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4Q Outlook: Fasten your seatbelts. It’s going to be a bumpier ride.

Global Investment Committee
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Quick, what comes after V?

Over the past six months, the global economy has experienced both its most startling descent and its most rapid comeback in modern history. Data since the April bottom have shown that global growth emerging from the worst of the coronavirus crisis has been stronger than our expectations. Indeed, the U.S. economy, among others, has thus far experienced a V-shaped recovery in a number of crucial sectors, from housing and manufacturing to consumer spending (on goods, at least). The path of recovery from here, however, looks to be bumpier and the trajectory flatter (figure below).

Figure 1 – After the Q3 bounce, a wobblier and flatter trajectory for U.S. growth 

The pandemic continues to hold back a number of economic sectors, mainly those that rely on large groups of people congregating in close quarters. A vaccine or effective treatments to minimize both the spread and fear of the coronavirus is the only way to bring the economy fully back to normal. A vaccine being approved, available and widely adopted in the second half of 2021 seems like a reasonable timeframe.

The more immediate source of downside risk is not the virus itself, but a failure on the part of policymakers to provide sufficient economic support to individuals, businesses and states whose budgets are currently under stress. Unemployment benefits comprised close to 7% of U.S. household income in July, but most of those benefits expired on 31 July. Loans and grants made through the Paycheck Protection Program are no longer available, and funds allocated directly to states and local governments through the CARES Act have largely dried up. Congress and the president have been unable to strike a deal for renewing any of these provisions, forcing the U.S. economy – in contrast to its better-supported peers – to clear a rather large gap without government assistance between now and … well … it’s not exactly clear.

We may be starting to see the effects of this policy failure. Core retail sales for August declined slightly after strong gains in the prior three months, and consumer confidence has been uneven. Small business failures are creating permanent job losses, even as many workers who were temporarily laid off in the spring have been able to return to work. The better-than-expected labor market recovery to this point should support incomes and spending and allow the U.S. to avoid a double-dip recession. But the lack of federal support will slow the pace of recovery dramatically as the year draws to a close.

The good news is that no other major economy has allowed its fiscal stimulus measures to lapse in quite the same way as the U.S. The global manufacturing rebound, led by China and now Europe, is a sign that demand is recovering. Even so, the U.S. consumer remains one of the primary engines of global growth. Should the world’s largest economy slow materially into the end of the year, the consequences will be global in nature.

Financial markets reflect current (and future) fundamentals

Given these risks to the economy, how can we be comfortable investing in equity and credit markets after seeing their valuations climb in a historic rally? Markets are supported by both the cumulative upside surprises to the economy since the end of the recession (figure below) and the apparently faster-than-expected progress toward a COVID-19 vaccine. The latter factor has driven expectations for next year’s earnings growth higher in recent months, even as both 2020 and 2021 profits are set to come in well below what we had forecast coming into the year.

Figure 2 – Global equity markets have risen as economic data has soundly beaten expectations 

The other factor supporting financial markets is the global commitment to ultra-easy monetary policy, which has pushed both current interest rates and expectations for future rates to all-time lows. Just last month, the Federal Reserve all but committed to keeping its policy target at zero until well into the middle of this decade. Dovish central banks have helped foster a quick return to normal in financial markets (figure below).

Figure 3 – Crisis averted as financial conditions loosen dramatically 

The S&P 500 Index’s impressive return to all-time highs in August, as well as its pullback in September, are likely signs of the bumpier ride to come. Even so, we are not assuming a purely defensive crouch in our equity or credit portfolios. September taught us that high valuations can make markets vulnerable to sudden selloffs, even without a clear driver. However, we still view the fundamental underpinnings of the equity market – and the recently embattled technology sector, in particular – as strong over all time horizons. Even a fiscal hole in the U.S. that lasts for several months is unlikely to seriously derail this new bull market in risk assets, which is still in its infancy.

One thing that sudden drops and sharp increases in financial markets have in common is their ability to elicit feelings of fear, confusion and regret in investors. Being “on the sidelines” in cash ended up hurting investors more in the second quarter than it helped them in the first. Today’s markets – with high equity market valuations and low interest rates – present a challenging investing environment for the years ahead. But a mix of long-term trends and short-term opportunities should help investors of all types increase their expected risk-adjusted returns, at least beyond those currently offered by cash.

In a challenging investing environment, uncertainty can be your friend

Short-term investment outcomes are nearly always harder to predict than long-term returns. That’s because virtually anything can drive markets over the next day, week or month. A smaller collection of variables – valuation and demographics, as examples – account for the bulk of the variation among financial assets over periods of several years or more. Because both of those long-term factors are currently headwinds to high returns and income generation, it’s more important than ever to take advantage of short-term uncertainty in security selection and asset allocation decisions.

The U.S. election certainly counts as a source of short-term uncertainty. While this year’s presidential race has seen steadier polling than the last one (figure below), investors seem reluctant to price in a specific outcome. In fact, more seem to be pulling money out of the market, perhaps an attempt to time a reentry point after the results are known – a strategy we would advise against.

Markets may have over-learned the lessons of 2016, when an unexpected outcome provoked a sudden (though temporary) reversal in market leadership. As a result, with no specific result priced in, it’s likely that any outcome will affect markets at least modestly over the final two months of the year.

We listed some potential “winners” for some of the likeliest outcomes when we wrote about the election in September. A “Blue Wave” scenario in which Democrats capture the White House and Congress could result in higher taxes on corporations and high-income individuals, but it would also likely release a new flood of deficit-financed stimulus that could help the economy in 2021. Municipal bonds, in particular, could be helped by the dual tailwinds of higher demand for tax-advantaged investments and greater aid to cash-strapped states and localities.

Figure 4 – 2020 is a steadier race than 2016, but not a closer one 

ESG investing could also be a relative beneficiary of a change in energy regulation and infrastructure spending focused on mitigating climate change and promoting clean energy sources. In the event the election delivers a continuation of the status quo, the same investments that performed well in the final months of 2016 – financials, industrials and other cyclicals – would likely do well. Commercial real estate would also be a net winner from a low-tax, low-rate environment that would endure for at least another four years.

Regardless of the outcome, we expect U.S. monetary policy to remain extremely accommodative for the coming years, a standout even in a world of seemingly permanent central bank dovishness. In particular, the Fed’s new approach to inflation – encouraging the economy to borderline overheat before beginning to raise rates – could favor real assets or those that perform better as the U.S. dollar weakens. We currently favor allocations to TIPS and real assets (both public and private) as hedges against rising inflation expectations, as well as emerging-market debt, which benefits from looser financial conditions associated with a weaker U.S. dollar. EM economies also generally carry less debt than the U.S. and other developed countries, which could help their credit ratings improve relative to developed economies running far larger deficits.

The pandemic has also affected several ongoing economic trends, including the growth of e-commerce, the persistence of low global interest rates and the reshuffling of global supply chains. All of these trends appear to be accelerating and should continue to do so beyond 2020. E-commerce sales as a percentage of total U.S. spending have hit our 2025 projections five years ahead of schedule due to the pandemic. This rapid growth benefits retailers with large online presences, but we believe it will also help sustain high returns on investments in both public and private industrial real estate, much of which is used for storing and shipping goods bought and sold online.

The trend toward ever-lower interest rates is perhaps the most consequential trend of the last 40 years, especially as it impacts the optimal mix of assets in an investment portfolio. Government bonds retain a modicum of diversification benefit to a portfolio. However, they produce only a small fraction of the income that they did just a few years ago, thanks to central banks promising to keep rates low in perpetuity to help the global economy recover (figure below). With lower rates, as we know, comes a more aggressive search for yield among income-seeking investors. We see all income-producing assets as potential beneficiaries of the repricing that could accompany this increase in demand, and we are particularly keen on leveraged finance and private credit to perform well in this early recovery stage.

Figure 5 – Central banks have convinced bond markets that rates are staying low for a long time 

Lastly, the pandemic shined a bright light on the inadequacy of just-in-time global supply chains, particularly for medical equipment and pharmaceuticals. Areas of the real estate market that stand to benefit from on-shoring should see price appreciation if these moves take place. We are also likely to see a greater emphasis on food security and increased productivity for farms. Farmland has continued to be a good income-producing diversifier in portfolios, with defensive properties that have served it well during the coronavirus crisis. Investors looking for income-producing assets with less correlation to the bond market may find it a valuable addition to their portfolios.

More uncertainty from here

If the second quarter was the fall and the third quarter was the bounce, then the fourth quarter marks the start of a highly uncertain period for the global economy and investors. Successful investing will require capitalizing on the murkiness of the policy environment and the power of accelerating trends. In other words, we don’t think uncertainty should be used as an excuse to remain disengaged from the financial markets.

For many investors right now, income generation is the most difficult portfolio mandate to fulfill. But high-growth assets should also retain a prominent place in portfolios, particularly given the likelihood that the pace of the recovery is destined to slow down (if it hasn’t already) and the prolonged period of ultra-low interest rates has just begun.

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Dimitri Stathopoulos
United States
All market and economic data from Bloomberg, FactSet and Morningstar.

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature.

Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

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Alerian MLP Index is the leading gauge of energy Master Limited Partnerships (MLPs). The float-adjusted, capitalization-weighted index, whose constituents represent approximately 85% of total float-adjusted market capitalization, is disseminated in real-time on a price-return basis (AMZ) and on a total-return basis (AMZX). Bloomberg Barclays High Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds. Bloomberg Barclays Corporate High Yield 2% Issuer Capped Index measures the USD-denominated, highyield, fixed-rate corporate bond market and limits each issuer to 2% of the index. Bloomberg Barclays Municipal Bond Index covers the USD denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and prerefunded bonds. Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency) Bloomberg Barclays U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers. Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Bloomberg Barclays U.S. Mortgage Backed Securities (MBS) Index tracks agency mortgage-backed passthrough securities. Bloomberg Barclays U.S. TIPS Index is an unmanaged index that includes all publicly issued, U.S. Treasury inflation-protected securities that have at least one year remaining to maturity, are rated investment grade, and have $250 million or more of outstanding face value. Cliffwater Direct Lending Index (CDLI) seeks to measure the unlevered, gross of fee performance of U.S. middle market corporate loans, as represented by the asset-weighted performance of the underlying assets of Business Development Companies. Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the $US-denominated leveraged loan market. ICE BofA Preferred Stock Fixed Rate Index is designed to replicate the total return of a diversified group of investment-grade preferred securities. S&P Global Infrastructure Index is designed to track 75 companies from around the world chosen to represent the listed infrastructure industry while maintaining liquidity and tradability. To create diversified exposure, the index includes three distinct infrastructure clusters: energy, transportation, and utilities. JPMorgan Emerging Market Bond Index tracks the performance of bonds issued by developing countries. MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. MSCI US REIT Index is a free float-adjusted market capitalization weighted index that is comprised of Equity REIT securities. The MSCI US REIT Index includes securities with exposure to core real estate (e.g. residential and retail properties) as well as securities with exposure to other types of real estate (e.g. casinos, theaters). MSCI World High Dividend Yield Index targets companies with high dividend income and quality characteristics and includes companies that have higher than average dividend yields that are both sustainable and persistent. NCREIF Property Index is a quarterly time series composite total rate of return measure of investment performance of a very large pool of individual commercial real estate properties acquired in the private market for investment purposes only. S&P 500 Index is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization. S&P U.S. Treasury Bond 1-3 Year Index is designed to measure the performance of U.S. Treasury bonds maturing in 1 to 3 years. S&P U.S. Treasury Bond 7-10 Year Index is designed to measure the performance of U.S. Treasury bonds maturing in 7 to 10 years.

A word on risk
All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investing involves risk. Investments are also subject to political, currency and regulatory risks. These risks may be magnified in emerging markets. Diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss of income. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Credit ratings are subject to change. AAA, AA, A, and BBB are investment grade ratings; BB, B, CCC/CC/C and D are below-investment grade ratings. As an asset class, real assets are less developed, more illiquid, and less transparent compared to traditional asset classes. Investments will be subject to risks generally associated with the ownership of real estate-related assets and foreign investing, including changes in economic conditions, currency values, environmental risks, the cost of and ability to obtain insurance, and risks related to leasing of properties. Socially Responsible Investments are subject to Social Criteria Risk, namely the risk that because social criteria exclude securities of certain issuers for non-financial reasons, investors may forgo some market opportunities available to those that don’t use these criteria. Investors should be aware that alternative investments including private equity and private debt are speculative, subject to substantial risks including the risks associated with limited liquidity, the use of leverage, short sales and concentrated investments and may involve complex tax structures and investment strategies. Alternative investments may be illiquid, there may be no liquid secondary market or ready purchasers for such securities, they may not be required to provide periodic pricing or valuation information to investors, there may be delays in distributing tax information to investors, they are not subject to the same regulatory requirements as other types of pooled investment vehicles, and they may be subject to high fees and expenses, which will reduce profits. Alternative investments are not appropriate for all investors and should not constitute an entire investment program. Investors may lose all or substantially all of the capital invested. The historical returns achieved by alternative asset vehicles is not a prediction of future performance or a guarantee of future results, and there can be no assurance that comparable returns will be achieved by any strategy.

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