The chief investment officers and other leaders within the investment divisions at Fidelity Investments gather regularly to discuss market conditions, significant risk factors, and other dynamics driving the performance of the financial markets. In the Fidelity Investments roundtable discussion that took place in late March 2013, our investment professionals identified several key themes that could influence investor returns. Jacques Perold, president of Fidelity Management & Research Co., moderated the discussion. [Note: The following views represent those of one or more individuals, and should not be considered as the collective view of either Fidelity Investments or any particular investment division.]
Let's begin today by turning to our fixed-income division. David, what are some of the big-picture issues our research analysts are focused on?
David Hamlin (Fixed Income): I think we're beginning to see some evidence the world may be trending in the direction of deglobalization—diminishing interdependence between businesses, nations, and other global constituents with respect to trade, investment, technology, culture, politics, and other aspects. From 1990 to 2007, globalization proceeded at an astonishing pace and influenced every dimension of the financial markets. Since then, there have been extraordinarily accommodative central bank policies to spur economic growth and rising global currency tensions. Ultimately, everyone is fighting over a fixed amount of global demand for goods and services, and if the economic pie were to be no longer growing, there could be a period when all the constituents begin to compete over the size of their slice of the pie. The prospect of deglobalization thus comes down to future GDP growth and job growth.
What are the implications of deglobalization?
Hamlin: It's possible that corporations—and countries—could increasingly become more desperate to grow profits and nationalistic fervor heats up. Then it would not be unlikely to see currency wars, a trade war, and maybe even a military war. If you think of what transpired during the globalization period of the past couple of decades—access to cheap labor, higher productivity, higher growth, increased commodity prices—all of that could reverse. Globalization was a boom of cheap labor and capital, pushing goods prices down and financial asset prices up. If it unwinds, the result would likely be deflationary for financial assets and inflationary for goods.
Tim Cohen (Equities): I also think we should keep in mind that increased productivity in the U.S. and the growing middle class in the developing world might indicate that a period of deglobalization could still be several years or decades away.
Hamlin: Clearly, productivity was crucial to the U.S. economy over the past decade. As fixed-income analysts, we are constantly thinking about prevailing risks, and we continue to be mindful of the potential impact of those risks on the fixed-income markets if indeed a severe, de-globalization cycle transpired.
Shifting gears a bit, there continues to be positive new data pointing to a U.S. residential housing market recovery. What are people around the table thinking about how this recovery influences the prices of financial assets?
The following participated in this quarter's Investment Roundtable:
President, Fidelity Asset Management
Chief Investment Officer, Pyramis Global Advisors
Chief Investment Officer, Equities
Chief Investment Officer, Global Asset Allocation
Group Chief Investment Officer, Equities and High Yield
Group Chief Investment Officer, Equities
Chief Investment Officer, Money Markets
President, Fixed Income and Vice Chairman, Pyramis Global Advisors
President, Fidelity Management & Research Co.
Executive Vice President, Investment Business Development
President, Money Markets
Chief Investment Officer, Bonds
Chief Investment Officer, Global Asset Allocation
President, Global Asset Allocation and Vice Chairman, Pyramis Global Advisors
Head of Fixed-Income Research
Chief Investment Officer, Equities
SVP, Global Equity Research
Sector Allocation Portfolio Manager, SelectCo.
Sector Allocation Portfolio Manager, SelectCo.
Hamlin: There is a view in the marketplace that the recovery in U.S. housing is going to be the “white knight” for an acceleration of the domestic economy in 2013 and beyond. While many of our fixed-income analysts believe an improvement in housing will provide a positive boost to economic growth, we are skeptical as to whether it will contribute as much to U.S. GDP as it has in prior economic recovery cycles. The health of the country's residential real estate industry varies widely from market to market. The vitality of residential real estate is based on local market conditions, income levels, etc.
As a result, the nationwide average uptick in housing prices of late may be skewed somewhat by other factors, such as recent large-scale purchases of homes at discounted prices by private equity and hedge fund investors who are using them as income [rental] property. In some markets, these purchases have accounted for as much as 5% of the housing stock that has been sold.1 Another factor to keep in mind: When mortgage rates begin to rise, higher rates will act as a dampener on rising home prices. Further, the growth of home prices historically has been very consistent with the growth of income levels; to date, income levels in many areas have yet to accelerate.
Chris Bartel (Equities): There has been a tremendous amount of sales activity in some local markets, such as in parts of Arizona, and it could go on for some time. But at some point when the supply of homes for rent begins to exceed demand for rental properties, I would be concerned if many of the private investors choose to exit the market at the same time, which could be a problem for pricing in these markets.
Bruce Herring (Global Asset Allocation): As our colleague Peter Lynch often maintains, it is important to keep in mind that in this country, housing tends to have a tremendous psychological component to it. When housing prices start to move higher, people start to feel confident in their wealth and they typically start to spend more. With affordability at all-time highs, Americans have had tremendous capacity to buy homes, but not the willingness. Now, with prices moderately ticking up, I suspect more people are feeling better about their wealth and may have greater confidence to spend on discretionary items such as washing machines and refrigerators, as well as furniture, cars, boats, hotels, and airline tickets.
Brian Hogan (Equities): It's likely the bursting of the housing market bubble a few years ago created a generation of Americans who didn't want anything to do with owning a home. These are younger people who saw their parents and relatives living the American dream, and then saw them become underwater on their mortgages after the financial crisis in 2007-2008. It's the same thing that occurs after a massive correction in the stock market or any asset class. Such a downturn creates opportunities for some people who take a longer time horizon and see value in lower stock prices. It is also a good reminder that starting points do matter in any investment. Those who bought stocks four to five years ago at the bottom of the market and held on have made out quite well, as have those who purchased homes near the bottom of the housing cycle.
Cohen: Beyond the psychological factor, rising home prices may provide some relief to homeowners who have been underwater on the mortgages and have been unable to benefit from lower mortgage rates. As prices rise in certain markets, more of these homeowners may be able to refinance and access low prevailing mortgage rates.
Denise Chisholm (Equities): What we are seeing with the housing market recovery today is not unlike what transpired in housing from 1975 to 1982, which was a very long and slow recovery. That often creates a sort of “Goldilocks” environment —not too hot, not too cold—for riskier assets.
With the recent improvement in housing and the outlook for the U.S. economy, are fixed-income portfolio managers growing concerned about the prospect of inflation ticking up?
Hamlin: At this time, the market consensus appears to be that the Federal Reserve is likely to begin to pull back on its quantitative easing around the end of 2013 or early 2014, and that at some point before then interest rates are going to become more volatile. However, this is the fourth straight year investors have expected rising rates [via fed funds futures]2 and nothing has materialized, so the market's predictive power is somewhat dubious. A major reason for the lack of inflation has been a decline in the rate of global growth, which has trended downward since 2011.3 Meanwhile, the U.S. employment-to-population ratio4 has continued to remain at a historically low level since 2009, which suggests that U.S. economic acceleration has yet to materialize. Until we see a pickup in U.S. and global growth, inflation—and interest rates—are likely to remain muted.
When the Fed does indeed decide to pursue a shift in monetary policy, what are the implications?
Bob Litterst (Money Markets): Given the size of the Fed's balance sheet and its ongoing quantitative easing (QE)5—at the current rate of $85 billion per month—I struggle with the notion that it can exit from its U.S. government securities holdings in a manner that will effectively control the pace at which rates increase. Unconventional central bank policies that have been implemented are unprecedented in nature and scope, and when the Fed decides to slow or stop its purchases of government securities, I expect the market's response will be difficult to predict. I have a hard time believing it won't be disruptive to the markets.
Bob Brown (Bonds): As most of us are aware, the Fed has been purchasing securities to keep rates low and drive more demand for riskier assets. This policy is intended to improve market psychology and economic momentum. Today, many people generally are feeling better than they were a few years ago, but the improved confidence levels have yet to influence consumer spending at lower income levels and corporate spending in any meaningful way. There has not been any wage inflation either, which would be an indicator that the economy is improving in a more broad-based way.
Among our fixed-income team, there is general concern about the prevailing risk of the Fed's exit, the ability of sovereigns to repair their balance sheets, and a lack of data indicating a more inclusive U.S. economic recovery. The European Central Bank has done a good job engineering stability in certain foreign bond markets, but the strength of the recent rally in eurozone bonds is somewhat concerning because the structural challenges in most highly indebted sovereigns have not been addressed. For these reasons, many of our fixed-income strategies continue to be positioned for a period of potentially higher volatility.
The solid performance of U.S. stocks so far in 2013 would seem to indicate that the outlook for the U.S. economy is fairly positive...
Hamlin: Historically, the equity market tends to rally in advance of an economic recovery, and that very well could be the case. But it's also possible that the recent rally in stocks is a false indicator, particularly if you analyze other less-favorable factors indicative of the health of the economy.
Herring: A good example is the growing number of Americans who are now receiving food stamps [now known as the U.S. government's Supplemental Nutrition Assistance Program]. Today there are more than 46 million people on food stamps, an all-time high.6 This suggests there are a growing number of people who haven't participated in the domestic economic recovery.
Tony Rochte (SelectCo. Equities): I think what we are seeing is that there are two different economies that exist, and a growing bifurcation of wealth between the working class and the folks who have been able to easily refinance their mortgages at a 3% rate. The upper-income portion of the labor force appears to be participating in the U.S. economic recovery, but it may take further participation at lower-income levels to see a greater acceleration in growth.
Hogan: To me, this dispersion of wealth is the latest sign of how some developed countries are starting to resemble emerging-market countries, at least in some areas. In the past, some common themes that have contributed to the volatility in emerging markets have been financial crises, currency devaluation, rising inflation, political instability, and tremendous wealth disparity. Ironically, we are now seeing some of these same problems in the developed world: the recent banking crisis, an explosion in the size of the balance sheet of the federal government, political instability, and there also seems to be greater wealth dispersion.
Andy Windmueller (Global Asset Allocation): One explanation for the exacerbated bifurcation of wealth could be a shifting composition of the labor force. The skill sets required for the jobs that were lost a few years ago in the recession may be very different than the nature of the jobs that are being created today. New technologies and productivity enhancements may be having a more pronounced effect in certain areas of the workforce, and there may be an underappreciation of the magnitude of this trend.
What particular areas of opportunity are there in the equity market?
Chisholm: Despite the mixed perspectives on the U.S. economy, I would argue the U.S. consumer is now in one of the healthiest states in many years, and for a few reasons. First, U.S. crude oil production has been rising to the highest level since the 1970s; historically, increased domestic production has often put pressure on oil commodity prices and energy stocks.7 Lower energy costs, combined with a steady decline in net debt per households over the past few years, put the consumer in a healthier position to spend.8 Historically, when the energy sector has underperformed relative to the broader U.S. equity market, 71% of the time the consumer discretionary sector has outperformed.9 In addition, when unemployment has been above 5%, the consumer discretionary sector has outperformed the broader equity market 76% of the time over the subsequent year.10 So these positive factors [i.e., energy and household deleveraging] are supportive of outperformance by consumer discretionary stocks.
Roy Justice (Equities): From a technical perspective, the performance of the energy sector relative to the broader U.S. equity market has a tendency to spike higher and then go through long corrective phases. This long corrective phase occurred following energy sector peaks in the late 1950s and again in the early 1980s.11 With the run-up in relative returns during the past several years, energy may be in the early stages of a corrective phase that could last a decade or longer.
Meanwhile, the performance of the U.S. consumer discretionary sector relative to the broader U.S. equity market has been in a 40-year downtrend going back to the early 1970s, and only recently the trend began to turn higher.12 Consumer discretionary stocks have been roughly flat since the mid 1990s, which shows that the recent age of the overleveraged U.S. consumer didn't mean this sector was a particularly exceptional investment.13 However, with the sector's outperformance relative to the broader market since 2008, it may still be in the early days of a multiyear bull market trend.
Chris, from a fundamental perspective, what are our equity analysts seeing in the consumer discretionary sector?
Bartel: There are a lot of good individual stories in this sector, and a common theme among them is tied to the wealth bifurcation topic we discussed earlier. For example, certain high-end luxury retailers that have had pricing power and profit margin expansion have handily outperformed the broader market. This is largely because many upper-income Americans have been less affected by the sluggish GDP growth of the past several years. At the same time, retailers that market generally to lower-end consumers by and large have not experienced the same fundamental business improvement, and thus have not performed as well.
More broadly speaking, how are companies executing?
Hogan: We've seen some improvement in corporate profit growth after a decline in the second half of last year. Overall in 2012, S&P 500 companies experienced combined earnings growth of about 4%, which coincided with multiple expansion for the S&P 500.14 I do think it's possible that the equity market may continue to remain healthy this year and achieve further multiple expansion even if there isn't robust earnings growth, on average. A lot of the serious headwinds equity investors have faced, including the U.S. fiscal cliff and the eurozone debt crisis, have moderated to some extent and appear less threatening.
Herring: Historically, when corporate earnings and the macro backdrop go from “terrible” to “mediocre,” investors tend to respond more favorably to equities. I think that is part of the reason why stocks have fared pretty well over the past several months.
Cohen: It's also worth recognizing that there are a lot of fundamental economic and business factors that still remain below long-term average levels, such as unemployment, corporate capital spending, merger and acquisition activity, and consumer spending. I don't mean to suggest we will see improvement in all of these areas, but I do think there are more areas where there is potential for improvement than there are that are currently overheated or above trend.
How are our equity portfolio managers reacting to current market conditions?
Hogan: We continue to see more managers maintain conviction in their best ideas and hold onto those ideas for extended durations. Generally speaking, we believe that our global research capabilities are a competitive advantage in helping us unearth and invest in strong businesses poised to outperform over the long term.
Andy, are there any common investment themes among our asset allocation strategies?
Windmueller: There have been some common asset allocation themes among our portfolio managers. For example, many of our strategies have increased exposure to U.S. equities over the past few months, reflecting steady economic growth, an improvement in the housing market, and a continued backdrop of low inflation and accommodative Fed policy. This positioning reflects a view that existing economic conditions and the near-term outlook for the U.S. are more favorable than those in other developed-country equity markets. In addition, some of our strategies have begun to reduce their overweights to high-yield bonds in response to rising valuations.
2. Source: Bloomberg, Fidelity Investments as of Mar. 31, 2013.
3. Source: Various national statistics offices, Haver Analytics, Federal Reserve as of Mar. 31, 2013.
4. Source: U.S. Bureau of Labor Statistics, Haver Analytics as of Mar. 31, 2013.
5. Quantitative Easing: A form of monetary policy by central banks used to increase the money supply through the purchase of assets, such as mortgage-backed securities and other government issued bonds. QE increases the money supply by allowing financial institutions to obtain greater capital, with the hope that increased capital and lower borrowing costs (rates) will encourage bank lending and consumer spending.
6. Participation in the U.S. government’s Supplemental Nutrition Assistance Program (SNAP) was 46.6 million people as of fiscal year 2012, the largest number ever and an increase of 4% from the prior year. By comparison, roughly 26 million people participated in SNAP in FY 2007. Federal spending on SNAP was $78.3 billion in FY 2012, up 3% from the prior year. Source: “The Food Assistance Landscape: FY 2012 Annual Report,” U.S. Department of Agriculture.
7. Source: Haver Analytics, Fidelity Investments as of Mar. 31, 2013.
8. Source: Haver Analytics, Fidelity Investments as of Mar. 31, 2013.
9. Source: Haver Analytics, Fidelity Investments as of Mar. 31, 2013.
10. Source: Haver Analytics, Fidelity Investments as of Mar. 31, 2013.
11. Source: Haver Analytics, Fidelity Investments as of Mar. 31, 2013.
12. Source: Haver Analytics, Fidelity Investments as of Mar. 31, 2013.
13. Source: Haver Analytics, Fidelity Investments as of Mar. 31, 2013.
14. Source: FactSet, Fidelity Investments as of March 22, 2013.