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July, 2014
Global Economic Review & Outlook

Navigating Complacency in a Growth Regime

We believe:

The U.S. remains in the middle innings of economic recovery

Low inflation and accommodative monetary policy support measured global economic growth

We are increasingly optimistic about emerging markets near term and maintain a positive long-term outlook

Because the Great Recession was atypically severe, we are likely to see a lengthier recovery cycle

Equities and convertibles offer additional upside, with especially compelling valuations in growthoriented securities



Markets everywhere rebounded in the second quarter, as the snow melted in the U.S. and central banks globally continued to spew liquidity, pushing interest rates down. Corporate earnings continued to surprise on the upside, and nothing bad happened in Washington. The S&P 500 Index returned 5.2% (Figure 1), as investors continued to chase all yields—including earnings and dividend yields—down.

As we look to the second half of the year, we see continued upside for equities and convertible securities, particularly those of growth companies. Although the bull market is in its fifth year, we believe equity valuations are still attractive. While our long-term optimistic outlook remains intact, low market volatility and high investor confidence (Figure 2) suggest that the market has become complacent, which could contribute to short-term volatility and market rotation when something unexpected does occur. However, we remain confident that equities have more room to run.

Consistent with our positive outlook, we are focused on identifying a well-balanced breadth of secular and cyclical growth opportunities. In her recent testimony before the Senate Banking Committee, Federal Reserve Chair Janet Yellen warned of “substantially stretched” valuations in selected sectors, and we remain vigilant to the potential risks of securities with the highest price-to-earnings multiples. Many of the high-duration, high-growth equities that were sold off during the first quarter have gained back ground, as positive economic data emerged indicating that the first quarter GDP drop of -2.9% was temporary and largely weather driven. Nonetheless, these higher-growth companies may still be most vulnerable to vacillating market sentiment, which has led us to reduce some positions into strength. Looking longer term, we believe that many of the market’s near-term concerns should continue to dissipate with good economic growth and solid corporate earnings.

Market Review

After a first quarter characterized by rotational markets resulting from heightened uncertainty about the economy, investors increasingly embraced the idea of a not-too-hot, not-too-cold economic scenario during the second quarter. Market participants took the weatherinduced decline in first quarter U.S. GDP growth in stride, choosing to focus on better news elsewhere, such as continued growth in payrolls, the sustained rebound in auto sales, strength in manufacturing, brisk mergerand-acquisition activity, and all-time highs for corporate profit margins (Figure 3). Unlike the first quarter, when Chair Yellen roiled the markets with unexpected comments about a potential timetable for interest rate increases, the Fed’s communications during the second quarter focused on the need to keep rates low for a long time—and this consistent and transparent message seemed to soothe investors.

“We are focused on identifying a well-balanced breadth of secular and cyclical growth opportunities.”

Against the backdrop of brighter sentiment, the U.S. market continued to advance. The S&P 500 Index gained 5.2% (Figure 4) and reached a new high that was nearly three times its 2009 low. Convertible securities posted solid gains, performing in line with the equity market. Within the U.S. equity market, sector performance reflected a barbell effect, with both cyclical and yieldoriented sectors surpassing the index’s return. Energy led for the quarter (Figure 5), as the U.S. government eased export bans and geopolitical uncertainties pushed oil prices higher. Cyclically oriented materials and technology sectors also performed well. Meanwhile, investors’ quest for yield contributed to robust returns in the utilities sector.

Elsewhere in the developed markets, euro zone equities advanced, with the MSCI Europe Index gaining 3.7% (USD), supported by the core and periphery economies alike. Markets cheered the European Central Bank’s commitment to bolstering the region’s still-fragile growth through a raft of measures, including cutting euro zone interest rates on ECB bank deposits to negative real levels. In regard to Japan, investors were further encouraged by economic progress, with the MSCI Japan Index returning 6.7%.

While developed markets posted respectable gains, the emerging markets led the way. As U.S. interest rates defied widespread expectations and declined, appetite for the emerging markets grew as the carry trade returned to favor. The shadow of rising geopolitical tension in the Middle East was offset by enthusiasm elsewhere, such as the election of Prime Minister Modi in India, who ran on a platform focused on economic development. Investor optimism about emerging markets was broad-based, with rebounds that extended to economies with weaker balance sheets, including Brazil, Turkey and South Africa.

The 10-year Treasury bond continued to rally, as investors were undeterred by the Fed’s wind down of QE by year end and the likelihood of higher interest rates next year. We believe much of the global enthusiasm for Treasurys can be attributed to euro zone investors’ quest for yield. Due to accommodative ECB policy and declining risk premiums in the periphery, euro zone sovereign yields have dropped significantly, causing U.S. Treasurys to look even better by comparison (Figure 6).

Over recent months, an upsurge in global capital market activity has underscored the improving health of the global economy. Stock buy-back activity has been brisk, and merger-and-acquisition activity is at its highest level since 2007, helping to fuel market gains. A number of deals announced recently have broken from precedent, in that the acquirers’ stocks have often risen as much as those of the target companies.

Global convertible issuance has also been robust (Figure 7) and well diversified by sector. The first half of the year ended on a particularly strong note: June saw the second highest monthly volume and highest level in terms of deals in the past six years, according to Barclays. In addition to small and mid-cap companies, first-time issuers have been well represented, which suggests increased recognition of the merits of issuing convertible securities.


We currently estimate 2014 global GDP growth in the 2.0% to 2.5% range. A global backdrop of low inflation and slow economic growth should support accommodative monetary policy, which would benefit equities and equity-sensitive securities.

Some have pointed to the rising levels of debt to GDP as a threat to the global recovery. In our view, the debt level to GDP is a less telling gauge than a country’s interest coverage ratio, which has improved for many major economies in this lower interest-rate environment (Figure 8). For example, interest payments on the U.S. national debt have dropped significantly as a percent of GDP, falling to 2.3% in 2013 from more than 4% in 1996.

United States. In our view, GDP growth for the U.S. will likely be in the 2.5% to 3.0% range for the second half of year. We believe the U.S. economy is in the middle innings of its recovery, positioned for continued steady expansion over these next few years. We expect U.S. GDP growth to accelerate during the second half of 2014, as warmer weather, an improving job market, and positive wealth effects support the housing market and consumer spending. We believe global outsourcing and productivity enhancements can help support corporate profit margins.

However, while the 288,000 jobs added in June support our view of a strengthening economy (Figure 9), we believe we would need three or four more consecutive months where payroll growth exceeded 250,000 jobs before the U.S. economy would reach the “escape velocity” to achieve growth in the 3% to 4% range.

Because the Great Recession was atypically severe—impacting both consumer and business confidence more seriously than previous recessions—this recovery cycle will likely not be typical either. Unlike “normal” recoveries, which have tended to be in the range of five to seven years, we believe this recovery could extend several years longer, given the sluggishness of job growth in the recovery to date, lack of fiscal stimulus via tax cuts that normally act as stimulants, and very few inflationary pressures. Although the investment community and the Federal Reserve seem to have high conviction in the economy’s trajectory, that confidence does not appear as widespread among businesses and individuals. Ironically, this lack of confidence in the recovery may help sustain it. For example, we have not yet seen the rebound in capital expenditure spending that has been typical of late-cycle recovery. Although new orders of core capital goods and the percentage of corporations planning to increase capital spending has rebounded from recessionary lows, neither measure has taken off (Figure 10). A low interest-rate environment and attractive valuations are likely also helping to forestall a capital spending boom, as companies are finding it cheaper to buy instead of build. There’s considerable cash still on the sidelines of the market, as well.

Therefore, despite the gains we’ve seen in the U.S. equity markets since the 2009 low and over recent months, we believe stocks have more room to run. In addition to stock buy-backs and merger-and-acquisition activity, the equity markets are likely also getting a boost as investors’ ongoing quest for yield has pushed earnings yields down. Equity valuations are attractive according to a variety of our favored measures, including earnings yields relative to both Treasury yields and inflation (Figure 11). Based on a P/E for the S&P 500 Index of 16.7x 2014 earnings—equal to a 6.0% earnings yield—and a 10-year Treasury yield of 2.6%, the equity risk premia (the difference between the 10-year Treasury yield and the equity earnings yield) is currently +340 basis points. This level is within the cheapest quartile over the past 60 years. Valuations typically look stretched when equity premia drop below zero. If we use real earnings yields (reflecting an inflation rate of 1.8%), the current +420 basis point differential is in the cheapest 30th percentile over the past 60 years. Valuations typically look stretched when real earnings yields drop below +200 basis points.

We also maintain our view that the case for growth is especially compelling. Growth stocks continue to trade at relatively depressed price-to-earnings ratios versus non-growth stocks (Figure 12). At current levels, the growth premium is about 10%, despite long-term sales growth differentials that are approximately twice as high. Moreover, in every business cycle since the late 1970s (Figure 13), growth has outperformed value during the late stage of the business cycle, and as we have outlined, we do not believe we are yet in a latestage environment.

Additionally, although Chair Yellen recently spoke to the “substantially stretched” valuations the Fed sees in some sectors, the valuations of top-growers overall seem far from stretched by historical standards. During the 1999-2000 tech bubble, for example, the valuations of the top-growing stocks rose to more than 4.5x that of the average stock. Currently, the multiples of the highest growers (relative to the average) are essentially at their long-term average of 1.8x (Figure 14).

Euro zone. The euro zone recovery remains more muted than in the U.S., but it is a recovery nonetheless. Accommodative monetary policy and a “whatever it takes” approach from the ECB should be supportive to economic growth and risk assets, and spreads have converged between the core and periphery. We believe select segments of the European economy can also benefit from an improving U.S. economy and stabilization within the emerging markets.

The European recovery has also been uneven, and largely led by the United Kingdom and Germany (Figure 15). While the U.S. economy is benefiting from an energy renaissance (e.g., innovations in shale) and resurgence in manufacturing, the euro zone is not enjoying these tailwinds, with manufacturing data looking far less promising (Figure 16). Moreover, given its proximity to and reliance on Russia and the Middle East, the euro zone may be vulnerable to increased geopolitical risks. However, valuations remain reasonable and reflect the near-term outlook.

In this environment, we have been focused on sectors and industries that would benefit from asset reflation, including asset managers, real estate and associated industries, and select consumer discretionary industries that may benefit from a “wealth effect.” We’ve also found compelling prospects among industrial companies that are more global in scope and therefore less dependent on Europe alone.

Japan. The initial green shoots of Abenomics have surpassed our expectations. For example, the Japanese economy has been more resilient to the recent impact of the value-added tax than we had originally expected. Still, we are cautious: Despite the enthusiasm around Abenomics, and signs of inflation and GDP growth that exceeded consensus expectations (Figure 17), lasting structural reforms are in nascent stages. Significant challenges lie ahead, such as curbing a substantial trade deficit. We expect additional policy measures to be implemented later this year. Although the stimulus undertaken by the Bank of Japan has been massive so far, we believe Japan is still in the earlier stages of its quantitative easing, and we expect another round of stimulus that targets further asset inflation.

While remaining attuned to the broader challenges facing Japan, we have found select bottom-up opportunities, including in financial, industrial and consumer companies that may benefit from more stimulus and additional weakness in the yen. Our recent research trips to Japan have contributed to increased optimism around developments within real estate, manufacturing and automation.

Emerging Markets. Our near-term outlook on the EMs is becoming more optimistic and our long-term view remains positive. Structural reforms are occurring, and many countries have reduced their current account deficits and fiscal deficits. As the current election cycle has progressed, uncertainties have been reduced and the potential for reforms has increased.

Still, we expect continued volatility and uneven data from the EMs in 2014 and beyond. As we have discussed in past commentaries, EMs no longer share uniform growth, monetary policy and reform trajectories as they did in decades past. We believe this divergence is positive both for the global economy as well as for active investment managers. Selectivity will remain key.

Looking to the second half of the year, an improving global economy has removed some of the headwinds faced by export-driven emerging markets. In regard to EM bellwether China, we continue to believe that a slow landing is the most likely outcome for that country’s economy. Targeted stimulus measures, moderate monetary easing and seasonal effects have contributed to incrementally better data. We expect the government to continue to push forward with economic and market reforms; these may put downward pressure on near-term growth rates, but we ultimately believe these measures will support the soft landing scenario. The property sector remains the wild card in the Chinese economy—housing and land prices have soared over the past decade, with some analysts pegging housing market spending at more than 10% of GDP. Still, the relatively low leverage in Chinese households will likely help prevent a collapse. Overall, we believe that after underperforming during the first half of 2014, the Chinese equity market could outperform during the second half of the year.

“Our near-term outlook on the EMs is becoming more optimistic and our long-term view remains positive.“

In our past commentaries, we’ve discussed our preference for emerging market economies that have made considerable strides vis-à-vis economic reforms. We have an increasingly positive outlook for India and believe the prospects are good that recently elected Prime Minister Modi can have a long-term transformative impact on that economy. Near term, we are selective in our exposure given the significant rally we’ve seen in that market. We are also watching Indonesia with great interest, as presidential election results are tallied. If Joko Widodo takes the reins as we expect he will, we would view that as a decisive positive for that economy, with increased opportunities for investors.

Our emphasis on economic reforms has also led us to opportunities in Mexico and the Philippines. Mexican equity markets have recently lagged due to weak first half economic data (not unlike the U.S.) but more recent accommodative monetary policy, along with progress on key reforms and improved consumer sentiment should result in economic acceleration. We remain positive on the Philippines, although the rally we’ve seen during the first half of the year has reduced the opportunities we are identifying, on a relative basis.

In contrast, we are cautious about countries with current account deficits, such as Brazil, Turkey, Russia and South Africa. This skepticism put us at odds with market sentiment during the second quarter, as declining U.S. interest rates reignited the carry trade. However, with little progress being made on structural issues within these economies, we do not believe the recent rallies in these markets are sustainable. Moreover, our wariness of the Russian equity market is exacerbated by our view that depressed valuations do not fully reflect the macro risks facing Russia’s economy. We have found opportunities within current-accountdeficit economies on a bottom-up basis, but are seeking to mitigate the country risk through requiring particularly good risk/reward characteristics.

Strategies for a "Goldilocks" Environment

We believe that even in a bull market that has room to run, we should guard against the market complacency that could give way to short-term volatility. Accordingly, we are maintaining well-balanced portfolios that emphasize both secular and cyclical growth opportunities, while avoiding significant sector concentration. While we believe we have entered a growth regime, we are approaching the highest-growth names with added caution and have sought to manage position sizes by selling some of the highest P/E names into strength.

“We are encouraged by the trends we see in the global convertible market—increased issuance, declining redemptions and reasonable maturity, yield and premium attributes.”

The Treasury rally may continue for a while, given continuing choppiness in euro zone economic growth, accommodative ECB policy, and the heavy allocations that European institutional and individual investors have historically made to fixed-income securities. For example, Mercer reports that the average fixed-income allocation for institutions in many major European economies is more than 50%, with allocations in excess of 60% for plans in Germany, Norway, France and Spain. Still, we believe investors should be prepared for a ramp-up in rates beginning in 2015.

We believe convertible securities and alternative strategies, such as long/short equity, may be more effective than government bonds for addressing the potential risks of an overly complacent market. We are encouraged by the trends we see in the global convertible market—increased issuance, declining redemptions and reasonable maturity, yield and premium attributes—as well as by the likelihood for even more robust issuance in the second half of 2014. We are approaching the most equity-sensitive convertibles with care, as we do not wish to sacrifice the downside protection that more balanced convertibles may offer. And in regard to alternatives, long/short equity strategies may provide advantages for capitalizing on the equity upside, with potential resilience should the markets experience bouts of short-term turbulence.


We are confident the five-year bull market has considerable upside remaining. The global economic recovery should continue, fueled by low inflation and a “not-too-hot, not-too-cold” economic environment. Central banks have flexibility to delay interest rate increases until economic growth more firmly takes hold.

Growth stocks look inexpensive relative to nongrowth stocks, and we believe we have entered a growth regime. Since the 1970s, growth stocks have typically led the market during the late stage of the business cycle, which we believe lies ahead of us. We expect interest rates to begin rising in 2015, creating significant headwinds for government bonds. Convertibles and alternatives may provide welcome resilience to rate increases, along with the opportunity for upside equity articipation.