Markets & Economy
Portfolio managers Rob Lovelace and John Smet, and economist Jared Franz share their thoughts on the outlook for global equities, fixed income and economies as they look ahead to 2019.
Will McKenna: Hello, and welcome to Capital Group's 2019 Outlook. I'm Will McKenna, and I want to thank you very much for joining us.
Today you're going to hear from three veterans from our investment team. And they're going to talk about the key issues driving the global economy, as well as equity and fixed income markets around the world.
Now, as you know, this event is available for CE credit. At the conclusion of this webinar, you'll be redirected to a quiz that you need to take in order to earn that credit. And then, if you're watching a replay of this webinar, simply follow the link below to take the CE credit quiz. And please do allow up to 10 business days for processing your credit.
Now, before we get started, let me cover just a couple of housekeeping details. This event is pre-recorded, and so we gathered questions from you ahead of time — and I literally have hundreds of them right here, so thank you for those. We'll be addressing many of those in today's discussion.
Now, meanwhile, if you do experience any technical difficulties, just let us know in the Q&A window on your screen.
Now, let me introduce today's speakers. Joining me today are Rob Lovelace, John Smet and Jared Franz. Many of you know Rob. He is an equity portfolio manager with 32 years of investment experience, and he's responsible for a number of our global equity strategies.
John has 36 years of experience, and he manages several of our fixed income portfolios.
Jared has 12 years of experience and he's our U.S. economist, and he'll also be covering the global economic picture for us.
Thanks so much for being with us today, folks.
Let me step back for one second and just revisit the year that was in 2018. After years of relative calm, we saw the return of market volatility. It was back with a bang, as rising rates, a strong U.S. dollar and trade tensions all combined to rattle the market at times. And as of the date of this recording, international and emerging market stocks took the brunt to that downside volatility. But U.S. stocks were also not spared. Bonds also hit a bit of a rough patch in the face of rising U.S. interest rates.
So, with all of that as our backdrop, as we look ahead to 2019, Jared, I wonder if we can start with you and get your view on the global economy next year. Why don't you start with the U.S. and talk about where we are in the cycle, and then maybe cover the large economies around the world for us.
Jared Franz: Sure. So, as I think about the U.S. and where we are, heading into 2019, I like to think of the cycle since we began in '09. So, we went through the early cycle, the mid-cycle. I think we're now heading into the late cycle. And the late cycle's an important kind of a cycle marker because it usually implies higher cost pressures, higher wage pressures, rising rates from the Fed as you mentioned earlier. Also some profit compression and some rising imbalances in the economy.
So, I think that's where we're headed in 2019. The other thing we need to remember is that we're also heading into the middle part of the fiscal cycle. Now, we got a lot of fiscal stimulus in 2018 that was both on the individual and on the corporate side. We think we're going to get the apex of that stimulus at the end of 2018 into 2019. But as we head into the latter part of 2019, that's going to start to fade.
So, that's important to remember. And as that stimulus fades, so will economic growth along with that. And so, we think we've reached kind of this apex in economic growth, about 3% or so. And we think we're going to head to 2% to 2.5% by the end of 2019.
So, that's where I think we are in the economic cycle for the U.S. In terms of non-U.S. — Europe and Japan, let's say, some of the major economies — they've also seen much slower growth in 2018 than we've been expecting. Part of the Europe case is due to the manufacturing slowing. And that's related to China, another major economy that has seen some slowing.
And so, as we look at 2019 and we aggregate these economies together that represent a large component of global GDP growth, we're looking at a slightly slower 2019 than 2018. Nothing in the recessionary kind of category, but just a slowing versus what we saw in 2018.
Will McKenna: I remember sitting here this time last year and there being a little more optimism and excitement about Europe, coming off a strong 2017. We'll come back to that topic later, but you mentioned the R word, recession, and that indeed is one of the most frequent questions that we got from our audience coming in.
Now, I think it was Paul Samuelson who famously said, “The markets have predicted nine of the last five recessions,” so I'm not going to hold you to an exact date. But maybe you can provide your perspective on what you see as potential causes, potential imbalances. What should we be watching out for next year?
Jared Franz: I think when we say ”late cycle,” there's no rule of thumb that once we hit the late cycle, a recession happens in X amount of time — let's say a year or even two or three years. We've seen late cycles that last a year and we've seen late cycles that last three years. The '90s late cycle was one of those.
And so what late cycle tells you is that you should be more cognizant, more circumspect of the economic environment. And that's what we're doing. We're basically looking at these imbalances, turning over every rock, looking at the corporate sector, looking at imbalances in shadow banking — even the fiscal side is an imbalance that we're monitoring. And so, we're looking to those imbalances to see how could these turn into a recession or, if the economic slowing did happen, how would that transpire?
So, we don't have a rule of thumb saying that once we're in the late cycle, recession's going to occur. But we do have this kind of internal clock to say, "OK, now that we're in the late cycle, we need to really be careful.”
In terms of clouds on the horizon, we have this trade war that’s ongoing with China and the U.S. We're already at 10% tariffs on $250 billion of imports from China. It doesn't look like there's any respite in the next six to 12 months on that, and we could be ramping up to 25% on $200 billion, another, you know, the whole kit and caboodle of $450 billion.
And those those numbers — now, once you get to $450 billion and 25% tariffs on those — those numbers get you into kind of uncertain territory, and I worry about that. So, doesn't look like we're going there in the near term, but it's something to keep an eye on.
Will McKenna: OK, great. And we'll be turning back to the topic of trade as we go down the path.
John, let's talk about bonds. You know, Jared painted a picture of the macro backdrop, which I know the bond guys look at. Help us understand what's your outlook for fixed income in 2019? Will the Fed remain on course? What does it mean for investors?
John Smet: So, Will, let's talk about the Federal Reserve first. Right now, the funds rate is 2.25%. We think the Fed will increase another quarter percent — so we’ll be 2.50% — and then, somewhere in the spring of 2019, go up another quarter to 2.75%.
So, 2.75% — this is the neutral rate that the Fed has talked about before; the rate that doesn't decrease the economy or increase the economy; the rate the Fed really wants to be at. So, at 2.75%, we think next year the Fed will pause because we're at the neutral rate, but also because — surprisingly — inflation has not done that well, has not gone as high as most economists thought it would. Inflation expectations are not that high.
We also see that the economy may be slowing from Jared's 3% to 2%. So, for those reasons, we think we're going to be done raising the Fed funds rate. So, that means to us that the Fed funds rate to the five-year, seven-year part of the curve will be stable, will not move up much through 2019.
On the long end, we worry about supply. We have an increased deficit, so we have more Treasury supply. In 2017, we had to finance $2 trillion in government bonds. This year, it's $2.4 [trillion]; 2019, $2.7 trillion. So, a lot of government supply that needs to be purchased by investors. We also worry while there'll be more supply, there may be less buyers. Pension funds, we think, will — for a variety of reasons — be purchasing less. The Federal Reserve will be purchasing less. And foreign buyers, we think, will be purchasing less.
So, while the short end of the curve and the intermediate end will be stable, we worry there may be some rise in rates on the 10- and 30-year part of the curve.
Will McKenna: OK. And I know another big topic that we've been talking about is this shift from QE to QT, from quantitative easing to tightening, here in the U.S. Been happening for some time. But now, looking outside the U.S., it looks like the European Central Bank may start raising rates soon, and the Bank of England's already doing it. Maybe Japan will get in on the act. Are we on the verge of a global monetary tightening phase, and what would that mean for bond markets?
John Smet: Well, quantitative easing, we know, really reduced the volatility in the bond markets. It lowered interest rates, and it really led to great returns in riskier parts of the bond market. You know, high yield did very well in the last 10 years. Emerging markets bonds did very well. Investment-grade credit did very well.
So, we think there's a very strong probability that [with] quantitative tightening, the exact opposite will happen. And we've already started to see that. Volatility has gone up in the bond market. We've seen interest rates rise in government bonds. And we've also started to see returns in riskier parts of bonds not do that well. Emerging markets bonds have not done recently as well as governments. High yield has not done as well as governments. Investment-grade credit has not done well as governments.
So, we think that that quantitative tightening, which is a global phenomenon, will be one of the strongest drivers of returns for fixed income investors. Thank good[ness] for government bonds, and we think we've already seen a lot of the rise, but we really worry about what happens to the riskier parts of the market in 2019.
Will McKenna: OK, great. Rob, let's bring you into the conversation. I know equity markets have also been volatile, perhaps partly due to this transition from QE to QT. As a global equity manager, maybe you could take us on your tour of the world and talk about the opportunities and risks as you see them out there.
Rob Lovelace: Thanks. And, well, I think the setup with Jared talking about the economy and John talking about fixed income really gets us focused on the main story, which is the United States. So, we'll go on a tour around the world, but it really is about the U.S. right now. As John outlined with quantitative easing, because the dollar is the reserve currency and because many economies are actually dollarized — Jared would know the exact number — but a large amount of that quantitative easing actually went beyond the U.S.'s borders and into other countries. I don't know, 50% or whatever number; I'm not sure it's measurable.
But it had a big impact, and it particularly — as John highlighted — had a positive impact on risk assets. And of course, that would mean emerging markets in general, equity markets and bond markets, but also because they tend to be dollarized. A small amount of money on a relative term to the U.S. economy has a bigger impact there. So, the emerging markets had a disproportionately large positive impact, as did Europe. So, it really had this interesting positive effect.
On the flip side, as we're having quantitative tightening, it has this adverse effect. And I think what you've seen in some of these other countries is sort of the canary in the coal mine, indicating how that lack of access to capital, or the withdrawal of capital, is having a negative impact there.
So, the U.S. economy is going to slow. That is showing up a little bit in corporate profits. I know that some people right now, at the end of the third quarter, are looking at the fact that companies are talking about things slowing. But it doesn't really feel like we're on the brink of a recession. But we probably have passed those heady days, and I think that's what you're seeing coming through in corporate earnings.
We thought, years ago, that we'd hit the peak in operating margins and profit margins —
Will McKenna: Profits, yeah.
Rob Lovelace: — for companies. We probably have seen that, now that wages are rising and other aspects of it. But it doesn't really necessarily speak to a link between the markets and what's happening in the economy. And as you highlighted at the beginning, stock markets predict nine out of every five recessions. That means four times, the market as a leading indicator went down and we didn't end up having a recession, or it was far enough away but it wasn't linked.
Will McKenna: Right.
Rob Lovelace: And that feels a bit like what we're having right now. The market is anticipating this slowdown because of lower profit margins — again, rising wages, higher interest payments — because of rising interest rates, all of these factors coming in, but not a huge setback in terms of a synchronized decline like we had a decade ago, which is so burned into everybody's mind.
But the U.S. is the story, and I'll come back to that again in a minute because I think it's really important to focus on. And we can pick this up later, actually, in the conversation relative to the internet stocks and, really, the impact of how unique that is to the United States.
Will McKenna: Yeah.
Rob Lovelace: The second country I'll shift to is actually China. Historically, people have placed China in the emerging markets category, and I think we need to stop doing that. China is its own center of gravity, and emerging markets are the other category. China, as the second largest economy — and close to being the second largest stock market, depending on how you want to measure it — it, too, is slowing. Very hard to know exactly what the numbers are, but similar to the U.S., we are hearing from the companies that we talk to that things are definitely slowing there. And that was even before we saw the tariff and other issues come into it. And the tariffs will only —
Will McKenna: Exacerbate, yeah.
Rob Lovelace: Aggravate or exacerbate that and slow it down more. So, China is slowing. The U.S. is slowing. We already know from quantitative tightening that the emerging markets are slowing. So, poor Europe, which is caught in the middle of this — which tends to get, actually, a lot of its growth from China and a lot of its growth from the United States — is really in a pretty tough position, because it hasn't had the momentum, either going into the Great Financial Crisis or coming out of it, to really sustain itself and sustain its own growth. China was big enough to sustain its own growth. The U.S. is big enough to do it. Europe isn't.
So, it's a pretty tough situation economically around the world, and with the peak in corporate profits in both the Chinese context and a U.S. context, pretty hard for the other areas as well.
Will McKenna: Right. And I had as a follow up to you, one of the frequent questions here — it's become almost a tradition for us to ask this — this disparity between the U.S. and developed international and emerging markets.
You've got a front-row seat to that as a global investor. Do you see that changing anytime soon? I mean, given the picture you just painted — with still some challenges out there — do you see that changing? Are there any catalysts out there?
Rob Lovelace: Well, American Funds has a strategy called New Perspective Fund®, started in 1973. So, over that 44-year history of the fund, it's actually really interesting that half of the time, 22 years, the U.S. did better than the rest of the world, and 22 years outside the U.S. did better. And this last decade, really post the financial crisis, has been very strongly dominated by the U.S. Part of it has been that we did quantitative easing earlier, and so the market recovery here was stronger and faster. Japan was very late to that game. Actually, I didn't even mention Japan. They used to be that really critical economy, and they're just not even part of the global scene as much as they used to be. So, the U.S. has really been in a strong position, post that very difficult financial crisis period. It really has been a leader coming out of it.
And I think what that has created is a situation where, again broadly, U.S. companies have done well. They’ve focused on profit margins, they've reduced headcount, they've increased the amount of technology that they're using in the workplace — and that's given us a strong base. And then that's all been complemented by Facebook, Amazon and these global leaders in, really, a newly created space in the last decade that's been a huge profit and just generator for returns in the stock market that exists only in a few other countries. So, that combination has really given the U.S. a leg up.
Do I think that will continue? Well, John highlighted an environment in which rates will still rise a little bit, so the dollar probably continues to be relatively strong if not stable. So you're not going to have the currency headwinds or tailwinds. We continue to have these amazing, fairly unique companies here that are operating, even though profit margins are coming down. China, Europe, Japan, emerging markets are all struggling even more than the U.S., and in some ways are impacted disproportionately because we've at least benefited from tax cuts that [do] not spill beyond our borders the way quantitative easing does.
Will McKenna: Right. Yeah. And we'll return to the FAANGs as a topic later as you mentioned. And I was surprised to hear the extent to which those stocks contribute to our market here and in Europe. Something like only 5% of the MSCI Europe has tech as a component. So, they just don't have that group of secular growers in there.
Rob Lovelace: That’s exactly right.
Will McKenna: You touched on it, Jared, earlier, the topic of trade. Obviously a big story for us in 2018. Rob, you mentioned that you are the principal investment officer of New Perspective Fund, one of our flagship global strategies — and now I should mention that the 40 Act fund is not available outside of the U.S., so apologies to our listeners outside of the U.S. It's a strategy that's designed to take advantage of changes in trade patterns around the world.
So, maybe a two-part question for you. First, just what's your perspective on the trade disputes? Where do you see this going in 2019? And then, how are you as a portfolio manager thinking about this in terms of the investment implications for the companies that you're looking at, and what you're looking for in terms of successful investments in this environment?
Rob Lovelace: Well, we're at the beginning of this trade reassessment period. Effectively, the Trump administration opened up fights on almost every front possible, and each one is playing out slightly differently. The U.S. — now U.S.-Mexico-Canada Trade Agreement — while it's been agreed upon, still has to get through the U.S. Congress. So, it's unclear whether it will get through, but at least we have an agreement in writing that we can debate. We're just beginning to work on what we might work with Europe, but I think we're waiting for the whole so-called Brexit to work itself out. But we also need to modify our trade agreement there. And then the Chinese situation is probably the most important, and we may actually see some ups and downs there in terms of trade and tariffs and other barriers, but it's actually in a much broader context.
I'd say U.S.-Mexico-Canada and U.S.-Europe, U.S.-U.K. are very much agreements that we just want to improve things from where they were in the past, maybe make them slightly more beneficial to the United States.
Will McKenna: So, kind of incremental gains.
Rob Lovelace: Exactly. U.S. in China is in a much broader political repositioning of both countries, in the context of China's becoming such a large and important country, and not really playing by the rules it was supposed to in terms of free trade and other disclosure and other types of agreements. So, that one is a whole separate conversation.
As we're working our way through it, it's messy and it slows the economies down. So, for sure there's a headwind created by each one of the renegotiations of these agreements. If we can actually get the renegotiated NAFTA through, it will give people confidence that at least this administration does actually believe in trade agreements; it simply wants to renegotiate them. And I think that will be a boost to the negotiations in Europe and beyond — again, with China off to the side.
But if this NAFTA, or the USMCTA, gets bogged down, that will actually continue to be a drag on the broader situation that we have.
Will McKenna: Are you thinking about different types of companies that have the ability to evolve and adapt and thrive? Any examples of companies — and of course, these aren't investment recommendations — but companies that exhibit those kinds of characteristics in this environment?
Rob Lovelace: These patterns have always existed. So, since New Perspective Fund was conceived in 1973, we've been through oil shocks, we've been through other trade wars, we've been through commodity price cycles. So, the fund has kind of seen it all.
And we tend to focus on multinational companies exactly because they’re positioned to deal with this, whichever way it goes. So, the auto companies are definitely affected by the U.S.-Mexico-Canada Trade Agreement. I think the key piece there that they're looking at is that it requires a minimum wage across the three countries that's much higher than the wage is in Mexico right now, so it will raise the cost of manufacturing autos. But they have plants in all the different areas. So, what you'll probably see in the short term is maybe less supply of certain types of models as cars manufactured in Mexico get shipped outside of the block, so they're not subject to this barrier. And those that are already manufactured inside the block in the U.S. and Canada are fine. So, they just shift based on what's happening. They may shift their sourcing a little bit, but it doesn't tend to have real long-term impacts on the companies. It just leads to these disruptions in the supply chains as they shift things around.
And ultimately, it's a tax on the consumer; it's the consumer who pays for this in the end. The companies tend to figure out ways very quickly to shift that around. So, I'm not really sure that it's the trade aspects that are getting us to think about things differently, but it does matter, really, which economies are growing and whether you’re positioned to be in them. So, I think those companies that have more access to the U.S., those that have access to Europe are the ones that we're most excited about. The Chinese one is the most challenging for us, because although it's a fast-growing economy, if this broader tension continues, that could be disruptive in China for quite a period of time.
Will McKenna: Got you. And this is not likely to end anytime soon. I mean, Jared, you brought this up earlier when you were talking about the economic picture. But tell us more about what you and the team are seeing in terms of what kind of hit will this be to GDP? What kind of hit will this be to earnings and things of that nature?
Jared Franz: Yeah. So, the biggest thing we're looking at right now is the China-U.S. trade relationship. And currently, we've instituted basically a 10% tariff on $ 200 billion. That's part of our forecast. We think it could go up marginally from here, but we don't think it's going to go across the board on all Chinese imports. The hit to GDP, if you — just the simple math of it — you have $200 billion of tariffs, 10% of that's about $20 billion. It sounds like a large number, but the U.S. economy is $20 trillion — that's with a T. And so, the impact is not as large as you would expect in the grand scheme of things.
Now as Rob said, hopefully the Trump administration believes in trade generally, and to the extent that we don't go down the path of just a full-scale trade war — let's say 30% on $450 billion of Chinese imports — if we don't go down that path, it can be essentially absorbed into the U.S. outlook. And we have done that. So, that's why that's part of our 2% GDP forecast. So, we'll wait and see what happens. But for now, it's a relatively benign impact on our outlook.
Will McKenna: OK. John, let me bring you back in the conversation. It seems like most eyes are on the Fed and rising rates. But also credit risk, as it turns out, may be the more important issue in 2019. I've heard you and the team talk about this. Tell us more. What do you see as the issues there, and how should investors be thinking about credit risk?
John Smet: I think a lot of companies followed the quantitative easing playbook. And if you think about interest rates going down, it encouraged people to reach out and grab for yield. So, companies could buy another company and issue a lot of debt — investment-grade debt or, in some cases, high-yield debt. Investors bought that at a very tight spread, and that was very attractive for the companies.
So, you have a lot of companies right now that issued a lot of debt, well-received by the marketplace. And now, they're looking at, “I've got $40 billion of extra debt,” “I've got $100 billion of extra debt — I'd like to de-lever my balance sheet.” Well, if you are going to go from a slower growing economy, and perhaps more volatility in spreads, it may be tough for those companies to do that, because they all want to de-lever, but we're a slow-growing, mature economy. And you have to refinance some of this debt every year. If you’ve got $100 billion in debt, you’ve got to come to market every year. And so, the market may not be that accepting.
So, I think we worry about that: large companies that may be downgraded with large debt from single-A to triple-B. And some companies may go from triple-B to on the edge of high yield. So, that transition we're seeing — there's a lot of debt and a lot of re-leveraging of corporate America. So, we worry about that.
And right now, we're not being paid that much. In the last few weeks, we're getting more yield premium, but really, we're not getting paid that much for the risk that we see in 2019, with more volatility, maybe higher bond spreads and big companies trying to de-lever. So, I think that the credit market — the investment-grade credit market — we see a lot of dangers there, and we just don't think we're getting paid for it right now.
Will McKenna: So, the idea is to upgrade and stay very high quality in that part of the world?
John Smet: Stay very high quality — and even owning Treasuries. Treasuries are probably our favorite investment right now.
Will McKenna: I was shocked to hear the percent of the investment-grade corporate universe that was double- and triple-B. What is that statistic? I don't know if you have that off hand, but some large percent of that market is kind of at the bottom end of investment grade, right?
John Smet: If you look at in the last 10 years, high yield has grown. But back in '08, triple-B bonds, which are the lowest part of the investment-grade spectrum, were about the same size as the high-yield market. Ten years later, high yield has grown a bit, but triple-Bs are now double — in fact, two and a half times the size of the high-yield market. And so, you've had this huge growth in triple-B bonds, and that shows the leveraging of corporate America. And so, a concern we have is, once again, in a slow-growing economy, what happens if one of these names gets downgraded to high yield? Well, a lot of people are forced to sell if a bond gets downgraded from high grade to high yield. And we think in 2019, that's something that we have to be very aware of and we worry a lot about. And we think, generally, that could lead to higher spreads throughout the investment-grade sector.
Will McKenna: So, time to be very risk-aware in your bond portfolio at this part of the cycle.
I'd love to shift into some of the opportunities that we see out there. And Rob, I'd love to start with you. Clearly, we've just described a lot of headwinds and crosscurrents out there in these markets, but where do you feel the excitement about some of the opportunities? Are there some companies you can talk about that help bring that to life?
Rob Lovelace: Well, let me start with a group of companies, which is the whole biotech area. And we really do invest them in a basket sense; we tend to invest in five or six different companies. And I'd say the most exciting opportunities right now are very much focused on cancer treatments and these sorts of personalized treatments as well, where people are able to actually — based on your body chemistry — give you treatments that work for it. And there's just so much excitement in it, and it's not just U.S.-driven.
I was recently in Copenhagen, and it's just amazing to see these sort of centers of excellence that have developed around the world, usually a combination of educational institutions and strong private sector. In the case of Copenhagen, it was Novo Nordisk, an insulin company. But you just have so many doctors there doing amazing things and thinking about delivery systems. And they tend to have offices in the U.S., and they travel back and forth. So, all these little companies know each other. And the major drug companies — Lilly, Merck and others — have really become the distribution arms, although they're specializing, too, either in diabetes drugs or cancer or other areas of focus.
But it really does look like over the next several years, absolutely groundbreaking, long-term treatments — not really outright cures for these types of diseases — but we are seeing in hepatitis and others some actual cures that have been developed recently because of the genetics work that's been done, because of the understanding of the DNA chains and these delivery mechanisms that they've come up with that are so powerful. And every day we have an exciting breakthrough, and every other day we have a failure of a test. And so this is why I'm super reluctant to name specific companies, because it could be literally next week that one has a stage-three drug that fails.
So, you've got to invest in a basket here. But when I think about what's going to drive the economy over the next decade — and it's why I highlighted my excitement about the U.S. and Europe in particular (the Chinese are coming along in this area) — but still, this is where some really interesting work is being done. This is absolutely going to be a key thing that's going to change our lives and create wealth where there was none before.
Will McKenna: It's an incredible thing. I mean, the cure for cancer was always almost said as a joke or a science fiction kind of idea when we were younger. But clearly we're —
Rob Lovelace: Well, at least, I guess you're always a survivor as opposed to ever being cured. But really having quality-of-life improvement and a lot less debilitating treatments to get you from here to there.
And then, you've got to highlight the FAANGs. It's really interesting when you think about what these internet stocks have done. So, mainly focused on Google and Facebook — Netflix to an extent — but Amazon … they have really changed the way the world works. And we all know it; it's in everything we do. But here's the amazing thing to think about: Who are the internet leaders in Europe? Who are the internet leaders in Latin America? Who are the internet leaders in India? It's Facebook. It's Google. To an extent, it's Amazon. There is a Mercado Libre and a few others in other parts of the world that are doing some internet delivery structures. But from a cloud-computing standpoint, it's all in the U.S.
And then people say, “Wait, wait, wait. There's Alibaba. There's Tencent.” Maybe they've heard of a couple in Europe — Yandex or others. And here's what's interesting: We dominate the entire world, except China and Russia. Why? Because China and Russia created their own internet.
Will McKenna: Closed, yeah.
Rob Lovelace: They closed their internets off from the world. And this is what was I was highlighting earlier about my excitement about the U.S. Because these companies are large, they're hard to catch up to and actually, as regulation comes in, they get even harder to catch up to. And you’re hearing [about] fewer and fewer new platforms or bases that are that are coming in to replace them. So, this is something that the U.S. has that's fairly unique.
These companies need to be smarter about how they interact with governments in Europe and other parts of the world, because they effectively are those countries’ internet companies. And it's why Germany a year or so ago said, “Hey, maybe we should create our own internet.” Now, it's sort of a false concept, because it would be too hard for them to do. But I think their reply was, “Pay attention to us. We care about our data privacy in the country.” And so, now there are rules on where servers need to be, so that German data’s kept in Germany and U.K. data's kept in the U.K. So, these companies are starting to figure it out.
But those companies — even though they rose the most, they've been the hardest hit in the recent decline, and they may not be the leaders coming out of it — if you ask me in 10 years what the most important companies are going to be, in addition to those biotech companies, it's absolutely these companies, because it's very hard for companies to catch up. And it will be the suppliers of critical infrastructure to them — whether it's chips, etc. — that will matter.
I think Apple's in a trickier spot, and it's why I like Samsung, actually, in terms of how the company is positioned, because it's not just handsets and devices; it also is creating memory and other basic things that we need. Because I've just lived through too many cycles as a long-term investor around devices — and they're great until they stop being great.
Will McKenna: Man, when Blackberry ruled the world, right? That's great.
You know, as you were talking through both of those examples, it made me wonder, is this where active managers like Capital Group can really help bring a different approach and navigate through these kind of choppy waters? You mentioned the volatility of the drug approvals and the volatility we're seeing now in tech stocks and getting through this kind of regulatory headwind versus more of an index-based approach.
But what's your perspective on that? Is that a place where a firm like ours can really shine in this period of the cycle?
Rob Lovelace: Well, I think the key thing, and it's probably more obvious in the biotech stocks now than it is in the internet stocks, but we were very early in the internet stocks. So, we were able to identify those, and we've held them for many, many … longer than a decade in some cases — some of them haven't been around that long — and the drug stocks are obviously the same. And the other thing about a lot of these biotech and smaller drug stocks is they're actually not around for that long because they tend to get gobbled up by the larger companies later on. So, there's actually only a limited space where you can get at them, and they tend not to end up in any of the indexes, or if they do, they're sort of medium-sized companies that no one else wanted to buy and they often, then, kind of max out on their growth.
So we're constantly looking and evaluating these companies based on new data that's coming out weekly, monthly and potentially changing our positions in them. The internet stocks are slightly different. I mean they're sort of large and well represented in the indexes, they sort of are the indexes in some way. But again, just because someone came up with this FAANG designation, they're very different companies.
Will McKenna: In fact, they're not a homogeneous group, right?
Rob Lovelace: At all, yeah. You know, a handset and device manufacturer all the way to a movie distribution platform to social media — they're only related because they were all innovative companies that were growing fast and had for a period high multiples. That's the only unifying piece. We differentiate between them; it's really important to. I think the outcome of those five, if not — you know, it's a broader group, actually, than even those five — differentiating them is going to have very different outcomes over the next decade. I think some are going to be big long-term winners. And some of them may not even be around.
Will McKenna: I do want to return to the topic of China a little bit, Jared — and Rob, I want to hear a little bit more about what we're doing there on the ground — but the Chinese economy’s slowing. Maybe you can talk about what you and the team are thinking about around China and its economy as it slows. To your point, it was slowing already before some of the tariffs came into effect. But where do you guys see this going next year?
Jared Franz: Sure. And with the China side, as you point out, 2018 has been a year of slowing generally. And we all have our kind of war stories of China where they have too much debt, they're levering up — and you can go back decades. Even the Fed was talking about this in the 90s — that there could be a hard landing in China — if you look at their minutes that they released. And in 2018 they began tightening monetary policy, tightening the debt side and really trying to bring China down to a more gradual, structurally lower growth trajectory. The problem was they didn't tell anyone that they were doing this. And so, as they were slowing credit growth, the data just kept on getting slower and slower and slower. And we've got one of the slowest credit growth [periods] that we've had in China for the last 20 years, all of a sudden.
And so, that's really been the beginning of the slowing in 2018. We basically approached this as saying, “OK, they're taking active choices to make sure that they're structurally slower growth.” And that's a good thing for the Chinese economy; it would be bad if they went back and kept on levering up and levering up. And so, it's better that they do it earlier rather than have a sharp, hard landing later. And so, part of it's a good thing that there is slowing.
And so, as we look into 2019, we don't see them going back to what they did in 2015 and 2016, when they had another slowing cycle. They levered up again, credit easing, pushed the property market up, infrastructure, all that stuff. They're not going to do that this time — and if they do, it's going to be much more muted and they might use the currency a little more in this cycle. And so, I think that's a good thing to the extent that we can take off the table the hard landing issue. But we're not optimistic that we're going to get a big ramp up in Chinese growth.
And so that has obvious implications for any of the countries like Japan and Germany, and even the broader European Union and the U.S., that have these kind of global manufacturing cycles that are all linked together.
Will McKenna: OK, great. You know, Rob, I know this is a very fluid situation and one that we're watching closely. I think our audience likes to hear how are we watching this, and I know we've beefed up our resources in that part of the world at Capital Group over the last handful of years. Can you talk about what's required to really do research there on the ground, the kind of things we've been adding in China?
Rob Lovelace: Well, we've been focused on China for a long time. We opened our Hong Kong office in the late ‘80s, and we've had an Asian presence since the early ‘80s. So, we've been in the region and paying a lot of attention to China. I remember actually in the late ‘80s going to Shenzen, which was a special economic zone which, at that time, was basically a bunch of warehouses and a few assembly plants and is now an unbelievably huge city of millions of people. I mean, it's just amazing how much that's changed over that time period. So, in addition to having some old-timers like me that have been there multiple times, we also now have an actual office in Beijing, and we have people scattered all around the world who actually do research on Chinese companies.
So, it isn't just about having people in country. We have people in London, in the U.S. that are Mandarin speakers. Many of them are Chinese born and raised, and so lots of different perspectives from different parts of the world that really is a hallmark of our integrated research that we do everywhere. But I think if you add it up, we probably have at least 40, if not 50, people that have some type of research responsibilities in China. And it’s the second largest economy, and given how large that market is, it's critical.
Unlike the U.S., where we're seeing a decline in the total number of companies that are listed in the stock market, in China there's a backlog of companies that are just waiting to do an IPO once the markets are stronger. China this year has had a bear market. It's down more than 20% peak to trough — well, we don’t have a strong peak — to current. But there are tons of companies that are just waiting to list. So, it's not just the current stock of companies we have to be ready for. It's a wave of IPOs that we're going to see if there's any sort of strengthening marketplace there.
So, we have analysts on the ground, we have analysts that come in and visit, we're cross-referencing them with companies that compete in the same industries outside. So, we're looking at the biotech companies, the consumer products companies, auto manufacturers — you know, there's even REITs there that we look at and have invested in.
And I'd say, in that aspect, it reminds me more of the old emerging markets days, because it comes down a lot to people. A lot of these companies are still family-owned, or at least a small group of people that control them. And so, you've got to get to know them and understand what their motivations are. And are they aligned with us as minority shareholders? Do they even know what a minority shareholder is? Do they care about us? Do they pay dividends? We have found a very high correlation with dividend payment and taking care of minority shareholders. So, you see in a lot of our strategies this idea that paying dividends is sort of a good, simple way to understand which companies will maybe take care of you, because they understand about returning money to investors.
Will McKenna: Right. I'm curious, we talked a little bit about emerging markets more broadly, and you mentioned a couple of the canaries in the coal mine — I assume in Argentina, in Turkey and so on. But when you look across there into 2019, are we still excited about some opportunities? Is it very selective? Is it narrow? Where are we finding those kinds of opportunities, or is it more risk than opportunity at this point?
Rob Lovelace: Yeah. I mean, the challenge is emerging markets as a category. Your question was related to emerging markets, excluding China.
Will McKenna: Right.
Rob Lovelace: And it's a mixed story. We do have this headwind because of quantitative tightening. And so, any economy that was fragile because of its indebted situation or fragile for political or other reasons — you highlighted Turkey and Argentina, two great examples, South Africa would be a third — that we've seen really struggling in terms of the economy, and therefore in the markets.
But I'll tell you, our analysts are finding really interesting opportunities, because you're able to buy some great companies at single-, even low-single-digit multiples in terms of price-to-earnings ratio. These are well-run companies that have survived tough economic situations in the past, often do business around the world — they happen to be domiciled in emerging markets — you can get at really attractive valuations.
I don't know if 2019's the year they're going to come roaring back. But I think, as John highlighted, as we get to at least a plateau in U.S. rates and not inflation running away, and if the U.S. has no, or only a mild, recession and if China stabilizes, you can actually come up with an environment in which these companies will do well, and the valuations are so attractive you have to pay attention.
I think the key thing people have to remember when they're investing in emerging markets, though, is this quantitative-tightening, this U.S.-interest-rate, world right now has a much bigger impact than maybe people remembered in the past —
Will McKenna: Right.
Rob Lovelace: — and that China will swamp the results no matter what you do, if you're investing especially in an index-type approach to emerging markets and you're not differentiating the countries and companies.
Will McKenna: So, if you have the ability to be a long-term investor, to see through some of the volatility that may be ahead of us in medium term, there's some great opportunities out there.
Rob Lovelace: Absolutely. Strategies like our New World Fund®, which is a fund that invests in companies wherever they're domiciled —
Will McKenna: Right.
Rob Lovelace: — that happen to do business in emerging markets — that's a very different approach that doesn't get as caught up in this “should China be in or out?” debate.
Will McKenna: Right, right. And I should mention, just to repeat, sorry for our friends outside the U.S. who don't have access to the American Funds.
OK, great outlook. Great insights on our outlook around the world. What are the portfolio implications from this? And John, I may begin with you. I think let's touch on two concepts first before we get into the actual portfolios. And those are two concepts we've been talking a lot about at Capital Group. The first is the four roles of fixed income that you and the team are emphasizing. And the second, on the equity side, Rob, is this idea of having some flexibility in your equity strategies and your equity approach.
So, John: four roles of fixed income. What is it? Can you explain what that is and how investors can use that to evaluate their bond portfolios?
John Smet: When you're looking to construct a portfolio to meet a specific objective — whether that's saving for retirement, whether you're in retirement or whether you're in a 529 plan saving for your son or daughter going to college — you're looking for a blend of assets to help you reach your goal. So, let bond funds be bond funds. That's the mantra we keep thinking about and we talk a lot about. So, bond funds can do a few things for you, and you should be very careful about having bond funds trying to do more than that.
So, bond funds can bring you income. And if you're a 70-year-old in a portfolio, that may be your primary purpose to own fixed income. And right now, with interest rates at 3%, up 2 percentage points in governments from where we were in the lows in 2016, fixed income can provide income.
We can protect your portfolio from inflation. We can buy Treasury Inflation-Protected Securities. That will be one of the few assets that will definitely do well in an inflationary environment. We don't see an inflationary environment in the future, but if we're wrong, we can own Treasury Inflation-Protected Securities. So, inflation protection.
We can diversify from equity. On those days when equity goes down, it's nice to have part of your portfolio that does well. That's another role of fixed income.
And finally, preservation. We know a lot of people look at fixed income for their safe money. And, you know, a really bad bond market — a terrible bond market — is a negative single digits: 2%, 3%. A really bad stock market is not negative single digits. So, when you think about preservation, think about fixed income.
Will McKenna: Well, as you point out, safe-haven bonds returning 3% for the first time in, I don't know how many years, that's an attractive investment on its own. So, again, the four roles: income, it's called fixed income for a reason; number two, inflation protection; number three, diversification from equity; and number four, preservation.
Given where we are in the cycle today, [does] any one of those four become more important, or first among equals, or how do you think about that?
John Smet: As we've talked a lot about this quantitative-tightening environment — it's a new environment that we've been in the first time in 10 years — we don't know how that's going to turn out. Quantitative easing was an experiment. Quantitative tightening is an experiment also, so we don't know how it's going to turn out. We think it's going to lead to more volatility, which we've already seen. We think it's going to lead to riskier parts of the bond market doing poorly, and we've just started to see that.
So, when I think about the risks out there, I think you want to be in very liquid securities. So, if there are incredible values created in emerging markets bonds or high yield bonds, you want to have the ability to move there quickly. You want to take advantage of attractive yields, and you want to take advantage of what we think will be pretty close to the end of the tightening cycle.
So, that leads to 5- to 7-year Treasuries. We think 5- to 7-year Treasuries have largely discounted the two to three tightenings that we have. So, if they happen, 5- and 7-year Treasuries should not go up in yield. Very liquid — most liquid market in the world — and providing a 3% return in a 2% inflation environment. That's not a bad place to be in this sort of new quantitative-tightening environment.
Will McKenna: Got you. That's very helpful.
Rob, on the equity side of the portfolio, we talk about this idea of flexibility. And I think what we mean there is the ability for managers to reach across borders and to reach across asset classes to find opportunities they think will be most attractive for investors. Maybe a two-partner also: What do you see as the benefits of that kind of flexible approach? And then, why would that be so important at this phase in the cycle that we're in?
Rob Lovelace: Yeah. I'm not sure if it's the cycle phase that really is the key here. I think it's actually a durable change. Giving your manager flexibility isn't so much about a particular portfolio strategy; it's about recognizing that the old construct we had of picking countries first and then going to your security selection doesn't work anymore. It's been short-circuited by companies that are doing business all over the world.
So, it's still fine to pick which region you want to be focused on, but then you have to give your manager a global footprint to be able to invest in it, whether it's the emerging markets opportunity or even the U.S. opportunity. You need to give managers flexibility. And then, when you do that, what you realize is it's super helpful with asset allocation. Because instead of having to do top-down and your own view on countries and regions, the manager's doing it. The manager is following where companies are doing better.
Will McKenna: From the ground up.
Rob Lovelace: From the ground up, at the security-selection level. Not with a top-down approach.
Will McKenna: Right. And obviously, that's what we do in NPF to arrive at whatever the distribution is of U.S. versus non-U.S. companies in that fund.
Rob Lovelace: In the New Perspective Fund context, we have seven managers within The Capital SystemSM — our multimanager system — and right now we have the highest exposure to the U.S. that we've had in decades. So, all these separate decision makers — including all the analysts who, together, manage part of the portfolio as well — what it says is that we're seeing more opportunities in the U.S. And as I highlighted earlier, I think eight of the last 10 years, the U.S. has been a stronger market than the non-U.S. markets anyway. So, it's been both compounding by being focused there and by the higher returns that you've seen in the U.S.
Will McKenna: So, market movement as well as conviction around buying.
Rob Lovelace: Correct. Looking forward, again highlighting some pretty unique things in the U.S. market — these leaders in the internet and tech space and some of the biotech and pharmaceutical companies — there's a lot going on in the U.S. when you think forward a decade about who the world-leading companies are going to be. There's a lot going on in the U.S. Doesn't mean you want to shift overly to the U.S., but as a global investor for 30 years, I'm more excited about the U.S. than I've been at any time in that period.
Will McKenna: Interesting.
Rob Lovelace: You know, I was there at the beginning of emerging markets. I still love emerging markets. There's a lot of exciting things going on there. But in a weak period, if this weakness continues in the stock markets, you definitely don't want to hide outside of the U.S.
As I highlighted earlier, the non-U.S. markets are more fragile right now than the U.S. So, even though the U.S. is set up for a correction and has only just touched on 10% from the peak, in terms of being down — Europe is more in the high teens, and China more than 20% — I'd still say you're safer in the U.S. than you are in other parts of the world. And when things come back, although you may see higher economic growth rates in some of these other countries — and I certainly see a lot in India that's very exciting right now, so there's specific companies and specific countries that we get excited about — I'd still say that long-term growth prospect for the United States is pretty good for several years.
Will McKenna: Around the FAANGs, I know you talked about [how] they're different beasts — and you mentioned Apple being different and Facebook facing regulatory scrutiny now — but is there not some nervousness about how far and fast those have come and where we go from here? Or do we maintain a good number of those convictions? How is the team talking about that?
Rob Lovelace: Well, within the FAANG itself, Amazon is one with a multiple over 50, and Netflix is one with a multiple over 50. But Alphabet (also known as Google) and Apple and Facebook all have multiples that are at or below market averages.
So, if you look at the FAANG group right now, it actually has a multiple — especially in price/earnings terms — that is very similar to the rest of the U.S. market. So, that premium that used to exist has been erased in the last month.
Will McKenna: Right.
Rob Lovelace: So, I think the market at this stage will move much more in line. That doesn't mean the market can't go down from here. We could easily have a bear market — so, another 10% down from where we are today — and these will not be defensive stocks. These are not going to be the place to hide.
Will McKenna: So, have the right expectations.
Rob Lovelace: It's been a lot of the consumer-related — you know, Coca-Cola and these types of stocks — that have been the most defensive in this particular decline.
Will McKenna: Right.
Rob Lovelace: It has not proved to be value versus growth, all these different categories that people have looked at. It's been pretty company-specific and pretty sector-specific in terms of what has held up well. And I'm not saying they'll be the strongest ones coming out. But when I can buy above-average growth, cash-generative companies at market multiple or below, that's what we're all trained to do. And that's what we're seeing now in terms of these opportunities. In terms of several of the FAANGs, not all of them.
Will McKenna: Got it.
Well, thank you so much for those great insights, guys, and I'll try to summarize, just in terms of the macro insights.
We talked a fair amount about volatility, and that investors should be expecting more volatility in 2019. We're calling it, “Prepare for the three Ts of volatility: tightening, trade, and too much debt.” Stay balanced and make sure your portfolios are well-diversified to weather market ups and downs.
When we talked about equities and equity opportunities, the theme that came through is that smart companies adapt and thrive. And Rob, you talked a lot about multinationals being an example of companies that are well-positioned to take advantage and be agile amid these uncertainties around trade and so on.
And our main takeaway there is this idea of staying flexible, and flexibility in your equity strategies. Work with managers that can reach across borders and asset classes to find what they think are the best opportunities.
We talked about fixed income, John. Really, the theme there — given where we are, late-cycle environment — it's really time for bonds to provide balance and stability. We talked about the four roles, and the key takeaway there is stay very alert to risk. We mentioned three actions here. Number one is upgrade your core bond allocation. Number two, diversify your portfolio income — make sure it's coming from a lot of sources. And own munis for more than just tax-free income.
So, that's a quick summary of what we went over today. I want to thank you so much, Rob, John and Jared, for your insights into the financial markets. We hope that you in the audience found this discussion helpful, and we look forward to working with all of you throughout the new year.
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