The U.S. is finally enjoying a self-sustaining economic recovery, but slow global growth remains a concern and financial markets are bouncing up and down by the day.
So what exactly does this U.S. recovery mean for investors?
The financial crisis has left us with a more complex investing landscape. Even with the October sell-off, risk assets have had a good run in the past few years. The U.S. is pulling ahead of Europe and Asia, which are struggling to maintain their current rates of growth or in some cases to grow at all. And with an overhang of debt globally, central banks in Europe and Asia will need to maintain easy monetary conditions, while the Federal Reserve, even as it begins to normalize rates in the U.S., will move very gradually and will certainly consider current market volatility.
This is an unusual configuration – and very far from a typical economic recovery picture. But we believe the lack of synchronicity in the global economy will create some of the most compelling investment opportunities over the next year.
Looking across borders
Perhaps the most significant implication: After a decade of weakness, the U.S. dollar is strengthening. While this is likely to be a trend over the next several years, we would actively overweight the dollar versus different currencies at different times; right now, we think the dollar will continue to do well against the yen and the euro, as well as the Australian dollar.
Cross-market opportunities in general should only increase in the near future. As the markets grapple with uneven growth from different regions and countries, we expect to see mispricings and occasionally overshoots, creating lots of opportunities for generating alpha within investment portfolios.
With easier monetary policy in the eurozone, Japan, China and many emerging markets, we expect plenty of liquidity in the marketplace. Broad market liquidity facilitates portfolio liquidity, allowing investors to allocate a portion of their holdings to cash or cash-like instruments that they can deploy when markets correct, such as we saw last month.
We think that policymakers will ultimately be successful in raising inflation expectations and, to a degree, raising inflation itself, so inflation-linked securities appear attractive over the longer term. We believe inflation-protected securities in the U.S. and Europe represent especially good value, with inflation expectations priced into these securities at only 1.5%–2% in the U.S. and less than 1% in Europe for short to intermediate maturities.
Low policy rates have also created attractive opportunities in countries where growth and balance sheets are relatively healthy. Mexico, for example, has one of the steepest yield curves in the world right now, anchored at the short end by the policy rate of 3%, which raises the potential for capital gains in the local bond market. In Brazil, given the re-election of President Rousseff, the market is turning its attention to a much-needed reform agenda. Considering Brazil has the highest real and nominal rates in the world, there are large opportunities for investors as the policy mix is altered in the years ahead.
Have risk assets had their run? With interest rates likely to remain low and liquidity ample, we expect risk assets, including the credit sectors of the bond market, to continue to benefit for some time. With valuations already healthy, however, strong bottom-up analysis is more important than ever to identify companies with the potential for tighter yield spreads. We focus our bottom-up credit analysis on identifying industries globally with some combination of pricing power, compelling growth prospects and barriers to entry: Such industries include healthcare, lodging, Asian gaming, pipelines, wireless telecom, cell towers, satellite, media and U.S. banks.
As always, we see opportunities in mortgage-backed securities. The non-agency mortgage segment is one of the cheapest credit sectors now, and as the Fed winds down its purchases of agency securities, they may underperform non-agencies.
Deal us in
The combination of uneven economic growth and low interest rates in much of the world means that market returns will probably be modest in the coming months and, in our view, for the next several years. To meet investment goals, achieving above-market returns by generating alpha is crucial.
Clearly, investors haven’t been dealt a perfect hand with the latest U.S. recovery. Investors can sit on some cash, but we believe being entirely on the sidelines is not a sensible option. There are opportunity costs to holding cash. The unique nature of the recovery and the current global dynamics are creating tremendous opportunities. With an understanding of the nuances of the macro picture and rigorous bottom-up analysis, investors have the opportunity to play this hand very successfully.