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Macro outlook

Midyear Outlook: Just how clear is the path ahead?

Global Investment Committee
Bringing together the most senior investors from across our platform of core and specialist capabilities, including all public and private markets
A square prism refracts light

Highlights


Brian Nick video thumbnail discussing the GIC 2020 midyear outlook

The bounce has begun; how high can we go?

Back in March, we were as stunned as anyone to be marching into an economic recession and an unprecedented global health crisis. We’re nearly as surprised to find, only three months later, that the global economy is once again expanding and financial asset prices are staging one of their strongest quarters in history. While health experts are quick to caution that the coronavirus remains a serious threat, high-frequency data — and our own eyes — tell us that commerce is returning as virus fears abate (wisely or not) and businesses reopen.

And so, it seems, passes the 2020 recession, the deepest and the shortest downturn the world has experienced since World War II. The National Board of Economic Research has pegged February as the end of the longest uninterrupted period of growth in U.S. history, but it also acknowledged that a new expansion may have begun as early as May. Asia, especially China, has been expanding for a few months now given its earlier and generally more successful experience with the virus. And Europe, which has experienced the worst of the fatalities per capita, is being supported economically by its strong social safety net and aggressive economic stimulus. In the wake of this severe global downturn, we find a recovery of highly uncertain trajectory.
 
Figure 1 – The U.S. economy can recover from this downturn faster than the last one  


As the figure shows, we expect U.S. economic activity to return to its Q4 2019 peak in the second half of 2021, clocking this recovery at twice the speed of the one that began in mid-2009. While that forecast might appear optimistic, we also see unemployment remaining between 8% and 10% through much of 2021. That’s because restrictions on how certain businesses may operate in the phased reopening could cause job creation to lag even as the economy grows.
 
As we wrote in March, the speed and trajectory of this recovery will be largely determined by economic policy. Global fiscal policy has been effective so far at replacing lost income and helping businesses of all sizes stay afloat. With reopening underway, policymakers will need to do more to a) ensure financial conditions don’t tighten; and b) cushion the demand shock by assisting distressed industries and unemployed workers.

Proceed with caution after a fabulous recovery rally
It would have been nice to know with certainty in our last quarterly outlook how close we already were to “the bottom” in global financial markets, particularly equities. Stocks have staged arguably the most impressive and unexpected rally on record since their bottom in late March. The first stage of that rally was marked by subsiding panic about basic market functionality, thanks to a hefty dose of liquidity from the Federal Reserve and its global peers. The second stage was dominated by a relatively small number of high-growth companies, mainly in the U.S., that became more attractive for their abilities to generate profits during the economic shutdown. The latest stage since mid-May has been driven by evidence that the coronavirus is being contained and the global economy is getting back to work. Its leaders include non-U.S. markets and more cyclical companies with lower valuations.
 
Despite rising equity market volatility in June, stocks are not likely to retest their March bottoms because a return to that level of panic remains unlikely. However, risk assets have undoubtedly priced in an optimistic scenario for the next 18 months: no serious second virus wave, a strong recovery in corporate profits and near-zero interest rates across the developed world. Only the last of the three assumptions seems solid to us.
 
Even so, valuation has become a concern, as the figure shows, as it was heading into this year. Interest rates have plunged and credit spreads have narrowed, even on lower-rated securities with elevated risks of default. And global equity markets are at their most expensive levels relative to expected earnings since the bursting of the technology bubble in the early 2000s. Even if stimulative economic policy helps markets continue to post impressive returns in the coming quarters, the long-term prospects for holders of diversified portfolios of publicly traded assets looks precarious.
 
Figure 2 – Valuations across asset classes return to elevated levels 


What comes next?
While the outlook for the balance of 2020 is clouded by uncertainty, the GIC devoted time at its last meeting to discussing how the longer-term outlook might influence — or already be influencing — our investment processes. Many industries face existential risk as fears of the virus affect consumer behavior and business investment. Assets tied to travel and leisure continue to trade at distressed levels. We think leisure travel will rebound before business travel, as families look to take vacations while companies continue to cut travel-related costs and reduce risks.

The long-term prospects for holders of diversified portfolios of publicly traded assets look precarious.    

Speaking of companies, what will become of all the office space leased to global firms, especially in densely populated cities, that were disproportionately affected by the coronavirus? While we don’t think 2020 will be the beginning of the “end of the office” by any means, we see the potential for significant changes in how offices are designed. As the figure shows, more employees have been pushed into less office space over the past 25 years. That trend may be primed to reverse as social distancing and employee safety take on greater importance. The average worker may commute less often to work, but once there will need more room to operate and a design built for greater flexibility, learning and collaboration.
 
Figure 3 – The trend toward less space per office worker is likely ending 

 
Health care is another industry likely to reinvent itself on the fly given its experience during this crisis. As the coronavirus became the primary focus for patients and providers alike, spending on other health care services fell precipitously. The industry will likely make greater use of telemedicine and ambulatory surgical centers. More countries may also incentivize domestic pharmaceutical production to exert greater control over drug manufacturing and avoid supply chain bottlenecks.

We also see this recovery leading to even lower interest rates around the world. Central banks have all but sworn an oath not to raise interest rates until well after the economy has healed, and the bond market seems to have gotten the message.

During the previous recovery, long-term interest rates initially rose quickly in anticipation of higher short-term rates. But this time rates in the most of the developed world remain at historical lows close to zero out to 10 years or more. Central bank balance sheets have ballooned as policymakers commit to quantitative easing policies as a means to reinforce their verbal commitments as the figure shows.
 
Figure 4 – Central banks are expanding their balance sheets again in rapid fashion 


Where does that leave investors looking for income? That question dominated the discussion at our June GIC meeting and serves as the foundation for our major investment theme for the balance of the year.

What to do about “even lower for even longer”
To state the obvious: It’s a lot harder to generate income than it used to be as shown in the figure. The long-term effects of the global financial crisis and aging global demographics created a heightened demand for “risk-free” income and — ballooning fiscal deficits notwithstanding — too few securities to supply it. And the coronavirus crisis has pushed rates down even further. Before 2008, a foundation could almost meet its distribution requirement using U.S. Treasuries alone, and a retired couple could sustain a reasonably comfortable lifestyle with a nest egg subject to relatively little market risk. Today that is no longer the case, requiring us as managers to consider not only how to meet and beat a benchmark, but also how to remain responsive to the persistent and growing demand for income.

In 2020, any solution for targeting higher income comes with increased portfolio risk. Diversifying the sources of those risks is key to an income strategy. Fixed income is the place to start, where investors are paid for credit, interest rate and liquidity risk. With yield curves flat in most of the world, it doesn’t really pay to focus on duration risk. But credit spreads remain well off their early-2020 lows, and even high-quality corporate and municipal bonds still trade at significant discounts due to lower levels of liquidity. Given the currently high corporate debt burden, however, managing risks in a bond portfolio requires careful research, especially in high yield. Investors can also consider allocating to emerging markets debt, which tends to provide more income than U.S. high yield corporate debt for a given level of quality.

With rates so low, however, investors must look beyond a fixed income-only solution. Even at the index level, global stocks provide a dividend yield to rival, if not exceed, high-quality bonds. We favor a more targeted approach to a dedicated equity income strategy, including dividend growers and publicly traded real assets like REITs and infrastructure. These dividend payers are also less correlated than the bond market to day-to-day moves in interest rates.
  
Figure 5 – Higher income now entails higher risks 

 
Perhaps the most fertile ground for income-seeking investors is in alternative asset classes. Direct ownership of real assets — real estate, farmland, timber — provides income diversification not only by source, but also by time horizon. These assets are often backed by long-term leases to tenants, making their income streams less volatile and the overall investment experience smoother.

Private credit has many properties in common with high yield corporate bonds and leveraged loans, but is typically only available through less liquid limited partnership investments. Backed by skilled management and investment selection, it’s another source of income that can perform in an economic recovery.

Looking ahead
In sum, growth is improving, but the investment horizon remains cloudy. The coronavirus and ensuing economic and market upheaval have rattled investors, challenged income generation and called into question the long-term health of key global sectors and industries. Navigating markets from here looks to be extra tricky. In the coming sections, we’ll share some of our best investment ideas from individual GIC members. We’ll wrap up with selective ideas for portfolio construction for the second half of the year.


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Endnotes
Sources
All market and economic data from Bloomberg, FactSet and Morningstar.

This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her advisors.

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.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

Glossary
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, high-yield, 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 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 pass-through 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. BofA Merrill Lynch 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 suitable 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. Nuveen provides investment advisory services through its investment specialists.