There are two kinds of people: Those who are prepared for elevated risks, and those who aren’t.
We were in London last week, expanding on our views for 2018 at our flagship conference for the EMEA region, “Solving for 2018.” Our theme was “The Good, the Bad and the Ugly.” Synchronized global growth and market momentum are “good” aspects of the current environment. The “bad” is that many years of central bank stimulus are ending. Evidence of market complacency we marked down as “ugly.”
Which do we view as more likely to play out in 2018? And how might investors prepare?
The Good
While the global economy will likely slow in 2018, we expect corporate earnings to continue growing. U.S. companies have a more favorable regulatory environment and tax reform, which should incentivize investment. In Europe, Japan and the emerging world, further earnings expansion can come from the uptick in growth and trade.
When we polled the audience, more than two-thirds were expecting economic expansion into 2019 or 2020. A similar proportion thought equities could be the best-performing investment category in 2018, and most of the rest picked commodities.
We go into 2018 broadly positive on equities. Our Asset Allocation Committee (AAC) prefers alternative investments to nominal fixed income and is positive on inflation-linked bonds and commodities as we anticipate rising prices. That seems consistent with our audience’s votes.
The Bad
The audience voted decisively for either rate hikes or inflation as the biggest risk for 2018.
Inflation went missing-in-action in 2017, but the 1960s showed how unemployment could fall for years with no effect on inflation until, eventually, a threshold is crossed. We expect that in 2018, but we also think the rise in inflation will be gradual. Linkers seem to us a reasonably priced way to hedge that risk. By contrast, investors are currently not being well compensated for investment grade bond risk, in our view.
The Ugly
With central banks behind them, markets have become complacent. Volatility is historically low; yields remain depressed and credit spreads tight despite rising leverage; equity valuations are not stratospheric, but we would describe them as full.
It has been 399 days since the last 5% drawdown for the S&P 500 Index and many believe we are due a correction. The catalyst could be an election result in Italy, Mexico or the U.S. midterms, uncertainty around NAFTA, a shock from central bank policy adjustments or a marked slowdown in growth—most likely in China.
It is true that markets have plowed through a series of shocks over recent years, but experience tells us that they ignore these things until they don’t.
The Prepared
How might investors prepare? In London, we discussed our AAC 12-month outlook and our view that the current economic and market momentum could continue through at least the first part of 2018. Should the first half play out as we anticipate, it could present an opportune time to begin positioning for higher inflation and adopt a more defensive profile.
Becoming more defensive does not necessarily mean substantially cutting back equities and credit. Instead, it could mean reducing equity-market sensitivity (perhaps by using alternatives such as low-volatility hedged strategies and put writing), improving credit quality (by considering emerging markets debt over U.S. high yield, for example) or seeking to take advantage of opportunities in less liquid strategies. Most importantly, we think it means recognizing that 2018 is unlikely to be a re-run of 2017.
As Clint Eastwood might put it, in this world there are two kinds of people: those who are prepared for elevated risks, and those who aren’t.
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Joseph V. Amato is President of Neuberger Berman Group LLC and Chief Investment Officer—Equities at Neuberger Berman. He is also a member of the firm’s Board of Directors and its Audit Committee. To learn more, see Mr. Amato's bio or visit www.nb.com.
Erik L. Knutzen is a Managing Director, and Multi-Asset Class Chief Investment Officer at Neuberger Berman. He drives the asset allocation process on a firm-wide level, as well as engages with clients on strategic partnerships and multi-asset class solutions. To learn more, see Mr. Knutzen’s bio or visit www.nb.com.
Brad Tank, Managing Director, joined the firm in 2002 after 23 years of experience in trading and asset management. Brad is the Chief Investment Officer and Global Head of Fixed Income. He is a member of Neuberger Berman’s Operating, Investment Risk and Asset Allocation Committees. To learn more, see Mr. Tank’s bio or visit www.nb.com.
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