INVESTING

Investors would do well to prepare for greater dispersion

Nov 20, 2019

Rick Rieder and Russ Brownback argue that – in contrast to the past decade of monetary policy lifting all economic boats at once – the years ahead are likely to be characterized by great dispersion between economies, industries and markets. Understanding that dynamic will be the name of the game for investment success.

For most people, the word “blob” conjures the image of an enigmatic green object that lacks a defined shape or size. But in the data-driven tech world, the word BLOB stands for “Binary Large Object,” a collection of binary data stored as a single entity in a database management system. “BLOBs” (as opposed to “blobs”) are used primarily to hold multimedia objects such as images, videos, and sound, though they can also be used to store programs or even fragments of code. As investors, we endeavor to avoid focusing on a blob of superficial themes and rather attempt to stay focused on the existence of the more modern and complex macro “BLOB” that consists of the deeper investment influences that truly matter today.

Indeed, the explosion of social media and rapid information dissemination seamlessly feeds the innate human desire to oversimplify complexity. Contemporary investors love to sum, benchmark, aggregate, and/or reduce a multi-faceted macro backdrop into comfortable portfolio solutions that miss important alpha-rich nuances. While these themes can be interesting, the conclusions can be meaningless and, at times, downright misleading.

Dispersion across economies and markets is critical for investors to consider

From a macro perspective, the U.S. has critical sectoral dispersion beneath the “GDP blob,” such as the increasing prominence of services sectors over goods sectors, investment in technology over physical capacity, and the resilience in housing versus cyclical (and political) constraints on exports. Dispersion also exists between real economy sentiment and actual economic activity, such that as survey data has deteriorated, production data has remained steady. Also, at the level of household net worth, there are divergent influences on wealth from house price appreciation versus financial market gains, which are quite stark and result in contrasting motivations that drive decisions to spend versus to save. Moreover, the subtle evolution in wage growth that is now dis-proportionally accruing to lower income households is a profound development with lasting macro implications. Similarly, the global economy has massive dispersion across regions and within both developed markets (DM) and emerging markets (EM), as a myriad of secular and cyclical influences collide with cultural, political and demographic diversity.

There is also massive dispersion across micro influences today. While the ongoing generic deceleration in corporate profit margins is an avant-garde narrative, margins still sit near a 25-year peak. And there is a demonstrable diffusion of actual margin performance across companies and sectors. For example, though information technology sector margins contracted a bit last quarter, they are still roughly twice as wide as the average of other sectors. And, while second quarter margins contracted for the utilities, materials, and consumer discretionary sectors, they expanded for the healthcare, industrial, and energy sectors.

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At the same time, splashy media headlines are created out of a false alarm over corporate leverage today. While there is little ambiguity that leverage has steadily ticked up the past few quarters, this simplistic analysis does not tell the full story. In fact, SPX index leverage, as of the end of last quarter, was around 2.6 times, but digging deeper it’s the more goods-oriented sectors that generally have higher leverage than the index average, while the services sectors have kept leverage at healthier levels. Moreover, gross-debt-to-free-cash-flow sits at a 25-year low while free-cash-flow margins are at all-time highs. Thus, in many respects, companies today are in better shape in their ability to pay down debt when needed, as compared with historical precedent. Further, much of the incremental debt growth over recent years has come from those very companies that hold tremendous amounts of cash on their balance sheets!

Many investors today look for investment success by positioning in generic factors or styles that history suggests will outperform at various points in the cycle. To wit, recently there was much focus on the violent bounce in the value factor vs. the growth factor, and some rashly concluded that markets were signaling a regime shift. To us, simplistic solutions, such as trying to identify “where we are in the cycle,” are incomplete analysis when taken in isolation. We’re convinced that generating return requires far more tactical precision. Specifically, evaluating the dispersion of cash flows and margins will be much more important to generating durable returns in the years ahead.

This is evident in equities today, where many indices have barely moved over the past 12 months, but a deeper dive into their component parts reveals significant performance dispersion (see graph). The same is true for the universe of credit assets. For what has broadly been a risk-on year, history suggested that low-quality spreads would have compressed versus higher-quality issues when in fact the exact opposite has unfolded. As we contemplate fourth quarter positioning, we hear overt and hyperbolic chatter about looming recession and how severe it is likely to be. But such superficial analysis misses the fact that while the growth outlook has clearly dimmed this year, it is hardly disastrous. The outlook is, at worst, a mixed picture with decidedly positive trends for consumption and services sectors against headwinds for manufacturing and industrial goods sectors that suffer from lingering trade frictions and the remnant impacts of the recent global policy tightening cycle.

Monetary Policy and the US Dollar

Yet suddenly, global central banks are easing again and while further policy rate cuts will continue to have a moderate positive impact on the global economy (save for negative rate policy, which we see as an unambiguous hindrance), global liquidity is now poised to return as the dominant positive macro influence. To us, the U.S. Federal Reserve’s policy posture has been the primary catalyst for broad U.S. dollar (USD) strength through both rate and balance sheet policy, and therefore has been exporting acutely restrictive monetary policy to already weakened foreign destinations, in both the DM and EM parts of the world.

Ubiquitous USD-denominated global trade financing leads to an outcome where marginal changes in global trade volumes are driven solely by the ebb and flow of USD funding sources, regardless of who the global trade counterparties are in any given transaction. Quite simply, a strong USD reflects tight credit conditions that are hampering global trade and exposing otherwise dormant vulnerabilities in the financial economy. That is all set to inflect positively going forward as new liquidity injections from both the Fed and European Central Bank can quickly reverse this onerous dynamic.

Investment implications

Putting it all together, we are becoming increasingly comfortable with incremental risk positioning during the fourth quarter, but we’re evolving to more of a “barbell” posture. Specifically, we like upside equity convexity, relative to pervasive negative sentiment, and think that corporate buybacks are still so powerful. We also like EM duration and foreign exchange, which is a sweet-spot asset class for a “liquidity-on” environment, and still offers compelling relative value. While we remain sanguine on the fundamental outlook for credit, we worry about the inability to transact at will in notoriously thin year end markets. We like pairing those with the USD as a hedge for the unlikely scenario that poor fundamentals transcend the nascent global easing cycle as well as the front end of the U.S. rates curve, which to our mind offers an asymmetric risk/reward profile, given the Fed’s pragmatism.

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