Challenges Ahead

by Eric Knutzen, CIO, Multi-Asset Class, Neuberger Berman

The events and data of recent weeks make us want to err on the side of caution.

Our Asset Allocation Committee’s quarterly Outlook will come out this week, and the headline is that members see a return to “two-tier growth.”

The last time we used this phrase was in the middle of 2018, when tax and fiscal stimulus propelled a faster rate of growth in the U.S. relative to the rest of the world. Once again, we believe the U.S. is experiencing better growth than other developed countries. This time, however, we expect U.S. growth to stabilize at a modest level of around 2%, diverging from Europe, Japan and parts of the emerging world as they endure a sharp manufacturing slowdown.

The U.S. Holding Fast

Since the Committee met in late September, economic releases have reinforced the theme.

The Markit Eurozone Manufacturing Purchasing Managers’ Index (PMI) data for September showed the sector in a meaningful contraction, taking us back to the dark days of 2011 – 12, when jobs were cut at the fastest rate in more than six years.

A week later, we learned that Germany’s factory orders had declined again in August. That raised fears of a technical recession at the heart of Europe after Germany posted negative GDP growth in the second quarter of the year.

Things look to be on a surer footing in the U.S., even if the picture is far from rosy.

The U.S. manufacturing index reading for September from the Institute for Supply Management (ISM) was shockingly poor. The survey panel for that index, however, is tilted toward large, multinational companies. By contrast, the more domestically sensitive Markit U.S. Manufacturing PMI showed a marked recovery from the 10-year low that we saw in August. A mixed, “Goldilocks” non-farm payrolls report a few days later confirmed the impression of an unspectacular but steady economic path forward.

Overall, the underlying story is the U.S. is holding fast while the rest of the globe endures a worsening slowdown.

Amplified Volatility

Accordingly, the Asset Allocation Committee upgraded its view on U.S. markets versus the rest of the world’s—but that regional preference should be taken in the context of a negative overall view on global equities. We do not currently anticipate a U.S. or global recession before the end of 2020, but the background of slowing global growth, seemingly full equity valuations and $15 trillion of bonds trading with negative yields make it difficult to take a positive view on any major asset class.

From a fundamental standpoint, upside in equities will require either significant multiple expansion or an uptick in global growth that works its way into earnings. The coming earnings season is expected to report a year-over-year decline and only modest year-to-date growth, however, and few expect much better next year.

Even if the economy surprises on the upside, several political and geopolitical risks are likely to amplify market volatility over the coming months. The U.S.-China trade dispute looks likely to be a source of uncertainty for some time. We are all strapping ourselves in for a bumpy U.S. election year with an impeachment inquiry underway. Brexit crosses another threshold this weekend. The heat is rising again in the Middle East. Debate over central bank policy is becoming ever more politicized.

Market Risks Skewed to the Downside

Looking at all of these factors, for the first time during the current expansion, the Asset Allocation Committee has taken a favorable view on holding cash, as it has downgraded its views on global equities and government bonds. Positive views are limited to specific pockets of value, such as U.S. small caps, better quality high-yield bonds and loans, and inflation-protected securities.

Otherwise the Committee is focused on hedged and uncorrelated strategies, where returns can be generated without high exposure to equity and interest rate risk, and private equity, where full valuations could be somewhat offset by operational improvements to underlying businesses.

As this cycle matures and market risks become skewed to the downside, we believe it is an opportune time for investors to err increasingly on the side of caution.

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