Protracted Downturn or "Muddle-Through"?

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[00:00:01] Hi everyone and welcome. You know, I think it’s pretty safe to say that I can sum up not only our capital markets outlook, but just about everybody else’s in one word, and say it with me: It’s “trade”. Of course, since the imposition of the first U.S. tariffs as we all know trade has fallen and GDP has fallen alongside of it in much of the developed world, and central banks have reacted to try to offset that weakness. One thing that I should point out is that the success in finding some level of balance is going to depend upon two ingredients. One, the respective trade sensitivity of a country or region. And secondly, the effectiveness of their policy in combating that weakness. Regardless, as we look into next year, we expect GDP will be weaker than this year. But country by country it’s going to vary based upon those two factors. Now one country that has largely stayed above the fray thus far is the United States; in part because of lower trade sensitivity, but also because of the massive fiscal stimulus injection that was put in place.

[00:00:59] For some time we’ve talked about the world’s reality being the US’s risk. I think more recently it’s become the US’s reality as well. Indeed, PMI has fallen below the all-important 50 for two consecutive months. Now why does that matter? What we know about falling PMI is that it relates to falling GDP and falling financial market performance. So, if I step back and try to think about this challenge - GDP and market environment - and dimension it, this is a way I’d probably say it: First, let’s imagine our base case is a protracted downturn and that means that growth continues to weaken in many cases to below trend, meaning financial markets’ performance is also equally challenged. Now there is an upside, if you can call it an upside. It’s a “muddle-through” where trade impacts are largely benign. Central banks continue to be highly accommodative and market performance is solid if unspectacular. There’s also a downside case, and that relates to the idea that the weakness in manufacturing eventually flows through to labor and investment and then things get quite challenging. What’s also equally challenging then is: how do I build a portfolio against the backdrop of these possible outcomes? And I would suggest it’s the same thing we’ve talked about for many years. Seeking out those ingredients that allow us to participate in markets as they move up, but also defend strongly should they turn down. And the reason we’ve talked about it for some time can probably be summed up in an interesting chart. If we take all the noise away from the S&P 500 for the last five years, you’re going to see three stages: The first is going to be the two years before the US election where largely overall the S&P price level was flat, but with lots of volatility. Then after fiscal stimulus was suggested and then introduced, the S&P rose by 800 points. But as that fiscal stimulus effect waned since then (January of 2018) to now, the S&P has largely been flat on price performance, and again with a great deal of volatility. So, the suggestion then and the suggestion now is to combat that with ingredients that allow us to participate in both outcomes: one, a strong market where we can be present, and in a difficult market where we can defend. Now I love the idea of discussing growth versus value and large-cap versus small-cap and U.S. versus international. But I’d rather us focus on things like quality and profitability and strong cash-flow generation regardless of what area of the world or what style or what capitalization that company falls within. Also, outside of the equity world I’d like to use high yield as another form of equity de-risk.

[00:03:34] We’ve spoken about this before and here’s the reason: we expect equity returns to be in the mid-single digits over the next five years. And as we woke up this morning high yield yield-to-worst was around that same level and why does that matter? As this chart shows, over the coming five years regardless of where you start, whatever your yield-to-worst is that is most likely going to be pretty close to your average annual total return. But what’s different about the two investments is the downside protection: high yield is superior in that regard and so this should definitely be in your toolkit in equity portfolio construction. But we shouldn’t be complacent just because high yield protects well to the downside versus equities. We also have to be selective within the space. And I would suggest globalizing your credit portfolio. As you can see here, it’s pretty straightforward, that a lot of areas around the world offer similar yields to US high yield, but with higher quality. That’s something we’d want to add inside of our portfolio. And on a more straightforward level, fixed income in the role of income. It’s still the same suggestion, which is a credit barbell, taking the aforementioned high yield and blending it with high-grade bonds. As you can see here, the yield that it offers relative to high yield is pretty high relative to history and it still comes along with another really important ingredient, just like high yield versus equities: great downside protection.

[00:04:48] I think it’s really important to note that these ingredients, as much as we talk about them, are incredibly important and worth you spending your time to get comfortable with them and consider involving them in your portfolio construction discussions. When your upside case is muddle-through, it’s pretty clear that we have to be smart in the ingredients that we choose and the combinations of ingredients that we deploy toward client portfolio outcomes. As always, it’s been a pleasure to be with you this quarter. And I look forward to talking more and more about this as we go ahead. Thanks again.


AB Market Strategist, Richard Brink, shares insights about the opportunities and challenges on the horizon for capital markets.

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