Opportunities in a Growth-Starved World
Featuring Jay Pelosky
Published on: May 23rd, 2019 • Duration: 34 minutesWhen the Fed pivoted dramatically earlier this year, markets rallied aggressively. Jay Pelosky, TPW Investment Management co-founder and CIO, thinks that the rally is over because the US economy has yet to bottom. Instead, he sees Europe and emerging markets bottoming first, giving equity investors a great opportunity to re-allocate assets. Pelosky joins Real Vision’s Ed Harrison to outline his thesis that “lower for longer” growth will yield investment opportunities in fixed income, currencies and commodities. Filmed on May 20, 2019 in New York.
ED HARRISON: Welcome to Investment Ideas. I'm your host, Ed Harrison. And today, we're talking to Jay Pelosky of TPW Investment Management. We're going to talk to him about his thesis of lower for longer, that is lower growth for a longer period of time, and what that means in terms of asset allocation. Looking forward to it, and hope you enjoy it.
Jay, welcome back to Real Vision. It's a pleasure to talk to you.
JAY PELOSKY: Ed, nice to meet you. And great to be back on Real Vision.
ED HARRISON: Well, I want to catch up with your tripolar world thesis. But from a different angle here, because as I was telling you before, off-camera, we do a six to 24-month time horizon here. And I know that you look over the six to 12-month horizon for not just in the investing world, but also politics, economics, etc. So, the first thing is, is what's your macro thesis based upon what you're seeing?
JAY PELOSKY: Yeah, that's a great, great question. And we love that time frame. So, congrats to Real Vision and to you for even thinking that way, right? In today's day and age, where everything is like today, tomorrow, yesterday type of feeling. So, that longer term outlook, I think, particularly from a global macro approach is really important. And that's the work we do at TPW Investment Management, global macro multi-asset.
And the theme we're working on at the moment is the lower for longer global growth path. And that path, we believe has significant investment implications. Namely, if you believe that growth is going to be lower but for longer, you want to be in markets that have room for multiple expansion, because earnings growth is not going to be that robust. So, that's the equity market component. We want to be invested in markets that have room for multiple expansion, which is primarily the non-US developed markets.
On the fixed income side, we want to be invested in instruments that offer yield, because we're not going into recession, we're not going to have the Fed raising rates sharply. So, you can go for yield poise. In the currency markets, we want to go for non-dollar currency exposure, because we believe one of the things that's going to fall out of the lower for longer growth path is a weaker dollar. And finally, that we just to commodities. And in commodities, if we have growth that's low, but it's still continuing, we have a weak dollar. That's a pretty good setup for commodities, particularly the base metals and the miners.
So, we are focused on ex-US developed markets that have room for multiple expansion, fixed income instruments that offer yield, non-dollar exposure, and industrial metals and miners in the commodity space.
ED HARRISON: That sounds great. Tell me a little bit about the economic environment that creates that just beyond the lower for longer. Tell me about, for instance, the three different parts of your tripolar world thesis- China, Europe and the US, where are they going?
JAY PELOSKY: Well, that's exactly the right approach to that is that we start off with this tripolar view framework, right? Our basic thesis, our structural secular theme that we expect to play out over five or 10 years, is the view that the next step of globalization is going to be regional deepening, or regional integration in each of the three main regions of Asia, Europe, and the Americas. And in that six to 12 to 24-month timeframe, we use a process we call our global risk Nexus scoring system. And that looks at economics, politics, policy and markets in each of the three regions, and globally.
And two of the things we look at in the economic section are potential growth rates in neutral rates of interest. And this is where it's really important for investors to understand that I think investors, by and large, have not really grasped the importance of these two issues. If you accept, for example, that the developed economies are decelerating towards their potential growth rates, potential growth rates are derived from demographics, right, population growth and productivity. And if you accept that potential growth rates in the developed economies are, say 2% in the US, 1% in Europe, 1% in Japan give or take, then you can understand where we are in the growth cycle, right?
And all of a sudden, that story in Europe, for example, which if you read the headlines is all about oh, Europe growth implosion, Europe is at the end of its growth path, etc. No, Europe is simply decelerating to its potential growth rate. And then the neutral rate of interest is the rate of interest that allows for a stable, full employment economy without inflationary pressures. And that helps you understand why interest rates are where they are. So, all the folks who over the years have been arguing for rates to go back to where they were in the last 15 or 20 years, have totally missed the boat. Because in this declining potential growth rate environment, neutral rates of interest follow it down, and you have a whole different macroeconomic framework.
And so, that's where we believe we are. We're decelerating towards these potential growth rates in the developed economies. And the question then becomes what are we looking for to confirm that, right? And so, we're basically looking for, or what are we looking before we get to the confirm? What are we looking for in terms of issues to support that bottoming?
And the first is the Fed, right? The Fed pivots and stops raising rates. Secondly, we have China's stimulus, very significant, right? Third, we have fiscal stimulus in Europe and Japan. And fourth, we expect to have- this has not yet really happened- central banks cutting in the emerging markets.
ED HARRISON: So, let me interrupt there for a second and ask you- I'm looking back say, six months, and we had a big hiccup in the markets, not just in the US, but globally. And then there was a risk rally in the United States with the Fed pivoting pretty brutally actually, where were we in that process in terms of this confirmation process that you're talking about?
JAY PELOSKY: Well, I think that that's a really good point to pick up. Because the Fed, I believe, recognized that in this low growth environment, it was running close to the point where it was going to raise rates too far, and really crash the economy.
ED HARRISON: Overtightening.
JAY PELOSKY: Overtightening. And that again, goes back to that neutral rate of interest, right? In a lower growth environment, you need lower interest rates to accomplish the slowing that the Fed was trying to get to. The other point that I think is also not quite fully appreciated in the markets is that the Fed also recognize that the last two recessions in the US were caused by financial market crashes, 2000 and 2008. And so, the Fed is very worried about the implications of a stock market crash for what it will mean for consumption and demand in the United States.
So, I think that's also it's not the Fed is protecting the equity market, it's that the Fed recognizes that in this environment that we're in, financial market crashes have big implications for the real economy. And that's why I think they pivoted. That set the stage for a fairly significant risk asset rally, right? We had the worst quarter in 20 years or so in Q4, and then the best quarter in 20 years in Q1. And the key was to be able to ride through that, right, because it's very hard. And this is where you get into market timing, very hard to sell at the top and buy back at the bottom, particularly when the space is only a couple months, right?
So, I think increasingly, investors are going to have to get used to the idea of riding through short term volatility if they have this longer-term view. And I think this is where the global macro space, the ability to have a framework, the ability to have a point of view, a theme that you can anchor to, allows you to hopefully outperform. And again, that's what we're aspiring to at TPW Investment Management. So, as I see it, we had the Fed pivot, we had aggressive China stimulus, we have European fiscal stimulus and Japanese fiscal stimulus, which don't get as much play. They're not as big as China, but they're important in helping those economies bottom.
And now where we are is, is in our view, we have this strategy we call the three-step risk asset process or RAP. And the three steps are anticipate, confirm and reallocate. So, step one is anticipate, and that's what we think Q1 was. The risk asset rally in Q1, was the markets anticipating the impact of the Fed pivot and the China stimulus. Okay, so that anticipation rode us back up to where we were several weeks ago, or a month or so ago.
Step two is confirm. And what we're for really is confirmation across three different levels. The first is in the economic data. So, think about China economic data and the bottoming in China, we think that's in place. We think China has bottomed. You will get PMIs, you'll get manufacturing-
ED HARRISON: Are you looking at absolute data relative to expectations type?
JAY PELOSKY: Both. We look at economic surprise indices, we look at the actual data. And the thing that we've looked at, Ed, that, again, I think doesn't get enough attention is the service side in the composite PMIs. Everybody in the marketplace loves to focus on the manufacturing PMIs, which have been definitely weak. But the service side, the consumption side of the economies has been pretty robust.
And that is explained by the fact that we have very low unemployment in most of the major regions of the world, right? US unemployment, record low. In Europe, unemployment's at several decade low, same with Japan has wiped 3% unemployment, right? So, unemployment's very low, wage gains are okay, so the economy, the bulk of the developed economies, 70% or so are consumption driven. Manufacturing's by 10 to 15% but yet somehow we persist in this idea that if the manufacturing segment isn't good, the whole economy is lousy. And I think that's a mistake.
So, we're looking for data confirmation in the economies. We've got it in China. We think we're getting it in Europe. And in Japan, it's coming. It's not fully there, fully visible. But definitely Q1, GDP in Europe was better than expected, in Germany, better than expected, in Japan, just came out over the weekend. Way better than expected. Okay, so we think the developed economies are bottoming.
Now, we want to see confirmation, not just in the data, but in the financial markets, primarily in the fixed income markets. And here, we're looking for confirmation at the long end, right? So, if the economies bottom, that long end of those bond markets, particularly in China, also in Europe, should be starting to reverse, right, should be going higher. Again, seen that in China, the 10-year bond in China has backed up about 30 basis points, check that box, confirmed. We haven't seen it yet in the bunds, right? The bunds are still minus I think, 10 basis points. So, that indicator, that confirmation by the long end of the European bond market has not yet signaled for us, okay? So, we're looking for that as well.
The other factor that has started to suggest the bottoming is in earnings revisions, right? If you look not just in the US, but across the globe, earnings revisions are working like they're bottomed and are turning up. So, the fear was that we were going to have an earnings recession, right? Two quarters of negative earnings growth, Q1 is going to come in better than expected, again, not just in the US, but in Europe and Japan, no, not negative, slightly positive, Q2 and 3 remains to be seen. But the revisions are starting to turn up. So, that's another indicator for us of confirmation of the bottom.
The third factor- so first data, then financial market, the third is policy. And here, we get to the great overhanging cloud of the trade fight between China and the United States, which on the one hand, might be construed as a healthy pullback, right, because we had that huge ramp in risk assets in Q1, healthy pullback may be a great entry point if you buy this thesis, this is the time to start putting some money to work. On days like today where China's down 2.5%, the chance to put money to work on a day like that.
And the other side of it is though, of course, if we really do have a full-blown trade conflict, then I think that's going to have an overhang on growth. And we would probably have to reassess our approach at that point.
ED HARRISON: Right. Well, tell me in terms of your original thesis, which is about outperformance because of multiple expansion outside of the United States. What does the economics tell you right now? That is where the US is relative to say, Europe or Japan?
JAY PELOSKY: Well, I think we were talking about our three-step risk asset process or RAP, right? So, the first was anticipate, we covered that. The second was confirmed, we covered that. And the third is reallocate. So, that's really where your question drives at. And the issue for us as we see it, we think the emerging markets, particularly China bottomed first, right, because they were the ones that really got in trouble last year with the Fed tightening. Remember, if you look back, actually the Chinese stock market bottomed in October. October. And it makes perfect sense, then six months forward, the economy's bottoming, right?
The markets are forward looking discounting mechanisms, right? People tend to forget that in the hustle and bustle of the daily action, forward looking discounting mechanisms. China's equity market bottomed in October, and lo and behold, here we are in April, May, and the economy looks like it's bottoming. Pretty much perfect textbook type of timing. Then we think Europe comes after, right, because Europe is tied closely via trade to China and China demand.
So, China bottoms first, Europe bottomed second. And we think the US is actually behind the rest of the world in this process, in large part because of the fiscal stimulus that the tax cuts gave in 2017-2018, which boosted US growth relative to the rest of the world, gave us a really big earnings boom in '18, right, led the market up sharply in the US. Now, all that's being given back. So, we expect the US to actually bottom last in this process.
And so, to get to the point of okay, what do we do with all this information? This great theme of lower for longer global growth, which emanates from the tripolar world framework? What does it mean for investing? And as we touched on at the top, it has significant implications. First off, if you think about the equity market, there's really only been one game in the economy, yeah, the US- since the bottom in '09. Uninterrupted, virtually uninterrupted eight or nine years about performance.
We think this environment could serve to catalyze a shift from US equity leadership, to non-US developed market equity leadership going forward.
ED HARRISON: And you're making a strategic call, not a tactical call here?
JAY PELOSKY: Yeah, because these moves are multiyear. When the US has leadership at last four years, when the US gives up leadership to other markets at last four years, people forget, because it was so long ago, but from about 2002 to 2007, the non-US markets significantly outperformed the US, in part because of the tech bubble. And then the collapse, right? Because the US is very tech centric, particularly in the equity markets, much less so in Europe and Japan, much less so.
So, in our view at when the lower for longer global growth path, going to have lower earnings growth, because the economy's not going to be as strong. We want to be able to be in markets that have room for multiple expansion. And today, lo and behold, the non-US developed markets are trading at about a 20-year low on a relative valuation basis to the United States. The US has no room for multiple expansion, we're trading at 17, 18 times forward earnings. Europe is trading at 12 or 13 times, Japan is 11 or 12 times, parts of the EM similar 10 to 12 times.
So, those markets are where you can get a little bit of earnings growth, a little bit of multiple expansion, and a little bit of currency appreciation, the three combined should lead to outperformance.
ED HARRISON: Well, let me play the devil's advocate here because before we got on camera, I was talking about Jeremy Grantham, he was talking about emerging markets in particular, outperforming. He was also talking about non-US developed market outperforming because of the relative value and potential for reversion to the mean in terms of relative value. Did he get it wrong timing wise? Or was there something wrong with his thesis at that particular time?
JAY PELOSKY: I think as I recall those suggestions, they were longer term. I think he was looking like seven to 10 cycle. So, we're probably in year two or three of that. So, it's still early from that timeframe. And that's a longer timeframe than then we operate under. We operate, particularly from a thematic point of view on that six to 12 to 24-month timeframe. Our tripolar world secular framework is a decade type of timeframe, but we don't trade necessarily off that.
So, I think Jeremy Grantham might have been a little bit early in his approach. And that's why for us, it's important this bottoming, right, in the ex-US markets, because once you get that bottoming and you start to go in the other direction, you can have people make the case, okay, I want to be invested in the markets as they bought them and turn up, as opposed to the US, it's decelerating. And we've been waiting for this break, the shift from US to the rest of the world for quite some time. And it was really pushed out by the tax cuts, right, because those tax cuts gave the US a little extra runway that the rest of the world really didn't have. And so, it's really delayed that process.
And what that meant, though, is the opportunity arguably, is bigger, because you've had- the US is 17 times earnings, rest of the world, they're13 times earnings. US is very over-owned. US dollar is 10% to 15%, overvalued by against virtually every other major currency. So, the setup is even better, even stronger, once you get that catalyst to make the shift. And so, for us, the catalyst is that confirmation of those bottoms, the trade deal actually going through, the earnings bottoms. And then you have that in equities. I want to find markets that have room for multiple expansion.
ED HARRISON: Now, you were talking about equities. But you also mentioned three other asset classes. Talk to me a little bit about debt. And you talked about the currency play in particular, how does that play into your asset allocation strategy?
JAY PELOSKY: That's exactly right. And we did touch on all four assets. And part of what we do it at TPW is we are multi-asset investors using only ETFs, which are great vehicles, little commercial for ETFs, right, great vehicles for asset allocation. So, in addition to the equity markets with room for multiple expansion, we also think there's an opportunity in the fixed income instruments that offer yield. And this is very controversial or contrarian at the moment, right, because people again, worried about that decelerating growth, worried about recession, don't want to be in high yields, right? Don't want to be in emerging markets.
We are taking the other side of that. Because again, lower for longer does not mean recession, it means the growth path gets pushed out. And so, we're not going to have the Fed jacking up rates, which creates the recession, which drives high yield down. So, for us, we're more than happy to sit in high yield and pick up 300 plus basis points over treasuries. So, we like US high yield, we like European high yield. We also like emerging market dollar debt. We've been in and out of the local currency, EM debt as well. And at this point, it's less attractive to us than the dollar debt, you don't really pick up that much in the way of yield.
There are also other instruments like financial preferred-s, which we think are really attractive. 5.5%