2018 Asset Class Outlooks

Transcription

1 218 Asset Class Outlooks JANUARY 218 We consider 217 to have been a strong year for risk assets, driven by buoyed market optimism following the presidential election, with promises of tax reform and a deregulatory environment set to potentially provide a strong tailwind. Equities saw double digit returns, with the technology sector alone up over 3% through the year, and spreads on investment grade and high yield bonds continued to grind tighter amid strong valuations and steady fundamentals. 1 We have maintained our general approach to moving closer to our benchmarks as valuations reached elevated levels, while seeking to find individual credits that can provide outperformance. 218 should see more of the same, as we find idiosyncratic investment opportunities while acknowledging that the broad macro play based on sector rotation is becoming increasingly difficult as sector and credit dispersion continues to tighten. Central banks will continue to be in focus as the European Central Bank (ECB) and Bank of Japan (BoJ) potentially begin to remove their stimulus, while the Fed is set to continue its rate hiking cycle and balance sheet reduction. The political sphere remains volatile, but we believe tax reform s passage in the dying days of 217 should provide a broadly positive start to the year. 1 FactSet. S&P 5 Information Technology sector. Total Return. 27 December 217.

2 INVESTMENT GRADE Generally, we expect more of the same in 218 in terms of broad market performance and the investment grade market. Overall, the economy is in good shape and we believe the macro environment will remain supportive, with % growth. The Federal Reserve s economic projections generally align with our own. While we are more confident in an upside growth surprise than a downside shock, we believe the macro environment remains in a supportive place for investment grade companies. Sector dispersion remains tight, however. When combined with limited volatility, this makes it difficult to make large macro predictions. We foresee this situation continuing and will focus on individual credit selection as our way to seek to generate alpha through 218. Demand should remain stable through much of 218 as the asset class has seen strong inflows despite incremental rate hikes and, generally, US investment grade assets remain well-liked by foreign investors. 2 Supply may be impacted by tax reform if companies repatriate assets and choose to issue fewer bonds, but we still see issuance likely remaining above $1T through next year; a good level of supply by historical standards. In terms of central bank impact, we expect the Fed to hike rates 2-3 times next year. Obviously, this will be driven by ongoing inflation data and growth statistics. While we do not make rate calls in our portfolios, we remain cognizant of the movements of the central bank. However, there are two concerns for the year: wage growth spiking higher and more rate hikes from the Fed than expected. The two are linked as, if we see higher levels of wage growth than anticipated, then the Fed might be tempted to step in and be more aggressive with hikes. It is difficult to anticipate Fed actions too closely, but we think the underlying strength of the economy justifies continued, steady hikes. While the long end of the curve has remained relatively anchored, the short end has been driven higher by Fed rate hikes, meaning that over the last year the yield curve has meaningfully flattened. 3 Some have speculated this points toward slowing economic activity, but it could just as easily be a result of long-end purchases by investors and foreign flows, while the short end of the curve is reacting to Fed movements. 4 Toward the second half of the year, we believe there is some risk from central bank balance sheets as the ECB and BoJ move toward ending their purchase programs. What does a world without active central banks look like? How thin are the markets, and could volatility spike up if there are more concerns as to the removal of that support? While central banks are beginning to end their balance sheet expansion, and the Fed has begun gently shrinking its balance sheet, we still see the broad monetary policy environment as supportive. If rates do move up and we see resulting negative fixed income returns, will we see the rotation from fixed income assets into more equity assets? Or will we see an end to strong foreign flows into the US as yields pick up elsewhere in the world and the cost of US dollar hedging becomes prohibitive? Therefore, we expect 218 will be a first half/second half play. We are predicting global coordination in the first half of the year, continuing 217 s general story, with the second half of the year becoming more of a struggle as central banks diverge. Yield % M US TREASURY YIELD CURVE 5 3M 6M 1Y 2Y 3Y 5Y 7Y 1Y 3Y Yield Curve as at 12/29/217 Yield Curve as at 12/3/216 Yield Curve as at 12/31/212 FED PREDICTIONS FOR ECONOMIC ACTIVITY E 219 E 22 E Longer Run Change in Real GDP (%) Core PCE Inflation (%) Federal Funds Rate (%) E = Expected 2 Morgan Stanley. 2 January Treasury.gov. 2 December Bloomberg. 4 December 217. Oxford Economics. 12 December FactSet. 2 December Federal Reserve. 2 December 217.

3 HIGH YIELD Through 218 we predict that we are likely to see high yield spreads stay tight and potentially grind tighter, while valuations are forecast to remain elevated. Across high yield we have migrated up in quality as a result of healthy fundamentals, so the strength is there in underlying companies to continue to support these relatively elevated valuation levels. Corporate spreads in both the investment grade and high yield asset classes are at tight levels. 7 While there were a number of sell-offs through 217 we largely predict that spreads will remain consistently tight through 218, with the times when the market does step wider providing principal opportunities to step in and make purchases. Macro and geopolitical risks still remain the most dominant form of external risk. We believe high yield is likely to be driven by an external event, due to its underlying internal strength as an asset class and long-term inverse relationship with Treasuries. An event that causes risk off behavior will likely impact high yield, be that North Korea or domestic political upheaval. Trade issues could become a problem through 218. These risks are still there but they are largely being overlooked by the market, as can be seen in volatility numbers. 8 Further, strong technicals remain supportive as despite outflows across high yield, negative net issuance has kept the overall size of the high yield universe shrinking. Analysts predict slightly below coupon return; as a hybrid asset class, economic growth keeps valuations high, but rising rates could impact the asset class at the margins. The 5-year Treasury keeps backing up and that impacts coupon returns; there could be some tightening to offset that, but a total return of coupon minus a slight price decline is the outlook barring some macro change. High yield is really only two years into a credit cycle there was a major correction in 15 with a rebound in 16. There was a spike in defaults, and a classic 1% HY selloff, which we think triggered a new cycle. 9 That scare led to more discipline and therefore, fundamentally, we believe the asset class is in much better shape. High yield defaults have been trending lower for much of the year and our forecast is for this to continue as credit fundamentals remain strong and companies continue to see leverage generally tick down after both spiked in As always, the Achilles heel is liquidity. A downward spiral off the back of outflows would likely lead to more severe outflows; liquidity isn t better, it only appears so because of low volatility. Tax reform affects the lower end of the quality spectrum, and we will wait and see in terms of its longer-term impact on the asset class, but nothing is going to make us change the portfolio or investment strategy. The unknowns are longer term and companies will adjust. There may be changes to the cost of equity vs debt. The interest expense deductions will likely impact cashflow, and there is some concern that the most levered companies will be worse off, but we believe that is largely priced in. Repatriation of overseas assets is expected to have a positive impact but it is likely to be a lot smaller in high yield than in investment grade. Defaults % Issuer Level HIGH YIELD DEFAULTS FELL IN Jan-7 Nov-7 Sep-8 Jul-9 May-1 Mar-11 Jan-12 Nov-12 Sep-13 Jul-14 May-15 Mar-16 Jan-17 Nov-17 Bps SPREADS COULD GRIND TIGHTER THROUGH Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 HY OAS (LHS) IG OAS (RHS) Bps 7 FactSet. 3 January FactSet. As indicated by the Merrill Lynch MOVE Index. 3 January BofAML. High Yield Chartbook. 3 January J.P. Morgan. Default Monitor. 2 January BofAML. High Yield Chartbook. 2 December FactSet. 2 December 217.

4 EQUITIES A favorable macro backdrop and accommodative monetary policy were catalysts for the double-digit equity performance in 217. We believe these fundamental underpinnings will continue into 218. We further believe progress on policy initiatives such as lower corporate taxes and the reduction in regulatory burden should be supportive of equities in 218. A sluggish economic environment favored growth stocks over the last several years because they rely less on the economy to grow earnings. If earnings growth continues to trend positively, cyclical value sectors might benefit. Equity markets had very strong performance through 217, with the S&P 5 leading the way, with particularly strong performance from sectors such as Technology. 13 The backdrop remains consistent to see further upside in 218, although potentially not as strong as 217. Investment activity such as stock buybacks, M&A, and renewed capital expenditures could reach new highs in 218 on sharply higher profits, cash repatriation, and lower policy uncertainty. The reemergence of capital spending is a theme that gained momentum in late 217 from hurricane and oil-related expenditures and should continue due to high business confidence and tax reform. Industries with higher exposure to industrial and technology equipment spending are expected to benefit the most. A combination of solid economic growth, low but gently rising core inflation, and already easy financial conditions should allow room for policy makers to normalize policy further in 218 without jeopardizing the cyclical bull market. While rising interest expense in a tightening cycle should be a gradual headwind for US corporates, we still expect this to be largely offset by rising profitability in 218. Market volatility collapsed in 217. An extended continuation of ultra-low volatility seems unsustainable. While strong fundamentals and a solid economic backdrop are supportive of continued equity performance, record low volatility may struggle to persist in light of ever-present geopolitical risks. Top risks we see to US equity markets include North American Free Trade Agreement (NAFTA) negotiations, North Korea s nuclear proliferation, and an uneasy relationship between the US and China. Bottom-up 218 consensus expectations are for S&P 5 revenue growth of 6% and EPS growth of 12%. 14 We feel that if corporate operating fundamentals remain strong, above average market valuations could continue to be supported. We would not be surprised to see market returns commensurate with realized earnings growth in 218. VIX Index Level Dec-7 LOW VIX IS CAUSING CONCERNS OF MARKET COMPLACENCY 15 Dec-8 Dec-9 Dec-1 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 14% 12% 1% 8% 6% 4% 2% % -2% -4% STRONG EARNINGS AND SALES GROWTH PROJECTED FOR S&P 5 COMPANIES E 218 E Earnings Sales E = Expected 13 Morningstar. 3 January FactSet. 22 December FactSet 2 December FactSet. 22 December 217. Past performance does not guarantee future results.

5 BANK LOANS For the floating rate bank loan market, we predict 218 will be another year of coupon clipping returns. Generally, we anticipate around 4-5% total return through 218. Floating rate securities are more flexible as rates rise, due to the ability of the yield of the instrument to move in sync with underlying rates (typically 3-month US LIBOR). Given their floating rate nature, bank loans stand to benefit from rising rates, having historically performed well in such environments. This can also be seen by looking at correlation, as bank loans have shown a negative correlation to US Treasuries over the last 1 years. 17 When Treasury prices decline (yields move higher), bank loans have tended to outperform. 18 Bank loans also often sit higher in the capital structure than other bonds and equities, thus helping to further reduce potential credit risk. The bank loan market experienced significant repricing activity during 217, which reduced the spread over LIBOR on many individual credits. These repricings reduced the credit spreads on loans, which has offset the benefit of LIBOR increasing. We expect repricing activity to continue through at least the early part of 218. CLO volume remains a significant portion of demand for bank loan assets, more than mutual funds and other investment vehicles saw near record issuance for CLOs, and estimates show that 218 could be even higher, although we are not quite as bullish as we expect $1B+ issuance. 2 GDP and general economic health continue to be a big focus of risk. The ongoing level of 2%+ GDP growth is solid for loans much stronger growth and we could see increasing Fed rate hikes, which is further favorable due to aforementioned negative correlation but downside risk remains to economic activity. We do not believe tax reform should have a major impact on the asset class it should be a minor tailwind for the asset class as the reforms are generally progrowth and economic activity is good for bank loans. Overall, we believe that bank loans will remain a solid asset class; fundamentals are good, and technicals should remain solid. 6% 3-MO US LIBOR CONTINUES TO CLIMB 21 5% 4% 3% 2% 1% % Dec-7 Dec-8 Dec-9 Dec-1 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 $B CLO VOLUME PROJECTED TO REMAIN HIGH IN YTD E E = Expected 17 Morningstar Direct. 1-year period ending November Morningstar. S&P/LSTA Leveraged Loan TR has -.45 correlation to Bloomberg Barclays US Treasury Index TR between December 27 and November December S&P/LSTA. 1 December S&P/LSTA Leveraged Loan Index. 2 December FactSet. 2 December S&P/LSTA Leveraged Loan Index. 2 December predictions are an average of Wells Fargo, J.P. Morgan, Bank of America Merrill Lynch, Nomura and Morgan Stanley outlooks.

6 The CBOE Volatility Index provides a measure of market expectations for near-term volatility as conveyed by S&P 5 stock index option prices. The Merrill Lynch Option Volatility Estimate Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options which are weighted on the 2, 5, 1, and 3 year contracts. The S&P 5 Index provides a broad, market capitalization-weighted measure of US large cap stocks. It includes approximately 5 publicly traded stocks of the largest US companies. The information presented herein has been prepared solely for informational purposes and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Unless otherwise stated, information or views herein contained are as of the date of this presentation. The views expressed herein, as well as forecast or portfolio strategies, may be changed in the future, reflecting change of various factors, including economic fundamentals. This presentation is not an offer, or a solicitation of an offer, to buy or sell any instrument. Nothing contained herein shall be relied upon as a promise or representation whether as to past or future performance. All investments contain risk and may lose value. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. There is no guarantee that referenced investment strategies, including hedging, will work under all market conditions. 218 PPM America, Inc. All rights reserved.