Portfolio manager Jody Jonsson, head of fixed income Mike Gitlin and economist Darrell Spence share their thoughts on global equities, fixed income and economies as they look ahead to the remainder of 2019 and beyond.
Will McKenna: Hello, and welcome to Capital Group's Midyear Outlook. I'm Will McKenna, and I want to thank you for joining us today. It's great to have you. Today you're going to be hearing from three veterans on our investment team, and they're going to talk about all the key issues that are 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 the webinar, you're going to be redirected to a quiz that you need to take in order to earn that credit. And if you're watching a replay of the webinar, simply follow the instruction to take the CE credit quiz at the end. Now, please allow up to 10 business days for processing your CE credit.
And before we get started, let me cover just a couple of housekeeping items. This event is being pre-recorded so that we can qualify for CE. So we gathered questions from many of you ahead of time, and we'll be addressing a lot of those questions in today's discussion. Meanwhile, if you do experience any technical problems, just let us know in the Q&A window on your screen.
Now, let me introduce today's speakers. Joining me today are Jody Jonsson, Mike Gitlin and Darrell Spence. Jody is an equity portfolio manager with 30 years of investment experience, and she's responsible for a number of Capital Group's global investment strategies. Mike is the head of fixed income, and he has 25 years of investment industry experience. Darrell is our U.S. economist — many of you know Darrell — and he's been in the business for 26 years. He'll be addressing not only the U.S. economy, but also the broader global economic picture for us.
Folks, thanks for being with us. Great to have you. So much to talk about. A few things going on in global markets as we reach the midpoint of 2019. And let's just jump right in.
Darrell, I'd like to start with you, as we often do, to get kind of a macroeconomic picture. It'd be great to get your views on the global economy. Why don't you start with the U.S. outlook as you see it, and then maybe take us around the other major economies around the world.
Darrell Spence: Sure. Admittedly, I'm feeling a little bit like a deer in the headlights right now when it comes to forecasting, simply because things seem to be changing almost on a daily basis. And I think that's what you're seeing reflected in the markets when they're moving around quite substantially day to day.
If, for a moment, you could put aside the trade stuff in the U.S. and look at the domestic fundamentals, you'd see an economy that actually looks pretty well-supported. Very tight labor market is leading to wage gains well in excess of inflation, and that's supporting the 70% of the economy that is consumer spending. Inflation itself remains very well-contained, and as a result, earlier this year the Fed went on hold.
And the drop in interest rates that that led to has reinvigorated the housing cycle, which was one of the weak spots in 2018. And so all of this has come together and, in our minds, extended the cycle.
Now unfortunately, this wonderful world where we put all of that trade stuff aside isn't the world
we live in, and we need to take that into consideration. And that is where a lot of the uncertainty is being initiated into the outlook. So given what we know right now about the potential path, let's say we increase tariffs on $200 billion of Chinese exports from 10% to 25% — that's about 0.2% of GDP. Certainly manageable for an economy the size of the U.S. If we do 25% on an additional $325 billion of imports, that's, from a consumer perspective, about the equivalent of a 25% increase in gasoline prices. So not necessarily an expansion killer, but certainly something that would put some depressing effects on the overall economy.
Then, where you really start to get into problems is when you go down the road of embargoes and boycotts and big supply chain disruptions. Imagine if you're a company operating in the U.S., or anywhere for that matter, and all of a sudden the price of your inputs goes up a ton. Or maybe you can't even get the inputs that you need to produce your product.
Will McKenna: Right.
Darrell Spence: That's an environment where you cut back on business investment, you start laying off workers. And that's the type of stuff that can ultimately lead to a recession.
And even further, the trade outlook has gotten a little more muddied with the proposition that would put tariffs on Mexican imports for non-trade or non-economic reasons — basically immigration. So in my mind, that suggests that the potential targets for tariffs, and the rationale for imposing them, [are] now broadening.
Will McKenna: It’s growing.
Darrell Spence: Yeah. And at the end of the day, our base case is still that nobody really benefits from a big slowdown in economic or global activity, and so the escalation will be a bit more limited. But I have to admit that the uncertainty inherent in that call is really, really growing. So you do have what would normally be a fundamentally healthy U.S. economy that has to deal with this trade uncertainty that has the potential to be very disruptive.
Will McKenna: That's a great overview of where we stand in the U.S. And I know you don't follow Europe, China, those markets directly — your colleagues do — but I know you know enough about them to help represent their views and your own views here. So maybe just give us kind of a quick tour of the world, as you see those economies at this point in the cycle.
Darrell Spence: Yeah. Outside the U.S., the big issue is trade, too. I mean, obviously the most significantly exposed right now is China. And our China economist does see things slowing down in the second half of the year, pretty substantially. He thinks it could be along the lines of the slowdown that we saw in 2015 and 2016, and he's a little less optimistic that this trade war will wrap up before the end of the year. He's on the ground in China; he sees the change in tone that is out there in terms of how the U.S. [is] viewed, particularly after the Huawei incident. He sees that the newspapers, which are largely controlled by the Communist Party, have really upped their rhetoric, their anti-U.S. rhetoric, and —
Will McKenna: So there's a hardening of attitude —
Darrell Spence: A hardening of a stance against the U.S. And for the Chinese administration to come to some type of agreement with the U.S. that also allows them to save face — and not look like they caved in to U.S. demands — is going to be very, very difficult. So he thinks that's going to put further pressure on the economy in the second half of the year.
The authorities will stimulate, but they'll pull the same levers that they've been pulling for the past number of years. And when you do that, the marginal returns tend to diminish over time. At the same time, one of the goals of the Chinese administration is to reduce the amount of leverage in the system. And most of the stimulus things that they've done in the past have increased leverage. So to the extent that they're reluctant to see a big increase in leverage, we'll probably see less stimulus. So he does see, again, a pretty difficult environment.
Will McKenna: Yeah.
Darrell Spence: You know, that bleeds through into other areas of the globe. Eurozone economic activity has been fairly weak recently. A lot of that is simply because of the slowdown in the German industrial sector, which has large exposure to China.
Will McKenna: Dependant on trade.
Darrell Spence: Yeah, but Germany and the German industrial sector is a big part of the eurozone, so obviously the weakness there feeds to other parts of the economy. In addition, they have political issues that are actually economic risk. You have Brexit — hasn't been settled, may not even be settled come the end of October. So you may end up getting a hard Brexit and the economic dislocation that goes around with that. And there's also a brewing battle over the Italian fiscal situation. We were just in Rome and Berlin a week or two ago, and the differences of opinion between Italian policymakers and German policymakers about what Italy should do to boost growth and what the Germans should do to assist in the whole process are extremely different.
So we're heading into this summer with a very high potential for tensions in that space to rise and perhaps lead to yet another European debt crisis. Which, again, would obviously have implications for economic growth.
And then, finally, Japan. Japan continues to do what Japan does: grows very slowly, generates very little inflation. So far, they have dodged the trade-war bullet. Discussions about whether or not we impose tariffs on Japanese auto imports have been postponed until November. Our Japan economist thinks that if Japan lowers tariffs on U.S. beef, they'll avoid the auto tariffs, but again, this is somewhat of an unpredictable administration, and maybe they'll still throw those out there in the hopes of getting something else in the deal. The issues for Japan are more near term. They have a consumption tax increase in October; if the economy remains weak, our economist thinks that that'll be postponed. But they're also exposed to the weakness in China, which again circles all the way back to the trade thing. So the underlying theme between the U.S. and Europe and China and Japan really comes down to trade.
Will McKenna: Right.
Darrell Spence: In which the outlook is quite uncertain.
Will McKenna: OK, great. One quick follow-up for you. It's become our tradition to ask you about when's the next recession. The Fed pivot, obviously, and the pause there I think made people realize, "OK, this thing has been pushed out." But you've got some interesting ways of looking at that. How are you thinking about that today? When might this cycle end, and what would cause it?
Darrell Spence: You know, when the Fed did the pivot, in our mind that really extended the potential for this cycle. One of the key ingredients for thinking that we might have a recession at some point in the next 18 to 24 months was that financial conditions would continue to tighten. That would start to impact some of the excesses that we're seeing within the corporate sector, in terms of their balance sheets and leverage in the corporate sector. And all of that essentially got postponed. And so we had a bit of a window there where we thought, "Geeze, the cycle could go on for two, three more years based on the fact that the Fed doesn't seem to be really in the business of raising interest rates anymore." That's still the case. But now we have this, obviously, specter of a trade war, and there's lots of ways that that can impact the economy.
I think it makes it a lot more difficult, frankly, to determine the path to recession than it would if we were going along kind of a steady monetary-tightening path. If things ratchet up dramatically within the next 30 to 60 days, obviously the risk increases. If for some reason, tomorrow things are all back to normal, then we've got an extended cycle. I wish I had a better answer than that, but so much of it really depends on decisions that are made regarding how we're going to fight or not fight this trade war.
Will McKenna: So, strong fundamentals in the economy, but then all these other factors creating headwinds.
Mike, let's bring you into the conversation. That's the macro backdrop. We already talked about what's going on with the Fed and pause in rates — obviously, all eyes on rates. But let's just start with what's your outlook for fixed income markets where we stand today in 2019, as you look forward.
Mike Gitlin: Sure. In the first six months of the year, bond markets had a really nice rally. So all the uncertainty that Darrell talked about has helped U.S. Treasuries rally. If you look at two-year Treasuries, 10-year Treasuries, their yields are down about 100 basis points today from where they were in November. So the uncertainty has helped the risk-free market, or Treasury yields, go lower. And at the same time, the risk-on that we saw because of the Fed pivot helped credit spreads tighten.
So if you look at total returns now for the bond market, year-to-date through about six months of the year, you have mid-single-digit returns for the U.S. aggregate, and 7-8% type returns for U.S. corporates and U.S. high yield. So it's been a very strong year for the bond market.
What we've seen recently, though, in the last month or so is a bit of credit widening. And so all that we gain back in credit spread tightening from the Fed pivot, now we're starting to see some of that widening. So in the last four weeks alone, high-yield spreads have widened 90 basis points. Investment-grade corporate spreads have widened 20 basis points. And so while Treasuries continue to rally, there is credit risk in the market that people are becoming more aware of.
Will McKenna: And I know credit risk has been a theme that you and the team have been talking about for some time. And perhaps investors were more focused on interest rate risk and not enough on credit risk. Talk more about that. Where do you see that today? Obviously, in corporate bonds and in high yield. Are we still at that kind of cautious place?
Mike Gitlin: Yeah. If you look back at 2018, what we heard all the time from folks out there was that they worried about interest rate risk. That rates were going up, that the Fed was hiking. And now, we have the opposite, where if you look at how the market's pricing and what may happen with the Fed, the market's now pricing in two cuts for the rest of 2019, and then two cuts in 2020.
So just six, eight months ago, there were three hikes expected and now four cuts in the next two years. So there's a dramatic switch in terms of how people are perceiving interest rate risk. We've been long duration, so our view has been we didn't worry as much as some others on interest rate risk. But we are worried on credit risk. When you look at investment-grade and high-yield spreads, and they're basically on the border of the richest quartile or the second quartile of richness, we get worried from a valuation standpoint.
Will McKenna: And this will tie into this big change in bond land around Morningstar splitting that intermediate category into core, core-plus. Pretty connected into this topic, I believe.
Mike Gitlin: It sure is.
Will McKenna: You kind of referenced it, but we have been talking about the shift from QE to QT, and maybe its shift back. But tell me, what's your view on that now? Is something fundamentally changed? Are we on a different path altogether, or is it a pause in the path, or —
Mike Gitlin: It's a different path altogether. You know, the Fed had made some progress in reducing its balance sheet. So at its peak it was about $4.5 trillion. Over the last few years, it's now come down to $3.7 trillion. But in September, they're stopping. So the balance sheet will pause at about $3.7 trillion. So what we saw as QT is effectively ending. And that's the Fed acknowledging some slower growth around the world that Darrell referenced, and also, quite frankly, a view that the equity market risk was relatively high. When we look at the Fed pivot, there are lots of folks who thought it might be related to the executive branch, or the President. And in actuality, it was more about global growth, in our view, and the equity market 20% decline we saw in the fourth quarter of 2018.
Will McKenna: Right. And curious to hear your views on markets outside the U.S. — maybe, in particular, emerging markets debt. I know we've got some favorable views about what's going on over there. Tell us more about that, from your position.
Mike Gitlin: Sure. When the Fed pivoted, that helps emerging market debt.
So emerging market debt doesn't love Fed hikes. And now that the Fed has paused and the market’s pricing in cuts, that's a positive tailwind for emerging markets. Inflation is pretty much under control in many of the emerging markets that we see. There was a lot of election risk in a lot of emerging countries in 2018. Much of that's dissipated, ex-Argentina, which has an election coming up. But other than that, a lot of the election risk we saw in 2018 is in the rearview mirror. And there's also a real significant yield cushion.
So there's a lot of positives on emerging market debt. It's not without risk. So trade wars that Darrell talked about. China and risk to China's growth, all are perils for emerging market debt, no doubt. But on balance, when you're looking for higher income, and you're thinking of, "Should I get that in corporate high yield or emerging market debt?" we think emerging market debt looks more attractive at this stage.
Will McKenna: OK, interesting. And we'll come back to that when we talk about portfolio allocation.
Mike Gitlin: Right.
Will McKenna: Jody, last but not least, let us bring you into the conversation and talk about equity markets around the world. Quite a bit of volatility keeping things interesting. You're a global investor. How about start with the U.S. as you see it today and then take us around the larger markets, the opportunities and risks that you're finding out there.
Jody Jonsson: Well, as Darrell's pointed out very well about China, I think the market is having a very hard time digesting the impact of changing trade policy. We've all come to know a world that's very global and very integrated, and when you start messing around with that, the market doesn't really know how to handicap it, because it's very binary. And it represents, possibly, a complete reversal of the world we've known for the last three or four decades — a world that's become ever more integrated and globally joined up for many industries that have global supply chains.
And so I think the market has been very slow to be able to figure out what the longer term implications are and whether this is just a short-term, tactical move on the President's part to get a response out of China, or whether it represents a kind of generational change in how we're dealing with other countries. And I think that's what's really on the mind of global investors right now.
The U.S. market has led the world. We've had better earnings growth, and we've also had a re-rating, so the U.S. market is more expensive. But when you take it apart sector by sector, if you take out the technology sector — which is roughly a third of the U.S. market and doesn't really exist in Europe, say, to the same extent — the valuations of other sectors are fairly comparable, whether it's industrials, health care, consumer staples. Those are fairly equal around the world. So a lot of people say that Europe is very cheap. It is cheap, but the returns are lower; the capital is not as efficiently used there. The banking sector, for example, is much, much lower return than in the U.S. and is not as healthy as in the U.S. So again, if you separate out banks and technology, the markets don't look that dissimilar. Asia, again, [is] very dependent on China, fairly technology-heavy, so all of this stuff around trade — and particularly the semiconductor industry — has a lot of ramifications for Asia and other emerging markets.
So there's always opportunity, despite the uncertainty. We always try to look for companies that are able to navigate this, and that's really the theme of New Perspective Fund®, which I'm involved in, which is that we invest in companies that benefit from changing global trade patterns. It doesn't mean that trade has to always be expanding. It means that companies that are nimble and facile in dealing with different sorts of economic and trade environments are best positioned to take advantage of them.
Will McKenna: And use these changes to their benefit, whatever they may be.
Jody Jonsson: Right.
Will McKenna: Well, that's a great view of the global equity markets. You know, as I look at the questions we get from our audience — and it feels like this one has become a bit of a perennial for us — we've just seen this return disparity between the U.S. and non-U.S. for a long time now. What's your view on this? You obviously, as a global investor — you sit on New Perspective Fund — your team can pick and choose those opportunities around the world. How long do you think this trend of U.S. stocks continuing to do better can continue? Are any catalysts on the horizon that might help reverse that or help us find better opportunities in Europe or wherever they may be?
Jody Jonsson: Well, I really don't think about the portfolios as just geography.
Will McKenna: Right.
Jody Jonsson: I have a number of companies in Europe in my portfolio that I think are special companies, that are doing something different from what other companies anywhere else in the world do, and they just happen to be based in Europe. It's not particularly a view on Europe per se, as to why they're in there.
One thing that's possibly changing is that U.S. technology companies have been the market leadership. And they have gotten very highly valued; many of them have market caps between $500 billion and $1 trillion. And I do think at some point the law of large numbers comes into play, and they may not be able to continue compounding stock price at a rate that allows them to continue to be the market leadership.
Will McKenna: And obviously, other headwinds that they're facing leads to —
Jody Jonsson: And there are other headwinds, such as regulation and antitrust, and a little bit of political noise around them. And so those are potential headwinds. And for the technology sector generally, it's challenging being in the midst of trade wars. The semiconductor industry, in particular, is one of the most globally integrated and one of the most sensitive to China, both as a customer of the American technology companies, but also as a country that wants to build its own semiconductor industry. And so it's very hard to tell exactly what the impact of all this trade will be for them, but it hasn't been good so far.
So there are lots of opportunities to buy excellent companies that are based in Europe and Asia and elsewhere.
It isn't really a call on U.S./non-U.S. As a global portfolio manager, I want to own companies all over the world, wherever they're based, that are truly excellent in their industries. So it's not a reason to give up on international investing.
Will McKenna: Right. Right. And I know our audience really appreciates some of those concrete company stories — and these aren't meant to be investment recommendations — but can you give us two, three examples of the kind of companies that are maybe domiciled in these other places but are, as you call them, special companies who are taking advantage of these changes and really thriving, even though they may be located in an area where the economy is not thriving?
Jody Jonsson: One of our large holdings in New Perspective is a company called Temenos, based in Switzerland. Temenos is essentially an IT service provider to the banking industry. And every time we meet with banks, we hear about how they need to modernize their technology. They need to go digital. They need apps, more online banking. And frankly, none of them are really prepared for it. Many banks are the product of mergers, so they have multiple IT systems that don't talk to each other. And none of them really know how to digitize themselves. And so they go to a service provider like Temenos to bring them complete packages that they can use to get digital and get online. And the market for their services just continues to grow and grow.
Will McKenna: I bet.
Jody Jonsson: And they are mostly dealing with customers outside the U.S., but they're now starting to make inroads in the U.S. as well.
Another company is a Dutch chemical company called DSM, which is mostly in vitamins and food additives. But they have a couple of very interesting initiatives, one called Clean Cow, which is an additive to cattle feed that reduces the amount of methane they produce, which is a key contributor to global warming.
Will McKenna: Right.
Jody Jonsson: Interesting little options like that in a portfolio of chemical businesses that are mostly around health and nutrition, so not your typical chemical company. Happens to be based in the Netherlands, really doesn't have much to do with the European economy.
Will McKenna: Where they are, yeah.
Jody Jonsson: It just happens to be based there.
Will McKenna: That's great. I do want to come back to some of the tech stocks and the FAANGs — a lot going on in the markets today, let's come back to that. But picking back up on the trade topic, with Mexico being the latest part of part of the story, Darrell, let me let me start this with you, and then I'll come back to you, Jody, in terms of New Perspective and how we navigate through this. How big of a hit to earnings and GDP do you and the team see this happening? Have you modeled that out, and what do what are you seeing out there?
Darrell Spence: Yeah, we have. And again, it depends on how far we go. If we just go one step, then obviously it's a smaller impact to GDP and the economy and earnings. And if we go more, and then we get beyond tariffs into non-tariff type of tit for tat, then obviously it's a bigger deal.
One thing to keep in mind is that the U.S. has a relatively low export share, as a share of its total GDP relative to most other developed countries. So however far this trade war actually goes, the U.S. does tend to walk away from it relatively less scathed than a lot of other regions might that have export shares of GDP anywhere from 40%, 50%, [to] sometimes greater than 50%. How big the impact ultimately ends up being really depends on how far the trade war goes. As I mentioned earlier, if it's an additional 15% tariff on $200 billion, that's a couple tenths of a percent of U.S. GDP. You go all the way out to where you start to see the boycotts and the embargoes and the supply chain disruptions, then you're talking about 1%, maybe even more, of GDP. And once that momentum starts to slow, then all sorts of other things can unwind and cause a much more significant downturn in the U.S. economy.
So in terms of the impact on earnings, if you get to that environment, you're talking about a quasi-recessionary environment, and in that environment earnings go down 15–20% or so. In the much more milder scenario, obviously there are a lot of U.S. corporations that get to their earnings from overseas and also get them from China, so clearly it will have an impact. But we still think if, for some reason, we were able to find some middle ground where we don't escalate much from here, earnings based on other economic developments within the U.S. are likely to grow low- to mid-single digits in 2019. So again, wide range of outcomes are realized, but there's also a wide range of ways that this whole trade situation could break.
Will McKenna: Well, let me open this question up to all three of you. From where you sit looking at these capital markets, do you think cooler heads will prevail and we'll get some resolution here with the U.S. and China, or are we in for a very long, protracted kind of process here?
Mike Gitlin: My personal view is it depends on where you're talking about. So I think many — Mexico, Europe, Canada — I think those are skirmishes. I think China's a long-term trade war. Make no mistake about it, China wants to be a global economic powerhouse. If you look at their Belt and Road Initiative, and the money they've been investing in economies around the world for the last six, seven years, it's about $750 billion, which — just to put that in perspective — it's larger than the Marshall Plan after World War II.
So China wants to be a global economic powerhouse. There is a rise in nationalism that comes with this trade war between China and the U.S. on both sides, by the by. So I would really focus on China and the U.S., and I think some of the other trade skirmishes will peter out over time.
Jody Jonsson: Yeah, I agree with Mike on that. I think there are short-term wins we could announce with China, where we buy some of their goods and they buy some of our goods. But I think there's this much longer term structural issue around intellectual property and the role of the government in supporting the development of certain industries and how they appropriate the technology to do that. And I think that's a very fundamental, almost existential disagreement between the U.S. and China about how the economies in the private sector interact.
Mike Gitlin: I agree with that. And we may, in the U.S., think along the terms of midterm election cycles, presidential cycles. I think China has a much longer term perspective than that, and so to watch this battle/war play out is going to be interesting. But I wouldn't necessarily think of short-term agreements as a long-term solution. This this will go on for a while.
Will McKenna: Right, so there may be some incremental gains along the way, but there's a deeper issue here —
Mike Gitlin: I think so.
Will McKenna: — we're going to be looking at for years. I do want to come back, Jody to … we were talking about your role, one as manager on New Perspective Fund, which is literally designed to take advantage of changes in trade patterns around the world. I guess, be careful what you ask for.
Jody Jonsson: We’re getting lots of change now.
Will McKenna: We've talked about the dispute itself and where we think that's headed, but let's talk about what are the investment implications. I've heard you talk about “smart companies find a way to adapt, and nimble companies thrive.” Can you give us a couple of examples of that and bring that to life?
Jody Jonsson: Well, I would say every company in our portfolio, of course, is doing a good job of navigating it. I think where it's tricky right now is the companies that are most impacted by these trade decisions are not the ones you would expect. So when the Mexico news came out, the Japanese auto companies were the ones hit hardest.
The European auto companies have quite a bit to lose in the dispute between the U.S. and China. In fact, the Europeans have a lot to lose in any sort of trade dispute because Germany in particular is so export-oriented. And so it isn't at all obvious that something we do against China helps the American auto companies and hurts others. In fact, on the face of it — Darrell and I were talking about this earlier — it often looks like it's just the other way around.
Will McKenna: Right.
Jody Jonsson: So what we try to do in New Perspective is invest alongside the companies that we think are as forward-thinking as possible, and have as much flexibility in their operations to move production as needed. Where it gets hard is something like the semiconductor industry where you build a fab, it's billions of dollars invested at a time. And it's not like you can just set up another one in another country tomorrow.
So I don't actually have a specific example, but I know, again, hearing our companies, you can hear their contingency plans about what they could move where, when. But you know there's only so quickly you can adjust. And I think one of the challenges of this environment is that it's so disconcerting for companies trying to manage a business to be able to do any sort of long-term planning.
Will McKenna: The goal posts seem to keep moving.
Jody Jonsson: Exactly.
Will McKenna: Right?
Jody Jonsson: And particularly when you're making capital investment decisions, you'd like to have some certainty about the outlook a few years out.
Will McKenna: It sounds like, though, the conversations you and the analysts are having with the companies — they're on it. They’re thinking through these contingencies, they have —
Jody Jonsson: The companies are very much on it. And it's constantly the topic of our discussions with company managements.
Will McKenna: You know, if you look beyond or look past the trade dispute, I know your colleague Rob Lovelace on New Perspective has been talking about this bigger secular phenomenon of just the vast number of companies in China that are now coming into the public markets and will be available to investors like us, and his view on what an important opportunity we have to keep our eye on there and have boots on the ground to go figure all that out. [I’m] curious [about] your thinking on that and how you see that opportunity unfolding.
Jody Jonsson: Well, we've had a research presence in China for a number of years now based in Beijing, and we have a number of analysts who are focused on specific industry areas of coverage. We can't actually manage money from Beijing, so we don't have investment professionals there, but we take a lot of their industry research and incorporate it into the research we're doing on companies all over the world as far as what the China markets look like for them and what Chinese competitors might be doing. Now that's morphing into more investment opportunity for us to invest directly into Chinese companies.
I would say so far, that's a fairly limited opportunity because a lot of Chinese companies don't really yet quite meet international standards of governance, accounting transparency and such.
But as the Chinese market opens up, and as the global indices include more Chinese companies, we think that will be positive pressure on the Chinese market to be more open, more transparent, really more appropriate for foreign investors. And so we expect more and more companies to become available to us. And we're beefing up those research efforts in China.
Will McKenna: Beyond China, in emerging markets more broadly, they too have struggled a bit, I think, with some of the turbulence that's out there naturally. How are you and the team thinking about emerging markets at this stage in the cycle? Are you finding opportunities there? Is it narrow and selective, is it wait-and-see? How are you thinking about EM?
Jody Jonsson: I think again it's so hard to paint all the countries with a single brush.
Again, EM depends a lot on what happens in China. So if China slows, that is going to have an impact on almost all emerging markets. But India, for example, is very self-contained, is not as dependent on exports and trade. And so there are a number of companies in India that we like such as the banks there, the private sector banks, that have multi-year runways for growth. And while they had a hiccup around the demonetization that happened a couple of years ago, the long-term trend there about people coming into the financial economy and becoming part of the economy and —
Will McKenna: Going from unbanked to banked, right —
Jody Jonsson: Becoming banked. And the need of credit to fuel growth in India is a very positive long-term story that really doesn't depend too much on what's happening elsewhere in emerging markets.
Brazil is interesting, too. There's been a change of government there. In a lot of ways there's [been] sort of a cleanup after some of the corruption that happened in Petrobras and other companies. And so selectively, we think there are some good opportunities there. But we really don't paint all the emerging markets with a similar brush because we are very company specific. We build the portfolios bottom up, one by one.
Will McKenna: Yeah. Let's shift gears. Mike, I'd love to come back to you, and we mentioned this topic earlier. What counts as big news in bond land for sure, is Morningstar splitting its intermediate bond category into the core and core-plus category. I know this is a topic near and dear to your heart; we've been talking about this for some time. My guess is our audience may now have heard about this. They may know about it, but maybe don't understand all the implications of it. Can you just kind of give us a primer — what happened, why did this happen and why is it important for investors?
Mike Gitlin: Sure. So if you look at the intermediate bond category — the intermediate bond category in the world of Morningstar is $1.6 trillion. That's literally four times larger than the next biggest category.
Will McKenna: Yeah, not small.
Mike Gitlin: It's a big category; it's an important one to get right. And what Morningstar just recently did was split it in half, effectively in half — half being core and half being core-plus. And I think that's a huge wake-up call. What that's basically saying is not all intermediate bond funds are created equal. And core is less than 5% high yield.
Will McKenna: The definition of core is less than 5% high yield, right?
Mike Gitlin: Yeah, so if you think about that, there's a huge difference in a core bond portfolio with 2% high yield than a core-plus bond portfolio with 20% high yield. They react very differently in different market environments.
And we believe the primary weighting in a balanced portfolio in the fixed income portion should be core. And so with Morningstar shining a light on all of these funds all over the place doing very different things — many of them reaching for yield — when you think of core-plus, for many folks that simply means “core-plus/high yield.” And we think investors can make a separate high yield decision and not just simply own a lot of high yield in their core bond fund. And I think Morningstar's change in this category is really important for people to take a look at.
Will McKenna: Is it fair to say that many folks with this split would end up having maybe too much or a lot more core-plus than they thought they had and need to probably think about, “Hey, I need to reallocate some of that back to core to reach my objectives for this client”?
Mike Gitlin: Well if you look what happened, seven of the 10 largest funds got put into core-plus.
Will McKenna: Because they had more —
Mike Gitlin: Because they had higher high-yield risk. So for them to be placed in the core-plus category tells you they're taking more risk. Again we think of your bond portfolio serving four primary roles. It's meant for diversification from equities, income, inflation protection and capital preservation. Nowhere in there does it say “replicate equity risk.” And the more high yield you have, the higher correlation you have to equities. So again when you think of a 60/40 portfolio for example — and the 40 being fixed income — the vast majority of that weighting should be in core so you have a more predictable outcome and less of a correlation to the equity market. So this is a big change, and it should help investors get to the right position in their overall portfolio, in terms of their bond weighting.
Will McKenna: Yeah, that’s great. Let's keep drilling down into the portfolio. I'd love to come back to you, Jody. We talked about some examples of companies in the broader context of what was happening with trade, but let's just dig into what are the opportunities, themes, ideas, companies that you and the analyst team you work with are most excited about today — and again, I would caveat this by saying of course these aren't specific investment recommendations — but what are the kinds of things when you guys travel the world that you're getting excited about out there? And some company examples would be great.
Jody Jonsson: Well, as I mentioned before, we talked about people coming into the banking system, for example, and the change that's happening in financial services around the world is very exciting — not only in developing countries where people are coming into the system, but in developed countries where we have kind of an explosion in what's happening in payments. I mentioned already the need for IT service around how banks are changing —
Will McKenna: Temenos.
Jody Jonsson: Temenos. Credit card companies like Mastercard and Visa are really the rails of the system on which a lot of new applications are being laid. And so I think there's quite a bit of interest in those areas and a number of companies there that participate in how all of that is changing. In some places that's disruptive to banks, in other places it somewhat reinforces the incumbency of the banks, but there's a lot of activity in that, so we're spending quite a bit of time on that area. And then also just other financial services such as an AIA, based in Hong Kong, but covers all of Asia with insurance and is rapidly growing in China. [It] has a very advantaged position within China essentially as a local company — not as a foreign company — because of the way its licenses are structured.
Will McKenna: And again, a lot of folks just don't have insurance.
Jody Jonsson: Right. And they’re moving to basic savings products and that sort of thing, basic protection for the first time. So we think there's still a long, long runway for growth there. In other areas, I would say I personally am a big fan of what I call the pick-and-shovel companies. For example, in health care it can be so difficult to try to predict the winners. I was in some meetings last week with biotech companies. In the meeting, in about 30 seconds was over my head in terms of how deep they were into the science.
But I know that every biotech company, every pharmaceutical company, needs to use basically the same sorts of equipment for genetic sequencing or for reagents or all the things that are integral to their discovery process. And so we have companies like a Thermo Fisher, for example, which supplies both governments, academia, and the pharmaceutical and biotech sectors, and is growing rapidly even in China. And even in a time when China was slowing down, they were growing at 20% in China, as China is developing its own health care industry. And then also all the testing around food and water and air quality relies on equipment that they make.
Another company would be Boston Scientific, which is in medical devices. It used to be things like just pacemakers and artificial hips and knees and that sort of thing, but now it's getting much more into interventional medicine, neuro-modular kinds of stimulation. Just a much more innovative, higher value preventive kind of medicine that also grows faster. And so again, it isn't as subject to all the pricing and political pressure as you see around pharmaceuticals and such.
So we're trying to find companies that are a little bit off the radar screen, maybe not right in the target when the politicians get worked up about these very populist issues, but that still have very long runways for growth and innovation.
Will McKenna: And I know in previous episodes, you've talked about the same concept around TSMC and some of those companies that are providing the guts of what a lot of the, then, semiconductor companies need to —
Jody Jonsson: That the whole industry needs. And so I'm not as good at picking the ultimate winner, but I know that there are certain companies in every industry that everyone needs to go to to be competitive, and so that's where I try to focus a lot of my investment decisions.
Will McKenna: I know we we’re going to come back to this idea of not just growth/value and how that’s going along, but the FAANGs — the tech stocks in particular. We've seen some bumps in the road. More recently, I think, the NASDAQ itself was recently flirting with or in kind of bearish territory, and yet we've had very strong conviction in some of these stocks. I know some of them are in in the top 10 in NPF. How are you and the team feeling about those today? Are we seeing this as a temporary setback or is this more headwinds they’ll be needing to face in the future?
Jody Jonsson: It's hard to talk about the FAANGs as a group. Each of them is a very distinct case, different from each other. These are companies that have tremendous businesses. They are very cash rich for the most part as companies, and they have a lot of resources and a lot of different ways that they are innovating and being very creative. But because of their size and their success, they will also have challenges. And I think the challenges they have now are very much a function of their success, whether it's Facebook and Google dominating the ad market, whether it's Amazon being so incredibly successful in retail — but the side effects of that in terms of what it's done to other parts of the economy are challenging.
And I think the companies have shown different degrees of how politically savvy they are about it. Some of the companies have dealt with it, I think, fairly effectively and others not so much. Sometimes the companies can be in a little bit of a bubble in Silicon Valley and not really think too broadly about the implications of their actions. And actually it's not that surprising to me that we're seeing talk about anti-trust and breaking up monopolies because that's generally what happens after companies have a long period of dominance.
It may or may not actually end up affecting their businesses because they are very strong businesses with pretty strong moats around them, but it could be a distraction for managements. And it may mean that these stocks are not quite the market leadership that they were before. It doesn't mean that the companies can't continue to do very well.
Will McKenna: They get rerated or —
Jody Jonsson: They just may not be the stocks everyone needs to own the way they did in the last several years. I do think the market is sending us some signals about its tolerance for business models that aren't really robust. And I think you've seen it in some of the IPOs that have come recently, where you saw that the Uber IPO struggled a bit. And companies that are coming public without having a real path to profitability, where they've just been essentially using the venture capital to subsidize subsidies that they're giving to their customers without a real path to making money. I think the market's patience for those business models is wearing a bit thin. So we've tried to focus on companies that are more self-funding, that have strong cash positions so they’re not as dependent on the whims of the IPO market.
Will McKenna: OK, great. Mike, we talked a little bit about some of the areas where you and the team are seeing opportunity. Any other parts of the bond market? I know we’re cautious on corporate credit. We like emerging markets debt. Anything we missed there, any other areas?
Mike Gitlin: The one area I would say needs to be a focus for most investors is municipal bonds. And I think sometimes it gets categorized too much as an asset class for the rich.
If you look at the tax bracket where muni bonds begin to make more sense for folks, it's in the low 20s for a federal tax rate, not just the highest 37% tax bracket. So muni bonds — while all asset classes in our view have a bit of a valuation challenge right now — [are] closer to being expensive than cheap. And munis are no exception. That being said, on a tax-equivalent basis, municipal bonds still are a great opportunity for folks. Tax-free high yield in particular, where you’re really … high yield’s a bit of a misnomer. It’s more crossover credit — double B, triple B. Muni is not a real heavy high-yield market. And so your taxable-equivalent yields at those highest tax brackets are very attractive still, even though rates are so much lower. So munis need to be in folks' portfolios — and not just at the highest tax bracket.
Will McKenna: For someone who didn’t know that much about it, the high-yield muni market just seems like this great secret hiding in plain sight — this great opportunity.
That's great content on the outlook or what I might call the “what” portion of what we talked about. How about now let's get into the “so what.” And the “so what” I think in this case is, what are the portfolio implications? And our audience always asks us, “That's great insight, but what should my allocation look like based on that, and how do you guys think about that?”
We typically get two questions in this area. In equities it's how much U.S. and non-U.S.? I was looking at the NPF allocations as an interesting benchmark for us there. And then, what types of bonds should I have in my fixed income portfolio? So if you think about that 40, if that's your 40% slice, how should we chop that up? So I'll come to you for that, Mike.
Jody, I think you see this probably from two sides. You're a manager on New Perspective Fund, which is a global equity fund, and can make those decisions — U.S., non-U.S. — of course, bottom-up. But also you're a member of Capital's Portfolio Oversight Committee, or POC. This is the group of experienced portfolio managers who help put together and develop our fund of fund offerings, both target date and objective-based funds and models. And [I] would love to have you talk just a little bit to our audience about what that group does, how you approach it. I know we approach things a little differently than many shops do. We have much more of a bottom-up philosophy where we let objectives drive the process, but we also let the managers within the ingredient funds who are closer to the opportunities help really drive some of those allocations at that level. But tell us about the POC — what you do there and what you try to accomplish — how it works.
Jody Jonsson: Well, our Portfolio Oversight Committee basically helps set and oversee the strategy for our multi-asset portfolios, of which target date is our largest but we have several others as well. And the key building blocks within our multi-asset series are funds that have either global flexibility from a geographic standpoint or some flexibility to kind of move within equities, let's say. Even funds that have a yield requirement generally can move a little bit more toward growth or more toward income as the market dictates, and as the opportunity dictates. And that's important because we feel like, particularly in funds such as target date where we're trying to achieve an objective, the ability to move where we see value broadly defined is really important. And particularly to be able to protect on the downside around sensitive times like a few years before or after retirement.
So that's a long way of saying that funds that have more flexibility to go globally or to not be so narrowly defined in a particular niche, I think are very useful. And again, to bring it back to New Perspective, that's why the fund has been successful. It is a growth fund, but it is not locked into owning only growth companies. So if we experience a time in the market where, let's say, commodities and energy are really out of favor, and they're the thing that we want to own a lot of, we have the flexibility to do that.
Will McKenna: Yeah, so in some ways, you're putting those flexible funds at the core of these models or funds of funds. And then the asset allocation actually drops out of that.
Jody Jonsson: Right. We're counting on the managers who are closest to the decision to be the ones making that actively.
Will McKenna: When you think about New Perspective Fund as kind of a flagship global fund for us, I was looking at some of the data, and it looked like we were at a pretty high allocation to U.S. relative to non-U.S. I think recently it was 55% U.S./45% non-U.S. And I looked back, end of 2012, it was the reverse. It was 45% U.S./55% non-U.S. So you are able to go where the opportunities are. Any perspective on that? Obviously that's the result of market movement, as well as where the team is seeing the opportunities, but does that feel like the right allocation today?
Jody Jonsson: In my own portfolio, I'm around 50/50. And I'd say if I compare what's happened over the last few years, we actually just did an analysis of this in NPF for our board a few months ago. And it was interesting, our representation in Europe, for example, I think had been about 40% a decade ago and is now down to less than 20%. And that's not because we're pessimistic on Europe. It's that a number of industries have become quite structurally challenged and have de-rated. So the autos, for example, trade at mid-single-digit multiples. The banking sector in Europe has essentially almost gone away, from a market capitalization standpoint. And so part of it is that the rest of the world has shrunk as the U.S. market has done pretty well.
Will McKenna: As you said they don’t have the tech. The sectors that have done so well —
Jody Jonsson: Right. Without the giant sectors like that, that we have as much of in the U.S., the rest of the world just has gotten a bit smaller in the indices that we're measured against, much less in our own portfolios.
Will McKenna: Right.
Jody Jonsson: So we have tended to favor U.S. stocks. But again, it's very hard to say the U.S. as a market should be massively over weighted. We've all been saying for a while that it feels like it's time for non-U.S. to do better than U.S., but it's not clear exactly what the catalyst would be for that.
Will McKenna: Well, and as you said, you're coming at it from those company examples that you shared earlier around biotech — or the pick-and-shovel providers to those industries.
Jody Jonsson: Yeah, we don't sit and make a top-down decision that the U.S. is going to be a certain percentage. It bubbles up from our selection.
Will McKenna: Right. That’s great. Well, let me come back to you, Mike. We talked about the equity portfolio. For what it's worth, our flagship global fund is about 55 U.S./45 non-U.S. now. When you think about that fixed income part of the portfolio, and obviously it should be aligned with the investor’s objectives, but [in] a typical portfolio, how might you think about dividing up that 40?
Mike Gitlin: Sure. For that 40, the primary weighting needs to be core. So if it's a 60/40 portfolio, having a core predictable outcome is critical. Again, back to the four roles of fixed income in a balanced portfolio — diversification from equities, income, inflation protection and capital preservation — you can get that from a core fund if it's truly core. Now with the category split with Morningstar, you should have a better guide to what's core and what's not.
So The Bond Fund of America®, our flagship core strategy, is the largest active fund in that Morningstar category. And it's meant to achieve a core outcome. Less than 5% high yield; predictable outcomes is its goal. And that should be 20–25% of that 40 weighting.
If you're looking at core-plus, something like [American Funds] Strategic Bond FundSM can help you get there. Interestingly in Strategic Bond Fund — and that might be 5% or 10% of the portfolio — the plus is not just high yield. When folks just rely on high yield for the plus portion of a core-plus strategy, you know its correlation to equities is going to be high. And Strategic Bond Fund majors in rates and minors in credit; that's how it achieves its excess return — or that's its goal, certainly.
And then for the 5%, 10% of the portfolio where you need higher income, [American Funds] Emerging Markets Bond Fund® can help you do that. If you think about tax-aware investors, you can put together Limited Term Tax-Exempt [Bond Fund of America]®, [The] Tax-Exempt Bond Fund [of America]® and American High-Income Muni[cipal Bond Fund]®.
So either way, you have a very good head start by having a core portfolio that's anchored in something like Bond Fund of America.
Will McKenna: Yeah, that's great. That's great guidance. And again, apologies to our listeners outside the U.S. The 40 Act American Funds are not available there, but I think some of the same principles still apply.
Mike Gitlin: Absolutely.
Will McKenna: This has been great. We’ve covered so much ground. I'd love to just take a minute and do a bit of a speed round, you know, to try to help summarize the two or three key messages you would want to impart to our audience of advisors and investors at this time. Darrell Spence?
Darrell Spence: Well, as you can tell from my earlier comments, a lot of what we're focused on right now has to do with trade because it's pretty instrumental in the economic outlook. And I think when you look at what the market's been doing, it's trying to figure this all out as well.
Mike, you mentioned that we're pricing in four rate cuts between now and the end of 2020, but yet the equity market, at least in the U.S., really isn't down all that much. There seems to be a bit of an inconsistency there because if you really think we're going to have an environment where the Fed cuts rates four times, it's probably not a really healthy earnings growth environment.
But again, I think that just is reflective of the uncertainty that we have when trade and policy decisions drive so much of the economic outlook. So at least from my top-down perspective, I think that's going to continue to drive a lot of confusion in the markets. It's going to continue to drive a lot of volatility, but also create a lot of opportunity if we can dig down and use our resources to figure out what's really going on.
Will McKenna: That's great. Jody Jonsson, equity markets, as you see them.
Jody Jonsson: Well, to piggyback on what Darrell said, obviously the markets are very focused on the near-term issue, which is trade. But I think where the opportunity lies is to the extent we can look through that and remain focused on the companies we think have very, very strong business models that can survive the near-term noise. That gives us opportunity when they throw out the baby with the bath water. So we're just trying to look for where we think the market is being overly pessimistic, for example — or maybe overly optimistic — and try to position around that. But it hasn't really changed our view on the fact that there are still lots of companies with great long-term outlooks.
Will McKenna: Great. Mike Gitlin, bond markets.
Mike Gitlin: I guess I'd say if we agree we're late cycle, which I think most people would agree, and we agree there's a reasonable amount of uncertainty out in the world right now, the message is not to change your overall allocation — 70/30, 60/40, whatever that may be — but it is to make sure that the fixed income portion of your portfolio is having the desired outcome that you need.
So stay core in your fixed income portfolio, don't take too much credit risk late in the cycle and preserve your capital for another day. So that is really important at this stage of the cycle.
Will McKenna: Fantastic. Well, that's all the time we have today. And thank you so much, Jody, Mike and Darrell, for your insights into the financial markets.
We hope you in the audience found this discussion helpful, and we look forward to working with you throughout the rest of 2019 and into 2020.
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