Markets entered 2018 with the wind at their back: double-digit equity returns, strong momentum, and expectations that the synchronized global growth and corporate earnings recovery we saw in 2017 should continue into 2018. So damn the torpedoes, full speed ahead? Not quite, as recent volatility suggests some storm clouds could be gathering. Central banks globally are moving away from emergency levels of easing, and large fiscal stimulus in the U.S. in the late stages of the business cycle could have unintended consequences. And, of course, valuations matter.
We are not suggesting a sustained bear market in risk assets as that would need either high odds of a recession or valuations that are not just rich, but in bubble territory. We see neither now or in the immediate future. However, we argue that rich valuations combined with crowded positioning is not an environment to swing for the fences, but rather to seek to grind out returns by pursuing multiple country- and sector-specific macro or micro relative value opportunities. Singles and doubles, as baseball or cricket fans around the world would say, is the way to go, instead of looking to hit the ball out of the park. We believe that solid defense and the sum of hopefully many small victories is the path to achieving investment goals in this environment.
In our 2018 outlook, we aim to provide investors insights into better portfolio construction and diversification using the full tool kit available in today’s markets: which asset classes are likely to offer above-average returns, how to ensure both traditional and alternative risk factor diversification and how to hedge left tail risks (i.e., low-probability but potentially severe outcomes) judiciously.
Review and outlook
As is our tradition, let’s first review the outcomes of our key investment ideas in 2017.
- Equities to outperform credit. All risk assets rallied, but global equities outperformed global credit assets on both an absolute and risk-adjusted basis in 2017 (see Figure 1). As we will detail later, following the recent sell-off we expect equities will likely continue to have better risk-adjusted returns for the rest of 2018.
- U.S. TIPS to outperform nominal Treasuries. The 10-year breakeven inflation rate (BEI) in the U.S. started the year close to 2.0% and ended the year at a similar level. The expected reflation did not occur, but favoring less liquid Treasury Inflation-Protected Securities (TIPS) over nominals did not detract from performance either. As we discuss later, re-emergence of inflation is a risk we think most investment portfolios are not sufficiently prepared for, and we continue to emphasize TIPS in 2018.
- Favor a modest overweight to emerging market (EM) assets. Across equities, local rates and currencies, emerging market exposure generally outperformed developed markets, albeit with higher volatility. Looking forward, many emerging market assets continue to show attractive valuations, and we still suggest having an overweight to EM assets, albeit selectively and with caution.
In summary, two of our three key investment themes in 2017 aligned with our expectations, and one was a wash. Looking forward to 2018, we believe that from here on, equities will continue to outpace other risk assets, on balance emerging markets are likely to outperform developed counterparts and markets will finally tip in favor of inflation-linked bonds over nominals. We will share additional high-conviction investment ideas in the ensuing sections, but let’s first briefly discuss the prevailing macroeconomic backdrop.
As we posited in our last Cyclical Forum held in December, the current Goldilocks environment of synchronized, above-trend global economic growth and low but gently rising inflation is likely to persist in 2018. Recent growth momentum has been even better than expected across many economies, providing a strong ramp into 2018. Moreover, easier financial conditions imply sustained short-term tailwinds, and fiscal stimulus in the U.S. and elsewhere in the advanced economies is forthcoming. Meanwhile, China keeps suppressing domestic economic and financial volatility while fundamentals in many other emerging market economies continue to improve. Taken together, PIMCO’s baseline forecast is for world real GDP growth in a 3% to 3.5% range in 2018 (see Figure 2).
However, a Goldilocks-extended scenario is very much baked into the consensus and asset prices. Our main conclusion from the forum was that 2017–2018 could well mark the peak for economic growth in this cycle and that investors should start preparing for several key risks that lie ahead in 2018 and beyond. (For details on our global macro outlook for 2018, including growth and inflation forecasts, please read our latest Cyclical Outlook, “Peak Growth.”)
Given this backdrop, we would like to highlight three potential risks and three investment themes that we think will be important in 2018.
Three interrelated risks could potentially confront investors this year:
Increased volatility as the Fed continues to unwind its balance sheet, combined with growing deficit financing needs. As the Fed works to remove the extraordinary stimulus needed for the economy to recover from the global financial crisis, it is simultaneously reducing the size of its balance sheet and hiking interest rates in a measured way. However, the Fed is likely to buy $200 billion less Treasuries and mortgage-backed securities (MBS) in 2018 than it did in 2017; the Treasury will need to issue approximately $400 billion more debt to fund the deficit and normalize operating cash after the debt ceiling resolution, in our estimations. Meanwhile data (see Figure 3) reveal that foreign governments are buying fewer Treasuries than they used to. This confluence of events could potentially result in increased volatility. Moreover the European Central Bank is expected to end its asset purchase program in 2018 and the Bank of Japan may raise its yield target for Japanese government bonds. While all of these moves are well-telegraphed, we feel the actual experience of less central bank support may be somewhat unexpected.
Unexpected increase in inflation. Output gaps are closing and commodity prices are stabilizing; input (producer) prices have already started moving up (see Figure 4). Meanwhile, the U.S. government is embarking on a path of fiscal stimulus, with the prospect of increased infrastructure spending following the recently enacted tax cuts. Stimulus coupled with more trade tariffs and trade frictions in addition to those already announced mean consumer price inflation may surprise above our base case. Data for December 2017 showed core U.S. Consumer Price Index (CPI) growing at the fastest monthly pace since January 2017.
Unusual stock-bond correlation behavior. We believe it is important to have high quality government bonds in a portfolio, especially as the business cycle advances. If the economy were to slip unexpectedly into a recession, it is likely Treasuries would be the best-performing asset and the only one with positive returns. Yet we caution that the stock-bond correlation may not behave as expected if either of the two scenarios just mentioned were to play out: rising inflation or increased bond market volatility. History has shown that a negative stock-bond correlation cannot always be relied upon (see Figure 5). Yet more and more leveraged investment strategies count on this continuing.
Greater volatility, higher inflation and the unstable stock-bond correlation are somewhat related risks that we think have heightened probability of manifesting through 2018. Even more troubling, as recent market events show, we believe most investors are ill prepared for these risks, having been lulled into complacency by their absence over the last several years.
Next, before delving into our detailed views across asset classes, we highlight a few important asset allocation and portfolio construction themes:
Consider embracing commodities. The past several years have been challenging for commodities, but there are a number of reasons we believe they can play a role in investor portfolios in 2018 and beyond. First, commodities historically have tended to do well in the later stages of a business cycle (see Figure 6, a stylized representation of asset classes through a business cycle). Unlike equities, which tend to anticipate changes in growth and earnings, commodities are more rooted in the present and tend to outperform as capacity constraints are developing rather than in advance. Second, a number of studies show roll yield on futures contracts may be the best predictor of long-term commodity returns. The crude oil futures curve today, for example, is decisively in backwardation, which generally leads to positive roll yield and often portends positive returns. In fact, crude oil returns tend to be positive even in the short term when the curve is in backwardation (see Figure 7).
MLPs appear poised for strong returns. Last year was not a pleasant one for master limited partnership (MLP) investors. The benchmark Alerian MLP index underperformed the S&P 500 and spot crude oil by 28% and 22%, respectively, in 2017. Several factors contributed to the weak sentiment throughout the year:
- Dividend cuts to preserve capital ended up spooking the sector’s core retail investor base.
- Access to equity capital markets became challenged, leading to a supply/demand imbalance.
- Many investors feared that tax reform regulation would negatively affect the MLP investment model.
In 2018, some of these concerns continue. However, we believe MLPs represent one of the most attractive opportunities for value-oriented investors seeking higher-yielding assets with potential to deliver attractive performance during periods of rising rates and higher inflation.
Our optimism for MLPs in 2018 is driven by projected growth in EBITDA (earnings before interest, taxes, depreciation and amortization) from project completions and improved underlying fundamentals. We expect the already attractive yields of the sector will become more secure if the average dividend coverage ratio is greater than 1.2 and leverage ratios fall to under 4.0. Moreover, dividend cuts and deleveraging that have occurred over the past 18 months have helped MLPs evolve into strong franchises that have strong credit metrics and are not as reliant on capital markets access. When the catalysts above are combined with PIMCO’s view that U.S. crude oil production growth is likely to be robust in 2018, we believe MLPs are an attractive investment for discerning investors.
Selectively invest in private assets. While private assets traditionally compensate investors who are willing to tolerate less transparency and lower liquidity, these strategies are not immune to the factors that have compressed expected forward returns in public markets. As such, we suggest a selective approach. One area where we are treading carefully is middle-market corporate lending, particularly in private equity (PE) sponsor-driven transactions. This area has seen significant return compression, as well as less disciplined lender behavior (this is arguably a near-term positive for traditional PE, along with the boost expected from recent tax law changes). As a result, we tend to prefer off-the-run situations or very large financings where others cannot compete. We also think that both direct corporate and residential real estate lending are reasonable investments, with less competition and more structural rights, as well as attractive asset values underlying the loans.
Asset allocation themes for multi-asset portfolios
We are modestly risk-on in asset allocation portfolios, focusing on multiple relative value opportunities across sectors and regions. Synchronized, above-trend global economic growth and low but gently rising inflation are likely to characterize 2018, but this scenario is already reflected in most asset prices. Risks to the outlook include greater volatility, higher inflation and unstable stock-bond correlations – and policymakers may not have sufficient tools to effectively counter a downside turn.
Given the recent cheapening, we are overall constructive on equities; we are overweighting non-U.S. markets relative to the U.S., where markets have already priced in a very optimistic scenario. That said, we do see an attractive opportunity in a combination of U.S. bank stocks and real estate investment trusts (REITs). We are moderately bullish on European equities, with growth in the region above trend and an accommodative European Central Bank (ECB). Attractive valuations and low corporate leverage are positives for Japan’s equity market.
We remain defensive on interest rate exposure, though we believe an allocation to government bonds is important in the late stages of a business cycle. Among developed market sovereigns, we find U.S. Treasuries the most attractive due to their higher yields and convexity characteristics. U.K. gilts and Japanese government bonds appear rich, and we believe valuations of eurozone peripheral bonds are suspect without continued ECB support.
We are overall neutral on credit. At this stage of a maturing business cycle, investors should appreciate the limited spread-tightening potential of corporate bonds and consider reducing allocations to the more speculative sectors. We see attractive opportunities in non-agency mortgage-backed securities, which will likely continue to benefit from an ongoing recovery in the U.S. housing market and remain well-insulated from many global risks.
We maintain an overweight to real assets, with a focus on U.S. Treasury Inflation-Protected Securities (TIPS). Inflation expectations have risen recently, yet we believe there is still value in TIPS as the market is underpricing U.S. inflation risk. We have a positive outlook on commodities, and we see real estate investment trust valuations as attractive given their recent underperformance.
We are modestly underweight the U.S. dollar, and we continue to believe that EM currencies are a relatively attractive and liquid expression of our global macro outlook. Given weaker valuations and heightened political and trade-related risks, we focus on a diversified basket of EM currency positions. Emerging Asian economies have benefited inordinately from global trade, but are likely to weaken in the face of slowing Chinese growth.
Global equities: positive
Global equities had a very strong year in 2017; the MSCI World Index was up more than 20%. It was the best year for global earnings since 2010, with MSCI World earnings per share (EPS) growing by 14%. Global EPS momentum was positive throughout 2017, and consensus expectations for 2018 EPS growth are 10% to 12% across various equity market regions. We believe these expectations can be realized if the synchronized global recovery continues. Meanwhile, positioning now is cleaner than it was to start the year, and as such, we believe a positive stance on equities is warranted. Moreover, supersecular considerations may point to a permanent drop in the equity risk premium (ERP) – please see the sidebar.
The issue, however, is that some markets such as the U.S. have already priced a very optimistic scenario, so earnings must exceed current expectations to justify their valuations. The tax cuts would have to result in increased capital expenditures, increased productivity and permanently higher earnings as opposed to one-off repricing of after-tax profits. Given this backdrop, we are opportunistic in equity markets, with a cautious outlook on the U.S. versus overseas markets that we feel are better positioned to outperform in 2018.
Eurozone equities: overweight
The eurozone demonstrated significant GDP growth last year, beating expectations. Germany’s Business Climate Index is at all-time highs (source: CESifo). The region benefits from any rise in bond yields given the high exposure to financials; moreover, private loan growth is quite robust and continues to portend well for eurozone bank earnings. The region also has high operating leverage and if expected real GDP growth of about 2.25% materializes in 2018, then earnings could grow by double digits over the course of the year. Since May 2017, in the aftermath of French elections, the market has unwound all its prior outperformance and now eurozone P/E multiples are cheaper again. Finally, eurozone price-to-book ratios are at close to all-time lows versus the U.S. A risk to this position is continued appreciation of the euro versus the U.S. dollar, something we don’t expect to repeat in 2018 based on current valuations.
Japanese equities: overweight
Japanese valuations appear attractive. Loan growth is positive and well above the historical median, which helps financials. Japanese profit margins and returns on equity (ROE) are hitting new highs, and companies are generating substantial free cash flow, which should lead to better balance sheet management and governance in the coming years. Japanese balance sheets remain underleveraged (see Figure 8) and could benefit from some increase in financial leverage. In addition, the policy divergence between the Bank of Japan and other major central banks (Federal Reserve, European Central Bank) could translate into a weaker yen, which is a positive for Japanese equities.
U.S. equities: neutral
A U.S. equity portfolio tilt that we believe is likely to outperform, as well as reduce volatility, is a combination of bank stocks and real estate investment trusts (REITs). In our opinion both sectors, with REITs in particular, are attractively priced and poised to outperform the S&P 500 in 2018. On the face of it, REITs underperformed the S&P significantly in 2017, while banks modestly outperformed (according to Bloomberg and S&P data). Yet as Figure 9 shows, both REITs and banks underperformed their historical rates and equity betas. What makes the combination above particularly attractive is that banks and REITs react differently to interest rate changes: Banks tend to do well when rates move higher, while REITs tend to do well when real interest/borrowing costs move lower.
Is this time different? A long-term view on the equity risk premium
Ravi Mattu, Vasant Naik
The rally in global equity markets has stretched traditional valuation metrics beyond the levels observed before the financial crisis of 2008–2009. For instance, the cyclically adjusted price/earnings ratio (CAPE), popularized by Robert Shiller, peaked at 27.3 for the S&P 500 at the end of 2006. On 26 January 2018, the CAPE for the S&P 500 was approximately 34.8. Similarly, the ex ante measure of equity risk premium (ERP) as estimated by PIMCO has steadily declined (see Figure A; the equity risk premium is the excess return provided by stocks over a “risk-free” rate). Measured over the period 1900¬–2017, it averaged 4.4% per year, but within that period the difference between the pre-WWII and post-WWII ERP was over three percentage points. At current valuations, we estimate the ERP to be 2.5%. If the appropriate valuation anchor for the ERP is the ultra-long-term average of 4.4%, then equities appear extremely rich today. However, in our view, the decline in macroeconomic volatility (the great moderation) in the postwar period should result in a lower ERP. Furthermore, the benefits of innovations in financial theory and financial intermediation have both contributed to the rerating of equities.
While a healthy skepticism of “this time it is different” is warranted, the ultra-long-term history of realized excess returns of U.S. equities is likely not a good guide to the “fair” value of the ERP. We offer two arguments in favor of higher valuations.
Decline in macro volatility
Evidence of a long-term decline in both the frequency and magnitude of U.S. economic downturns is incontrovertible. Over the period 1880 to 1949, the U.S. economy was in recession in 39% of the months (source: NBER data). Since 1950, we have been in recession less than 14% of the time. Measured differently, GDP volatility has declined from 6.6% in the prewar period to 2.1% in the postwar period (see Figure B). Similarly, unemployment rate volatility has fallen from 2.8% to 1.1% over this time. It would seem logical for the ERP to be lower today, since the magnitude and frequency of economic shocks households face have moderated.
Impact of financial innovation
Many investors have to bear significant costs that are routinely ignored both in calculating the ex ante ERP and in measuring historical stock returns. These costs include the fees paid to mutual funds, financial advisers and transaction costs. Financial innovation has changed the investing landscape dramatically in recent decades. The widespread acceptance of the benefits of diversification and market efficiency helped spawn the low-cost ETF and passive mutual fund industry. According to data compiled by the Investment Company Institute, the asset-weighted cost of equity mutual funds has declined from 1.04% to 0.63% over the period 1996 to 2016. These declines in management fees do not include the benefits to investors of lower transaction costs. Charles M. Jones of Columbia University in his 2002 paper “A Century of Stock Market Liquidity and Trading Costs” estimates that a 1% reduction in ERP is warranted by the decline in the frictional costs of stock ownership over the course of the 20th century.
Equities may deliver even lower excess returns than the current ex ante ERP of 2.5%, since a reasonable fair value of the ERP may be slightly higher. While valuations have entered the typical cyclical overshoot territory, it does not appear to be a secular calamity in waiting.
Global rates: underweight
We are taking a nuanced approach to investing in government bonds in 2018. The most important factor to take into account is that in a recession, owning government bonds is the best investment for a multi-asset portfolio, in our view. No matter one’s outlook for the Fed or the fiscal situation, it is important in our opinion to have an allocation to government bonds at this advanced stage of the business cycle. However, this does raise three questions: How much, which government and where on the curve?
In answer to the first two questions we like U.S. Treasuries at close to benchmark weights, while maintaining a slight underweight to U.K., France and Japan. We find U.S. Treasuries more attractive due to higher yields of 2.14% for two-year notes and 2.71% for 10-year notes versus the U.K., France and Japan boasting 10-year yields of 1.51%, 0.97% and 0.09%, respectively (all yield data as of 31 January 2018). We also believe the U.S. can offer superior convexity characteristics, as the other markets do not have a lot of room for yields to fall in a recession and higher probabilities that yields rise in many other potential scenarios.
In the U.K. the economy is doing well, inflation is above the Bank of England’s target and the business cycle is well advanced. We don’t expect 10-year rates to undershoot U.S. rates by more than one percentage point unless we see a hard and messy Brexit, which is not our base case.
Similarly, French real rates are close to historical lows compared with the U.S. (see Figure 10). Meanwhile any doubts of the eurozone construct would tend to widen French spreads relative to Germany, countering the tendency for yields to fall.
Finally, Japanese 10-year rates clearly don’t have much room to fall, especially as the Bank of Japan has made clear its preference for steeper curves and positive long-term rates.
In answering the third question, we think positioning to benefit from curve steepening is attractive going forward. Given the Fed has already hiked five times this cycle and the yield curve has flattened considerably, it is once again attractive to have a steepening bias despite our base case expectation for three more Fed hikes in 2018. Not only is there now room for the Fed to cut rates in the event of a slowdown, but historical studies on swap curves (see Figure 11) show that entering curve steepeners at current levels has tended to generate attractive returns over the subsequent 12 months.
Global credit: neutral
U.S. investment grade credit continued to richen throughout 2017, with credit spreads across most sectors now at their narrowest levels since before the financial crisis, which may limit further compression. This robust performance has been well-supported by a strong economic backdrop, rising corporate profits and additional tailwinds from tax reform, notably the expectation of lower corporate rates and repatriation. Nevertheless, the effects of tax reform will take years to be realized, and will have varied effects on corporations depending on their capital structure and international exposures. For instance, investment grade companies that are incentivized to deleverage or that currently hold cash offshore will likely benefit, while leveraged, below-investment-grade corporations, who now lose the ability to deduct interest payments, will likely be negatively affected.
While near-term recession risks are low, investors should be actively monitoring corporate leverage, which has risen somewhat over the past several years (see Figure 12) and left weaker credits exposed to rising interest rates and economic shocks. At this stage of a maturing business cycle, we believe it’s prudent to reduce allocations to the more speculative and lower-rated portions of corporate credit, and focus on higher-quality defensive and more liquid investment grade names with steady yield in attractive sectors. The sectors we favor include senior financials, housing and building materials, energy, healthcare, and telecoms. Sectors that are challenged or overvalued and hence we intend to avoid include retail, mining, utilities and technology.
In addition, opportunities remain in non-agency residential mortgage backed securities (RMBS), which offer moderately attractive loss-adjusted return potential on a hold-to-maturity basis, and have better downside mitigation than comparably rated high yield credit. We remain constructive on housing and consumer-related sectors, and believe tax reforms will increase after-tax incomes for the majority of non-agency borrowers, further improving affordability. Tighter spreads in non-agencies are justified by falling loan-to-value ratios (see Figure 13), improved affordability and a strengthening consumer balance sheet in an environment of tight housing supply.
Global real assets: overweight
Many investors think worrying about inflation is “so 20th century.” Yet there are many reasons to reconsider: The business cycle in the U.S. is mature, output gaps have closed, trade frictions are higher, and populism is on the rise. This is an environment where investing in real assets is likely to yield positive results, especially considering valuations are still attractive in many cases. We have already discussed how we believe the oil market in backwardation is a near-term signal to invest. More important is the fact that the biggest long-term driver of returns in commodities is roll yield (see Figure 14).
Roll yields across major commodity indexes are positive (or nearly so), effectively paying investors to hold an asset that diversifies from bond and equity market risk. It is important to note that investors are not confined to major published commodity indexes. Various “smart beta” strategies exist in commodities that are designed to increase actual and estimated return potential over published conventional cap-weighted indexes. Furthermore, commodity supply and demand are now well balanced after the supply shortage during the commodity “supercycle” followed by the surplus during the “commodity bust” of the last few years. In this situation, commodities tend to react more to idiosyncratic supply-demand imbalances, which increases their diversifying properties.
In addition to commodities, we note that U.S. 10-year breakeven inflation rates (which potentially include inflation and liquidity risk premia) are still below the Fed’s implicit target of about 2.35% for CPI. In particular, there is very little term premium in the inflation curve, and as such we like replacing some nominal U.S. Treasury exposure in our multi-asset portfolios with 10-year U.S. TIPS.
As we discussed in the equities section above, REITs in combination with bank stocks could be a potent portfolio strategy. Real estate valuations are still reasonable offering the potential for positive return along with inflation hedging (see Figures 15 and 16).
Currencies: modest underweight to U.S. dollar
The U.S. dollar depreciated versus most major currencies in 2017 – notably versus emerging markets. While uncertainty on U.S. trade policy did create bouts of volatility in foreign exchange (FX) rates, particularly in the more vulnerable ones such as the Mexican peso, our 2017 call of holding the bulk of our FX exposures in emerging markets turned out to be generally beneficial to portfolios. Valuations drove the U.S. dollar to underperform against key developed markets, such as the British pound, where moves in 2017 have all but undone the valuation gap that opened after the Brexit vote.
Market moves in 2017 weakened the valuation tailwind from several emerging market currencies. As we show in the chart, out of six major EM currencies, only the Brazilian real and Turkish lira have similar or more attractive valuations versus early 2017. Nevertheless, most emerging market currencies are likely to provide reasonable yield pickup relative to the U.S. dollar even after adjusting for inflation (see Figure 17). We continue to believe that EM currencies are a relatively attractive and liquid expression of our constructive macro outlook. Given weaker valuations and heightened political and trade-related risks, we prefer expressing this through a diversified basket of FX positions such as the Mexican peso, Argentine peso and Russian ruble.
We also employ currency positions as an active tool in portfolio construction. Select developed market currencies such as the Australian dollar tend to have a high sensitivity to global macro shocks. As such, we prefer holding long U.S. dollar positions against these currencies, especially as the cost of holding these positions is modest. From a portfolio construction standpoint, these positions tend to mitigate part of the left tail risk of our emerging market currency exposures.
We have spent a lot of time discussing valuations and positioning across traditional asset classes. Yet we strongly believe that outperforming in 2018 will depend on appropriately combining these traditional risk premia with structural alpha strategies that seek to isolate time-tested sources of return premium, also known as alternative risk premia, such as value, carry and momentum, among others. Further, investors should consider building a portfolio that is appropriately diversified and “downside aware.”
Our base case of continued synchronized global growth in 2018 could argue for a more aggressive approach to risk. However, there are important risk management considerations that hold us back. The first, which we have discussed at length, is valuations. The second is that in the case of an unexpected downturn, policymakers may not have many monetary or fiscal bullets left. Monetary policy still is operating at or close to the zero lower bound in many countries, and fiscal deficits are increasing. Also, global cooperation seems to be decreasing and geopolitical risk rising.
Weighing the combination of all these factors we prefer somewhat cautious positioning in which we do not expect an immediate sustained downturn but are prepared for the possibility that policy may not be very effective at truncating the downside if it does occur.