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At American Century Investments®, we are focused on deploying our unique insights and capabilities to solve investors' most pressing problems. As we look ahead to 2018, we see a landscape of varied investment opportunity that will require thoughtful, active solutions to help meet individual client objectives. To better understand the risks and opportunities ahead, we've gathered the heads of our investment teams to discuss the outlook in their respective markets.
Before turning to our chief investment officers for their market insights, let's recap the economic environment. It's clear that we are in the midst of a synchronized upswing in global growth. But it pays to think in terms of cycles, or stages. The U.S. is in a much later stage of expansion than are many European countries or Japan, for example. This cyclical thinking can be applied to monetary policy as well. Here again, the Federal Reserve is further down the road to higher rates and reducing its balance sheet than are other leading central banks. This has important implications for returns across asset classes and geographies, and we'll ask our investment leaders to offer insight on these conditions in the year ahead.
Similarly, this concept of cyclicality can be useful when viewing performance across or within asset classes—growth versus value stocks being a good recent example. Markets simply don't move in one direction; rather, different sectors and styles cycle through leadership as underlying economic fundamentals change. Cyclicality, mean reversion—these ideas are among the bedrock arguments for portfolio diversification, and these are themes you will hear throughout this discussion. What is clear is that with all markets appearing to be fully valued, we believe active portfolio management and individual security selection are of central importance to managing risks.
Regardless of economic and market conditions, our dedication and focus on meeting our clients' objectives remains first and foremost in our thinking. Thank you for investing with us.
CO-CIO, American Century Investments
CIO, Multi-Asset Strategies
We can point to a number of tailwinds for financial markets in the near term. Corporate America is producing positive earnings growth and looks poised to benefit further from tax reform and deregulation. The eurozone is enjoying improving growth and consumer confidence, while Japan's economy is as healthy as it has been in a long time thanks to years of determined fiscal and monetary stimulus. A coordinated upswing in global growth creates a rising tide that lifts all financial boats. That's the foundation on which a positive outlook for essentially all risk assets rests. If economic growth is good and earnings continue to expand, then investors likely can continue to justify current or even higher valuations, assuming inflation and rates don't rise sharply.
In addition, sentiment is positive—no matter how many missiles North Korea launches or how much political turmoil in Washington and European capitals, stocks keep rallying and credit spreads keep tightening. At the same time, volatility in both stock and bond markets is low, and it's manifestly true that financial assets tend to do best when volatility is low/falling, rather than high/rising.
Weiss: We need to acknowledge that valuations are high by many measures, particularly in .U.S. equity markets. Now, valuations aren't a great short-term buy/sell signal—what's rich can just keep getting richer for some time. Here it's good to recall that Greenspan gave his famous "irrational exuberance" speech in December 1996, and the tech bubble didn't burst until March 2000—there's no timetable on these things.
But I manage retirement portfolios, so I'm naturally inclined to focus on long-horizon investing. And it is true that valuation is a good indicator of future returns over long periods. So with valuations high today, it's reasonable to expect subpar returns on equities over an intermediate- to longer-term time frame.
Another big potential headwind we see is changing monetary policy. At its most basic level, extraordinary central bank policies in recent years have been highly effective at supporting asset prices in a whole range of markets and geographies—stocks, bonds, and real estate being the most prominent examples. And yet, all around the globe, central banks are beginning to shift the monetary regime from loose to tight. Central bankers are going to work very hard to make sure they don't pull the rug out from under financial markets. But as those stimulus policies are being unwound, it seems odd to think there should be no consequences for financial markets whatsoever.
G. David MacEwen
Co-CIO, American Century Investments, and CIO, Global Fixed Income
We recognize there is some anxiety about the turnover in the top leadership positions at the Fed. But we believe the Fed is clearly on a path to balance sheet and interest rate normalization, and that's unlikely to change under Jerome Powell's chairmanship. Compared with his predecessor, Powell has similar views regarding monetary policy. However, unlike Janet Yellen, Powell favors less government regulation. Indeed, all of the new appointees are likely to conform to the President's preference for easy monetary policy and less regulation with the aim of promoting economic growth.
We expect Powell to maintain the Fed's long-standing gradual path to normalization, particularly given our outlook for modest economic growth and contained inflation. In fact, we believe the Fed's current forecast for three rate hikes in 2018 might be too ambitious. The Fed's projection is based on inflation (core personal consumption expenditures, or PCE) reaching 2%—an unlikely near-term outcome, in our opinion. Year-over-year core PCE was 1.4% in October (the latest figure available as of early December), and without any specific catalysts driving prices higher, we don't expect much change in inflation. Therefore, barring any significant changes in the growth and/or inflation outlooks, we currently expect no more than two Fed rate hikes in 2018.
Also, there's some risk around the unwinding of the Fed's bond portfolio. But we think balance sheet normalization should have minimal impact on the bond market, given the Fed's commitment to transparency and the gradual pace of the winddown, combined with strong demand for U.S. fixed-income securities.
MacEwen: The U.S. is farther along in the economic and market cycle, so where the Fed leads, we believe others will eventually follow. We expect a gradual removal of global stimulus, as central banks seek to normalize monetary policy without jolting the financial markets. This is particularly true in Europe, where the ECB recently announced a tapering plan that was less aggressive than market expectations. Similar to the Fed's strategy, the ECB wants to avoid a rapid rate increase that potentially could cut off growth and trigger a stock market sell-off.
MacEwen: Our approach assigns different values or likelihoods to gauge the probability of different outcomes. Our base case is that we don't expect the U.S. market environment to change all that much. We believe the economy will continue to show modest gains, inflation will remain contained, and interest rates will trend marginally higher. Overall, the yield curve should remain relatively flat, with the front end rising on Fed normalization and the long end moving more modestly on fairly stable inflation and moderate growth.
Similar to 2017, we expect many of the best opportunities in 2018 to be in the credit and securitized sectors. Spreads have contracted significantly in these sectors, leaving little room for price appreciation. But we believe the extra yield corporate and securitized securities offer compared with U.S. Treasuries argues for a modest overweight to credit. Elsewhere, valuations appear attractive in the Treasury inflation-protected securities (TIPS) sector, where longer-term inflation expectations remain below historic averages. The 10-year breakeven rate remains below its historical average of approximately 2.0%. Over that longer time frame, we believe better global growth, stabilizing commodity prices, and modest wage growth eventually will create higher inflation than is currently priced into the bond market.
Head of Alternatives
It's typically hard for most investors to focus on diversification in a one-way market. We're not market timers—we believe an allocation to alternatives provides investors with portfolio diversification benefits and better risk-adjusted returns over time. We think it makes sense for people to think of their total portfolio over long horizons because this better reflects most investors' goals—saving for retirement, or a child's education, for example.
But in the context of a 2018 outlook, I do think that there is more uncertainty out there than perhaps markets are prepared for. Because valuations on both stocks and bonds are elevated, we think risk to investor portfolios is also elevated. Consider that many central banks around the world have begun to tighten monetary policy or have indicated that they intend to do so in the near to medium term, and that for certain parts of the credit market, this will be the first time in years that there is limited support from a government-backed buyer (the Fed, ECB, or government sponsored enterprises like Fannie Mae or Freddie Mac in the U.S. mortgage market).
To be clear, we're not doomsayers. There's an argument that today's valuations are justified by modest growth, low inflation, low interest rates, and healthy corporate profits. And it's certainly possible that those conditions could persist for some time. But we do think it makes sense to take a prudent, cautious approach to managing these risks. As a result, we think investors do well who diversify responsibly across asset classes, sectors, and geographies.
Keith Creveling , CFA
Co-CIO, Global Growth Equity
While there has certainly been an increase in stock prices in many global markets, high valuations have not altered how we view individual securities. We still use our disciplined process, relying on fundamental research, to evaluate each company we look at. Of course, as valuations increase, it may become more difficult to identify upside in companies, even those that can sustain the kind of earnings acceleration we look for. There are U.S. companies that still meet these criteria, which is one reason why our global portfolios maintain large positions in the U.S. Many of these companies are in the information technology and consumer discretionary sectors, where we see examples of companies experiencing inflection in earnings as beneficiaries of secular trends, such as the shift to digital platforms.
Greg Woodhams , CFA
That's right. The changes we're seeing in the technology sector—mobile, digital, cloud, artificial intelligence (AI), self-driving cars, and so on—are powerful, lasting developments we think have the potential to remake entire sectors of the economy. These secular trends are creating significant disparities within and across industries that we think present compelling opportunities.
We think about the investment implications of this problem in terms of free cash flow yields. That's because while earnings growth is strong at many firms, how they choose to deploy that capital will go a long way toward determining which companies survive and thrive going forward. This is why we believe active portfolio management is required to differentiate between the likely winners and losers. This points up a potentially underappreciated risk in the sector—tech stocks represent the largest sector exposure of passive funds by a wide margin, reflecting their leading position in broad market indices. So while we think these shares are supported by their solid earnings growth relative to the rest of the market, they are nevertheless vulnerable to a broad sell-off that sparks selling by passive investors.
Creveling: This trend is transforming industries beyond tech, including advertising, retail, travel, and even real estate. For example, the increasing shift from print, radio, and TV advertising to digital, such as web and mobile, is completely disrupting the traditional advertising model. That transformation is driving much of the revenue growth in a number of internet software and services companies, including Facebook and Google in the U.S., and Alibaba and Tencent in China. The increasing adoption of online platforms and e-commerce is also having profound effects on how consumers research, buy, and pay for goods and services; plan travel; and consume content. Online stores and other e-commerce sites such as Amazon are riding this trend, of course, but so are those companies who facilitate the digital exchange of payments. Examples include Visa, American Express, Worldpay, and PayPal. Online platforms are also becoming the first choice of more and more travelers, as evidenced in the success of online travel planners such as priceline.com and Expedia, based in the U.S., and Ctrip.com in China. We believe the secular shift to online platforms will continue and likely accelerate in 2018.
Woodhams: Sure. We believe we are in a new age for biopharma companies and stocks for two key reasons. The first relates to powerful new technologies that are transforming our understanding of biology and diseases. For instance, the availability and ease of use of gene-sequencing technology allows for the study and diagnosis of many diseases at the genetic level. That just hasn't been true before to the same degree. Another example relates to the ability to perform sophisticated analyses on medical records newly available in electronic format to be better able to understand factors that lead to disease.
The second big contributing factor is that after 20-plus years of research, we have only just recently reached the point where many treatment types are ready to be commercialized. For example, the first commercially successful RNA antisense drug was approved in December 2016. The first immuno-oncology cell therapy was approved in August 2017. The first commercial gene therapy in the U.S. will likely be approved in January 2018.
We believe these powerful, innovative new treatments can drive sustained profit growth in the industry. At the same time, we find valuations of many of these companies to be attractive. In addition, we will likely see continued consolidation and acquisitions in the biopharma space, especially if corporate tax reform leads to the repatriation of foreign cash by larger companies. And note that while concerns about drug pricing policy and regulation have been an industry headwind the last several years, we don't see any concrete steps to cap prices on the horizon. The one area of caution relates to the willingness of insurance companies to pay for the therapies. So our qualification is that companies with new therapies that serve unmet clinical need with acceptable economics to payors can outperform the overall market.
Phillip N. Davidson , CFA
CIO, Global Value Equity
Financials and energy have struggled, but I think these two sectors are not likely to be repeat offenders. Financials should have more stability in their business models due to more conservative balance sheets. While still relatively lower-return businesses, most of these companies have the potential to benefit from interest rate normalization, relaxed regulatory costs, and any changes in corporate tax rates. The continued improvement in returns will flow through to continued growth in dividends and book value. Historically, this has been more sustainable than high-risk, asset-driven growth supported by higher leverage that can end badly.
The energy sector is also having to adjust to a new normal of oil and natural gas prices. This painful process is resulting in the stronger companies right-sizing their cost structures and becoming much more focused on cash flow and return on capital, while the stocks remain out of favor. We believe security selection is always the key part of investment success, but we are also optimistic about this sector’s prospective relative performance. It is worth noting that several of the leading global energy companies have withstood the declining real price of oil and gas over the last 40 years, often offering compelling investment opportunities after periods of relative underperformance.
Vinod Chandrashekaran , Ph.D.
CIO, Disciplined Equity
It's true that the secular trends we've been discussing—such as the shift of advertising and consumer spending from traditional media/retail to online and digital, cloud computing, big data, and artificial intelligence—mean large-cap growth stocks in the technology sector appear to offer some of the best growth potential in the market.
This explains in part the popular fixation on the FAANG stocks (Facebook, Apple, Amazon, Netflix, Google), as investors have rewarded these companies for innovation as well as growth. From that perspective, FAANGs do currently look attractive based on our growth and sentiment measures, so we are invested in those names. However, we also think it's important not to lose sight of valuations. Long term, we want to look for growing, quality companies with lower valuations—these companies have best likelihood of outperforming the FAANGs and the broader market going forward.
Chandrashekaran: Some potential areas of opportunity we're seeing include capital goods, health care equipment and services, and materials companies. Another area we are overweight is the semiconductor industry, where we believe select companies are offering compelling quality, growth, and sentiment profiles. Top contributors in this sector are benefiting from strong demand for chips used in AI and big data applications.
Davidson: Value has underperformed for a decade or so, but we believe the underlying characteristics of value stocks—low valuations and low expectations of quality companies that are temporarily out of favor—will stand the test of time once again. Over time, equity returns tend to be mean reverting, which will result in the performance of growth and value stocks moving back toward their long-term averages. We are always amazed at how quickly investors forget about the internet bubble of the 1990s or other periods of significant disruptions. These bubbles are simply part of the fear and greed cycle, and we believe the underperformance actually sets the stage for stronger prospective relative performance for value investing. Although there are clearly some exciting newer, disruptive business models that have created wealth (and may continue to do so) at the expense of some disadvantaged companies, not all of these high-expectation stocks will prove to be rewarding investments.
Chandrashekaran: Outside the U.S., we continue to believe valuation factors remain attractive relative to history. There are fundamental reasons why this should be so. First, growth tends to do best as a factor or investment style when corporate earnings growth is comparatively scarce, while value tends to do better when earnings growth is distributed more broadly and is more abundant. You can see this most easily in the U.S., which is comparatively late in the economic cycle and earnings growth had been somewhat scarce, concentrated in a handful of sectors. This led to more concentrated, growth-oriented markets in recent years. But in late 2017, value-oriented stocks have done better in the U.S. on the premise that a much-anticipated corporate tax cut will improve earnings across the board.
Now look at growth prospects outside the U.S.—all the data we see suggest that we are in the early stages of a global economic recovery, where broad growth and corporate earnings are improving in both developed and emerging markets. This should be supportive of value stocks. That's not to say growth is disadvantaged outside the U.S. Rather, we see differentiated markets and conditions that should present opportunities for both growth and value to do well internationally.
Creveling: That's consistent with what we're seeing—as growth investors, we've recently been able to find attractive opportunities with both lower relative valuations and room for earnings acceleration. For example, in Europe, which as you said is earlier in the economic cycle than the U.S., economic expansion and ongoing central bank accommodation is driving earnings improvement. The emerging markets are experiencing ongoing success, a result of both synchronized global growth and improvement in local demand.
Creveling: Despite the prolonged runup that began in early 2016, we see room for emerging markets (EM) stocks to continue to gain. As I mentioned previously, the rally is being sustained by both synchronized global growth and improvement in local markets, a two-part catalyst helping companies achieve the kind of inflection in earnings that is at the heart of our investment process. EM companies are benefiting from increased demand from developed markets as consumer and business confidence increases. Improving local conditions are also helping companies through increasing consumer activity. An emerging consumer class is demanding better quality products, more luxury and status items, and greater access to health care, education, and financial services.
Macroeconomic conditions support EM growth as well. Comparatively modest local inflation and higher interest rates mean central banks have room to cut rates to further spur economic growth, something more difficult in developed markets, where aggressive stimulus programs have been in effect for several years. Additionally, a slowing in the U.S. dollar rally has taken some pressure off commodity prices and helped those EM economies making payments on dollar-denominated debt. Consequently, we view EM equities as still attractively valued relative to developed markets names.
Davidson: A U.S. correction is inevitable at some point, but we can only speculate when it will occur and the magnitude of the decline. While there are a variety of reasons that a correction could occur, we don't anticipate another U.S-led financial crisis. It is worth remembering that investing in high-expectation, high-valuation equities is fraught with risk, and indices tend to have heavier weights in these securities as their prices appreciate. Given that my team's value approach focuses on lower-expectation, lower-valuation, and higher-quality securities, we believe we avoid some of the risks that occur in a market decline.
MacEwen: We are finding opportunities outside the U.S., particularly in Europe, where economic growth is improving. On the one hand, we believe faster growth will put greater upward pressure on European interest rates compared with U.S. rates. To take advantage of this yield differential, we are implementing a global interest rates trade, taking long positions in U.S. Treasury securities and short positions in European (U.K. and Germany) government securities.
On the other hand, we are finding value among European corporate securities, which continue to benefit from the ECB's bond buying. Elsewhere, we expect synchronized global growth and investor demand for yield to continue to support EM bonds. Within this sector, we believe select U.S. dollar-based, investment-grade corporate bonds (which are insulated from currency fluctuations) offer opportunities.
MacEwen:The extended rally, combined with Fed normalization, ECB tapering, U.S. trade policy, and increased geopolitical tension, is causing us to proceed cautiously. Although fundamentals in the asset class have improved, we believe valuations appear stretched, particularly among external (U.S. dollar-denominated) corporate debt of lower credit quality. Accordingly, we think active management and individual security selection decisions will be very important. We will remain selective, focusing our exposure on countries and issuers with solid or improving fundamentals and attractive risk/reward profiles.
Chang: Traditional income investors are in a tough spot—bond yields are near historic lows, while valuations (as measured by credit spreads) are near historic highs. As a result, bonds offer less yield but with more risk than in the past. Indeed, roughly 60% of global core bonds yield less than 2%, while the duration on the Bloomberg Barclays U.S. Aggregate Bond Index is longer than it has been in decades (the longer the duration, the greater the price sensitivity to interest rate changes). This makes the bond market susceptible to even comparatively small rate increases.
The outlook for equity income investors is also somewhat complicated. Low rates encouraged many companies to issue debt to use in share buyback plans, driving share prices higher. But that becomes less attractive as rates rise. Also, dividend payout ratios on stocks are high by historical standards, which have also been facilitated by low interest rates—but greater interest expense weighs on profitability, which is also likely to weigh on payout ratios over time. At the same time, however, tax reform may well encourage companies to bring overseas cash back home. That could result in a temporary boost to payouts to shareholders in the near term.
But how ever these conditions play out in the short term, we encourage investors to think about managing risk and return across full market cycles, over longer time periods. For example, Fed tightening cycles are associated with strengthening economic conditions, so it's no surprise that stocks typically continue to rise in the year or two after the initial rate hike. But further out in time and further into the tightening cycle, market volatility typically rises and returns are less likely to be positive. The first Fed rate hike in this cycle was December 2015. Certainly, the monetary stimulus was like nothing we've seen before, so we should keep that in mind when making historical comparisons. Nevertheless, it seems prudent to hedge some of that risk now, while markets are at highs, rather than wait for volatility to pick up.
Weiss: Our forecast for future equity returns has several components, including valuation and volatility. At present, we have a bit of a see-saw relationship—volatility is historically low, and valuations are historically high. That's great while it lasts, but we're more cautious about returns over a longer time period. Or look at it this way—the risk/reward relationship in equities is skewed. Expected returns aren't great, but downside risk is potentially quite high. When you hold that sort of view in a retirement investing context, then you have to take a more cautious approach where it makes sense to do so. This means that we are reducing equity exposure for investors in or near retirement, whose account balances are large and have years of retirement income at risk in a market correction.
But for young investors who have comparatively small balances and many years until their anticipated retirement, we believe it makes sense to maintain a comparatively large representation in stocks. We think this asymmetric approach to risk management better reflects current market conditions and the actual distribution of risks along the path to retirement.
2018 CIO Roundtable
First Quarter 2018
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.