Given the many issues surrounding capital markets today, including the UK’s Brexit vote and China’s growth questions, we thought clients would value hearing Chief Investment Officer Eric Freedman’s thoughts on topics clients frequently inquire about. This quarter’s Investment Strategy will cover several topics, ranging from recent events to upcoming catalysts.
If we do not cover an issue that’s on your mind, please speak with your CAPTRUST representative, and we will gladly respond.
What is your overall view on the investment landscape?
We remain glass-half-full with respect to the investment opportunity set. We see the U.S. economy as moving toward the late stages of a traditional (if there is such a thing) business cycle, and the rest of the world is a mixed bag. While we are living in unprecedented times in some regards—most notably global interest rates at historically low levels—in other respects, economies and markets are following finance textbook theory. In a world of stalled productivity gains, demographics have driven economies. This has been a positive for some Southeast Asian and Latin American economies and a negative for Japan. Theory suggests markets should take a cue from central banks’ lead; more stimulus should drive asset prices higher, and the U.S. equity market’s positive response to post-financial-crisis accommodative policies set the bar for Europe and Japan.
At time of this writing, the U.S. equity market has just closed at all-time highs (surpassing levels not seen in over a year), which could instill investor confidence. Our base case is that global growth “muddles through,” and given low interest rates, should economies remain stable, riskier asset classes like stocks, high yield bonds, and parts of the real estate and commodity markets should perform well. Emerging market stocks, which have been laggards for the past five years, would welcome a shift toward a “reflationary” global economic orientation from a “deflationary” one, which we see as possible at this point in the business cycle. Despite our relative optimism, we think investors need to prepare themselves for a period of low returns.
Eric, CAPTRUST has been forecasting a low-return environment for the past few years. Can you discuss why?
Our team approaches asset class analysis from a building-block perspective, with the least risky asset classes at the bottom of the tower and the riskiest at the top. Think of each asset class block’s height as an investor’s required rate of return to invest in a given asset class, and the tower’s total height as the expected return for investable assets in total. The first building block is insured deposit cash, or the return you get from a savings or checking account. Cash is not yielding much right now, so that block is very short. I won’t bore you by going through each asset class, but the next block is short-term government bonds, then longer-term government bonds, then high-credit-quality corporate bonds, all the way to early-stage venture capital or angel investments at the very top.
Central banks control short-term interest rates, recently keeping their interest rate targets low to encourage spending and borrowing. Major central banks have also been buying longer-term bonds to suppress longer-term interest rates that are key to setting mortgage and auto loan rates. These actions leave our tower’s base at the shortest level in history.
Since investors recognize that bonds may not provide them with the same returns they enjoyed during periods when interest rates were higher, the compensation they require for investing in stocks, high yield bonds, or other asset classes goes down, shrinking the height of the blocks above them. Lower interest rates serve as a gravitational pull on asset class returns. That said, we do think interest rates will gradually move higher, and investors will eventually migrate to asset classes with greater return opportunities than fixed income.
What impact do you expect the Brexit vote to have on the global economy and financial markets?
From an economic perspective, the Brexit issue is most acutely a UK and European Union (EU) issue. The immediate impact was Britain “giving way” to France as the world’s fifth largest economy by gross domestic product due to the British pound’s sharp decline. While we don’t want to rule out the possibility that the UK could remain in the EU, all signs indicate it will leave.
The investment concern centers on the EU’s viability, more specifically the viability of the Eurozone, the 19 countries that form a tight-knit trading bloc with a common currency despite varied productivity and fiscal discipline. The EU and Eurozone have faced several tests, but a major economy’s departure leaves all European alliances vulnerable. Economically productive countries like Germany have expressed distaste for future taxpayer-funded bailouts for flare-ups like those orchestrated for Greece and Cyprus in recent years. Other countries accuse Germany (and other export-rich countries) of disproportionately benefitting from the euro, which trades at a level likely much lower than if the deutsche mark still existed, which helps German exporters.
An emerging isolationist political mentality within the larger Eurozone economies represented in Figure One could catalyze a country’s departure, and investors should be concerned about a domino effect. This is not our base case, but it is certainly a possibility. European leaders should make every effort to address the major issues faced pre-Brexit, namely the immigration crisis and a shaky banking system. The alternative could be a disorderly unwind.
Figure One: Eurozone Economies and Political Groupings
European equities are inexpensive relative to several of their global peers, especially considering where interest rates are. If economic momentum continues despite Brexit chatter, a highly accommodative central bank coupled with politicians incentivized to preserve remaining ties could make Europe an interesting contrarian investment opportunity.
You recently traveled to China to meet with investment partners and research firms. What insights can you share from your trip?
I cannot overstate how important China will be over the next 10 years. The path China follows will drive global corporate earnings and, therefore, equities, and its contribution to inflation will shape bond markets through interest rates. China, India, and Indonesia will be important growth stories over the next 30 years, but China will be the growth story. One economist I met with felt that China would represent half of the world’s incremental economic growth in the coming decade, and, if he is wrong, he felt the number would be higher. Other economists, perhaps most famously Larry Summers from Harvard, feel China’s growth rate will fall to more reasonable historical levels after its industrial buildout.
So who is right? We side with those more bullish on China. China is migrating from an industrial economy to become more service-based. While the service-based economy is taking share from heavy industry, the overall Chinese economy is slowing. We feel that China will grow modestly in the near term before a combination of demographics, consumer spending upgrades, and government initiatives kicks in to propel China higher.
We see two key variables when assessing Chinese prospects: what Chinese consumers are doing, and what the Chinese government is doing. The centrally planned Chinese economy is hyper-focused on moving up the value chain in manufactured goods and deploying new services to a growing consumer base looking to spend. The Chinese government recently released its five-year plan that highlights environmental awareness, increased urbanization targets, changes to their one-child policy, and a significant commitment to industrial innovation—all variables that can help spur more and higher-quality economic output.
On the consumer side, companies getting the China story right remains vital to global growth. Chinese consumers’ tastes are changing, with many who live in first-tier cities like Beijing, Shanghai, and Shenzhen less focused on accumulating “stuff” and more interested in new experiences, like travel. Other cities can more easily replicate the first tier’s consumption trends thanks to China’s commitment to connectivity through high-speed rail and a highly mobile-phone-engaged population, increasing growth prospects.
To be sure, China faces some challenges to its growth story. Its capital market structure remains underdeveloped, and governance has been shaky. China’s state-owned enterprises, government-created companies that still command significant portions of key industries, are saddled with debt and need reform. Finally, its currency policy is unclear, which could drive capital flows, especially given high debt levels.
Growth stories like China leave the investment glass still more than half-full for us, even if it means the total-return glass is a little smaller than it has been.