Buying time to build resilience

Mike Pyle: Our outlook for the remainder of 2019 has three key themes, first is what we call “Protectionist Push” and that’s really about the tensions between the U.S. and China in particular taking center stage. And there will be ebbs and flows, days of good news, days of bad news, but we really do see a pretty profound change in temperature in that economic and technological relationship. We think that is going to be with us for a long time and have profound implications for global economics in markets. Our second theme is “Stretching the Cycle” And in response to the uncertainty that we’ve seen coming out of geopolitics, we really do see a meaningful pivot from the world’s major central banks, the Fed and the ECB in particular. That pivot to a more dovish policy we see as underwriting the expansion and we see as a result of that, growth continuing for some period of time ahead. Our third theme is “Raising Resilience.” And investors need to be building resilient portfolios both against short-term risks as well as longer-term risks, be it climate change or what we talked about here, emerging and persistent geopolitical tension. The important thing is that with this shift from central banks and the extended cycle that we anticipate, it’s given investors an important window of time to build that greater resiliency into their portfolios.

In terms of how these themes flow through to our investment views for the remainder of 2019, it’s a nuanced message. On one hand, as we talked about, rising geopolitical risk around trade means that uncertainty is up. Prices have moved a long way too, and so overall we want to dial back portfolio risk. At the same time, with the pivot that central banks have made towards more accommodation, extending the cycle, it’s still an opportunity to bear risk, to seek selected places where we can seek return. We think that is centered in U.S. equities, even with the price run up this year, still reasonable valuations, and in U.S. credit and elsewhere, emerging markets included, an opportunity to generate yield in what we see as a relatively stable way. For U.S.-based investors, that means in the shorter term, somewhat increasing their allocations towards cash to be sure that as any shocks emerge, portfolios are resilient. Over the medium term, still viewing U.S. Treasuries as having an important stabilizing role in portfolios.

Phillip Hildebrand: Tom, from your perspective, what is unique about this juncture, both in terms of the economy but also how politics interacts and plays into the economic outlook?

Tom Donilon: Yeah. I think a couple things are unique. Number one, we do have an unusually large number of volatile and unstable situations in the world, and they aren’t all worst case scenarios, but there are a large number of them that have to be considered by markets. Second, I think we’re in a different stage in terms of the world order. The post-Cold War period has ended. We’re in a new phase at this point where you have a number of players, including obviously China is a big player right now. Third, I think the relationship between economics, technology and geopolitics is quite unusual. We see that in the competition that has developed between the United States and China over technology issues, which are really driving a lot of what’s going on between the two countries in terms of the interaction. And of course, we have the trade situation right now, which is one of the principle threats to the economic order.

Phillip Hildebrand: When we heard initially at the inauguration, the president articulated the America First Strategy, you couldn’t quite figure out what it meant today. It looks certainly from when I look at it from Europe or Asia, when I travel, when you look at it from outside the United Sates, it looks more and more that what this really means is the U.S. is exporting fragmentation, volatility, and these are all things that are very new. If you think of the post-war order, the hegemon so to speak has always been as a stabilizer, as a guarantor to some extent to the rules, of course with some enlightened self-interest in mind. Is this really a completely new game that we’re entering here?

Tom Donilon: It’s a very different approach. I think what we’re seeing right now is the implementation phase of the America First Policy that was put forth by President Trump. And it is a departure in a lot of ways as to the way the United States has conducted themselves with respect to alliances and trade, most directly international agreements, international institutions. So we are in a different phase here within the implementation of this. It’s most clear in the trade area, where today, the United States, I think it’s fair to say analytically as a matter of fact, is in trade disputes with most of its major partners around the world simultaneously. And it’s using a number of tools right now to press its case. And they’re unusual, especially tariffs, and a number of steps that have been taken that have typically been reserved for adversaries, right, during the Cold War. President Trump is undertaking to use these tools to impress the economic case for the United States in an unusual, and in some cases, unprecedented way. So yes, I think we’re seeing something different. I think we’re seeing the implementation of an America First policy, I think it is different in the way the United States has approached a number of key issues in the last 75 years, and it’s been disruptive, there’s no doubt about it.

Phillip Hildebrand: And of course, the key question will be, how does this impact market pricing? I think we have to assume that there is some sort of risk premium across all of this, on the other hand of course, investors are focused on the reelection campaign that is about to get going in earnest in a couple of weeks’ time. There is a Federal Reserve that’s back in play with potential interest rate cuts. So we have essentially countervailing forces that are going to make it very challenging to have a clear sense of how we should think about the implications.

Tom Donilon: A lot of different vectors, I think, a lot of different vectors. We do have an election coming up in the United States, and I think that the right analytical tool when you look at Washington right now, is trying to determine which way one of the parties is going to go is through the 2020 electoral lens, I think that is what is going on in the United States. And we’ve already had the election kick off in the United States with debates in the last week in June among 20 something Democrats. Second, we do have again, an aggressive trade policy which has to be considered by the markets. And we’ve seen that the president is engaged in yes, China, and I think the market thought that would be the principle focus, but he’s also engaged in other places and willing to use the tariff tool with respect to Mexico, and a non-tariff, non-trade arena, in order to pursue a policy of a political goal: that is unusual for a president of the United States, and I think that is going to continue. I think essentially what is happening is that President Trump’s approach to foreign policy has come into sharp relief. I think we now have a sense of his style, his approach, his goals, and I think we are going to continue to see that for the remainder of his term whether that’s through 2020 or thereafter. I think this is the Trump approach to foreign policy and economic policy.

Phillip Hildebrand: The big risk of course, is that this could undermine the very fabric of the global economy and really damage growth potential in the long term, potentially having effects on inflation in terms of higher prices as a result of it. So this would be a very unpleasant combination based on lower potential growth and higher inflation as a result of this fundamental questioning of the economic order. But just to finish, do you see a risk here tearing at the fabrics of the global economy that could lead to lower potential growth and higher inflation over time?

Tom Donilon: I do see the risk. There is a risk that in achieving short-term narrow goals if you will by the United States in the trade area for example, it could be through the approach risking the health of the overall system going forward. The United States at this point is not a strong supporter of the WTO system or the international free trade system generally; it’s seeking in many ways to upend that system and to, as I talked about, to interact in a transactional way with allies around the world. So the risk is yes, achieving some short-term goals, but the price is, when the United States steps back from leading that system, what happens? The system does start to fray, bad behaviors emerge throughout the system, but most importantly, I think when there is a crisis, if you don’t have a leader in the international system—for example, as we did in 2009--

Phillip Hildebrand: Yeah, I saw firsthand what happens in a crisis, how important that US leadership was.

Tom Donilon: And so that is the question: if you don’t have that leadership, if you haven’t built up these habits of cooperation and worked on the same values and outlooks, in a crisis, you can have grave difficulty which was really important in 2009, and you’re very familiar with this, that the United States was in a leadership position in working in a cooperative way with the world to address the crisis. It really made all the difference in the end.

Phillip Hildebrand: Thank you very much.

Tom Donilon: Thank you, Philipp.

Rupert Harrison: Okay Elga, so we’re half way through the year, it’s been a pretty volatile year already for investors. We’re talking about regime change and getting portfolios ready for regime change. What do you mean when you talk about regime change?

Elga Bartsch: Yeah. So regime change can mean one of two things. One is a regular regime switch that would be from a low volatility to a high volatility regime, so basically allows you to go back and forth between two states of the world and you can go back to how things were. But there is also the possibility of more radical regime change which basically changes more fundamentally the underlying system, the characteristics of it, and it means that you’re most likely not going back to how things were.

Rupert Harrison: I’d say I guess what is a little bit more difficult is thinking about when you can tell the difference between a regular regime change and a radical regime change is thinking about some of the different challenges we’re facing from US trade policy for example. Are there any signposts for you that would help us to distinguish between what is a regular regime change or whether we’re seeing the beginning of something more radical?

Elga Bartsch: One aspect I think is to constantly test the assumption of mean reversion, so whether you could really still think that you are in a stable environment. I think the minute you are starting to see developments that look very much like an escalation, that could be described as non-linear and where you really feel that tectonic plates are shifting. And I do think that what we are at the moment seeing in trade policy could be that, because it could mean that a lot of working assumptions on the global economy, deeper integration, leveraging scale, seamless technology, just-in-time management and all the benefits of globalization could potentially be on the line now. So--

Rupert Harrison: So this is something we have been thinking a lot on in the last months, particularly since in May we had Donald Trump’s tweets about the US/China deal setting off a whole new level of concern. I think there is an interesting debate about if this is a radical regime change where we’re really getting de-globalization, we’ve had maybe 30 years of maybe one directional movement to more integrated supply chains, lower trade barriers. If this is really going to reverse long term, what are the implications for the macro regime and for us as investors? And I think that one of the big debates is - Is this inflationary or deflationary for the world? And certainly what we’ve seen so far in the last few months is that it’s a deflationary: We’ve seen bond yields falling very dramatically around the world, we’ve seen growth fear rising, and for me, I think that is something probably that will last a little bit longer, because really this is about lower growth, even though tariffs can lead to an increase in prices short term, we can see cost shocks, low productivity growth. And in the end, this is a growth story. Is that something you’d agree with?

Elga Bartsch: Well, I would actually say that deglobalization will eventually lead to less growth and higher inflation pressures, because you are forced on to a less efficient production structure. Because you will need to move your production facilities around just to avoid the tariffs, and it’s no longer the most efficient structure. And I think if you look back over the last 30 years, on the benefits from globalization, clearly disinflation was one of them. And a material rise in profit margins was another one. And I think a lot of that speaks to a material decline in unit labor cost. So this could be unwound--

Rupert Harrison: But is there a difference between—I completely agree that higher costs, less globalization can hit corporate profits and that can definitely be a risk factor for equities.

But when we think about bond markets and inflation, we’ve seen cost shocks before; we’re familiar with for example an oil price shock that raises the price of oil; we’re familiar with the fact that central banks can look through those kinds of shocks, they don’t necessarily have to raise interest rates in response. And they haven’t set off a kind of spiral of inflation like we’ve seen a long time ago in the 1970s. Why should this be any different in terms of a cost shock compared to for example an oil price shock?

Elga Bartsch: Yeah. So I think first of all, of course at the moment, inflation expectations are well anchored. If anything they are below what central banks would like them to be at. But I think a key point is that currently the global economy is at full employment in many key important theatres like the U.S., it’s above full employment. And that I think increase the risk of this one-off cost shock from the tariffs like an oil price shock, creating second-round effects in prices and wages, and thus setting into motion. So the irony of this could be whether central banks, with all the stimulus that they have implemented, didn’t get inflation back to targets--

Rupert Harrison: Tariffs can do the trick. I guess one counter argument would be we’ve been thinking inflation was about to take off for some time now in this cycle. We see the unemployment rate in the U.S. continue to be dropping, haven’t seen that inflation being generated; we certainly don’t see that happening in the eurozone or many other parts of the world. So I guess I feel like maybe we need to see proof that this can happen before we start shifting portfolios to prepare for something that, at the moment, is quite theoretical.

Elga Bartsch: Yeah. But I think it’s important to already think through this because if we really had stagflation and some of the correlations and diversification strategies between equity and bonds would no longer work, because clearly the bond market, which at the moment, prices in a lot of Fed easing with very little inflation, looks vulnerable, whereas equities might actually be marginally better able to navigate.

Rupert Harrison: I guess what gives me a little bit of comfort is that if we’re still talking about a world where most of the shocks are going to come from concerns about growth, that’s probably a world where that negative correlation is going to help diversification in portfolios. But I think you’re exactly right that we need to think about scenarios where it doesn’t work, because it’s much harder to find sources of diversification.