Beneath the Surface
FIXED INCOME MARKET VIEWS*
Inflation, the southern euro zone, emerging markets and high-quality high yield stand out in an expensive market.
Investment Grade Fixed Income
The Asset Allocation Committee (“AAC” or “the Committee”) maintained its underweight view.
- While Committee members believe the Federal Reserve could ease by this fall to support the U.S. economy, and inflation remains benign, yields are very low for this stage in the cycle and some short-term factors weighing on inflation may reverse over the coming months.
Investment Grade Corporates
The Committee maintained its neutral view.
- Fundamentals remain stable, aggregate leverage appears to have plateaued and earnings are slightly beating low single-digit growth expectations, but investment-grade credit has rallied significantly already this year.
- Currency-hedged yields and steeper curves have generally favored European over U.S. credit.
The AAC moved from a neutral to an underweight view.
- In the first half of 2019, municipal bonds staged a strong rally tied to tight supply, diminished concern about rising rates, strong fund flows and increased demand in high tax states due to the state and local tax (SALT) cap.
- Although technicals are poised to remain supportive over the summer, municipal high-grade valuations now appear very tight relative to U.S. Treasuries.
Treasury Inflation Protected Securities
The Committee maintained its overweight view.
- TIPs have been beaten up and look attractive.
- Some short-term factors weighing on inflation may reverse over the coming months.
Developed Market Non-U.S. Debt
The Committee maintained its strong underweight view.
- While Europe has steeper yield curves and there is some benefit from hedging currency exposures for U.S. dollar investors, overall rates in Europe and Japan are still well below those in the U.S.
- The peripheral euro zone markets are one of the few places where the AAC favors interest-rate risk.
High Yield Fixed Income
The Committee upgraded its view from neutral to overweight.
- Higher-quality, BB rated high yield debt appears attractively valued.
- Supply-and-demand imbalances in floating rate loans and collateralized loan obligations (CLOs) may make them attractive places to take credit spread risk.
Emerging Markets Debt
The Committee maintained an overweight view.
- While much of the asset class’s excessive relative cheapness has corrected, a weaker dollar resulting from monetary easing could provide a tailwind.
EQUITY MARKET VIEWS*
Record-breaking index levels conceal lagging performance by riskier stocks and more pro-cyclical regions.
The Committee moved from neutral to a modest underweight for U.S. large cap and upgraded from neutral to a modest overweight in U.S. small and mid cap.
- The S&P 500 has rallied over 20% year-to-date and now appears fairly valued, with earnings growth expected to slow in the next two quarters (-2.6% in 2Q, -0.3% in 3Q) before rising 7% in 4Q 2019, according to FactSet.
- In a short easing cycle, the Fed is expected to cut rates by the fall, which could help extend the cycle into next year and support the high-beta and cyclical stocks that have recently been underperforming.
- Small cap stocks could stand to benefit, as they are more levered to the U.S economy and less to global trade dynamics, and they have also lagged the performance of large caps recently.
Public Real Estate
The Committee voted to maintain its neutral view.
- REITs have rallied by 22% already this year, as markets have priced in the benefits of potentially lower interest rates.
- The AAC anticipates a cyclical rally in response to eventual Fed easing, which could hurt defensive sectors like REITs.
Non-U.S. Developed Market Equities
The Committee reduced its overweight view to neutral.
- Employment, credit growth and consumer confidence remain robust, but global trade tensions have weighed heavily on the manufacturing sector, in particular, leading to persistently sluggish growth.
- The European Central Bank (ECB) is contemplating additional stimulus, but previous initiatives have yielded mixed results.
- Existing trade tensions between the U.S. and China, the risk of U.S. tariffs on the autos sector, Brexit and the leadership transition at the ECB could all weigh on performance.
- Japan is sensitive to global growth, trade dynamics and the effectiveness of China’s stimulus efforts.
- A consumption tax increase is due later this year, and that has historically dampened growth for a quarter—although the government is prepared to provide stimulus to reduce the impact.
- The Bank of Japan (BoJ) remains committed to low rates at least through Spring 2020.
- Worsening trade disputes and a stronger yen could be sources of risk.
- The U.K.’s ruling Conservative Party will elect a new prime minister after Theresa May resigned from the position in late May, potentially creating delay and further uncertainty ahead of the new Brexit deadline of October 31.
Emerging Markets Equities
The Committee maintained its overweight view.
- Current valuations remain attractive and dollar weakness resulting from looser Fed policy could provide a further tailwind.
- The AAC anticipates improvements in China’s growth during the rest of this year as fiscal and monetary easing, focused on the domestic consumer, gain more traction.
- While its ultimate significance remains unclear, investors were cheered by an apparently productive meeting between presidents Donald Trump and Xi Jinping at the G20 meeting at the end of June: the U.S. dropped its threat of new tariffs and adopted a softer stance on Huawei, and both sides pledged to keep talks open.
- Dollar strength, trade disputes, and China’s managed slowdown and its potential impact on global growth remain the key risks.
REAL AND ALTERNATIVE ASSET MARKET VIEWS*
Mainly neutral views, with a tilt to hedged beta and commodities that could evolve with the macro conditions.
The Committee voted to maintain a neutral view.
- Oil producers continue to adhere to production cuts set last year to reduce the global oil glut, although the duration of these cuts remains up for debate.
- Demand for oil could slow if global growth remains subdued or U.S.-China trade tensions worsen, but supply could tighten in the event of worsening tensions between the U.S. and Iran.
- Dollar weakness resulting from looser Fed policy could provide a tailwind.
The Committee downgraded its overweight view in Lower-Volatility Hedged Strategies to neutral but maintained its overweight view in Directional Hedged Strategies.
- Intra- and inter-asset class correlations have risen as markets have rallied this year, and therefore the Committee prefers to take beta, albeit in a hedged manner, with more directional strategies.
The Committee maintained its neutral view.
- The AAC continues to advocate a consistent, strategic and disciplined investment plan in private markets.
- Committee members favor the following: high-quality high yield bonds; preferred securities; CLO mezzanine and structured credit with a one- to three-year duration; and long volatility exposure in EUR/USD.
The AAC maintained its small underweight.
- Market participants are still long.
- The dollar appears overvalued based on purchasing power parity (PPP) metrics.
- The Fed has taken a dovish stance, and the recent fall in short-term interest rates is likely to weaken the USD if it is sustained when risk appetite normalizes.
- A U.S. slowdown and a recovery elsewhere should reduce the global growth differential.
- The U.S. is running a twin deficit.
- Risks to the view include the persistent growth differential, which leaves us with a short-term yield differential that is supportive of the dollar, albeit at tighter levels than recent records; and the potential for risk aversion around trade discussions, which could underpin the USD.
The AAC moved from a neutral to an underweight view.
- Purchasing Managers’ appear to have stabilized, but at a low level.
- The risk of U.S. tariffs on the auto sector remains live.
- ECB monetary policy looks very likely to remain accommodative.
- European parliament group formation, the potential for a snap election in Italy and Brexit still weigh on the euro.
- Risk to the view include that the ECB appears less concerned about the growth outlook than the markets, and will be headed by a new president after Mario Draghi steps down; the fact that, despite recent deceleration, growth is still expected to be at trend and the euro zone would be a likely beneficiary of any pick-up in global growth later this year; and the euro zone’s large current account surplus.
The AAC moved from a neutral view to an overweight view.
- Long yen remains attractive during periods of risk aversion and both PPP and real exchange rates suggest the JPY is undervalued.
- Japanese growth appears set to improve from one-off factors, and extremely low unemployment should support inflation.
- Japan runs a current account surplus.
- A future trade agreement with the U.S. could be more hawkish on JPY weakness.
- Risks to the view include the still-wide yield differentials in both nominal and real terms with the U.S., exacerbated by the BoJ yield curve-targeting policy; an ongoing rebound in risk sentiment, following May’s market sell-off, could lead to further JPY weakness; and market participants likely still holding a slightly long JPY position.
The AAC maintained its small overweight view.
- The GBP appears undervalued based on PPP measures, which includes a large apparent political risk premium.
- Despite Brexit uncertainty, U.K. Job creation and wages have been stronger than expected and overall activity has remained remarkably healthy.
- The Bank of England (BoE) may be unable to look through improvements in the economy for much longer.
- Risks to the view include political uncertainty as the Conservative party chooses the U.K.’s new prime minister; evidence from the U.K.’s trade balance that GBP weakness is not boosting exports as much as expected; and slowing in both wage and the stock-building activity that came before the previous Brexit deadline.
The AAC moved from a large to a small underweight view.
- The CHF continues to appear very overvalued on PPP measures and safe-haven flows will likely continue to unwind should Europe’s prospects improve.
- The strong CHF continues to cause low inflation.
- The CHF is one of the most attractive funding currencies.
- Risks to the view include Switzerland’s current account surplus; the potential for Switzerland to benefit from improvements in European growth; the potential for political uncertainty, especially around Brexit and Italy, to cause risk aversion; and potential hawkishness on CHF weakness in the forthcoming U.S.-Switzerland trade deal.
UP FOR DEBATE
Are we finally going to see some inflation?
At this quarter’s meeting of the Asset Allocation Committee (AAC) there was plenty of debate over the timing and extent of the coming Federal Reserve rate cut—would it be 25 basis points as early as July, or 50 kept in reserve for September?
That aside, there was broad consensus on four things: first, that rates would indeed be cut this year; second, that the first Fed cut in more than a decade would be a significant event, likely to catalyze an uptick in risk appetite; third, that the cuts are unlikely to go as far as markets currently expect; and fourth, that those cuts could well coincide with the trough of a cyclical soft spot in inflation data.
For that reason, the AAC envisions a short rate-cutting cycle—something more like the Q3 1998 cycle rather than the sustained cuts put in to battle the post-dotcom capex crash or the last financial crisis. In the days after the meeting, a strong rebound in the June non-farm payrolls data added weight to this view.
While headline inflation data has been weak for some time in the euro zone, and surprised markets by ticking lower in the U.S. in May, AAC members see a different dynamic beneath the surface.
We believe that gaps in the U.S. data resulting from the federal government shutdown at the start of this year could account for as much as 30 to 40 basis points of understatement in the Consumer Price Index (CPI). That may explain some of its softness relative to other measures such as the U.S. Producer Price Index (PPI), for example. A weak non-farm payrolls release for May and a slight dip in the growth rate of average hourly earnings should be weighed against the fact that wages are still growing at 3.1% per year, and that the U.S. Job Openings and Labor Turnover Survey (JOLTS) shows employers still hiring and employees still just as willing to quit their current jobs for something better.
More timely, leading indicators of inflation, such as the U.S. Manufacturing Institute for Supply Management (ISM) Prices Index, are beginning to suggest a turn in the tide. Similarly, while the Philadelphia Fed’s Prices Paid and Prices Received Indices continue to show a decline in what manufacturers are paying for their inputs as well as what they receive from their customers, it is notable that the gap between their input costs and the prices for their goods has jumped substantially over the past five months. A weakening dollar is likely to push costs up and widen that gap further. As that becomes less sustainable, the pressure to pass costs on to the consumer will grow.
There are signs that markets have half an eye on these incipient inflation pressures. Although the recent dovish turn from the Fed and the European Central Bank (ECB) was met with sharply lower nominal bond yields, inflation-protected bonds got an even stronger bid, pushing breakeven inflation rates up after a period of decline. Yield curves also steepened.
In terms of asset-class views, the Committee’s outlook for inflation and rates underscores its overweight stance on inflation-protected securities, on some parts of the commodities complex and on the pro-cyclical industrial and materials equity sectors. However, real estate securities, which provide real-asset exposure, have already benefitted from a strong rally and could be vulnerable to a broad risk-on, high-beta rebound.
Asset Allocation Committee
About the Members
Neuberger Berman’s Asset Allocation Committee meets every quarter to poll its members on their outlook for the next 12 months on each of the asset classes noted and, through debate and discussion, to refine our market outlook. The panel covers the gamut of investments and markets, bringing together diverse industry knowledge, with an average of 27 years of experience.