Question and Answer with Jeffrey Phlegar, Chairman, Chief Executive Officer

Q: 2019 started as an extraordinary year with double-digit market gains in the first half, which quickly turned to panic selling and a spike in volatility, as a prolonged trade war with China seemed increasingly likely. Markets have stabilized more recently, as trade war risks appear to have attenuated. What are your clients saying and what are their concerns?

A: Clients remain very concerned about hitting return targets and the transition to less liquid asset classes (i.e. private credit) continues in the hope of achieving those targets. Hedging costs remain a headwind for European investors of dollar-denominated products, and we have seen a reduction in USD exposure.

In the United States, growth continues to decelerate after a strong 2018, towards a pace that is closer to its underlying trend rate of 1.75–2.00 percent.1 The key question is whether a weak manufacturing sector will impact the services side of the economy, aggregate hiring, and consumer spending. So far, these spillovers have been relatively modest. In fact, the consumer has held up extremely well. But much will depend on the trade conflict with China, whether policy responses abroad will be sufficient to support global growth, and how aggressively the Fed acts in the face of these issues.

Even if the trade war with China moves into detente and global policy easing supports growth, the US is still late in the economic cycle. This does not necessarily mean a recession is imminent, but it does mean there are a couple of imbalances that make the economy vulnerable to any sort of shock. One key vulnerability is the labor market, which is quite tight, resulting in rising labor costs that will continue to weigh on corporate profit margins. The overall level of corporate debt is a second vulnerability, which looks a bit more worrisome after significant downward revisions to recent years’ corporate profits in the national accounts.

Q: The near-term state of the global economy and the overall level of interest rates are two of the chief preoccupations of investors today. It seems as though even economists can’t agree on where the economy is headed. What is your perspective on the health of the US economy and how should investors think about the prospects for interest rates in the future?

A: The absolute level and trend for global interest rates remain a source of intense debate. The FOMC continues to discuss new options for its policy toolkit aimed at fighting low inflation and providing more policy space in future downturns. But it is quite possible that structural trends will keep global risk-free rates quite low for many years to come; that is, not just “low for long,” but “low forever.” As we see it, there are a number of structural factors that may continue to exert significant downward pressure on interest rates, including;

- An aging population leading to excessive savings and muted growth in the work force.

- Low productivity growth, which given recent trends in investment spending is unlikely to change anytime soon.

- Demand for safe assets, partly due to regulatory changes (such as bank liquidity requirements) that incentivize or compel holding of government bonds (the original “financial repression”).

The common thread to the above factors is that they all lead to excess savings relative to the demand for investment. This is what lowers the equilibrium interest rate that is consistent with trend growth. The economy may chug along at a roughly two percent pace over the longer run, but achieving this might only be possible with a much lower term structure of interest rates than in the past.

Q: With economic and earnings growth slowing in the US, how should investors weigh valuations for US equities?

A: Within equity markets, the US equity market has outperformed international markets over the last six years, and the momentum money has remained in the US. The US market is now trading at 17x earnings, based on earnings estimates for the next 12 months (as measured by the S&P 500 Index), representing a 30% premium to the MSCI ACWI ex US PE of 13x. While part of that premium can be explained by the higher weighting of Technology and the lower weighting of Financials in US indices, roughly 80% of the premium is due to US stocks in each sector trading at premiums to their foreign counterparts.2

One could argue that being domiciled in a stronger economy warrants a premium, but it is worth noting that many US companies derive a significant portion of their revenues from outside of the US, while many international companies derive a meaningful portion of their revenues from the US. So growth expectations should converge.

The other noteworthy valuation disparity we see is between growth stocks and value stocks. While international growth stocks have historically traded at a 35% premium to international value stocks, that premium has now reached 80%.3 There are a few reasons for this:

- As most investors feel that we are in the later stages of the economic cycle, they are reducing their exposure to cyclical stocks and increasing their exposure to stocks of companies whose earnings can continue to grow, even in a more challenging economic environment.

- Investors are reducing their exposure to manufacturing-oriented companies, which must redesign their supply chains to cope with new tariffs.

- Lower interest rates are causing yield-oriented investors to shift assets into the equity markets, especially into the stocks of companies with secure and rising dividends.

Q: Many investors are concerned with the high level of leverage in the corporate bond market and the likelihood of seeing massive downgrades in the BBB segment of the market. Can you shed some light on this?

A: With respect to the US fixed income market, investors are concerned with the high level of leverage in the corporate bond market and the likelihood of seeing massive downgrades in the BBB segment of the market. To put this into context, non-financial BBBs with leverage of greater than 3.0x have estimated outstanding debt of $822 billion. In June 2007, that number was $116 billion. “Weak BBBs” as defined by the agencies currently total almost $700 billion. The agencies ultimately determine whether a company is downgraded. Prior to the previous recessions, fallen angels were highly correlated with weak BBBs 1-year prior. Based on this relationship and the face value of debt levered greater than 3.0x ($822 billion), we would not rule out approximately $700 billion of debt being downgraded as part of the next recession – this would be 25+% worse in terms of the downgrade experience than the early 2000s and GFC experience.4

Q: If we expect economic uncertainty and market volatility to persist, what can the average investor do to build more resilient portfolios? Are the traditionally defensive strategies worthwhile as they become more crowded/ expensive?

A: We believe investors should avoid the temptation to reach for the extra-yield in the absence of sufficient compensation for the additional risk. In addition, we fade cyclicals to look to non-cyclicals and consider moving up in the capital structures. Consumer credit vs. corporate deserves consideration as a high grade alternative.

In sum, we continue to encourage investors to focus on the long-term, as market timing is incredibly difficult. Overall, maintaining some dry powder at this point in the cycle may be prudent, and opportunistically being a buyer in periods of weakness can benefit investors who maintain a long-term view. While growth is slowing, we feel a recession is not imminent, and the propensity for a 2008-like financial crisis appears limited. But most importantly, examine your overall risk and make sure it is still in line with your goals and expectations.

1 Source: MacKay Shields

2 Source: Factset, MSCI USA Index as of 8/31/2019

3 Source: Factset, MSCI ACWI ex US Index as of 8/31/2019

4 Source: MacKay Shields, Bloomberg. Bank of America Merrill Lynch. Based on the ICE BofA ML Global Corporate Index using only the BBB Nonfinancial component. GFC: Global Financial Crisis

It is not possible to invest directly into an index. Past performance is not necessarily indicative of future results.

INDEX DESCRIPTIONS:

S&P 500 INDEX

The Standard & Poor's 500 Index (S&P 500) is an index of 500 stocks seen as a leading indicator of U.S. equities and a reflection of the performance of the large cap universe, made up of companies selected by economists. The S&P 500 index is a market value weighted index and one of the common benchmarks for the U.S stock market.

ICE BOFA ML GLOBAL CORPORATE INDEX

ICE BofAML Global Corporate Index tracks the performance of investment grade corporate debt publicly issued in the major domestic and eurobond markets. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date and a fixed coupon schedule. Qualifying currencies and their respective minimum size requirements (in local currency terms) are: AUD 100 million; CAD 100 million; EUR 250 million; JPY 20 billion; GBP 100 million; and USD 250 million. Original issue zero coupon bonds and pay-in-kind securities, including toggle notes, also qualify for inclusion. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. Contingent capital securities (“cocos”) are excluded, but capital securities where conversion can be mandated by a regulatory authority, but which have no specified trigger, are included. Other hybrid capital securities, such as those issues that potentially convert into preference shares, those with both cumulative and non-cumulative coupon deferral provisions, and those with alternative coupon satisfaction mechanisms, are also included in the index. Equity-linked securities, securities in legal default, hybrid securitized corporates, taxable and tax-exempt US municipal securities and DRD-eligible securities are excluded from the index. Index constituents are market capitalization weighted.

MSCI USA INDEX

The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market. With 637 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US.

MSCI ALL COUNTRY WORLD EX-US INDEX

The MSCI All Country World ex-US Index (the “MSCI ACWI ex-us index”) is a market-capitalization-weighted index maintained by Morgan Stanley capital international (“MSCI”) and designed to provide a broad measure of stock performance throughout the world, with the exception of U.S.-based companies. The MSCI ACWI ex-us index includes both developed and emerging markets.

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