Investment Outlook

Q4 2018 CIO Roundtable: Building Defenses to Withstand Volatility

Introduction

For quite some time, we’ve observed the world’s central banks pursuing divergent fiscal policies as local economies recovered from the 2008 financial crisis at their own pace. However, even with these differences, global economic growth was steady (though slow) and synchronized. In that environment, investing was less challenging as rising growth rates lifted all markets. As the global economic growth cycle matures, we expect more divergence between major economies worldwide. In 2018, we’re experiencing economic divergence among developed markets as growth in Europe moderates while the U.S. enjoys something of a second wind fueled by unprecedented corporate tax cuts.

Signs of economic divergence reinforce our view that it’s time for investors to expect—and prepare for—periodic bouts of volatility, which is normal.

Some of those signals are coming from emerging markets. EM were already experiencing a challenging year when a series of damaging political and policy decisions sent Turkey’s currency and financial markets into a tailspin. Meanwhile, Argentina struggled with mounting debt, causing the peso to plunge. Contagion fears fueled sell-offs in other countries and dampened investor enthusiasm for riskier assets.

Global trade tension is another potential source of volatility. So far, trade disputes have affected soybean farmers along with steel, aluminum, automotive, and electronics companies. There’s a lot of bluster from all the parties, so it’s hard to differentiate between negotiating tactics and trade policy. We can’t predict whether there will be a prolonged trade war or the outcome, but it’s hard to imagine a clear winner.

None of this is to suggest that investors should be fearful. To us, economic divergence and volatility are simply reminders of the importance of applying research and judgment to investment decisions. Active selecting of asset classes, countries, and industries as well as individual securities based on research and analysis will be more valuable as the growth cycle matures. In this environment, we believe market performance will be less synchronized across regions, countries, and industrial sectors. 

Now, with the slow withdrawal of monetary and fiscal stimulus and rising interest rates and trade tensions, investors and markets will be more selective, placing greater emphasis on the fundamental attributes of individual securities. This is the time to actively identify compelling forward-looking opportunities and build defenses to withstand a changing market environment and return of normal volatility.

Thank you for investing with us.

G. David MacEwen

G. David MacEwen

Co-Chief Investment Officer

American Century Investments

CIO, Global Fixed Income

 

Victor Zhang

Victor Zhang

Co-Chief Investment Officer

American Century Investments

  • Global Macroeconomic Outlook
  • Global Equity
  • Global Fixed Income
  • Multi-Asset Strategies
  • Key Takeaways
First Topic

Global Economy: U.S. growth outpaces other markets

Reforms Stimulate U.S. Economy

We expect the U.S. economy to continue expanding at a healthy, sustainable pace, largely due to the still-unfolding effects of tax and regulatory reform. We believe this fiscal stimulus will support capital spending and employment and should keep annualized gross domestic product (GDP) at the high end of our expected range of 2% to 3%.

Global Slowdown Fears Are Fading

With growth modestly improving in Europe and Japan, fears of a significant slow-down outside the U.S. have subsided. However, European and Japanese growth rates continue to lag U.S. GDP, and central bank stimulus continues to drive economic gains in those regions.

Emerging Markets Outpace Developed Markets 

We expect global GDP to advance approximately 4% in 2018, with EM expanding faster than developed markets. Like past years, accommodative monetary policy will primarily drive global growth, as significant fiscal expansion (outside the U.S.) remains unlikely. Trade tensions and geopolitical issues remain potential headwinds.

Second Topic

Inflation: Global inflation edges higher

Energy Prices Fuel Gain

Global inflation recently hit a four-year high, topping 3%, largely due to soaring energy prices. Excluding the volatile energy and food segments, though, worldwide price gains have been more subdued, which is keeping the core rate of global inflation near a more-modest 2%.

Growth Lifts U.S. Inflation

We believe the strong U.S. economy, tight labor markets, robust corporate profits and spending, and continued wage growth will continue to push U.S. headline and core inflation higher. Additionally, it appears likely that core inflation, as measured by personal consumption expenditures or PCE, is poised to top the Federal Reserve’s (Fed’s) 2% target.

Eurozone Price Gains Hit Five-Year High

Headline inflation in Europe has steadily increased, and in the eurozone, it recently hit a five-year high. But core inflation, which is key to central bank policy, remains below target levels. Meanwhile, Japan continues to struggle with stubbornly low inflation, which prompted the Bank of Japan to abandon its 2% inflation target earlier this year.

Third Topic

Monetary Policy: Policymakers pursue different strategies

Fed Stays the Course   

With its ongoing rate-hike and balance-sheet-reduction campaigns, the Fed continues to separate itself from central banks in Europe and Japan. We expect the Fed to raise rates one more time in 2018, lifting the federal funds rate target to a range of 2.25% to 2.50% by year end. We also expect additional rate hikes in 2019.

Bond-Buying Is Poised to End in Europe

The European Central Bank (ECB) extended its bond-buying program’s expiration date from September to December. The ECB left interest rates unchanged at 0%, but we expect the central bank to begin normalization in mid-2019. Meanwhile, Japan’s central bank is maintaining its aggressive stimulus programs.

Rates Rise in the U.K.

Amid firming economic growth and an improving labor market, the Bank of England raised its benchmark lending rate from 0.50% to 0.75% in August. However, policymakers noted that future rate hikes will be gradual and limited.

Fourth Topic

Interest Rates: Rates to slowly trend higher

Treasury Yields Remain Rangebound

After spiking in May, U.S. Treasury yields have declined and remained in a narrow range. Nevertheless, absent trade and geopolitical conflict, we believe yields will gradually increase as more central banks begin normalization. We expect the 10-year Treasury yield to slowly rise and trade in a range of 2.95% to 3.25%.

Central Bank Policy Keeps Non-U.S. Rates Lower   

Modest global growth, muted inflation, and accommodative central banks are keeping interest rates relatively low in Europe and Japan. Rates should remain slightly higher in the U.K., largely due to inflationary pressures and recent central bank tightening.

Rate Disparity Is Wide  

Fed tightening and growing U.S. Treasury issuance are keeping U.S. rates  elevated versus rates in other developed markets. We are looking to markets where rates are more likely to fall or remain stable, including Canada and select emerging markets, to help diversify duration risk in the U.S. and Europe.

Victor Zhang, Co-CIO, American Century Investments: After a long stretch of highly correlated, albeit slow expansion, growth among global markets is no longer synchronized. How do you see this affecting the market, Keith?

Keith Creveling, CIO, Global Growth Equity: The divergence among developed markets growth has increased over the last few quarters, with the U.S. leading the pack. While the economic recovery has matured, unprecedented corporate tax cuts have boosted U.S. growth over the past two quarters. At the same time, European growth has moderated, and Japan continues to see pockets of improvement aided by the government’s ongoing accommodative policies. Emerging markets, which had outpaced developed markets, have been pressured by political and macroeconomic conditions, and this has furthered the divergence among global markets’ growth rates. All this will likely increase volatility. In our view, economic divergence will continue as the global recovery matures, trade conflicts escalate, and interest rates inch higher. This creates opportunities for active managers.

Keith Creveling

Keith Creveling, CFA

Co-Chief Investment Officer

Global Growth Equity

In our view, economic divergence will continue as the global recovery matures, trade conflicts escalate, and interest rates inch higher.

- Keith Creveling

Global stock markets initially took the trade disputes between the U.S. and China in stride, but the recent escalation in retaliatory tariffs has raised concerns among investors. Where are you seeing the biggest impacts?

Creveling: The trade disputes have affected companies in the steel, aluminum, automotive, and electronics industries, along with soybean farmers. It remains difficult to separate negotiating stances from actual policy intent, and it’s nearly impossible to predict the outcome of a prolonged trade war. As we formulate this quarter’s outlook, U.S. and Chinese officials are discussing plans for additional trade talks later this year. In the shorter term, we are evaluating the impact of imposed tariffs on individual companies’ earnings, as well  as the companies’ ability to pass on higher costs through price increases.

We are also noting China’s evolving policy moves to support domestic demand as a hedge against the potential impact of further trade war escalation. An example is our investment in construction names, including Chinese cement companies. Such companies should be direct beneficiaries of increased infrastructure spending resulting from increased bank lending and accelerated fiscal spending.

Kevin, what’s your take on tariffs?

Kevin Toney, CIO, Global Value Equity: We believe the impact will vary from company to company and could be transitory in many cases. Some companies will be hurt, some will benefit, and others will experience few or no consequences. Some will adjust their supply chains by finding different sources for inputs. Others may move production outside the U.S. For example, Harley-Davidson has said it will move some production overseas to avoid tariffs. The best scenario is that countries settle their trade differences with new pacts, such as the preliminary new agreement between the U.S. and Mexico. In any case, while we are keenly aware of tariffs and trade wars, they do not materially change how we assess individual stocks.

Kevin Toney

Kevin Toney

Co-Chief Investment Officer

Global Value Equity

We like to see companies go beyond the foundational tech investments that simply keep the lights on. The most compelling companies make strategic investments that can give them a competitive advantage.

- Kevin Toney

Greg, should we be concerned that higher costs from tariffs will spur inflation?

Greg Woodhams, Co-CIO, Global Growth Equity: Historical context is important here. Inflation peaked in the U.S. in the late 1970s and early 1980s, before dramatic action by the Fed brought prices under control and fundamentally changed expectations for inflation. The ensuing decades also saw the proliferation of free-trade policies worldwide that further suppressed prices. Important milestones include China’s entry into the global economy in 1980 and the ratification of the North American Free Trade Agreement (NAFTA) in 1993. 

Now, however, these decades-long trends may be ending, as the free-trade regime is under threat from left- and right- wing politicians around the globe. Inflation expectations, too, are rising, albeit from a very low base. Expectations are important because what we think about future inflation colors our decisions to spend or save and at what rate. It also influences businesses’ decisions to enter into contracts with suppliers, customers, and workers.

Another link to the 1970s and ’80s is that a recent U.S. Producer Price Index report showed year-over-year price increases in nine of 10 categories. This high diffusion of producer price inflation is unusual for this stage of the economic cycle and hasn’t occurred since the late ’70s.

Greg Woodhams

Greg Woodhams, CFA

Co-Chief Investment Officer

Global Growth Equity

Secular growth companies, whose earnings are driven by innovation or an earnings dynamic that is independent of the economic cycle, should have an advantage.

- Greg Woodhams

How does this translate to companies and stocks?

Woodhams: From an investment perspective, higher producer prices—whether resulting from a stronger economy or from tariffs—will challenge companies that must pass on those incremental costs to maintain profit margins. We don’t see any relief from the Fed either. The notes from the central bank’s policy meeting show the Fed recognizes its accommodative stance won’t be appropriate if current economic conditions persist. Said differently, rates may be too low given the pace of economic growth, low level of unemployment, and uptick in inflation. The combination of reluctance to accept price increases because of a low inflation mindset and a vigilant, less-accommodative Fed implies that profit margins will face cost pressures.

Of course, this scenario won’t affect all companies equally. Cyclical growth companies, whose earnings growth depends on earnings power latent in the economic cycle, tend to have a higher percentage of their costs associated with producer price inflation. An inability to pass on those prices represents a headwind to cyclical growers. On the other hand, secular growth companies, whose earnings are driven by innovation or earnings dynamics independent of the economic cycle, should have an advantage.

The impact of U.S. tax cuts is still rippling through the economy. Are management teams making smart decisions with their tax savings windfalls?

Toney: This is something we’ve been watching closely because bad decisions on acquisitions and capital projects are all too common. Corporate technology spending has been strong, and this is expected to continue. That’s been great for the sellers, but there’s a buyer on the other side of every deal. We like to see companies go beyond the foundational tech investments that simply keep the lights on. The most compelling companies make strategic investments that can give them a competitive advantage. 

For example, Zimmer Biomet, which manufactures orthopedic products such as artificial joints for knee, hip and shoulder replacements, has invested in computer-assisted robots  and multi-axis grinders to precision polish medical devices. It also has automated certain manufacturing and inspection processes, including on-machine inspection and process controls.

Paychex is another U.S. company making accelerated tech investments due to tax reform. These investments will improve the company’s software offerings by allowing customers to customize the user interface and provide tighter integration with other human capital management systems. The latter will minimize duplicate entries, add mobile access, and expand employee self-service functions. These projects were all in the pipeline, but Paychex pulled them forward due to increased availability of capital from tax reform.

Political uncertainty is another key topic affecting the outlook for global markets. Keith, how do you see this affecting European stocks?

Creveling: In Europe, we’re watching two political situations that could have an impact on stock performance. The newly formed government in Italy, a coalition featuring the populist Five Star Movement and the center-right League, may pursue populist policies rather than a pro-reform, pro-business agenda that would be more attractive to investors. The appointment of a new economic minister, who immediately said Italy would remain in the eurozone and focus on debt reduction, mollified investors somewhat. However, we remain concerned about political developments in one of Europe’s largest economies.

The U.K. faces a different sort of political dilemma. If the ruling Conservative party is unable to reach a trade deal with the European Union (EU) before its scheduled exit (Brexit) from the EU next year, the economic consequences could be significant. The uncertainty around the ongoing Brexit negotiations has clouded the outlook for the U.K. economy for most of the period since the Brexit referendum in June 2016.

Several issues remain unresolved, including questions about trade arrangements, the U.K.’s bill for exiting, the possibility of a hard border between Northern Ireland (part of the U.K.) and the Republic of Ireland (part of the EU), and the free movement of citizens and workers between the U.K. and the EU. Each could have a negative impact on U.K. businesses’ ability to compete in the new post-Brexit environment. The U.K. government is currently negotiating on all these points and has suggested an adjustment period that would allow for a smoother transition if the parties can’t reach a deal by the March 2019 deadline. So, the uncertainty surrounding this complex resolution is ongoing.

Political issues, combined with macroeconomic factors, have also contributed to heightened volatility in emerging markets (EM) in recent months. Should we be worried that turmoil in Turkey will have spillover effects to other countries?

Creveling: We don’t believe all EM should be painted with the same brush. In our view, Turkey is an extreme and isolated case, and an example of poor domestic policy. The economic issues that were pressuring the Turkish lira have been in place for some time, but the recent political confrontation between the U.S. and Turkey helped exacerbate the situation. President Erdogan’s adamant stance against hiking interest rates to maintain high growth rates rather than tame inflation helped fuel the swift drop in the currency in August. While Turkey’s government does seem to be moving incrementally in the right direction on economic policies and has provided banks with additional liquidity, it remains unclear if the government is committed to the fiscal and credit policies necessary to stave off recession. 

Brazil is another EM country that bears watching as its presidential election approaches. Many investors remain on the sidelines, awaiting the outcome of the presidential election for insight into how government policy will affect the macroeconomic climate. Brazil appears to be at the low point of the economic cycle, with the potential for recovery.

Companies have deleveraged, strengthened balance sheets, and stockpiled cash. However, it remains to be seen if any incoming administration can deliver on promises for necessary reforms. In the meantime, we have found select opportunities in companies with strong individual fundamentals despite macroeconomic headwinds. An example includes home furnishings retailer Magazine Luiza, which is benefiting from its exposure to e-commerce (penetration remains at a low level in Brazil), despite the weakened consumer outlook.

Turkey and Brazil aside, EM face headwinds from trade wars, the stronger U.S. dollar, and higher U.S. interest rates. However, we don’t expect the anticipated U.S. rate hikes this year and in 2019 to significantly hamper EM performance if those rate hikes are well-telegraphed. Additionally, with stronger domestic demand, muted inflation, and improved current account balances, most EM countries appear better positioned than in recent history to withstand the effects of a dollar rally.

Cleo, at the beginning of our conversation we noted more volatility coming back into the market. Are there alternative strategies that investors should be considering?

Cleo Chang, Head of Investment Solutions: We’ve noticed that correlations between equities and bonds have ticked up with the return of volatility. Because of their low correlation to other strategies, we believe it makes sense to think of alternatives as the third piece of a portfolio. Further, among alternatives, equity market-neutral strategies tend to have the lowest correlation due to their lack of market beta. Interest in market neutral is growing as reflected in strong flows into this category during the first half of the year. 

Clients are also expressing concern about downside risk. According to a recent study, 56% of investors say they believe the equity market is at its peak and think the opportunity for outperformance is going to be constrained going forward. Long/short equity strategies may be appropriate for those who hold this view. On the long side, managers can be optimistic but cautious, managing to lower levels of market exposure and higher cash balances so they can be opportunistic. Short positions can capture gains when stock prices fall and can help reduce downside losses.

Cleo Chang

Cleo Chang

Head of Investment Solutions

Because of their low correlation to other strategies, we think it makes sense to think of alternatives as the third piece of a portfolio.

- Cleo Chang

Vinod, earlier in the conversation Kevin discussed how companies are investing in technology to gain efficiency and better serve customers. These technologies are also affecting the asset management industry itself. Can you give us a peek under the hood at how investment managers are using Big Data and artificial intelligence (AI)?

Vinod Chandrashekaren, CIO, Disciplined Equity: Big Data and AI have revolutionized how the world solves problems. From radiology to e-commerce, machines are informing critical decisions more than ever, so it makes sense that we would find applications in financial services. Just consider all the information available from conference calls, annual reports, investor events, patent data, supplier networks, and competitive positioning metrics. But while the data are vast, many aren’t valuable or predictive. Uncovering signals amid this noise requires targeted algorithms and thoughtful technology decisions.

In this Big Data–driven investment landscape, we believe teams with dedicated technolo-gists (closely aligned with business needs and asking the right questions of the data) using flexible platforms (open to all the advancements around them) are positioned for success.

Vinod Chandrashekaran

Vinod Chandrashekaran

Chief Investment Officer

Disciplined Equity

Subtle shifts in communication patterns, coupled with a variety of other complementary indicators, reveal meaningful, price-predictive information.

- Vinod Chandrashekaran

How does this work in practice? For example, how can you apply it to quarterly corporate earnings calls to inform investment decisions?

Chandrashekaren: The language a company’s management uses—or doesn’t use—on an earnings call can flag potential issues in a stock. We group this language into four broad categories. The first category includes “sins of omission,” or instances of corporate management not disclosing certain details or relevant information. The second is the extent to which management resorts to exaggeration or using overly scripted language. Of course, earnings calls are rampant with corporate enthusiasm, but there’s a spectrum.

Our AI model negatively views abnormal levels of corporate spin, especially in the face of analyst uncertainty and questioning. Third, we are attuned to obfuscation, or the tendency of management to use overly complex language or details to avoid directly answering a direct question. Finally, the fourth category relates to the blame game, or management’s tendency to take ownership of successes and attribute failures to external forces or conditions beyond its control.

Starbucks makes a good case study. Once a growth darling, with consistent year-over-year double-digit comparisons, Starbucks is now a company in transition. Its fundamentals  are beginning to reflect a company entering a maturation phase. While I personally appreciate having three Starbucks within 10 minutes of the office, it’s hard to ignore the pressures of cannibalization on same-store-sales. So, too, are the competitive pressures of an increasingly crowded coffee market—cheaper options from fast-food restaurants and the differentiated draw of local gourmet cafes that your hipster friend always raves about. The company ultimately issued lower guidance than it suggested in its quarterly earnings call, and the stock declined sharply as a result.

It’s in these moments of transition, when underlying fundamentals begin to shift behind the scenes, that management feels the most pressure to maintain its growth story from previous years. Subtle shifts in communication patterns, coupled with a variety of other complementary indicators (e.g., short interest, insider trading), reveal meaningful, price-predictive information. Starbucks’ calls demonstrated a gradual decline in tone relative to industry peers well before its stock price tumbled. The decrease might seem clear from this conveniently quantifiable vantage point, but from call to call, these shifts are far subtler.

Victor Zhang, Co-CIO, American Century Investments: Although U.S. interest rates have been rising, they remain relatively low. What’s the Fixed Income team’s outlook for rates?

G. David MacEwen, Co-CIO, American Century Investments, CIO, Global Fixed Income: Since the Fed started tightening monetary policy in December 2015, U.S. interest rates have been on a slow trek upward. We saw some sharp rate volatility earlier this year, due to tax reform and some stronger-than-expected economic data. But the volatility has largely subsided, and we believe solid, sustainable economic growth, higher—but not out-of-control—inflation, and continued Fed normalization will gradually drive rates higher. Absent any significant trade or geopolitical events, we expect the 10-year Treasury yield to gradually move higher over the next several months, ultimately trading in a range of 2.95% to 3.25%. We expect the two-year Treasury note to trade in a range of 2.45% to 3.00% over the next several months.

Absent any significant trade or geopolitical events, we expect the 10-year Treasury yield to gradually move higher over the next several months, ultimately trading in a range of 2.95% to 3.25%.

- G. David MacEwen

With shorter-maturity yields rising at a faster pace than longer-maturity yields, the Treasury yield curve continues to flatten. Is this cause for concern?

MacEwen: Some in the financial press worry that the yield curve is close to inverting—and an inverted yield curve has often been an indicator of economic recession. We don’t share those concerns. The U.S. is still in the early months of fiscal stimulus from tax and regulatory reform, and we believe this backdrop should support solid, sustainable economic growth. Meanwhile, inflation is not rising at a pace that would require the Fed to aggressively raise short-term rates, causing the yield curve to invert. We believe the yield curve may continue to flatten in the short term, as the Fed tightens, the U.S. Treasury issues more notes, and longer-maturity rates slowly move higher. However, once central banks outside the U.S. begin to normalize, we may see longer-maturity U.S. rates move up a bit faster.

Does the Fixed Income team expect other developed market central banks to follow the Fed’s lead and normalize monetary policy?

MacEwen: It appears central bank policy will gradually converge over time. Economic growth and inflation data are slowly improving in Europe and the U.K., which may push rates higher. Although the European Central Bank (ECB) continues to provide support, it is slated to conclude its bond-buying program in December. So far, the ECB doesn’t have any plans to begin reducing its bond portfolio, and it continues to hold the key eurozone lending rate at 0%, where it’s been for more than two years.

We don’t expect the ECB to start raising rates before mid-2019. In the U.K., normalization is underway, albeit slowly. The Bank of England has raised rates twice since late-2017, to 0.75%, and policymakers insist additional rate hikes will be gradual and limited. Elsewhere, the Bank of Japan shows no signs of tapering its stimulus program. Short-term interest rates remain -0.1%, and policymakers are targeting a 10-year government bond yield of 0.20% or lower. Growth in Japan remains sluggish, and inflation is less than 1%, suggesting the central bank will maintain its stimulus efforts.

Looking beyond the developed markets, political and economic factors are creating challenges for certain EM countries. Have these developments changed the team’s view of EM bonds?

MacEwen: Uncertainties surrounding global trade policy remain a headwind for EM assets. But much of the recent volatility is due to turmoil in Turkey, where damaging political and monetary policy decisions recently sent Turkey’s currency and financial markets into a tailspin. The central bank’s refusal to raise rates in the face of a deteriorating macro environment triggered the currency’s downturn. Escalating political tensions with Western allies, whose funding is critical to the Turkish financial system, also pushed the lira lower. Turkey has limited domestic financial resources, so it must attract U.S. dollars and other foreign money to keep its economy growing. This makes Turkey particularly vulnerable to Fed rate hikes, further exacerbating the situation.

Given the size of Turkey, negative investor sentiment has spread to other markets. However, we believe the problems are largely self-inflicted and specific to Turkey. The last significant sell-off in EM assets occurred in 2013, and it also targeted countries with high external funding needs. But compared with that period, we believe most EM countries are in better economic shape today. We have seen weakness in other countries that rely on external funding, such as Argentina, South Africa, and Indonesia. But, unlike Turkey, central banks in those and other EM countries have indicated they will raise interest rates if necessary. For example, recent weakness in the Argentinian peso prompted the central bank there to immediately raise interest rates to 60%, highlighting the difference between policy-makers in Argentina and Turkey.

Overall, we view this latest unrest as an opportunity to invest in EM bonds offering solid fundamentals and attractive risk-adjusted returns. Risk remains elevated in certain countries, but we believe the widespread negative market sentiment has unfairly punished many others, creating opportunities for active managers.

Despite mounting challenges for income investors, demand for yield remains strong. Cleo, other than traditional bonds, where are you finding opportunities to generate income?

Cleo Chang, Head of Investment Solutions: For investors who are concerned about rising rates but still want to generate investment income, alternative income solutions may deliver benefits to a diversified portfolio. These strategies focus on niche areas of the credit market, including floating-rate credit instruments and asset-backed securities (ABS), where uncorrelated return opportunities still exist.

Floating-rate securities, such as leveraged loans and collateralized loan obligations (CLOs), have performed well in the current environment. CLOs generally have delivered higher yields than comparably rated high-yield bonds, while bank loans should continue to benefit from rising rates. What’s more, these securities have shown resilience during past credit cycles, with low default and loss rates.

Given that consumer fundamentals remain strong, we believe ABS offer attractive opportunities. These securities tend to have relatively short durations, which is an important consideration in rising-rate environments. ABS have also shown resilience during equity market sell-offs, and they typically offer uncorrelated performance versus investment-grade corporates.

We recommend investors use these and other alternative income solutions to complement their core bond exposure and help hedge against rising rates. They also may provide downside protection for the overall portfolio.

CLOs generally have delivered higher yields than comparably rated high-yield bonds, while bank loans should continue to benefit from rising rates.

- Cleo Chang

Sector Outlook

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U.S. Treasuries


We expect short-maturity Treasury yields to continue rising on Fed tightening and growing Treasury issuance. Absent trade or geopolitical conflicts, we expect healthy economic growth and higher inflation to gradually push 10-year Treasury yields higher. We look for the bench-mark yield to settle in a range of 2.95% to 3.25%. Against this backdrop, we continue to underweight Treasuries in favor of more attractive opportunities in spread sectors.

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U.S. TIPS


We believe core inflation will continue to edge higher, but we think year-over-year headline inflation likely will decline for the next few months, largely due to base effects from last year’s hurricane. Given that TIPS are indexed to headline inflation, we do not expect the securities to offer much upside potential in coming months. Accordingly, we recently took profits in and exited our TIPS position in core portfolios. We will watch for opportunities to repurchase the securities if valuations improve.

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U.S. Securitized


We believe securitized bonds offer better yield and total return opportunities than Treasuries. Within the sector, we continue to favor mortgage credit, including non-agency commercial mortgage-backed securities (CMBS) and non-agency collateralized mortgage obligations (CMOs), which we believe offer better relative value than fixed-rate agency mortgages. We are increasing exposure to floating- and fixed-rate securities.

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U.S. Credit


Corporate fundamentals and earnings remain positive, but we believe much of the positive effects of tax reform are already priced into bonds. We are reducing our overweight in the investment-grade corporate credit sector in favor of securitized bonds. We continue to find value among high-yield corporate bonds, particularly within the BB credit-quality bucket. We are also increasing exposure to bank loans.

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U.S. Municipal


With U.S. economic data generally improving, state and local finances across the country remain healthy overall. We expect municipal bond (muni) issuance to slow from 2017, largely because of federal tax reform. Meanwhile, demand for tax-exempt munis should remain healthy, particularly from high-tax states. We continue to favor securities in the higher education, transportation, and hospital sectors. Additionally, given our outlook for healthy economic growth, gradually rising interest rates, and generally healthy credit fundamentals, we have a slight bias toward lower-quality securities (investment-grade securities with BBB credit ratings) and higher-yielding sectors (charter schools and special tax).

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European Sovereign


European government bond yields remain at low and relatively unattractive levels, primarily due to ongoing central bank stimulus. However, European growth is improving, and we believe inflation and rates likely will head upward. In this environment, we are underweighting European sovereigns, preferring markets where rates are likely to fall or remain stable. These include Canada and select local emerging markets.

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European Credit


We continue to find the best credit valuations within the banking and insurance industries. We are also finding value among select industrial hybrid bonds.

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Emerging Markets Debt


We continue to reduce exposure to external (U.S. dollar- denominated) debt in favor of select local currency exposure, which is less vulnerable to rising U.S. Treasury yields and a stronger U.S. dollar. We remain mindful of geopolitical risks, particularly in Turkey and South Africa, and the effects of global trade policy on EM countries, specifically Mexico and Russia.

Victor Zhang, Co-CIO, American Century Investments: Rich, I feel like the theme that characterizes your thoughts about global markets can be summed up in one word—divergence. Divergence from the past; divergence in fundamentals around the globe; divergence in short- and long-term outlooks; and divergence of performance within and among U.S. stock sectors. Tell us why you see economies and markets diverging?

Rich Weiss, CIO, Multi-Asset Strategies: Let’s start at a high level. Consider that in 2017, the global economy enjoyed a synchronized upswing. But paths have diverged so far in 2018, as U.S. growth is accelerating while much of the rest of the world is experiencing much slower growth. Similarly, the greenback slid throughout 2017, but in 2018, the dollar has been on a tear higher. Volatility reached all-time lows last year but returned with a vengeance earlier this year. FAANG stocks (Facebook, Apple, Amazon, Netflix, Google) and just a few sectors led the market for much of 2017 and well into  2018. But in recent months, we’ve seen evidence of sector rotation away from the tech and consumer discretionary sectors and possibly a change in market leadership.

A key reason for these changes is that massive tax cuts and deficit spending are providing fiscal stimulus to the U.S. economy at a stage in the economic cycle when we’d normally expect more modest growth. In addition, the U.S. is engaged in escalating trade tensions with major economic partners, in opposition to much of the post-World War II free-trade regime. So, yes, we’re diverging quite a bit from historical precedent, and we believe this is leading to a wider range of risks and outcomes for economies and markets.

Rich Weiss

Rich Weiss

Chief Investment Officer

Multi-Asset Strategies

Tariffs are generally negative for both inflation and global growth, so applying tariffs may invite inflation without a potential economic benefit.

- Rich Weiss

Can you elaborate on the different outcomes you see?

Weiss: First, the positives—U.S. unemployment is at multi-decade lows, consumer confidence and spending are up, corporate profits are at records, and corporate spending on capital improvements is rising. These capital expenditures have important implications for worker productivity and growth going forward. All else equal, higher productivity means higher growth. And though it’s not a one-to-one relationship, higher productivity is also associated with higher wages. A sustained increase in business investment would be a positive development for the economy going forward. So, there are potential positives we see that could well make this the longest-running economic expansion in U.S. history when all is said and done.

However, downside risks are also elevated. Bond yields, inflation, and trade barriers are all rising. At the same time, the Fed is clearly committed to reducing its balance sheet and raising interest rates further. Those conditions are likely contributing to the fact that the housing market is cooling, and the dollar is strengthening. The stronger dollar and trade war may already be hitting the manufacturing sector, where the purchasing manager’s index (a broad measure of U.S. manufacturing activity) still signals expansion but recently registered its slowest rate of growth in nine months.

Tell us how tariffs add to the risk or uncertainty you see going forward.

Weiss: Tariffs are generally negative for both inflation and global growth, so applying tariffs may invite inflation without a potential economic benefit. Of course, inflation declined from 1980 through the 2008 financial crisis. But that doesn’t mean it’s dead. Inflation has been rising steadily since 2015 and the risk of even higher prices is real—it was worries about inflation and resulting rapid increase in interest rates that sparked the sharp sell-off in stocks earlier in the year.

The Fed, too, is in a quandary. Notes from its most recent policy meeting indicate that another rate hike in September is almost certain, but the outlook becomes much less clear thereafter. Why? Because of uncertainty around heightened trade tensions and their negative economic consequences.

Also, consider that in the past, U.S. consumer spending could be enough to support global growth—massive imports of cheap foreign goods not only suppressed inflation here but also benefitted the exporting countries. But with trade barriers emerging between the U.S. and some of its largest trading partners, tariffs are also bad for global growth more broadly.

You are often at pains to point out the difference between your short- and long-term outlooks. Can you explain why that’s so important?

Weiss: Sure. Time horizon is central to making a financial plan because it significantly affects how much risk you can afford to take. First, let’s look at the 2008 financial crisis and consider the event from the point of view of someone in or near retirement compared to a young investor. Older investors approaching or already in retirement with substantial equity exposure likely had years of income wiped off their portfolios. That’s a devastating blow to someone who’s drawing down their account and no longer making contributions. Contrast that scenario with someone who was still 10 or 20 or more years from retirement in 2008. Of course, their account balances declined, too. But if they stayed true to their plan and didn’t abandon equities, then they continued to make contributions, bought stocks at attractive prices, and fully participated in one of the longest bull markets in history. Two investors—same exact market, but totally different experiences and financial outcomes because their time horizons differed. 

A less dramatic, but no less important, example can be seen in EM equities. This is a high-risk, high-reward asset class that has historically delivered significant gains, but with commensurate volatility over time. Off the top of my head I can think of the Mexican peso crisis, Asian debt crisis, and multiple Russian ruble meltdowns over the last 20 years or so. But those crises punctuate periods of strong growth, such that EM stocks overall put in higher highs and higher lows and have performed very well over time. For an investor with a short time horizon, this sort of volatility is undesirable. But investors who have time on their side and have been able to watch the price chart move higher after each crisis, then owning EM equities has been rewarding. Same asset class, same market, totally different experience depending on the time horizon. 

These are also excellent arguments in favor of holding a well-diversified portfolio. In 2008, high-quality bonds rose even as stocks sold off sharply, offsetting declines and allowing investors to rebalance by selling winners (U.S. Treasury bonds) and buying losers (stocks). Or in the EM example, holding these stocks provides an excellent diversification benefit and potential boost to portfolio total return. And because we’re talking about holding these stocks in a well-diversified portfolio, investors may be less exposed to the volatility of EM stocks. Uncorrelated, high-volatility, high-return assets also help make the case for systematic portfolio rebalancing, which would have you consistently selling after rallies and buying after sell-offs in the asset class.

Uncorrelated, high-volatility, high-return assets also help make the case for systematic portfolio rebalancing.

- Rich Weiss

Can you give us highlights of your short- and longer-term outlooks, say six to 12 months versus three to five years?

Weiss: In our short-term, tactical portfolios, we remain neutral on stocks versus bonds and cash. Stock valuations are high by historical standards, but record profits help valuations. And while bond yields are more attractive than a year ago, or even just a few quarters ago, so too are equity dividend yields. Within equities, we are neutral on large-cap stocks versus small in the U.S. Our market and economic momentum and sentiment indicators favor large-caps, but we recognize that stronger U.S. growth and tax cuts tend to disproportionately benefit more domestically oriented small-cap stocks, so we are monitoring this closely.

Similarly, we maintain our long-running overweight in growth stocks relative to value. Here again, the case is a bit less compelling than in the past because growth stocks tend to do better when corporate earnings growth is less abundant. But tax cuts have helped push profit growth in the U.S. to record highs, perhaps explaining some of the changing market leadership and sector rotation we’ve seen in recent months. 

Longer term, we’ve been more cautious on stocks for investors in or near retirement. Beginning in late 2017, we saw risks as elevated and believed that some downside protection was preferable for investors with large account balances and little time until their retirement dates or other savings goals. That change was beneficial during the market volatility in the first half of the year. However, realized volatility in markets remains very low by historical standards, and our measures of stocks’ attractiveness relative to bonds has increased. As a result, we are moving back to neutral allocations all along the retirement glide path. Risk management is a central tenet of our approach, so we’ll continue to monitor these allocations carefully for our clients.

Key Takeaways

  • We believe volatility will increase as developed market economies diverge. Expect security selection to become more important as the market becomes more discerning under volatile conditions.
  • Trade tensions and geopolitical issues remain potential headwinds for emerging markets, but we expect EM growth to outpace developed markets.
  • In the U.S., the stimulus from tax and regulatory reform support capital spending and employment, which should benefit corporate earnings and keep annualized GDP at the high end of our expected range of 2% to 3%.
  • The strong economy, tight labor markets, robust corporate profits and spending, and wage growth may push U.S. inflation past the Fed’s 2% target. Inflation is rising but below target in Europe while inflation remains stubbornly low in Japan.
  • We believe bond yields will gradually increase as more central banks begin normalization, and we expect the 10-year Treasury yield to slowly rise and trade in a range of 2.95% to 3.25%.
  • Select corners of the agricultural market, along with the steel, aluminum, automotive, and electronics industries, are feeling the impact of trade tensions. With decades-long trends supporting free trade under threat, tariffs could put upward pressure on inflation expectations.
  • Inflated costs will challenge cyclical growth companies that are unable to pass along the increases to their customers. We prefer secular growth companies, whose earnings are driven by innovation  or earnings dynamics independent of the economic cycle.
  • With a March 2019 deadline looming, critical issues in the United Kingdom’s departure from the European Union (Brexit) remain unresolved. Uncertainty is clouding the U.K.’s economic outlook and threatening businesses’ ability to compete in the post-Brexit environment.
  • Tax cuts have stimulated corporate technology spending. We’re watching for companies that reinvest their tax windfalls in initiatives that go beyond “lights on” tech to include projects which improve their competitive positions.
  • The same technology that enables companies to be more competitive is finding its way into investment portfolios as asset managers use Big Data and artificial intelligence to inform investment decisions.

Investment Outlook Brochure

Q4 2018 CIO Roundtable

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The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.

International investing involves special risks, such as political instability and currency fluctuations.

Historically, small- and/or mid-cap stocks have been more volatile than the stock of larger, more-established companies. Smaller companies may have limited resources, product lines and markets, and their securities may trade less frequently and in more limited volumes than the securities of larger companies.

References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.

American Century Investments uses a multifactor stock-ranking model incorporating a variety of stock attributes, which fall into four categories or factor families: valuation, growth, quality, and sentiment.

Diversification does not assure a profit nor does it protect against loss of principal.

Alternative mutual funds that hold a variety of non-traditional investments also often employ more complex trading strategies than traditional mutual funds. Each of these different alternative asset classes and investment strategies have unique risks making them more suitable for investors with an above average tolerance for risk.

As with all investments, there are risks of fluctuating prices, uncertainty of dividends, rates of return and yields. Current and future holdings are subject to market risk and will fluctuate in value.