Market Outlook

Q1, 2020: Extraordinary Measures for Ordinary Times

Summary

Growth, Inflation & Policy

  • 4Q saw scattered economic improvement as recession fears subsided across global markets. Hopes for a 2020 rebound rest on the historic policy reversal and restart of “QE” by the U.S. Fed and continued monetary stimulus from the ECB, BoJ and PBoC.
  • Global inflation picking up in the intermediate-term with most core measures in the U.S. trending higher. Developed market inflation, however, will remain structurally constrained by poor demographics and high debt levels.
  • Global monetary policy environment is increasingly supportive, but focus will now shift to whether recent increases in inflation will limit that support.
  • The outcome of the closely-watched U.S. presidential election will likely only be seen as disruptive if Elizabeth Warren or Bernie Sanders are elected.

Equities

  • U.S. equity valuations in top-quintile imply muted forward long-term returns substantially below those of the last decade. The tactical outlook will be impacted by interest rate and “QE” backdrop and multiple expansion if the cycle continues, especially in “story” stocks.
  • Lower valuations for international developed equity will not be enough to materially overcome slowing growth, poor demographics, heightened geopolitical risk and trade tensions.
  • Long-term return expectations for emerging market equity remain relatively stable as higher growth and less foreign consumption dependency should drive earnings growth in excess of developed peers; tactical outlook has improved as Fed pivot to more QE and deficits should limit dollar strength.
  • Higher EBITDA multiples and robust private equity fundraising imply lower net fund multiples than the last decade.

Fixed Income & Credit

  • A structural ceiling on developed market rates from demographics and debt overhang could get tested by supply/demand imbalances.
  • The quality and stability of global credit markets has been negatively impacted by multi-year period of negative real rates and reach for yield.
  • Higher leverage, lower underwriting standards and limited covenants will pressure default and recovery rates and increase deal complexity during the next U.S. credit downturn. We believe issues will be most acute in the U.S. loan market (although pricing on the margin has improved as loans have trailed).
  • Higher yield in hard currency emerging market sovereign debt almost completely offset by expected increase in defaults. At >350 bp spread over emerging markets and generally lower duration, frontier market debt offers a more compelling risk-return.

Real Assets

  • U.S. commercial private and listed real estate cycle peaked/peaking from a cap rate perspective, but strong demand and stable NOIs/yields should contribute to mid-single-digit gains. Rising yields and/or an economic slowdown represent key downside risks.
  • Wide dispersion and muted returns expected in commodity futures on slower global growth and negative roll yield environment (-3%).
  • MLPs attractively priced with more sustainable self-funded yields. ▪ Gold will continue to benefit if pool of negative-yielding sovereign debt—now at $12 trillion—grows.

Opportunistic

  • Across most hedge fund and liquid alternative categories, near record low hurdle rate/opportunity cost of U.S. and global core 60/40 portfolios  (expected 10-year nominal returns of 3.5% and 2.9%, respectively) and higher expected volatility are offset by high fees and declining manager alphas.
  • Value-biased long/short equity managers appear well-positioned to benefit from higher volatility and mean reversion of style and sector trends.
  • The closed-end funds space is widely unattractive as discounts have closed to less than historical averages across almost all sectors but energy.

Asset Allocation

  • Unrealistic expectations for forward returns based on the last 10 years pose a significant risk for U.S. investors. Current low bond yields and high equity valuations will result in 10-year forward returns 3-4% below those of the last 10 years. As evidence, over the last 20 years, diversification across asset classes and geographies with regular rebalancing has delivered higher returns and less risk than U.S. stocks.
  • Cash and short-term bonds do not have the explicit convexity of tail risk hedges, but they have implicit convexity (“shadow value”) if used tactically to deploy into potential future dislocations. Unlike most other hedges, cash and short-term bonds have very low fees and liquidity risk.

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