CIO Roundtable - Nothing Endures But Change

By Neuberger Berman :

By Joseph V. Amato, President and 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

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 anti-establishment 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

Selected Recent and Scheduled Elections in the Developed Markets

Tank: While the shifting political landscape has gotten a lot of attention, a related sea change is the transition from central bank-dominated 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)

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 towards emerging markets equities might be to tilt portfolios toward 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.

Alternatives: Helping Narrow the Return Gap

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.

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 bullish on it now. While there are concerns that the potential repeal of the Volker 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.

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

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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