By Neuberger Berman :
By Erik L. Knutzen, CFA, CAIA, Chief Investment Officer-Multi-Asset Class
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.
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 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.
The area of the economy that could be most impacted by the election is trade. Trump's views here diverge from recent Republican free-trade 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 short-term 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.
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.
- Joseph V. Amato , Co-Chair & President and Chief Investment Officer-Equities
- Erik L. Knutzen, CFA, CAIA , Co-Chair & Chief Investment Officer-Multi-Asset Class
- Thanos Bardas, PhD , Portfolio Manager, Head of Global Rates
- Alan H. Dorsey, CFA , Chief Risk Officer
- Richard Gardiner , Head of Investment Strategy Group & CIO, Neuberger Berman Trust Company
- Ajay Singh Jain, CFA , Head of Multi-Asset Class Portfolio Management
- David G. Kupperman, PhD , Co-Head, NB Alternative Investment Management
- Ugo Lancioni , Head of Global Currency
- Wai Lee, PhD , Head of the Quantitative Investment Group, Director of Research
- Brad Tank , Chief Investment Officer-Fixed Income
- Anthony D. Tutrone , Global Head of Alternatives
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.
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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.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.