP growth of around 2.5% in 2017, compared to reports of 0.8%, 1.4% and 3.2% over the first three quarters of 2016, respectively. Inflation will likely move toward the Fed’s 2% target rate and maybe even run a little bit hotter than that. The FOMC will likely find this environment supportive of continued normalization in the federal funds target rate; following
its 25 bp hike in December, the central bank is projecting three rate increases during 2017 to bring the target rate to 1.25–1.5% by the end of the year. The yield curve could steepen as long rates move higher while the shorter end of the curve remains tethered. While Treasury yields will likely rise, we believe supply-demand technicals and the pull of the global rate structure should keep them relatively in check. We believe the 10-year Treasury could finish the year near 3.0%, compared to around 2.5% as of December 15, 2016. Treasuries could be challenged in such a rising-rate environment, though credit instruments could find these trends supportive. Corporate spreads appear reasonable relative to historical levels and credit fundamentals. In fact, I don’t think the credit cycle is quite ready to turn in 2017, though when it does fundamentals could help make the transition less painful than usual. Conditions like these also lend support to the value of flexible investment mandates that allow managers to take strategic advantage as circumstances change. EQUITIES: BACK TO BASICS Amato: I think GDP growth and its impact on corporate earnings is the most important element in the continuation of the post-election equity rally in the U.S. As of December 15, 2016, the most recent estimate of third quarter GDP growth was 3.2%, and the Atlanta Fed is projecting fourth quarter GDP of 2.4%. These are decent numbers in the context of recent trends, but still a far cry from a truly robust expansion. The hope is that the new administration’s plans for meaningful fiscal stimulus, including both corporate and personal tax cuts and an increase in infrastructure spending, can provide the tailwind needed to boost growth above these levels. Improved growth will likely fuel an acceleration in corporate earnings and serve as a strong foundation for further improvement in U.S. equities and multiple expansion, which for much of this year was driven by lower bond yields. Of course, this scenario is not without its risks. Anti-trade sentiment in the U.S. and other developed market economies could have a very negative effect on global growth. Policies such as renegotiating the North American Free Trade Agreement, fighting the Trans-Pacific Partnership or increasing auto tariffs could set off a domino effect across the globe, exacerbating the slowdown in trade we’ve seen in
recent years. The stronger dollar is already beginning to make things difficult for large, export-intensive companies, and these problems could persist as ongoing Fed normalization puts upward pressure on the currency. Since the election, the dollar has risen 4% against a basket of global currencies and even more against the currencies of key trading partners like Mexico and Japan. Net net, however, my outlook for U.S. equities is far healthier than it was before the election. U.S. DOLLAR RISING IN ANTICIPATION OF TRUMP POLICIES U.S. Dollar Index (DXY) 130
120
110
100
90
80
70
‘86 ‘88 ‘90 ‘92 ‘94 ‘96 ‘98 ‘00 ‘02 ‘04 ‘06 ‘08 ‘10 ‘12 ‘14 ‘16
Source: Bloomberg. As of December 15, 2016. Note: The DXY Index is a measure of the value of the USD relative to a basket comprised of major world currencies.
Tutrone: I believe the re-emergence of corporate fundamentals will be a key driver of stock prices and thus an opportunity for active managers to generate alpha, on both the long and short side. With more normalized monetary and interest rate policy likely for the U.S., many overly leveraged, lower-earning, lower-quality companies will be viewed more critically relative to their higher-quality peers. This, in turn, will likely be reflected in increasing valuation dispersion among companies, which could support the efforts of active managers.
EMERGING MARKETS: BOTH WINNERS AND LOSERS EMERGE Knutzen: I anticipate performance dispersion will also be evident within the emerging markets. We became more cautious on the emerging markets following the election, as the potential of higher U.S interest rates, a stronger U.S. dollar and tension over trade issues heightened the risk of equity and fixed income investing in the region. That said, I believe there is still a robust long-term case for emerging markets investment, and post-election market movements have resulted in fixed income yields and equity valuations that are more attractive than before. Generally speaking, I believe it’s unwise to treat the whole of the emerging markets as one monolithic block; over the longer term, pro-growth U.S. policy likely will benefit some markets while hurting others, mainly according to their economic focus. For example, any trade constraints pursued by the Trump administration would likely hurt Latin America far more than Asia, as it’s difficult to replace the value-add that Asian exporters bring to the table. Infrastructure spending in the U.S. would likely increase the demand for select commodities along with specialized engineering and technology skills. A ramp-up in U.S. energy production would likely help a variety of emerging economies, many of which are net consumers. Amato: Against this backdrop, one sensible approach toward emerging markets equities might be to tilt portfolios towards domestic companies trading at a reasonable price with low debt levels. This could help to minimize the threat of both interest rate sensitivity and diminished global trade. Tank: The Trump victory has undoubtedly had a negative impact on emerging debt markets as they experience the double-whammy of higher interest rates and growing risk aversion. However, the pickup in growth and the reduction in the account deficits of many emerging economies could help mitigate some of the downside risk here. Of course, China continues to be a source of concern for global growth in general. While the country’s short-term position remains positive, there are risks that its recent stimulus measures have created bubbles across a variety of financial and real assets as its economic growth rate continues to slow. Meanwhile, the yuan has weakened of its own accord in recent months, sparking capital outlflows and pressuring the central bank. How China manages these issues over the next 12 months is vitally important, and not just for emerging markets.
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ALTERNATIVES: HELPING NARROW THE RETURN GAP
Tutrone: Private debt is another example of a strategy designed to capture alternative sources of risk premia, in this case illiquidity and complexity. I was bullish on private debt before the election and remain
Meanwhile, the anticipated increase in volatility and return dispersion that Joe spoke of earlier also stands to benefit long/short hedge fund managers, as alpha on the short side becomes more available. Even within sectors that appear directionally bullish, like energy and infrastructure, winners and losers will likely emerge.
PRIVATE DEBT HAS PROVIDED ATTRACTIVE ABSOLUTE YIELDS Fixed Income Yields 24% Historical yields for second lien and mezzanine private debt have been attractive across different interest rate and economic environments due to the illiquidity premium
22% 20% 18% 16% 14% 12%
ILLIQUIDITY PREMIUM
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Knutzen: Despite the many changes that are underway in the investment environment, we anticipate the chronic gap between long-term investor needs and what can be generated from traditional market exposures will likely persist. The combination of low interest rates, low inflation, muted economic growth and elevated valuations across many stock and bond markets is inspiring many investors to look for alternative sources of returns and diversification to meet their goals. Among these are volatility-capture strategies—like options writing—designed to monetize alternative risk premia in an effort to improve portfolio risk-adjusted return potential.
bullish on it now. While there are concerns that the potential repeal of the Volcker Rule limiting banks’ proprietary trading activities—and thus the reintroduction of banks as liquidity providers in the private debt market—would squeeze out alternative providers, I think there’s sufficient supply to absorb the additional demand that’s likely to come online over the next 12 months. And this supply is likely to be bolstered by increased M&A activity as the incoming administration takes a less interventionist approach to deals.
10% 8% 6% 4% 2% 0% ‘04
‘05
‘06
‘07
‘08
Private Equity-backed Mezzanine
‘09
‘10
‘11
U.S. 10-Year Treasury
‘12
‘13 U.S. High Yield
‘14
‘15
‘16
Second Lien
Source: Bloomberg, S&P LCD. Monthly data from January 2004 to November 2016. For illustrative purposes only. U.S. High Yield is represented by the Barclays U.S. Corporate High Yield Index. Second Lien yield is represented by the second lien portion of the S&P LCD Leveraged Loans Index. Assets classes and indexes shown may have significantly different overall risk-return characteristics, which should be considered before investing. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.
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ASSET ALLOCATION COMMITTEE OUTLOOK
Market Views Based on 12-Month Outlook for Each Asset Class
Below-Normal Return Outlook
12-month Outlook in Line with 5- to 7- Year Annual Return Outlook
Above-Normal Return Outlook
FIXED INCOME Global Bonds Investment Grade Fixed Income U.S. Government Securities Investment Grade Corporates 10
Agency MBS ABS / CMBS Municipal Bonds U.S. TIPS High Yield Corporates Emerging Markets Debt
EQUITY Global Equities U.S. All Cap U.S. Large Cap U.S. Small and Mid Cap MLPs Developed Market—Non-U.S. Equities Emerging Markets Equities Public Real Estate
REAL AND ALTERNATIVE ASSETS Commodities Lower Volatility Hedge Funds Directional Hedge Funds Private Equity
As of December 8, 2016. See additional disclosures at the end of this material for additional information regarding the Asset Allocation Committee and the views expressed.
Regional Focus Fixed Income, Equities and Currency
Below-Normal
Neutral
Above-Normal
REGIONAL FIXED INCOME U.S. Treasury 10 Year Bunds 10 Year Gilts 10 Year JGBs 10 Year EMD Local Sovereign EMD Hard Sovereign EMD Hard Corporates
REGIONAL EQUITIES Europe Japan China Russia India Brazil CURRENCY Dollar Euro Yen Pound Swiss Franc EM FX (broad basket)
As of December 8, 2016. See additional disclosures at the end of this material for additional information regarding the Asset Allocation Committee and the views expressed.
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SOLVING FOR 2017
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Asset Allocation Committee 1Q17 Outlook: POST-ELECTION, MARKETS CAST THEIR VOTE The Asset Allocation Committee gathered off-cycle in November to discuss the U.S. elections and the impact of Donald Trump’s assumed reflationary policy on our investment outlook, deciding at the time to shift our bias toward U.S. equities and away from non-U.S. assets. Since then, U.S. stock indexes have continued to surge, with some establishing new all-time highs. With the benefit of a month of post-election clarity, we have reassessed our outlook in light of recent market activity to determine our First Quarter 2017 Outlook. Have certain markets gotten ahead of themselves? Perhaps. But it’s hard not to remain constructive on U.S. equities and pockets of the commodity complex given the new pro-growth, pro-inflation impulse coursing through markets and poised to continue next year as the Trump administration takes office and begins to execute its policy agenda. MARKETS MAY BE LOOKING AHEAD, BUT WE STILL FAVOR U.S. EQUITIES Given our belief that a Trump presidency and Republican-controlled Congress would usher in a pro-growth, pro-inflation environment in which central banks play a less meaningful role in capital market performance and investors demand greater compensation for the risks they bear, in November we increased our 12-month outlook for U.S. equities across the capitalization spectrum to slightly above normal. While we acknowledge the strength of the equity markets’ rally in the weeks after our move, we have maintained our equity preferences in our First Quarter 2017 Outlook. The U.S. equity market continues to be biased higher, as corporations stand to profit from a more business-friendly landscape marked by proposals to lower taxes, reduce regulatory burdens and enact robust fiscal spending programs; small businesses tethered to U.S. growth, in particular, could thrive, as they may benefit from those aforementioned factors without also being punished by the anti-trade rhetoric and strong U.S. dollar impacting large multinationals. We also continue to
favor master limited partnerships (MLPs) due to increased inflationary pressures and expected lower regulatory restrictions. In contrast, we lowered our outlook on emerging markets equities to perform slightly below normal over the next 12 months; a stronger dollar and higher U.S. interest rates should weigh on the asset class even as the anticipated increase in U.S. infrastructure spending helps support certain markets. In November we also reduced our return outlook to below normal for a number of domestic investment grade fixed income sectors on expectations of higher interest rates. With yields on U.S. Treasuries having backed up to 2016 highs across the curve, however, our view here has grown less pessimistic; updating our views for the first quarter of 2017, we increased our outlook for these asset classes to slightly below normal. That said, we remain neutral on TIPS and high yield debt, and thus continue to prefer these categories on a relative basis within the fixed income complex. Looking abroad, our outlook for emerging markets debt remains slightly below normal for reasons similar to those driving our opinion on emerging markets equity; we do prefer hard currency issues to debt denominated in local currency within the EMD space. We also maintained a below-normal outlook for global bonds.
A NEW INVESTMENT ERA BEGINS While Donald Trump’s victory was not the outcome expected by most of the Committee—or the markets—“surprise” may be too strong a term for it given the accelerating anti-establishment and anti-globalization trends we’ve noted across the developed world in recent months. Though the June Brexit vote was perhaps the most notable pre-Trump example, developed markets in general have witnessed the rise of populist politics and politicians bent on upending the current world order, one in which developed country middle and lower-middle class citizens perceive themselves to be suffering at the expense of the elites and rising emerging countries. In the weeks since Trump’s election we have already seen Italian voters defeat a referendum to reform that country’s constitution, effectively forcing the resignation of Prime Minister Renzi and calling into question Italy’s future in the euro zone. And with a slew of European elections and referenda looming over the next six months, we’ll soon learn if Trump’s ascendency represented the climax of such sentiment or merely an exclamation point within a still-unfolding narrative. As stated in our November special report, we believe that Trump’s victory heralds a fundamentally changed investment environment, one in which we envision more corporate profitability, more volatility and a higher risk premia for assets. Market activity in the weeks that have followed the election suggest that many investors feel the same. While Trump and his potential policy agenda garner the lion’s share of headlines, another key to this updated framework is the apparent inflection point in global central bank credibility. (We had anticipated this transition in a number of our CIO Weekly Perspective posts, including the October 30 effort from Brad Tank titled “Populist Fears, Globalist Tears”.) The basic mission of central banks historically has been to smooth economic activity: to make sure the highs aren’t too high and the lows aren’t too low. It could be said that central banks have been “oversmoothing” since the Great Recession, artificially removing risk from the economy and thus incenting greater risk-taking by market participants. Given expectations of greater fiscal stimulus and a more activist approach to economic policymaking, however, we believe volatility is likely to increase, as is the risk premia investors demand. In fact, with central banks becoming less central to investment performance, the whole nature of “risk on” versus “risk off” has
fundamentally changed, suggesting the correlations with which the market has grown comfortable over the years need to be reconsidered. For evidence one need only look at the poor post-election performance of emerging markets equities—typically considered a “risk on” beneficiary—in the face of surging U.S. stocks as investors digested the potential negative impact of U.S. policy on these markets. Real interest rates in the U.S. have headed higher following the election, and we believe the bias for rates remains higher over the coming 12 months due to three factors: higher economic growth expectations, higher inflation expectations and an increase in risk premia. For investors, the challenge of anticipating markets going forward will likely rest in attributing the appropriate level of importance to each of these factors. Growth is typically positive for risky assets and higher risk premia are negative, while inflation may be positive if it’s driven by “good” reasons like stronger employment. That said, the gravitational pull of global rates, while diminished, is still powerful and could represent a limit to how far U.S. Treasury yields will decouple from the global rate structure. Long-term potential GDP growth is another wild card for rates, as economies are ultimately constrained by structural limitations. While changes to tax policy and infrastructure spending may introduce an intertemporal increase to potential growth, it is unclear how impactful this can be on worker productivity, which has been on a downward trend since the early 2000s. Productivity tends to revert to the mean over time, in this case positively, but how quickly that will happen in this instance remains to be seen. Finally, the fixed income market tends to value persistence above all; while U.S. GDP growth may appear to be on the upswing for the next year or two, the lack of clarity beyond that could keep a lid on Treasury yields, particularly at the long end of the curve. RISKS ABOUND Though many markets have been riding high in the weeks that followed Trump’s victory, significant risks are likely to persist. The shift in economic policy-making from highly transparent, methodical central bankers to legislators and governments that are noisy by nature certainly presents headline risk and the potential for spikes in volatility. There’s also a good chance over the next 12 months that overly optimistic markets could be profoundly disappointed by a disconnect
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between policy rhetoric and action. At some point higher interest rates likely will serve as a drag on certain sectors of the economy, such as housing; in fact, mortgage applications fell to 2016 lows post-election as rates moved higher. And if economic growth doesn’t materialize as forecast we may find ourselves facing the worst-case scenario of low growth combined with higher interest rates and higher deficits. 14
The area of the economy that could be most impacted by the election is trade. Trump’s views here diverge from recent Republican freetrade orthodoxy and more closely resemble those of the Reagan administration, which took a combative stance against trade partners like Japan and Germany. China, the U.S.’s second-largest trading partner, might represent this era’s version of Reagan’s 1980s battles. On the campaign trail Trump vowed to label China a currency manipulator, bring cases against China to the World Trade Organization and potentially slap a tariff as high as 45% on imports from China; since his election, Trump already has antagonized the Chinese by fielding a phone call from Taiwan, a major breach of diplomatic protocol. Given the president’s wide latitude on trade issues, we’ll need to watch the new administration’s approach closely; while anti-trade policy would obviously affect industries that are dependent on exports, it could be a significant impediment to economic growth and may weigh on foreign investment. Meanwhile, a major trade war likely wouldn’t be good for any risk asset. For hints on where Trump may be headed with regard to trade policy, Brad Tank suggests looking into the book American Made by Dan DiMicco, former CEO of Nucor Steel and current trade adviser to Trump, which advocates for the tactical activist approach of the Reagan administration, as characterized by the 1985 Plaza Accord. DiMicco is believed to be among the contenders for U.S Trade Representative. LOOKING TOWARD INAUGURATION In our November special report we suggested keeping an eye on key Trump appointments for signs of how campaign talk may translate into a policy agenda once he takes office. His designees for key posts in his administration are almost uniformly against regulation of the industries they’ve been tapped to oversee, suggesting that President Trump intends to govern in a manner mostly consistent with Candidate Trump—if not entirely in line with his oft-stated intention to “drain
the swamp” of Washington insiders and the moneyed elite. Take, for example, the following nominees: Treasury: Steven Mnuchin, current Hollywood financier and former Goldman Sachs banker and hedge fund manager; has said that he wants to “strip back parts of Dodd-Frank”. Commerce: Wilbur Ross, billionaire investor who made his fortune restructuring distressed companies in industries as disparate as steel, textiles and financial services; outspoken critic of trade deals like NAFTA. Health and Human Services: Tom Price, orthopedic surgeon and Republican congressman from Georgia; outspoken critic of the Affordable Care Act. Labor: Andy Puzder, CEO of fast-food parent company CKE Restaurants; outspoken critic of the Obama administration’s labor policies and minimum wage hikes. Despite the pro-business bona fides of his recent cabinet appointees, Trump himself has begun to throw his weight around in ways that are not exactly corporate friendly. For example, the president-elect employed some combination of carrots and sticks to convince Carrier Corp. executives to keep 1,000 (estimates vary) manufacturing jobs in Indiana rather than move them to Mexico, an exercise of executive power that has concerned some free-market adherents. Boeing was also taken to task publicly, as Trump called for the cancellation of the government’s contract with the aerospace company to develop a new Air Force One fleet given costs. Though investors will likely spend significant time and effort trying to divine what path the Trump administration will take, the reality is that actual change will take time. Now is the time to maintain focus on a long-term time horizon. While markets are driven by shifting shortterm expectations, we believe the resulting volatility stands to benefit active managers in both equity and fixed income. It could also benefit long-term investors, who can exploit their extended time horizons by hedging risks across their portfolio as necessary and taking tactical positions should opportunities arise.
FIXED INCOME GLOBAL FIXED INCOME Treasuries: After reducing our outlook for U.S. Treasuries to underweight in the aftermath of the U.S. elections, the Committee moved back to slight underweight for our First Quarter 2017 Outlook as yields moved closer to fair value. Inflation and growth expectations along with risk premia—the three primary components of 10-year Treasury yields—have all increased post-election, driving yields higher. That said, the gravitational pull of the global rate structure, marked by accommodative policy in Europe and Japan, persists and could keep a lid on U.S. rates even as investors now need to be paid far more to hold U.S. Treasuries than they did before the election. As expected, the FOMC resumed federal funds rate tightening in December, hiking its target rate by 25 bps; the central bank expects three additional 25 bp rate hikes in 2017.
Developed Market Non-U.S. Debt: We reduced our outlook for developed market non-U.S. debt to underweight following the U.S. elections and remained there in our latest reevaluation. Expectations that a Trump presidency and an associated loosening of fiscal purse strings would lift global growth and inflation have pressured yields worldwide. With yields on 10-year JGBs pushing above zero for the first time since February, the BOJ offered to purchase an unlimited amount of short-maturity issues as part of its new “yield curve control” policy, but found no takers at its below-market ask. With a host of impactful elections on tap across the euro zone in 2017, the ECB announced that it would extend the duration of its quantitative easing program until at least December 2017 while reducing its monthly asset purchases to €60 billion per month (from €80 billion) beginning in April 2017.
IS GLOBAL GROWTH POISED TO RETURN? Global Real GDP Growth (%) 6.0 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 ‘80 ‘81 ‘82 ‘83 ‘84 ‘85 ‘86 ‘87 ‘88 ‘89 ‘90 ‘91 ‘92 ‘93 ‘94 ‘95 ‘96 ‘97 ‘98 ‘99 ’00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 ‘13 ‘14 ‘15 ‘16 Global Real GDP Growth
Source: Bloomberg, International Monetary Fund.
35-Year Average (1980 – 2015)
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HIGH YIELD FIXED INCOME
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The Committee maintained a neutral weighting in high yield fixed income. Though there may still be some room to run in credit as spreads are within historical averages, caution may be warranted given the rally in high yield since March and its post-election resilience as other fixed income sectors mostly struggled. Security selection remains important, especially in the energy sector, where valuations are high among companies viewed as “survivors” amid the volatility in oil prices.
EMERGING MARKETS DEBT We maintained a slightly underweight outlook for emerging markets debt. The results of the U.S. elections introduced a high level of uncertainty over trade relations between emerging countries and the U.S., with the more open economies and those with close links to the U.S. most at risk; these include Latin American markets like Mexico and Colombia as well as Asian economies like Taiwan and South Korea. In the short term, we believe that continued concerns regarding the new Trump administration’s policies will result in increased volatility in EM assets, though we anticipate a certain amount of resilience given a pickup in growth and reduced current account deficits. In our view, local-currency bonds appear less attractive than hard-currency bonds given the upward pressure on rates through the reflation channel as well as the pressure on foreign exchange via the trade risk channel.
EQUITY U.S. EQUITIES After upgrading our view on U.S. equities across the capitalization spectrum to slightly overweight in November, the Committee maintained our outlook in our latest reassessment despite the sharp post-election rally. Though market valuations remain at the high end of historical ranges, the U.S. equity market continues to be biased higher, as corporations stand to profit from a more business-friendly landscape marked by proposals to lower taxes, reduce regulatory burdens and enact robust fiscal spending programs. Small businesses tethered to U.S. growth, in particular, could thrive, as they may benefit from those aforementioned factors without also being punished by the anti-trade rhetoric impacting large multinationals.
NEW ADMINISTRATION POLICIES EXPECTED TO BOOST EARNINGS S&P 500 Calendar Year Bottom-Up EPS (U.S.$) 150 132.74 116.76 117.97 118.78
120 102.43
108.47
94.86
90 83.2
83.1
81.79 71.43 59.34
60
30
0
‘06
‘07
‘08
‘09
‘10
‘11
‘12
‘13
‘14
‘15
‘16
‘17
Source: FactSet.
PUBLIC REAL ESTATE The Committee maintained its slight underweight for public real estate. REITs delivered strong performance for much of 2016, benefitting from the global search for yield. The asset class has sold off post-election in the face of climbing interest rates, however, and remains vulnerable to the potential for further rate increases.
NON-U.S. DEVELOPED MARKET EQUITIES We reduced our outlook for non-U.S. developed market equities to neutral at the post-election meeting in November and maintained that outlook for the first quarter of 2017. Europe: The Committee maintained our neutral bias toward European equities. Though European equity markets continue to look cheap by many measures, investors are likely to express a preference for U.S. risk assets in the new pro-growth, pro-inflation Trump regime. With a host of impactful elections on tap across the euro zone in 2017, the ECB announced that it would extend the duration of its quantitative easing program until at least December 2017 while reducing its monthly asset purchases to €60 billion per month (from €80 billion) beginning in April 2017.
Japan: We maintained our neutral view on Japanese equities. Japanese stocks have spiked post-election, with the Nikkei Index hitting 2016 highs in recent weeks. The rally likely has been driven in part by the prospect of a pro-growth Trump administration and the stronger dollar/ weaker yen that is likely to result, to the benefit of Japanese exporters. With yields on 10-year JGBs pushing above zero for the first time since February, the BOJ offered to purchase an unlimited amount of shortmaturity issues as part of its new “yield curve control” policy, but found no takers at its below-market ask.
India: In November the Indian government launched a “demonetization” program through which all 500 and 1,000 rupee notes currently in circulation must be exchanged for new bills before year end, with the intention of rooting out tax cheats and the likely unintended consequence of reduced consumption in the near term. The Reserve Bank of India recently surprised markets by holding key rates steady following its December policy meeting, citing inflation concerns and general global uncertainty. The central bank also trimmed its expectation for full-year fiscal 2016 growth to 7.1% from 7.6%.
EMERGING MARKETS EQUITIES
China: China remains a key risk to the emerging markets and global growth in general, as Beijing faces a number of potential bubbles—in real estate, in debt, in commodities—that will require a deft policy hand to negotiate safely. An already-contentious relationship with President-elect Trump adds another layer of complication to the geopolitical landscape.
The Committee downgraded emerging markets equities to slight underweight from slight overweight at our November meeting and maintained that position for our First Quarter 2017 Outlook. A stronger dollar and higher U.S. interest rates could weigh on the asset class even as the anticipated increase in U.S. infrastructure spending potentially benefits certain markets directly while helping to support global growth in general. The prospect of trade reform and tariffs further complicates the situation for emerging markets equities and currencies. In our view, valuations in the complex remain broadly attractive, presenting an opportunity to invest in high-quality names at a discount. China remains a key risk. Brazil: While it was hoped that the removal of former President Rousseff would allay the political uncertainty that has gripped the country, new President Terner finds his administration similarly enmeshed in allegations of corruption. Terner, meanwhile, has pressed ahead with his financial and economic reform agenda since taking office; while these measures have been welcomed by investors, they are unpopular with large swaths of Brazilians. The latest batch of economic data indicated that the Brazilian recession has persisted into third quarter 2016, though expansion is likely to return in 2017. Russia: Russia has been one of the top performing emerging equity markets following the U.S. elections. Expectations that a Trump administration could lead to a thaw in tensions between Washington (and the West in general) and Moscow has contributed a certain amount of optimism, while Russia also has enjoyed the recovery in oil prices throughout the year and stands to benefit from a planned global production cut in 2017.
REAL AND ALTERNATIVE ASSETS COMMODITIES The Committee has maintained its slight overweight on commodities. The Bloomberg Commodity Index is on track for its first annual gain since 2010 as prices across the complex have rebounded sharply throughout the year. The agreement between OPEC and several major non-OPEC oil nations to cut production in 2017 will likely help support prices that, at around $55/bbl, are already more than twice their early-2016 lows. Gold, in contrast, has struggled post-election in the face of a stronger dollar and higher bond yields.
HEDGE FUNDS We maintained our slight overweight in lower volatility and directional hedged strategies. Investing conditions over the past year have, for some strategies, been even more challenging than 2008, as high holdings concentration and crowded markets exacerbated poor performance. The potential for increased volatility and greater dispersion of stock performance could benefit active managers in general and long/short strategies in particular. Arbitrage strategies could be challenged if the potential loosening of financial industry regulations results in greater competition from bank proprietary trading desks.
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PRIVATE EQUITY AND DEBT Just as in public market equities, valuations for private equity have increased; that said, we favor a steady investment plan in private equity rather than trying to time the market. We continue to be positive on private debt. While there are concerns that the potential repeal of the Volker Rule limiting banks’ proprietary trading activities would squeeze out alternative providers, there appears to be sufficient supply to absorb the additional demand that’s likely to come online over the next 12 months. And this supply is likely to be bolstered by increased M&A activity as the incoming administration takes a less interventionist approach to deals. 18
CURRENCY USD: We are neutral on the U.S. dollar. U.S. economic data remain strong, and a rally in inflation expectations has led to higher yields, helping support the greenback. Risks to our view include a more dovish Fed as a result of a strong dollar, a weakening in economic data and a collapse in inflation expectations should President-elect Trump’s proposed infrastructure program begin to be questioned. Euro: We are neutral on the euro. The ECB continues to push the currency lower with dovish rhetoric while political uncertainty weighs on the currency as well. The ECB tweaked its easy monetary policy by extending the duration of its quantitative easing program until at least December 2017 while reducing the size of its asset purchases by €20 billion per month beginning in April 2017. Risks to our view come from the region’s large current account surplus and the potential for a rise in risk aversion that would trigger capital repatriation.
Yen: We have a slight overweight on the yen. Purchasing power parity and real exchange rates may suggest the currency is undervalued following its recent weakness. Moreover, we believe being long the yen remains a valid trade during a period of risk aversion. A risk to our view comes from the upward trend in global yields as the BoJ holds Japanese sovereign 10-year yields at 0%, causing interest rate differentials to move against the yen. Pound: We are neutral the pound. We believe the currency is likely to be driven largely by economic data and sentiment surrounding the Brexit deal. The Bank of England has eased aggressively and is likely to wait for more data before doing so again. Surveys and other data so far suggest Brexit has had only a limited impact on the U.K. economy, although we believe it will take time for the real impact to be reflected. In the short term, the weaker currency could attract capital despite the heightened political uncertainty, persistent current account deficit and rising inflation as a result of the pound’s depreciation in an environment in which the central bank is unable to raise rates. Swiss Franc: We are underweight the franc, which continues to appear overvalued. If its efforts post-Brexit are any indication, the Swiss National Bank is likely to attempt to fight further appreciation in the currency, the strength of which has been a source of disinflation in the Swiss economy. An additional factor weighing on the franc is that, from a technical perspective, the franc remains one of the most attractive funding currencies. Risks to our view include the potential for increased geopolitical uncertainty, Switzerland’s positive current account balance and what appears to be limited damage to projected economic growth despite the franc’s strength.
OIL PRICES HAVE STABILIZED AS SUPPLY AND DEMAND CONVERGE World Liquid Fuels Production and Consumption (millions bpd) 100
4
96
3
2
92
1 88 0 84 -1 80
-2 1/12
4/12
7/12
10/12
1/13
4/13
7/13
10/13
1/14
Implied Stock Change and Balance (right axis)
Source: U.S. Energy Information Administration.
4/14
7/14
10/14
1/15
4/15
World Production (left axis)
7/15
10/15
1/16
4/16
7/16
World Consumption (left axis)
10/16
1/17
4/17
ABOUT THE
ASSET ALLOCATION COMMITTEE Neuberger Berman’s Asset Allocation Committee meets every quarter to poll its members on their outlook for the next 12 months on each of the asset classes noted and, through debate and discussion, to refine our market outlook. The panel covers the gamut of investments and markets, bringing together diverse industry knowledge, with an average of 24 years of experience.
COMMITTEE MEMBERS Joseph V. Amato President and Chief Investment Officer Erik L. Knutzen, CFA, CAIA Chief Investment Officer—Multi-Asset Class
David G. Kupperman, PhD Co-Head, NB Alternative Investment Management Ugo Lancioni Head of Global Currency
Thanos Bardas, PhD Portfolio Manager, Head of Global Rates
Wai Lee, PhD Head of the Quantitative Investment Group, Director of Research
Alan H. Dorsey, CFA Chief Risk Officer
Brad Tank Chief Investment Officer—Fixed Income
Richard Gardiner Head of Investment Strategy Group, Chief Investment Officer—Neuberger Berman Trust Company
Anthony D. Tutrone Global Head of Alternatives
Ajay Singh Jain, CFA Head of Multi-Asset Class Portfolio Management
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This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Diversification does not guarantee profit or protect against loss in declining markets. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results. The views expressed herein may include those of the Neuberger Berman Multi-Asset Class (MAC) team, Neuberger Berman’s Asset Allocation Committee and Investment Strategy Group (ISG). The Asset Allocation Committee is comprised of professionals across multiple disciplines, including equity and fixed income strategists and portfolio managers. The Asset Allocation Committee reviews and sets long-term asset allocation models, establishes preferred near-term tactical asset class allocations and, upon request, reviews asset allocations for large diversified mandates. ISG analyzes market and economic indicators to develop asset allocation strategies. ISG consists of five investment professionals and works in partnership with the Office of the CIO. ISG also consults regularly with portfolio managers and investment officers across the firm. The views of the MAC team, the Asset Allocation Committee, and ISG may not reflect the views of the firm as a whole, and Neuberger Berman advisers and portfolio managers may take contrary positions to the views of the MAC team, the Asset Allocation Committee and ISG. The MAC team, the Asset Allocation Committee and ISG views do not constitute a prediction or projection of future events or future market behavior. This material may include estimates, outlooks, projections and other “forward-looking statements.” Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. This material is being issued on a limited basis through various global subsidiaries and affiliates of Neuberger Berman Group LLC. Please visit www.nb.com/disclosureglobal-communications for the specific entities and jurisdictional limitations and restrictions. The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC. ©2016 Neuberger Berman Group LLC. All rights reserved.
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