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Lazard Capital Allocator Series
Capital Market Viewpoints
1Q17
Outlook
The Lazard Capital Allocator Series Investment Team
(“Investment Team”) has taken recent economic and global
developments into consideration in constructing what it
believes to be an optimal asset allocation for the first quarter
of 2017. The Investment Team’s methodology remains “top
down” by nature. Historical relationships combined with information contained in the futures markets are used to develop a
forward-looking worldview that endeavors to anticipate major
turning points in various asset-return cycles. The process tends
to be gradual and directional in terms of specific asset allocation recommendations.
A range of factors—from legislative changes to geopolitical
events—are analyzed in the process of identifying and
anticipating secular and cyclical adjustments in the relative
performance of assets both domestically and across countries.
This information is applied to the Investment Team’s rules for
determining how and when to choose a style, location, and/
or size of an investment, and whether to do so in a passive or
active mode.
RD12102
Major Reallocation Changes in LCAS Portfolios
for the First Quarter 2017:
• Increased equity exposure, particularly to US small and mid
cap equities
• Significantly decreased fixed income exposure
• Increased exposure to nontraditional investments to allow for
tactical engagement
A Brave New Investment World
It is a new world. Global asset allocators woke up in different market
environments after the 23 June Brexit vote and the 8 November US
presidential election—events that called into question assumptions
about economic growth, fiscal and monetary stimulus, and geopolitics.
The stark rejection of Italian voters to a referendum in December was
the exclamation point for a year when populist rage surprised, then
shocked, and finally overwhelmed elites. James Carville distilled Bill
Clinton’s 1992 presidential election campaign in a single, memorable
phrase, “It’s the economy, stupid.” A variation for ballot-driven markets in 2016 could be: “It’s the politics, stupid.”
Each upheaval was dreaded by markets, and yet each sell-off was swiftly
erased by investors (Exhibit 1). The impact of Brexit lingered for a few
weeks; the US presidential election was absorbed in days; the Italian referendum was shaken off in hours. Animal spirits, long dormant, stirred.
After Donald Trump’s election, the markets anticipated that the federal
government might break its deadlock and cut taxes, lower regulation,
and increase infrastructure spending. At the same time, investors
appeared to downplay (or in some cases ignore) Trump’s previous statements on trade, immigration, and foreign policy.
Investor enthusiasm gained momentum on evidence that the global
economy—and the US economy in particular—was strengthening.
US GDP grew at an annual rate of 3.5% in the third quarter, up from
anemic levels in the first half of 2016 and the strongest pace in two
years. In light of this data, the US Federal Reserve’s decision to raise
the fed funds rate in December—only the second rate hike in the past
decade—was taken as a sign of confidence.
US equities jumped while emerging markets, under pressure from a
surging US dollar, dropped. Japanese equities also declined sharply
after the US presidential election. European equities slid as economic
and political uncertainty continued to undermine investor confidence.
In the old investing world, deflation was the major concern, in the
new world, it’s inflation. Before, monetary policy was the tool to support economic growth, now the tool appears to be fiscal stimulus. Six
months ago, investors were desperate as yields hovered at historic lows
and even entered negative territory. Today, upward pressure on interest rates is growing.
We have entered a new paradigm. Fiscal policy is taking over from
monetary policy, which should create more “normal” market conditions. These conditions will likely be more volatile and characterized by
higher interest rates compared to the previous environment. For global
investors, opportunity and uncertainty beckon. As we explain below,
the events of the past several months have shifted our perspective on
asset classes, even as we remain highly sensitive to potential risks to our
outlook. We have implemented three major reallocation changes:
• Increased equity exposure, particularly to US small and mid cap
equities
• Significantly decreased fixed income exposure
• Increased exposure to nontraditional investments to allow for tactical engagement
We believe that global economic growth is resilient and that, over
time, equities will continue to offer more opportunities for returns
than bonds will. In fact, one of the perplexing questions is what
constitutes a “safe” asset in the current environment. We believe fixed
income is vulnerable as interest rates continue to normalize to a higher
level. This is especially true for the US Treasury market, which has
been a safe haven trade for quite some time.
We remain vigilant, as volatility can meaningfully impact markets over
the short run. However, we also believe economic or political trends
will produce both economic winners and losers, which skillful investment managers can seek to exploit.
Exhibit 1
UK Equities Surged after Brexit; US Equities Jumped after the Presidential Election
FTSE 100 Index
S&P 500 Index
7,000
2,275
6,700
2,225
6,400
2,175
6,100
2,125
5,800
Mar
2016
Apr
2016
As of 31 December 2016
Source: Bloomberg
May
2016
Jun
2016
Jul
2016
Aug
2016
Sep
2016
2,075
Jun
2016
Jul
2016
Aug
2016
Sep
2016
Oct
2016
Nov
2016
Dec
2016
Exhibit 2
US Consumer Confidence Has Risen to a Decade High
Exhibit 3
Interest Rates Rose Sharply After the US Presidential Election
University of Michigan Consumer Confidence Index
US Treasury Yield (%)
115
3
95
2
Average
75
1993
1996
1999
Yield curve as of
30 September 2016
1
55
1990
Yield curve as of
31 December 2016
2002
2005
2008
2011
2014
2017
0
0.5
2
5
10
As of 31 December 2016
As of 31 December 2016
Source: Bloomberg
Source: Bloomberg
“Trumpflation” or Stagflation?
The election of Donald Trump to the presidency, while the
Republican party retained control of both houses of Congress, has
changed market sentiment in the United States. Expectations have
risen that the federal government can break the legislative gridlock of
the past several years. A number of important initiatives now seem
not only possible but plausible, such as infrastructure spending, tax
reform, and a lighter regulatory regime. Fiscal stimulus may take over
from monetary policy. The era of “Trumpflation” has arrived.
US economic growth appeared to be accelerating. GDP expanded at
a 3.5% annualized rate in the third quarter, the highest in two years.
November’s job numbers came in strong, and the unemployment rate
dipped to 4.6 percent, the lowest since August 2007. Consumer confidence in December rose to a decade high (Exhibit 2), partly reflecting
the fact that median US household income, adjusted for inflation,
grew at its fastest rate since the survey was started in 1968. In addition, the US housing market continues to improve, and the S&P/
Case-Shiller Home Price Index shows that home prices have nearly
recovered their losses from the global financial crisis.
Equity markets appeared, at times, exuberant. The S&P 500 Index
gained nearly 5% in the weeks after the election, betting on pro-growth
30
initiatives from Washington, D.C. The mood in the bond markets
was different, where additional debt expectations and rising inflationary pressures caused a sell-off. The yield on the benchmark 10-Year
Treasury rose sharply by about 70 basis points (bps) (Exhibit 3).
The decline in bonds was partly driven by rising inflationary expectations as well as the likelihood the Fed would raise interest rates, which
occurred at the December meeting. The new rate, 0.50%–0.75%,
is still low in historical terms, but the Fed indicated that three more
hikes were likely in 2017. This was higher than the one or two hikes
Fed officials had forecast in September—an example of how Trump’s
election has seemingly changed expectations.
In this environment, equities with exposure to the US economy and
infrastructure have benefited. Financials, energy, and industrials sectors
have outperformed since the election. On the other hand, more defensive sectors, such as health care and consumer staples, have lagged.
The prospect of higher interest rates and stronger growth boosted
the US dollar (Exhibit 4). Ironically, we believe this makes Trump’s
pledge to increase US manufacturing jobs more difficult as the rising
US dollar will make US-based corporations and manufacturers less
competitive. In addition, the Fed’s campaign could be too aggressive,
threatening to choke off growth.
Exhibit 4
The US Dollar and Commodities Prices Increased Due Partly to Stronger US Economic Growth Prospects
DXY US Dollar Currency Indexa
CRB Raw Industrials Indexb
104
500
100
480
96
460
92
Dec 2015
440
Mar 2016
Jun 2016
Sep 2016
Dec 2016
Jun 2016
Aug 2016
Oct 2016
Dec 2016
As of 31 December 2016
a DXY Index is a measure of the US dollar’s value relative to a basket of select foreign currencies that represent the United States’ major trading partners.
b CRB Raw Industrials Spot Market Price Index is a measure of price movements of 22 sensitive basic commodities whose markets are presumed to be among the first to be influenced
by changes in economic conditions.
Source: Bloomberg
One of the most important questions facing investors in 2017 is
determining whether rising interest rates are: “good,” i.e., representing
healthy economic growth and a normalization of rates; or “bad,” reflecting inflationary pressures from structural imbalances in the economy.
One driver of inflation comes from commodities prices, which have
been rising in 2016 after hitting lows early in the year. Surprisingly, this
trend continued as the US dollar strengthened (Exhibit 4), an unusual
development given that commodities are priced in US dollars and thus
usually decline when the US dollar gains purchasing power. While this
would likely contribute to inflationary pressures, years of investment
in commodities production during the boom years before the global
financial crisis has left meaningful capacity.
Another important issue is the rise of populist, anti-globalization views
in developed markets. Given the importance of exports to emerging
markets economic growth, a threat such as trade barriers can have an
outsized impact on emerging markets. We find it notable that protectionist sentiment—note Trump’s slogan: “America First”—has risen
steadily over the past several years.
Another potential source of inflation is wages, which have been rising.
The US unemployment rate is about 4.6, a low, which implies that
the labor market is near full employment—thus giving workers more
bargaining power for higher pay. However, labor participation in the
United States has also declined since 2007, implying slack still exists in
the job market.
Europe: Political Uncertainty Ahead
The question of “‘Trumpflation’ or stagflation?” cannot be answered
with certainty yet. So far, the markets appear to be pricing in an optimal scenario for Trump’s administration—prospects of an effective
federal government while downplaying Trump’s statements on immigration, trade, and international alliances. It is also important to note
that, while Trump is working with a Republican-controlled legislature,
there is no guarantee that his proposals will actually be implemented
as the potentially significant increases to the federal deficit may cause
concern. However, we believe the 10-year Treasury yield low in July
after the Brexit vote likely marked the end of the secular stagnation.
Emerging Markets: Caught between
Higher Growth and Higher Rates
The uncertainty around a Trump presidency and his proposed policies
had a direct impact on emerging markets equities, which tumbled
in November after Trump’s election. The decline erased their yearto-date outperformance compared to US equities, though emerging
markets equities finished 2016 up strongly. This result was notable,
considering that the MSCI Emerging Markets Index had posted three
calendar years of negative returns prior to 2016.
Going forward, emerging markets investors face a number of questions. One concern is the potential impact of accelerating US economic
growth, which should be a boon for emerging markets exporters.
Another is a strong US dollar, which can make emerging markets
companies more competitive while at the same time making it more
difficult to repay US dollar–denominated debt. Finally, commodities
prices continue to have significant influence on emerging markets
equities, even though emerging markets are diverse economically. The
bottoming of commodities prices in the first quarter provided vital support to the emerging markets rally in 2016. Further stability or inflation
in commodities prices would benefit the asset class, in our view.
This near-term uncertainty overshadows the improvements in emerging markets fundamentals as well as the asset class’s long-term positive
outlook. We believe that 2016’s performance is not—potentially
yet—an inflection point that signals a rotation out of developed markets into emerging markets.
Many investors are growing optimistic about Europe as it enters 2017,
even though equity performance mostly lagged in 2016. The global
economy is accelerating, US prospects have risen, and European
manufacturing activity and economic sentiment have reached levels
last seen in 2011. The European labor market appears healthier, and a
weaker euro versus the US dollar has made European exporters more
competitive. At the European Central Bank (ECB), monetary policy
remains accommodative.
Europe does face a number of political challenges as the Brexit
negotiations play out and populist, euro-sceptic arguments dominate
upcoming elections in a number of countries, including France (in
April/May) and Germany (October). If populist-driven figures take
power in a major European government, the euro and the structure of
the European Union (EU) could be called into even greater question.
However, we believe the likelihood of this is low.
Investment Insights
Market conditions have changed dramatically since the US elections,
and we are adjusting our portfolios accordingly. We believe the new
administration, working with Congress, could deliver significant
regulatory and tax reforms, along with an infrastructure package, that
would be stimulative to the US economy. In our view, this would have
two likely outcomes—equity assets with exposure to US growth will
be supported, while interest rates would experience upward pressure.
The implications are significant for investors in US fixed income, which
have been bid up over the past several years as central banks pushed
down rates and investors, desperate for yield, turned to lower quality
securities. We see potential for significant downside if US economic
growth climbs to its historical range of 2%–3% (it has been below 2%
for most of the past six years) and inflation hits 2%. The benchmark
10-year Treasury, in our view, could rise well above the 2.6%–3.0%
threshold established by consensus. If rates continue to normalize,
it would not be unreasonable to see the 10-year Treasury bond yield
in the 4%–5% range. Duration-sensitive investment across both the
equity and fixed income markets would be especially vulnerable.
However, we do not believe that the recent rise in interest rates is
due to inflationary pressures. Supply and demand in commodities
appear to be still in balance. We are also watching wage pressures in
the US labor market closely, but we believe that the low rate of labor
participation implies more slack than is apparent in the current unemployment rate.
demand for emerging markets products. At the same time, despite
strong performance this year, we believe emerging markets equities
remain relatively inexpensive.
In Europe, we continue to have ongoing concerns about political
uncertainty, especially the challenges posed by the Brexit process as well
as the number of important elections scheduled for 2017. We note that
the European economy is recovering and that the ECB has maintained
loose monetary policy. However, the labor market remains relatively
inflexible and the debt overhang is formidable. In politics, officials must
contend with euro-sceptic contenders, though we believe scenarios of a
breakup of the EU or a dissolution of the euro remain extreme.
We believe large cap US equities, on the other hand, appear more fully
valued, which has partly driven our decision to lower our allocation.
However, a stimulus from the federal government should benefit the
US economy and assets with the most exposure to US growth—such
as small and mid-cap stocks, which are more domestically sensitive.
Small businesses, in particular, would benefit from lower regulation as
they typically do not have the scale to efficiently address government
requirements. We have raised our allocation to these asset classes. We
are much less confident in prospects for US fixed income, especially
high quality bonds. As a result, we have decided to reduce our allocation and now have a significant underweight to the asset class.
We have maintained our allocation to emerging markets equities.
This reflects the growing fundamental strength in emerging markets,
despite the pressures caused by the US dollar and more hawkish Fed
interest rate policy. We believe that a growing US economy will raise
The “relative” nature of returns is a central concept in our assetallocation process. In this changing and uncertain environment, and as
always, we remain confident that our versatile framework will reward
risk-takers who stay the course with attractive relative returns over time.
Lazard’s 2017Q1 Asset Class Viewpoints
Attractive
EQUITY
Fair Valued
United States
Emerging Markets
Cap
Small Cap
Mid Cap
Large Cap
Style
Value
Non-Traditional
Cash
Non-Traditional
Credit
Region
FIXED
INCOME
For illustrative purposes only and, along with allocations and security selection, are subject to change.
Unattractive
Japan
Europe
Asia Pacific ex-Japan
Growth
US Treasury
Lazard Capital Allocator Series Capital Market Viewpoints
This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management.
Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a
robust exchange of ideas throughout the firm.
Important Information
Published on 20 January 2017.
The information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All
opinions expressed herein are as of 31 December 2016, unless otherwise specified, and are subject to change.
Allocations and security selection are subject to change. The securities and funds identified are not necessarily held by Lazard Asset Management for all client portfolios and should not be considered a recommendation or solicitation to purchase or sell any security or fund. It should not be assumed that any investment in these securities or funds was, or will be, profitable or that the
investment decisions we make in the future will be profitable or equal to the investment performance of the securities or funds referenced herein.
There is no assurance that any security or fund referenced herein is currently held in the account’s portfolio or that any security or fund sold has not been repurchased. The securities or funds
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Certain information included herein is derived by Lazard in part from an MSCI index or indices (the “Index Data”). However, MSCI has not reviewed this product or report, and does not endorse
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Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile,
and less subject to governmental supervision than in one’s home market. The values of these securities may be affected by changes in currency rates, application of a country’s specific tax laws,
changes in government administration, and economic and monetary policy. Small- and mid-capitalization stocks may be subject to higher degrees of risk, their earnings may be less predictable,
their prices more volatile, and their liquidity less than that of large-capitalization or more established companies’ securities.
Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities
markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in emerging markets countries.
Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Investments in Japan are subject to certain risks, such as the risks associated
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not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal
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