<p>Political risk lurked around every corner in 2016, and the turbulence is set to continue. Uncertainty surrounding the Trump administration and several pivotal European elections are on the horizon, so how do you position for maximum risk-adjusted returns? Panelists from across the investment spectrum came together to offer their points of view on the opportunities that lie ahead in the coming year.</p>
<ul>
<li><p>David Polak - Equity Investment Specialist at American Funds</p></li>
<li><p>Paul Grillo - Senior Vice President, Co-Chief Investment Officer, Total Return Fixed Income Strategy at Delaware Investments</p></li>
<li><p>Francis Gannon - Co-Chief Investment Officer, Managing Director at The Royce Funds</p></li>
</ul>
Video Image:
Duration:
0000 - 00:56
Display Date:
Thursday, January 5, 2017
Transcript:
Gillian: Welcome to Asset TV. I’m Gillian Kemmerer. A series of political earthquakes have rocked the global financial system this year and the excitement is not set to stop. With a U.S. inauguration and a series of European elections on the horizon, how can you position to capture maximum upside? Today we have a diverse set of panelists assembled who will deliver their predictions from the frontlines of the world’s equity and debt markets. Welcome to the 2017 Outlook Masterclass. First of all, thank you so much for joining us – we’re excited to hear some of your prediction and thoughts today. So let’s get started with the graphic that I sent to all of you ahead of our discussion. It’s one that really caught my eye on Bloomberg. It just came out last week and it’s a survey of economists that was taken around the time of November 18th to 28th and it was essentially asking these economists what they think the biggest global political risk will be coming up in 2017. Some of these risks have already begun to show their true colors in 2016. So as we start looking at this graphic, I want to get started with you, Frank. Talk me through how you navigated 2016 and what you’re looking, not necessarily forward to, but looking at the closest in 2017?
Francis Gannon: Sure. One of the most interesting things from our perspective this year was actually not the political environment, believe it or not, although it’s probably something everybody’s talking about these days. The most significant thing from our perspective in our asset class – which is small caps – was the significant bear market we had that bottomed in February of this year. We had over 26% correction in the Russell 2000 and not many people are talking about it. They didn’t talk about it while it was happening. So it was almost a stealth bear market that took place in the market this year from our perspective. And then you’ve had this incredible stealth bull market, if you will. The Russell 2000 is up over 45% from its low. And so it’s been a powerful surge to the upside. But that critical, from our perspective as a value investor, that down market really enabled us to set up our performance, not just for the remainder of this year, but what we think will be a very interesting 2017 as well.
Gillian: And you are focused on small caps, so what are some of the opportunities that are coming down the pipeline for you? Paul, when you look at this and when you think back over 2016, what sticks out for you?
Paul Grillo: Yeah, definitely the election in the U.S. and the Trump victory and the Republicans were able to keep control of Congress. So that set up for continuation of risk-on in the fixed income markets it started with the incredible technical set up earlier in the year with the ECB deciding to buy corporate bonds along with their government purchases. It had a foundation and OPEC members trying to put a floor under the oil price. And also the Federal Reserve postponing rate hikes. Now you have a new impetus for markets to like what they see and the possibility of stimulus going forward, maybe tax cuts, maybe some infrastructure spending, maybe a repatriation. And the fixed income markets have taken their cues from this. And we’ve seen incredible reductions in risk premia across many asset classes.
Gillian: I feel like it’s been hard to figure out where to put your focus on the fixed income market. We were just looking at a bottoming out of U.S. Treasuries, now we’re looking at Europe – [it was] just announced today there might be a tapering coming up on the horizon. So certainly got our eyes on it and Europe’s really taken a big center stage more recently. So, David reorienting a little bit, you obviously have a global markets focus, how did you look at a picture like this? What was the most important factor for you in 2016?
David Polak: I think the first thing that leaps out is that the question was what was the likeliest source of global political risk? And of course political risk doesn’t necessarily translate to market return or market risk. And that’s pretty evident in what happened with the Italian elections. Here we have another event that wrong footed the markets. So after Brexit, people thought the markets would go down, they went up. After the election here, people thought the markets would go down, as Frank mentioned, they went up quite startlingly. And then coming into the Italian election, same thing, markets back up again, Italian banks going up around 20% in the matter of a few days after the resignation of Renzi, the prime minister, following his loss in that referendum. So political risk doesn’t necessarily mean economic risk. But a lot of these political earthquakes as you mentioned in your opening remarks are, well, at least the way we see them at American Funds, is they are signposts to a changing, if you like, global order. When we started the year, markets by and large were very much focused on deflation. It felt like we would be in a deflationary environment forever. And of course nothing lasts forever.
And slowly during the course of this year we’ve had these signposts that say that electorates are fed up with the current status quo. They don’t think that quantitative easing, the lower interest rates are really helping them. So they are in many different ways asking for something different. And that something different – could be infrastructure spending, stimulus, more fiscal policies – would lead to a rotation or a number of rotations in asset classes. It would lead so far to bonds going down, value stocks going up, small cap going well, growth stocks not doing as well as value stocks. There’s some significant moves. So it feels that we’re on the cusp of lots of changes, or indeed, in the midst of some changes. And at American Funds we’re trying to figure out, not so much what the outlook is for 2017, sorry about that, but we’re looking a little further ahead. What’s the outlook like for the next three, five or even eight years? And are we at a turning point, are these signposts providing a useful signal for those longer time periods?
Gillian: It’s a great point – we look at so much of this market volatility as a snapshot around an election or around a referendum, but these politicians and these policies are in place for four or five years, maybe longer down the line. And something like Brexit could be forever. So I want to reorient this question a little bit and talk about some of the lessons that you’re going to take from what happened in 2016 into 2017. And actually, Paul, I’m going to start with you on this one. What are some of the things that you want to carry over and really implement in 2017?
Paul Grillo: Yeah, I think going forward in 2017 the big question for us is how long this credit cycle can last. So we found out that we’re very late in the credit cycle. We had some significant bad behavior on the part of corporate managers, when it comes to bond investors, if you will, doing very equity-friendly activity at the expense of say bond ratings or risk premia there. But what you had was central banks and they’re coming into the market and creating a favorable technical pushing this credit cycle out farther, giving corporations a runway, if you will, to refinance, to do more of this type of activity. We’re hoping it’s a year – 2017 – that offers us some growth potential, some possibilities for stimulus, especially of the U.S. economy. And in that case we can see the credit cycle going to very late innings. And we can keep exposures and things like corporate bonds, both investment grade and high yield and maybe some other volatile markets like the emerging markets as well.
Gillian: Okay, great. Frank, how are you thinking about what happened in 2016 and bringing that knowledge into next year?
Francis Gannon: Well, it’s interesting, building upon what David said, you know, part of what happened in 2016 really is a culmination of many years before 2016. And in the small-cap space remaining true to your discipline I think has been extremely important as an active manager in the small-cap space. It hasn’t helped you necessarily over the past several years as many unintended consequences of what the Federal Reserve has done through quantitative easing and various programs have played out real time within our space. But sticking to your discipline, from our perspective, is probably the most important thing I can think of… that as the market does shift and it does seem like it is a significant shift in the market, not just from where you’re going to be generating your alpha going forward, but from deflation or stagflation to more potential nominal growth. And it becomes potentially a growth year environment; it could be significant going not just in 2017 but the years ahead. So staying true to your discipline I think is one of the things that we have spent a lot of time on in our firm, The Royce Funds, thinking about over the past several years. And it has helped us in what has been a difficult period in terms of the overall market. But as that shifts now I think we’re on the cusp of what will be another interesting period in the overall market.
Gillian: When you say staying true to your discipline, do you mean remaining unemotional in the face of volatility or more sticking to your due diligence process through [inaudible]?
Francis Gannon: It’s a see all of the above. You know, I think it’s staying true to your discipline in terms of how you look at a company, not just from a short-term perspective but from a long-term perspective. It’s staying true to your discipline in terms of how you value those companies and your due diligence process along the way. And what we found was, you know, the most interesting opportunities in a world, in our world we’re in the most cyclical areas of the market, that for all intents and purposes safety was overpriced. And I think we have lived in a world over the past several years where people have overpriced safety, be it bonds or utilities or REITs at various periods of time. And they forgot about the power of compounding, which is something that I think we as investors try to find, these great businesses that we can own for long periods of time and benefit from the power of compounding. And that has not been in investor’s kind of mindset for a long period of time. They have been worried about downside protection. Well, you can still achieve downside protection and still participate in the overall market. And I think that’s what investors are going to wake up to over the next several years.
Gillian: Perfect, thank you. And, David, lessons from 2016?
David Polak: Probably three – I’ve had the advantage of listening to my two colleagues here. So one would be, again, taking that longer time frame. What were the markets, all these moves, these convulsions telling us in 2016? If you look back to maybe 2002, it was with the benefit of hindsight, clear that at that point, commodities were cheap. 2009, growth was cheap, there was a world starved of growth, cyclical growth, growth stocks were very cheap. What is cheap? What are the markets telling us are cheap now? And could it be that inflation is cheap? So that’s one of the things we’ll take as we look forward, is there that turning point? The second thing, which is kind of a parallel thought, is even if we might be seeing a rotation, a key focus on individual companies, at American Funds, we build from the bottom up. And there have been some huge strides in technical innovation, in medical science, the internet is increasingly being used as a global distribution system. The mapping of the human genome 15 years ago has led to scientific discovery, there are some significant medical breakthroughs. The question is how do they get priced? So we will be looking at… let’s not just rotate from one area to another. Let’s continue to focus on good companies and good valuations regardless of where they fit. We’ll think about that, but let’s focus on the companies.
And then the third lesson from 2016 is asking ourselves at American Funds the question, how did commentators, economists, pollsters and the media get all of these earthquakes so wrong? Are they all living in a bubble and therefore we have to turn that question on ourselves, are we living in a bubble? Are we missing some of these points? What is it that’s going on out there? When we go and see a company, we try to see not just the management, but also the next layer of management, if we can, people in the workforce, their suppliers, their competitors, their customers. You need a much broader view than you get if maybe you just go and see a company, which in some ways was by just narrowing or having it living in an echo chamber is what we think the pollsters and the media and the economists did. We want to make sure we’re not making that mistake ourselves at American Funds.
Gillian: There is a pundit that said after the U.S. election that data was dead. And they were speaking with a manager the morning after, he said, “Well, it depends which data you’re looking at.” So if the same people are looking at the same data and broadcasting it, it’s not impossible for it to go wrong.
David Polak: Data’s not dead, it’s just not read.
Gillian: Good point, very good point. So, Frank, I’m going to position over to you one of the political earthquakes that we had up earlier was the Donald Trump election. So I want to know how you’re looking at the small cap, if you’re looking at it differently post the U.S. election.
Francis Gannon: Sure. Small caps were a clear beneficiary of the post Trump election. November, in fact, for the Russell 2000, was the best November in the history of the Russell, quite a powerful move. But I think what’s … the shift that we saw in November in the market has been something that has actually been building throughout the year. I alluded to the fact that you saw a bear market in the small-cap world. And I’ve always been a believer that what has been working going into the bear, kind of at the peak of the market is typically not what works coming out of a bear market. And the clear shift within our space this year has been from growth to value. And it just actually got exacerbated in the month of November. And we think, what we saw over the past several years, in particular as the market peaked in June of 2015, was a two standard deviation event, in terms of the outperformance of growth over value. Growth had actually outperformed in six of the past seven years in the small-cap space. And we think value is just starting to kind of reassert itself. And as a big believer in reversion to the mean, that’s where we think the small-cap market is going to be heading over the next several years and should remain in that particular way. So post the Trump election, while we have, you know, I think, all come to appreciate the potential that could be out there. The question now is what is priced into the market at current valuation levels.
The market, you could argue was expensive to a certain degree, at least in the small cap perspective going into the election, and it had become even more expensive post the election. So I’ve been jokingly saying to my colleagues that even in a Trump administration, a correction will not be outlawed within the equity space. And I think you are going to see some corrections at some point going forward. That being said, I think that correction should be used to be bought in the overall market as we think ahead over the next three to five years, if the significant shift that we’ve been talking about, from growth to value, from deflation to potentially a more growth environment could be significant for small-cap companies, especially in the United States.
Gillian: And until mid-January these policies are still just campaign promises, so certainly that’s a thing to keep an eye out for and see what actually translates as opposed to what’s been priced in. So, David, I want to talk to you a little bit about globalization. We said data wasn’t dead, one of the things that’s echoing in that chamber among media, economists, etc., is the question: is globalization dead post both the Donald Trump election and Brexit?
David Polak: It brings to mind the Time magazine – or was it Newsweek? – cover in 1979, the death of equities. And now we have the death of globalization, which is probably a little too early to be calling that. Globalization has taken on many different facets over the decades. And the most recent wave of globalization has been the increase in trade of stuff. And as China has built out and industrialized an urbanized economy, we have seen huge trade flows of metals and steel and the stuff it takes to build a more rapidly industrializing country. What we’re seeing now though is increased communication or trade of ideas. We’ve gone from, if you like, a transportation explosion to a communication explosion. And that’s much harder to put tariffs on. How do you put tariffs on ideas that go around the world? How do you put a tariff on the internet as a distribution system? And so we think the globalization genie is out of the bottle. It will be very hard to put it back. Also as you change trade agreements, if that is indeed what happens, they take a long time. They can take decades in and of themselves. So it’s unlikely that there’s going to be a significant shift, even in the trade of goods. But when we look at… you know, there are going to be some areas that could be more at risk. And there are going to be some opportunities on the other side of that. So again it comes back to this idea of look at the individual companies, look where they might be at risk, look at the ones that may have opportunities and make assessments on valuations and everything along those lines.
Gillian: Very interesting point. Paul, how did the U.S. election reverberate through the fixed income markets?
Paul Grillo: Yeah, big reverberations of firstly inflation expectations based on market valuations, expanded. So we saw breakeven rates go to some 2% on the 10 year. Along with that, yield curve movements happened after the election. So the U.S. yield curve moved on the order of 30 to some 60 basis points after the election, higher in yield. Maybe expecting some expansion of inflation as I’ve said, or maybe expecting some better growth going forward. And rates have to react to that. Yield premiums and corporate bonds as I have discussed, liked the results of the Trump election. So these corporations, again we’re in very late innings of a credit cycle here. The market participants are looking for any signs that we could push this credit cycle out further, better earnings, better cash flow to these companies to service their debt. So for the U.S., especially U.S.-based companies, they like the results of the election. There’s a lot of nervousness in the emerging markets of course, post global financial crisis we’ve seen a tremendous buildup of debt across many EM countries.
Gillian: Dollar denominated?
Paul Grillo: Dollar denominated, yes. And of course that servicing, it gets more expensive as the dollar increases versus their currencies. So there’s a lot of nervousness there. We saw the Mexican peso go down some 12% after the election. We saw the yield curve jump up 100 basis points, just because they had to build in some more risk premia based on the results of the Trump election. So, some pretty significant moves in the fixed income markets on the back of the election results.
Gillian: Not surprising. It’ll be interesting to see what happens after the Fed makes its final decision to raise rates. We’ve all but priced it in but obviously we have yet, at the time of taping, to find out exactly what they’re going to do.
Francis Gannon: Well, one of the more interesting things, too, is as the baton is really being passed here from monetary to fiscal policy, if it does happen next year, we are talking about doing an enormous fiscal policy at a moment where the economy is not in recession. And what does that mean to the markets and the economy in general? So I think that’s going to be one of the more interesting things, how that plays out in the overall economy next year. And I’d love to hear your thoughts on that.
David Polak: So I think one of the questions is it doesn’t feel like we’re in a recession at the moment, but we could be close to one, right? And jobs have been improving, the unemployment number’s been improving. But it just doesn’t feel like the quality of those jobs is everything that people want, hence potentially the outcome of the election. So it feels that there’s something existential that isn’t working in America. And there’s certainly a lot that isn’t working in the world. The cylinders in Europe and Japan are simply not functioning. The Chinese have stimulated their economy, and that’s begun to move again and maybe the incoming administration can take a look at what the Chinese have done with their economy and think about how that could be applied here. So I think it’s less about the headline numbers, it’s more about the quality of the economic activity beneath it.
Gillian: It’s an interesting point, and Paul, I’d be curious to know what you think. We’ve heard the Fed say that they’re going to raise rates a couple of times this year. They obviously have not; they’re saving it all for December. But if fiscal policy starts to get enacted and the neutral rate rises, do you think we’re going to see a lot more pressure on the Fed?
Paul Grillo: It’s going to be a very interesting transition, something that Frank’s alluding to, that the Fed and most central banks around the world have been very, very sensitive to financial conditions. And financial volatility, market volatility has either stopped them from increasing short rates, or even put them more into stimulus mode. So right now you could have a runway for the Fed based on financial market outcomes, which seem to be pretty good right now after the election. It could give them a runway to increase rates maybe at a swifter pace than what’s discounted in fed funds futures right now. So we do have December baked in the cake – it looks like – for expectations. And fed funds futures is predicting right now another hike in July of 2017 and maybe another hike in December of 2017.
Francis Gannon: What’s interesting about that, though, it’s not that long ago it was lower for longer, right, that was the mantra for a long period of time. And actually when you think about the world we’ve been living in, that was a big part of the world we were living in.
Paul Grillo: Exactly, yeah.
David Polak: But one point on that, Frank, is we have a chart that goes back to, I think it’s 1870, looks at the 10-year Treasury yield. And the anomaly was the run up to 1981 where the 10-year hit around 14.8%. You’ll know better than I do, Paul. And I’ve been in the market since the ‘80s, and so all of my career the interest rates, as denoted by the 10-year Treasury have been coming down. So now that the yields are going back up again, there must be so many people in the markets who have been during this period where that markets come down, who instinctively think, oh, they’re going to go back up to these high levels again. If you go back beyond that, go back into the early 20th century and into the 19th century, you can see periods of three decades where yields stayed below 3% for the 10-year. Now, if we went to 3% people are saying, “Oh my gosh, the 10-years on, you know, are shooting up.” In the historical context not so much, so it could be lower for longer, but not quite as low as maybe we thought.
Gillian: Interesting point, and actually the next question I was going to ask you was whether or not you thought we were at a turning point for global markets. You said globalization isn’t dead and obviously you gave some great reasons for why the tenor of globalization has changed. But do you think we’re at this big watershed moment?
David Polak: I suppose at the beginning or the end of each year we always think we’re at a watershed moment. It always feels like that, the calendar drives it. But 2016 did feel like there was a change in the weather. And it comes back to this idea that there may be more growth coming in the world and that may be stimulated by fiscal policies. It’s certainly needed in Japan and Japan has been in a funk as an economy for a while. And it’s certainly the case in Europe. And so both of those markets… if you just look at the market in general, standard significant valuation discounts to the United States, so taking the S&P 500, you are looking at around 17 times forward earnings. Everyone has their favorite way of measuring the valuation – let’s just take the straight PE, so 17 times forward. Europe and Japan are on around 14 times. Now, there’s some differences in composition, so you have more lowly valued sectors in Europe than you do in the United States.
Gillian: I.e., financials?
David Polak: More financials, more utilities, more telecoms, less companies like Amazon, so less internet, less biotech, less semiconductors, less tech hardware, less everything in technology. But you’ve still got company by company significant valuation discounts for companies that are domiciled in Europe and in Japan. Now, remember, let’s just take Europe as an example, the top 20 companies in Europe, get around a third of their revenues from Europe, a third from the U.S., which is a stronger economy and a third from the emerging markets, which even though they have slowed down a bit, are still the most rapidly growing parts of the world. And so then if you bake in the fact that the euro has gone down by about 25%, those companies are now more competitive against American companies. The U.S. equity market has outpaced the European and, well, the whole of the international markets now for 82 straight months. It’s the longest period on record. And yet you’ve got cheaper valuations, you’ve got a little bit more exposure to cyclicality if we do see a rebound in cyclical stocks and you’ve got currency tailwinds with both the euro and the yen. So maybe the big shift that’s coming out of 2016 globally could be that whilst the U.S. remains a stock market where we see lots of opportunity in individual companies, you may begin to see a shift in those relative rates of return towards international stocks.
Gillian: Great points and I want to stay on kind of where we are in various cycles. And, Frank, I want to kind of bring this over to you. Large cap and small cap have different cycles, so where are we in the small-cap cycle right now?
Francis Gannon: Yeah, it’s actually quite interesting. You know, I think everybody has been talking about how long in the tooth this market rally has been – going back to March of 2009. And for the large-cap space that is true, it has been a long period of time. But within small caps I think people forget we’ve actually had two full bear market cycles since the March 2009 bottom. So you could argue on some level that while corrections can happen and my guess is they probably will happen within … especially within the small-cap space, going into 2017, you could argue that the market still has a way to go if you look at historical context in terms of where a small cap market tends to go post a bear market. So we’re not even halfway there yet if you go back and look at historical norms. So that means there’s probably a lot more upside in the small-cap space. But I think it’s important that investors realize that there tends to be different cycles in the markets, especially between large and small. And over the past several years people have missed these bear markets within the small-cap space, which have created, I think, quite interesting opportunities for investors.
Gillian: And yet another interesting point of entry right now.
Francis Gannon: Possibly.
Gillian: Okay. Paul, where are we in the credit cycle right now and do you think that the position we’re in could extend its duration?
Paul Grillo: Yeah, we’re definitely in the seventh or eighth inning, so leverage among both investment-grade companies and high-yield companies has increased especially over the past three years. As I alluded to earlier, on the investment grade side, it is because companies are taking advantage of low rates and doing equity friendly type activity, returning money via debt market funding through dividends, buybacks. Organic growth has been hard to come by for some of these investment-grade companies, so they have elected to do some big mergers and acquisitions. And for all those reasons leverage has increased in investment grade. Interest coverage is coming down, which is somewhat troubling, but it’s coming down from a very good level. So investment participants still have some comfort in investing there. And ratings haven’t come down that bad. So we saw some big ratings downgrades in the energy market on the back of 2015 commodities moves. But that picture has improved. For the high yield side, leverage has gone up, but more for economic challenge reasons. Those corporate managers are doing a good job of paying attention to the balance sheet liquidity, maturity walls. But they have run into some challenges, especially again in energy, metals and minings. And we had some idiosyncratic events in the retail sector, in restaurants and in health care as well.
All these signs are pointing to very late cycles. And we’re all wondering how far this thing can be pushed out. And that’s why we’re hoping this bit of stimulus that we get here can improve the earnings picture. We’ve been in somewhat of an earnings and revenue small recession, if you will, over the past four quarters. It looks like we’ve broken out on the upside in a small way with this last quarter. And maybe this stimulus package gives us a nice runway into 2017 for some late inning action in the credit cycle, if you will.
Gillian: Did the OPEC meeting in Vienna change any of your thoughts on some of the energy guys at all and what they might be facing going into 2017?
Paul Grillo: Well, I think the interesting thing was all the good things happened at the beginning of the year, especially with the central bank moves and the postponement of short rate moves by the U.S. Fed. Now unfortunately OPEC is going to have to live with the deal that they cut. And many of them are revenue hungry. And they’re going to be acting in a world with lower oil rates, some budgetary challenges. And I think we’re going to see some of these countries cheat here and there on the agreement. So now that they’ve struck the agreement, they have to live with it. And it’s quite likely we will see some disappointment in the price of oil going forward.
Gillian: Okay. Now, David, you talked a little bit about some of the areas of opportunity that you’re seeing. But I’d like to drill down a little further into that. What are some of the most specific opportunities you’re seeing outside of the United States right now?
David Polak: If you look at some of the lowest valuations, even after the move, European banks seem to be pricing in fairly catastrophic outcomes – flat yield curves, no credit growth, increased regulation, increased need for capital. U.S. banks have essentially repaired their balance sheets. European banks are some way from doing that. But it’s almost a litany of what more can go wrong. And the answer was until a few days ago, well, the Italian election can go wrong. Well it did, and the stocks went up. So it feels as if they’re at a particularly low level, and it doesn’t mean those problems have gone away. But the valuations seem to be encompassing a lot of the things that can go wrong. So that’s one area that we think is worthy of, you know, further analysis – look at the individual companies, etc. Some of those multinationals that I mentioned, they can be in the pharmaceutical sector, which has been beaten down hard. They can be in some of the industrial sectors that aren’t really seeing the growth. But again they are selling their drugs and they’re selling their manufactured goods into markets like the United States and like China for instance, with a much more competitive exchange rate. So they can either put that through the margin or they can expand market share. Those are two of the main areas we focus on, multinationals and pharmaceuticals.
But there are individual companies that are in the area of, let’s say, robotics or artificial intelligence, or the internet. So those can be Japanese or Chinese companies. Some of the most cutting-edge internet models are coming out of China. So, for instance, Tencent, which has been just a fabulous stock but we continue to really like the company, are doing what we think are groundbreaking or bleeding edge stuff in chat, mobile payments, games via the internet, because they’ve dealt with a population of young Chinese people who skipped the analog age. So they do everything on the internet and particularly on the mobile internet. So you’re getting different things from different countries, partly being driven by the circumstances of that country or that market. But we can find opportunities for companies that we think are growing very fast with a long runway of growth and opportunities of companies where we think the valuations are baking in a lot of the bad news, but necessarily that bad news getting a little less bad.
Gillian: Okay. So, Chinese internet companies certainly ones to watch, [inaudible].
David Polak: And they’ve been the ones to watch for a while but we think they will continue to be. Again, you’ve got to be valuation sensitive; things don’t always grow to the sky forever.
Gillian: Sure. Frank, you’ve touched on it already but it will be interesting to dive a little deeper, small caps had an interesting year. Talk to us a little bit about the growth value shift.
Francis Gannon: Sure. The growth to value shift is significant now, and it’s one that we think is going to continue to play out over the next several years. I alluded to the fact that you saw a two standard deviation event in the performance of growth over value within our space that really peaked in June of 2015, at the beginning of what was a bear market. But what you’re seeing is in the small-cap space, much like the large-cap space domestically in the United States, you’ve seen a broadening of the rally in the equity market since the market bottomed. 2015, you had a very concentrated market in the United States – referred to [as] “fang” on a regular basis – even in the small-cap space, it was very concentrated. It was concentrated in biotechnology companies and more specifically non-earners within the market. What has happened in the rotation from growth to value is, believe it or not, earnings matter again. Fundamentals matter again. We had lived in an environment where earnings didn’t matter as much. Non-earners were outperforming because of what was happening in terms of the Federal Reserve and the unintended consequences, and access to capital by companies who probably shouldn’t get access to capital. But in an environment we lived in over the past several years they were able to access the capital markets.
So this rotation from growth to value we think has a long way to go. And it’s not just because you’re seeing the big growth areas in the small-cap space start to underperform, biotechnology being probably one of them and the other being the internet portion of growth. You’re seeing industrial businesses that have done okay in an anemic economic environment start to benefit. We’ve had many companies come through our office in the past several weeks talking, post the election, talking about as much as the infrastructure and the fiscal policies that would be wonderful to jumpstart the economy. They don’t need the infrastructure spending; it would be nice just to get economic growth to break out of this anemic economic environment. So the better companies have been able to do well in that environment, right. They’re using the strength of their balance sheet now to take advantage of the missed steps of their over-leveraged brother in this environment. And so we’re seeing that. And that will continue, I think, to play out over the next several years. And in that environment you should see industrial businesses do well. You know, one of the things I spend a lot of my time thinking about is innovation. Innovation, you know, David referred to it in internet stocks. Well, there’s an enormous amount of innovation taking place in the United States in boring old traditional industries like machinery, right. And so when people think of innovation, they immediately think of growth. When I think of innovation, I think of these wonderful value companies that have been left behind over the past several years. And if they see anything in terms of top line growth, it should mean further multiple expansion going forward.
David Polak: I could answer one thing there, sort of carry on a riff that Frank started there is this idea of battle hardened companies, companies that have learned to get by in a tough economic environment. It could be that there isn’t much growth and so they manage themselves to a leaner, more efficient system. Or it could be, we saw this in Japan over many decades, an overvalued currency has meant they’ve had to compete that bit harder. And then when their currency got devalued it flowed through to the bottom line. And those are the kind of companies we’re looking for in Europe – companies that have had to deal with an overvalued currency and a very anemic economic growth, and yet have managed to find growth markets. The valuation hasn’t recognized that yet – they’re battled hardened, they’re more efficient than they were. They’ve got their supply chains in order, then when the currency comes out, it takes a while to feed through, but the operational gearing can be really quite significant and they can be very good investments.
Francis Gannon: And what’s fun about that, to be honest with you, is if value does take over. And I think it already has. Obviously you can see it in the numbers. But if value continues to do well, what you’re going to see in the market is active management come back with a vengeance. And I think that is one of the things people have to think about going into 2017, ’18, ’19 and beyond because those battle hardened companies that David is referring to, which you can find all over the world, and operating in various different scenarios. Active managers can take advantage of that much easier than a broader index. And I think that is going to be one of the takeaways, I think, of this new shift that we’re seeing in the overall market is the return of active management should be a major theme for investors going forward.
Gillian: This is definitely something I actually want to come back to. Paul, I want to come back to fixed income for a moment though. You talked a little bit about U.S. corporates, how have fixed income investors reacted to corporate financing behavior this year and what are they going to carry with them into 2017?
Paul Grillo: Yeah. This year, I think, they’ve been really influenced by the technicals created by the central banks. If you roll it back a year into 2015 though, that was a year where once again corporate managers doing equity-friendly things at the expense of bondholders, if you will, or levering their balance sheets or ratings volatility. Bond investors did react in 2015, demanding wider risk premiums. And as you know, it was a year where risk premiums widened through most of the year. Some of it had to do with the commodity challenges as well. And then we got into January and February, which were incredibly volatile months for the fixed income market. They influenced almost every other capital market on the globe as well. And unfortunately central banks felt they had to step in once again. So this year it’s been more of a balanced, I would say, approach to investing in the fixed income markets. In many senses we’re driven by the technical of the central banks buying corporate bonds now for the first time in a decent way. But what I like and what Frank said and some of the good things that I’m seeing in the markets are we’re seeing some attention to fundamentals again. So it’s not solely a risk-off, risk-on environment in the credit markets, just like Frank was saying. We’re seeing investors react to some earnings challenges or when earnings environments get favorable for companies.
So in pharm, and I think David talked about this, when you had the drug price challenges you saw some decent moves in the risk premiums of the pharmaceutical companies, or some in the restaurant area, in the retail areas. You’re seeing some of the challenges of internet versus brick and mortar. And they’re starting to get again, reflected into the capital markets instead of fixed income markets to the extent that companies want to do more equity-friendly behavior or finance a big acquisition in the debt markets. It’s getting a little bit more challenged and we take heart, like my two compatriots here, because we would like to see a return to fundamentals and the possibilities for active managers in that environment going forward.
Gillian: Okay. So, some very similar thoughts here and David I think this is now a good time to talk a little bit about where you stand on the active versus passive debate.
David Polak: Well, the American Funds are an active firm. So we would stand very much on the active side. But I think it’s worth reflecting on the fact that the debate over recent years has taken on a semi-religious intensity of two competing orthodoxies. And there’s room for both, there is room for passive and there is room for active in peoples’ portfolios and models. The issue that’s sometimes missed though is that one of the things that passive has brought to the table is costs. So, one of the things that active managers should be doing is offering their services at the best possible price. And so passive has done a good thing for the industry in forcing active managers to charge a reasonable fee for their services. And it’s also put more pressure on active managers to do the work that we’ve all been talking about – focus on the fundamentals. Active will come back if active managers start getting their results right. But folks who think they can, by choosing passive, can control their costs are maybe missing the point that they aren’t necessarily controlling their outcome. And it’s the investment outcome that is going to swamp any savings you make in costs. And so when fear, where we came out of 2008 and 2009, when fear supersedes greed people will go to managing their costs, because they’re fearful about outcomes. But if we move into a period where outcomes can really be differentiated by good active management, then greed will take over.
People will look at the compounding of a superior active fund – superior active manager and they will see what they’re missing out on. And this is real money, this means that you can retire earlier. You can send your kid to college. You don’t have to work as long, all those things come in. And longevity risk, the risk that you’re going to run out of money, could be a real issue if people focus too much on managing cost and not thinking about the eventual outcome.
Gillian: All interesting points. So a unanimous decision that active management is poised for, not that it ever went away, but what some might call a comeback coming into 2017.
David Polak: Hopefully.
Gillian: Hopefully, okay. Paul, I want to switch over to you and talk a little bit about international flows. How have they affected the returns in valuations in the fixed income market?
Paul Grillo: Sure. It’s been the case once again and I keep coming back to this topic, markets influenced by central bank actions, what they’re buying, putting into their balance sheets and probably keeping for a long time. That’s creating incredible challenges for savers and savings institutions. And it’s been the case over the past few years now, especially in zones like Asia and Europe, where you have these savings institutions challenged for a good rate of return, return against their liabilities, more and more they’re trying to seek out the higher yielding parts of the globe. And those have been the U.S. because of a little bit better growth rates, and the emerging markets. So you’ve seen some tremendous flows come from both these lower yielding areas, Asia, Japan especially, and the euro zone. And these flows are entering these markets and many times keeping valuations on the rich side of fair, if you will. And it’s probably what’s baked into some of the pricing that we have right now. As I have discussed, we’re late innings in the credit cycle. Yet you have yield premiums once again that are a little bit on the rich side of what we see as a fair value or a long-term norm over many, many years.
Gillian: And surely we’ll see some massive currency impact as well.
Paul Grillo: Exactly, and that’s why one of the big dangers here in 2017 is going to be the speed at which you have dollar appreciation, because many of these flows are depending on some stability there. And as you’ve said earlier, many emerging market corporations have issued in the U.S. markets because they were very receptive to capital coming into U.S. dollar-denominated emerging market offerings. Those companies are going to be incredibly tested if we have a swift higher move in the dollar.
Gillian: Speaking of emerging markets, David, I know you look at them closely, are they still relevant after the stellar year that they had?
David Polak: Yeah, they’re definitely still relevant. One of the questions that we ask ourselves at American Funds is what do we mean by emerging markets? Emerging markets really came into being in the early to mid-’80s. The World Bank approached a number of asset managers, ourselves included, to put together funds and indices that would reflect this growth in what was then called the third world. They wanted to create an equity culture that would offset all the debts that the World Bank had into the third world. And when you look at how emerging markets and economies have developed since then that hasn’t necessarily been captured in how we think of emerging markets. If you were just to take the MSCI Index, China is a dominant part of that, if you would add Korea and Taiwan and maybe think about it as greater China, you have over half of the index is in greater China. We at American Funds would make the argument that Korea and Taiwan have moved on from being emerging markets. And so when we ask investors in our funds, “What are you trying to capture with emerging market exposure? Are you trying to get some kind of investment sort of travel agency?” What their answer is, “We’re looking to get access to the fastest growing economies on the edge of the world.” And our emerging market indices of funds are necessarily capturing that.
So there are big state-owned enterprises in places like China and in places like Brazil that have very slow growth, they’re very bureaucratic. Is that what people think they’re investing in when they’re making emerging market investment? Also some of the best emerging market opportunities, take health care, are available to multinationals selling drugs and healthcare services into places like Brazil and China, Indonesia, etc. So I think I’m right in saying that the MSCI Emerging Market Index only has 2% exposure to health care, whereas the world has 12%. And it’s those multinationals that are getting the benefit of rising standards of living, rising health care spending in places like China. So thinking about the emerging markets, you need to think about them in a flexible way we think. You need to have, and this is where active management comes back in because if you’re questioning exactly what it means, what you’re trying to capture, you need analysts on the ground doing the work with companies, because it’s about investing in companies, certainly in equities, not countries. And keep an eye on where the opportunities are and allow flexibility within your funds to invest either in multinationals or emerging market stocks, keep focused on valuation. Political risk is important, as we saw in Brazil, as we continue to see in Russia – I think it was in one of the slides – but it’s just part of the mosaic, it’s not the driving force.
Gillian: Okay. Frank, where are you seeing some opportunities in the small-cap market going into next year?
Francis Gannon: As we’ve been talking about, fundamentals matter again, earnings matter again. And we continue to think you’re going to find them in very economically sensitive and cyclical areas of the market going forward. It’s not going to take a lot of top line growth for these companies to continue to move going forward. So we’ve positioned our portfolios that way. We had positioned them that way during the previous corrections in the small-cap space. I do believe that safety is still an area of the small-cap space which is overpriced, as people have been positioned for anemic economic growth kind of into eternity. But I think where we continue to find opportunities are in the industrial area, boring technology companies, not the sexy part like the internet, you’re finding in financials. But not just within the banks, within the small-cap space, but capital markets businesses as well. And we’re staying away from some of those areas of the market that have really benefitted from the environment we have lived in over the past several years. So you don’t see us owning REITs and utilities. You don’t see us owning a lot of health care in this market. Health care has been an area of great growth over the past several years within the Russell 2000, and biotech in particular. But a lot of that area within small-cap space do not have any earnings. So we think you should keep a cyclical tilt in the overall portfolio. And that’s how we’ve positioned our funds. And they are clearly benefitting from the initial push post the election.
Gillian: Perfect, thank you. Paul, what sectors in the taxable fixed income market do you like going into 2017?
Paul Grillo: Sure. 2017 is going to be all about bond math really. So the fact that we’re moving towards higher rates is going to affect many of the high-quality markets. It’s likely to depress a lot of bond prices as we move higher in yields. The investment-grade corporate markets should do okay but we’ll have a depressing of bond prices there. Treasuries and mortgage-backed securities are going to underperform in that environment. You are quite likely to get better or more satisfactory returns in things like the traditional high yield bond market. You have a starting yield there of about 6½%. You’re likely to get a default rate that’s somewhat benign. We had a default little hill in 2016 with the energy. But for the past five months default rates are back to about 2½%. So a benign default rate should give you decent returns in high yield bonds. They’ll be less interest rate sensitive. You may see some mid-single-digit returns in that sector. And then the bank loan area is another area with a starting yield of about 6%, again much less interest rate sensitivity in that area since those loans float, and it’s a very credit sensitive area. So the low default rates should be a benefit for that area as well, mid-single digits is probably a return to expect in that area as well. The emerging markets which offer pretty attractive yields as well is going to be volatile. So you may get some good returns in some sectors of the emerging market areas, but it’s going to be volatile. And really you’re going to have to take a longer term view of your holdings in that area and do some risk management when you have political or economic risks that pop up.
Gillian: Okay. We are coming to the end of our discussion, so I want to give each of you an opportunity to offer some closing remarks to anyone who’s watching this program what you think that they should take away from it. David, I’ll start with you.
David Polak: Thinking about 2016 is a year where a period of quantitative easing, lower interest rates that have been in place since 2009, that period is making way for something else. And that something else at the moment feels as if it’s going to have more cyclical growth. There’s going to be more stimulative fiscal policies. And that means a reshaping of portfolios. It could be more focus on small caps. It could be more focus on value versus growth. And it could be more focus on international rather than the U.S. But investors should keep their eye on the long term, not really think about what 2017 is going to be. Are we going to see a sector rotation? Are we going to see risk-on, risk-off? Those feel like they’re phrases that are beginning to move into the past. They’re beginning to become history. It’s more of a focus on fundamentals. As Frank said, if some of these shifts that we’ve been discussing do take place or they have taken place, if they continue to pick up traction, there’s going to be much more focus on fundamentals. Which companies do well in this environment? Which are the battle hardened companies? Which are the valuations you should focus on? Stock dispersion as we move away from low interest rates and quantitative easing, stock dispersion which has been at all time lows, should begin to widen again. And stock dispersion is the difference between within a sector, the best returning company and the worst returning company. That then begins to make the case through results for active management.
Gillian: Great points. Paul?
Paul Grillo: Yeah. I think 2017 holds with the possibility of higher growth, with that you should see higher inflation expectations and a higher rate environment. The better prospects for growth should push us out into the late innings of the credit cycle as we have discussed, so you can be comfortable with exposures in the corporate markets. It should also give us an environment where we have less of an influence on the central banks in capital markets. It’s going to allow for more idiosyncratic events and it’s going to allow a better environment for active managers. So look for that in 2017, look for some depressed results in the high quality markets reacting to the interest rates and some better results in those sectors that can absorb interest rate increases.
Gillian: Wonderful, thank you. Frank, take us home.
Francis Gannon: So I think the thing that I take away from listening to this today is that 2016 represents an inflection point in a variety of different markets. In the small-cap market from our perspective, it was that transition from growth to value. And that happened before the election and is going to continue on after the election and into the next coming years. So I think from our perspective focus on value within the small-cap space. We are living in a world now where fundamentals matter once again, and in that particular type of world where hopefully we will see a return to a normalized environment. Now, we can all argue what normalized might be, but a more normal environment, perhaps from an interest rate perspective, perhaps from an access to capital perspective. And in that environment we think small caps should be positioned quite well in an environment where you see value particularly do well. So I think from our perspective in the small-cap space to stay active, find great businesses and own those great businesses for the next three to five years and I think the outcome is going to be quite exciting.
Gillian: Wonderful. Thank you so much for taking the time to share your expertise with us and we look forward to having you back in 2018, where you can gloat over how right you were in your outlook.
David Polak: Or in eight years’ time for the long-term investor.
Gillian: Exactly, thank you. Thank you so much for tuning in. From our studios in New York, I’m Gillian Kemmerer and this was the 2017 Outlook Masterclass.
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