Quarterly Update

Oct. 2018

Matthew Peron, Chief Investment Officer, Senior Managing Director | Oct. 2018

Go East for Growth

For advanced economies, growth-supporting trends are diminishing

Link between slower growth and subpar returns apparent in Europe

EM Asia equities remain strong

Over the last 30 years, investors have enjoyed a long run of exceptional returns. Supported by extraordinarily healthy business conditions and profit growth, real total returns for global equities in the United States and Western Europe have averaged 1.5 and 2.2 percentage points, respectively, above each region’s historical averages since the mid-1980s. But the global economic landscape is likely to look quite different over the next decade, and those counting on continuation of this golden age of equity investing may be in for an unpleasant surprise. 

For advanced economies, the major trends supporting economic growth the last 30 years are diminishing or even declining.  Labor forces are rapidly aging, and productivity gains have stalled.  At the same time, government debt loads are fast approaching levels that significantly curb potential growth.  In fact, for many regions and countries, long-term GDP forecasts are at record lows. 

The implications of this for equity investors is significant.  Many factors have an impact on equity prices, but, over the long run, stock returns tend to reflect the cash flows (earnings and dividends) supplied by companies.  And corporate cash flows are ultimately driven by economic growth.   Research has shown that equity returns have been higher in periods with high GDP growth and lowest in the periods with slow growth (see chart).

Indeed, the link between slower secular growth and subpar equity returns is already apparent in the economies of Europe, which have been particularly symptomatic of the negative structural developments out at play.  Over the past five years, City National Rochdale clients have significantly benefited from our bias to domestic equities and long-term strategic underweight to other international developed markets.  But as we look forward, even the U.S. is not immune from global trends.  The Fed now has 1.8% long-term trend growth estimate for the U.S.  That’s down from more than 3% in 2000. 

After asset allocation, the most important decision in portfolio construction is where to invest regionally and, at a time when the outlook for growth is muted in the U.S. and elsewhere, we find our heads increasingly turning east.  Emerging Asian equities represent some of the best long-term value that we see across the global capital markets.  Asia boasts superior demographics, higher savings and investment rates, and rapid pace of urbanization and per capita income levels.  It has a consumer economy that will be accelerating as a result of the growing middle class. All of this should lead to higher earnings growth, which is ultimately what drives markets.

A key element of investment success is a long-term perspective.  With it, investors can assess the impact on their portfolios of fundamental, economic and demographic changes. They can then allocate their portfolios more effectively, focusing on attaining the returns necessary over an extended time horizon to meet their investment objectives.  

The past year has served as a painful reminder that emerging markets can be very volatile.  However, from a long-term perspective, the reasons for owning EM Asia equities remain just as strong as they were before this year’s declines.  The gloomy atmosphere today has deflected attention from emerging markets’ growing resilience to external threats, a result of structural improvements over the past two decades and their growing independence from the industrialized world’s business cycle.  While there are risks associated with our positive outlook, our view is that the long-term growth profile of Emerging Asia equities is compelling enough to overcome short-term gyrations and to warrant an increasing place in your portfolio when the dust settles.

Key Points

For advanced economies, growth-supporting trends are diminishing

Link between slower growth and subpar returns apparent in Europe

EM Asia equities remain strong

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Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability. Emerging markets involve heightened risks related to the same factors, as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

Concentrating assets in the real estate sector or REITs may disproportionately subject a portfolio to the risks of that industry, including the loss of value because of adverse developments affecting the real estate industry and real property values. Investments in REITs may be subject to increased price volatility and liquidity risk; concentration risk is high.

Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy, and market risk. Investors in MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated schedule K-1 form rather than Form 1099. MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Income Tax).

There are inherent risks with fixed-income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer-duration fixed-income securities and during periods when prevailing interest rates are low or negative. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT), and taxable gains are also possible. Investments in below-investment-grade debt securities, which are usually called “high yield” or “junk bonds,” are typically in weaker financial health and such securities can be harder to value and sell, and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.

Investments in emerging market bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. Emerging market bonds can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Returns include the reinvestment of interest and dividends. Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk. Past performance is no guarantee of future performance.

Index Definitions

The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.

The S&P/LSTA Leveraged Loan 100 Index (LL100) is a daily tradable index for the U.S. market that seeks to mirror the market-weighted performance of the largest institutional leveraged loans, as determined by criteria.

The Standard & Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.

Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.

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