BRUCE LOVE, MANAGING EDITOR, FA-IQ: Well, hello, and welcome to this podcast from the downtown Manhattan recording studios of Oppenheimer Funds. I’m your host, Bruce Love, the editor of the Financial Times’ Financial Advisor IQ publication. And with me today is Krishna Memani, who is the chief investment officer of Oppenheimer Funds.
Hello, Krishna, how are you today?
KRISHNA MEMANI, CIO, OPPENHEIMERFUNDS: I’m good, thank you.
BRUCE LOVE: Fantastic. And Krishna oversees the investment teams at Oppenheimer Funds and you’re also head of fixed income, so we might pick your brains today on a few central bank and monetary policy issues, as well. Because basically today we want to get your opinions on what financial advisors should be looking for in 2018.
So, Krishna, in a nutshell, what will financial advisors need to do differently for their clients in 2018, do you think?
KRISHNA MEMANI: The biggest difference between 2017 and 2018 isn’t necessarily the fact that the economic environment has changed dramatically or the policy environment is likely to change in 2018. It’s a fact that 2017 was a fantastic year for the markets. As a result, the primary difference that a financial advisor has to think about for 2018 is how much risk to take. And, given the rally we have had in 2017, that would have to be lower in 2018 rather than higher.
BRUCE LOVE: So it seems like it’s an issue more of you’re not expecting risk to go up dramatically, but you want to at least position yourself to be prepared for what’s to come ahead.
KRISHNA MEMANI: Indeed. So it’s not that the economy will do worse, it’s not that inflation will pick up. It’s not that the markets are not going to perform appropriately. It’s just that markets have had a significant run, so you have less upside and more downside.
Having said that, our outlook is still for the markets to have a decent run in 2018 across the globe.
BRUCE LOVE: So give us a little bit more of an idea of where you think we are in the current cycle, then. Are we on the verge of ending? It doesn’t sound like you think that.
KRISHNA MEMANI: No, far from it. We think growth in the world is synchronized and 2018 growth will be better than it was in 2017. In fact, in emerging markets growth is getting deeper and less China-dependent, which I think is a very good thing for the global economy, as well. Developed markets continue to do very well. Inflation looks extraordinarily controlled and one of the worries that central banks have is the fact that inflation may be trending lower and, as a result, they may have to maintain support for the global economy longer.
So, no, I don’t think we are anywhere close to ending the cycle. It’s just simply that the upside is modest and downside is significant if our views are wrong.
BRUCE LOVE: Well, that sounds like good news for clients. And a good story for advisors to be able to tell clients, as well. Sounds like this detachment from China in the global economy is a good thing, less correlations.
Whilst they’re telling their clients these stories and whilst they’re positioning the portfolios accordingly, what do you think advisors should be looking for as signals that the cycle may be ending or changing next year?
KRISHNA MEMANI: Sure. So couple of things to be watching out for. First, and most important thing to be looking out for is inflation. If inflation is picking up in the U.S., in developed markets or on a global basis, then the entire thesis falls apart. So watching out for inflationary signs in the U.S. is probably—because the U.S. is the furthest along in the cycle, I think is something to be mindful of. And specifically wage inflation is something to be watching out for.
Employment rates have dropped to a low enough level so that if the Phillips curve is indeed alive, we should see the results of that sometime in 2018. I don’t think we would, but that’s something to be looking out for.
The strength of the dollar is another thing to be watching out for. The strength of the dollar would indicate that funds would be coming out of emerging markets back into the U.S. the way it happened 2015 and 2016 and I think that would be bad for the global economy.
Rates rising meaningfully, in Europe, in U.S. Again, unlikely to happen, but something to be watching out for.
And finally I think looking out for a slowing growth trend in places which have surprised us the most, which is Europe and emerging markets. If growth trends in those markets start turning negative, I think that would be something to worry about, as well.
BRUCE LOVE: So there are plenty of things to look out for. Inflation, rate rises, employment, dollar, slowing of growth. So there’s plenty of things for advisors to keep their eyes on.
KRISHNA MEMANI: Of course. It’s not a perfect world by any measure at the moment. But, having said that, things are pretty good.
BRUCE LOVE: And obviously we’re not saying that anything is going to happen in any of those arenas. You’re saying, Krishna, those are the things to look out for this year.
KRISHNA MEMANI: Indeed.
BRUCE LOVE: Okay. So let’s turn our mind to some domestic macro issues, then. And you were telling me that you weren’t that worried about large U.S. debt and rising deficits. Why is that?
KRISHNA MEMANI: So, deficit is a significant economic issue for sure. When debt levels increase meaningfully it ends up being highly negative for economic growth. Having said that, U.S. debt level’s significantly higher than where they have been in the past, are not extraordinarily high. And the main issue that we have to deal with right now is not deficit as much as it is lack of growth. So, if we can sustain the growth at a meaningfully higher level for an extended period of time, the deficit problem resolves itself on its own.
So, focusing on growth at this point is more important. Deficit and related issues we will deal with later on.
BRUCE LOVE: So, should you be looking at economic indicators like production, like retail sales, things like that? Or is that getting too fine a point? What should you be looking at?
KRISHNA MEMANI: I think that is getting too fine. The bottom line is, debts never get paid back. That’s a fact. There’s no pocket of gold somewhere that you can extract and pay all your debts back. That’s not how things work. Debts become manageable because you’re growing at a fast enough rate to be able to pay those debts if the debtors want you—or if the creditors want you to do that.
So the key thing to focus on is really growth. And in that context, the key thing to focus on is productivity growth.
BRUCE LOVE: Right.
KRISHNA MEMANI: Right now, the biggest challenge the U.S. economy has is the fact productivity growth at this point in the cycle is significantly lower than what it has been. So if we do things that curtail growth to control deficit that will end up being a longer-term problem and make the problem even harder than what it is right now.
BRUCE LOVE: So what are the sorts of things that you would see that would reflect us doing things to limit growth?
KRISHNA MEMANI: I think what we need to see today more than anything else is an increase in the investment cycle. So the one unique thing about this cycle relative to previous cycles has been the fact that investment never picked up. If you look at consumption, a significant part of U.S. growth, consumption is actually at a pretty good level. Despite the fact that incomes are not growing at a very rapid clip, consumption is quite decent. So I think that’s a good thing.
What has been missing this time around is a pickup in investment. And that is a longer-term problem. If you don’t have investment increasing in a meaningful way, future productivity will remain relatively low. So, when we think in terms of policies, whether it’s related to deficit, whether it is related to interest rates, whether it’s related to taxation, what we should singularly focus on is what are the things that we can do that will increase investments and, as a result, increase the productivity growth of the U.S. economy.
BRUCE LOVE: Fascinating. So, yeah, looking at investment and growth, you see that happening, you’re going to see the U.S. continuing to build a healthy and a wholesome economy. I mean, the picture you’ve painted so far is not a bad picture by any stretch of the imagination. So let’s turn our mind to actionable ideas, then. Let’s think about, what’s your thoughts, Krishna, on investment opportunities for clients in this current environment and going through 2018?
KRISHNA MEMANI: So, in the current environment for investors, having a significant allocation in equities is the single most important thing.
BRUCE LOVE: You get a lot of growth out of that.
KRISHNA MEMANI: Yes. Equities will do very well in the current environment and they will do significantly better than bonds in the current environment. So despite the fact that we think markets have had a good run, equities are probably going to still provide better returns in 2018. So that’s one.
Second, equity returns overseas—international equities and, more importantly emerging market equities—are going to be significantly better than U.S. domestic market returns. And the reason for that is straightforward. Valuations in emerging markets and international equities are much better than what they are in the U.S. and the growth outlook is better overseas, in Europe, for example, or more importantly, in emerging markets, than it is in the U.S.
So, focus on equities, focus on international equities. Bonds are going to provide you decent coupon-type returns. So you own bonds to provide diversification in your portfolio, to provide a ballast in your portfolio. Don’t expect spectacular results out of bonds, whether those are government bonds or credit.
BRUCE LOVE: It’s still a necessary part of a balanced portfolio, though.
KRISHNA MEMANI: Of course, of course. They are still a good source of income and, more importantly, they are a good source of diversification, protecting your downside in case anything goes wrong.
BRUCE LOVE: Sometimes difficult for advisors to get that message across, but it’s a very important message, to be sure. So, Krishna, let’s turn our thoughts closer to home, to domestic markets again and let’s talk about the Fed. Krishna, do you think it’s making a mistake by keeping interest rates low for so long?
KRISHNA MEMANI: I don’t think so. I think for rates to rise meaningfully what we need to see is some evidence of inflation before tightening too hard. So, coming out of the financial crisis, the Fed kept rates low for a reasonably long period of time and I think that was the right decision.
Now that employment rate is down to 4%, it’s a good question to ask whether we need to keep rates this low. The proof of that really has to come from inflation. If the inflationary outlook is modest, then the fact that employment rate is low in and of itself doesn’t require us to tighten policy.
Let me give you an example. Japan has significantly lower unemployment rate than the U.S., but has no wage inflation. And I think the U.S. is in the same position. As long as wage inflation is relatively modest and therefore overall inflation is relatively modest, tightening policy too soon doesn’t serve any purpose.
BRUCE LOVE: Right.
KRISHNA MEMANI: So I think the Fed has the right policy outlook—tightening, but gradually. Be mindful of what the inflation outlook looks like and, if inflation is picking up, they will pick up the pace of tightening and, if it isn’t, then there’s no point pressing too hard.
BRUCE LOVE: There’s no point pressing too hard for the Fed, but for client portfolios, what are these effects going to be? Keeps going the way it’s going, what are the effects on client portfolios? They start to build, what happens then?
KRISHNA MEMANI: I think one of the challenges for client portfolios is how do you generate income in client portfolios when rates are this low. So I think the way we would suggest people think about income is not focus singularly on bonds as the source of income. The total return of the portfolio and other non-traditional sources of income is what clients should be thinking about, rather than depending singularly on bonds to be generating the income.
The other point is, yes, the Fed policy has created a problem in terms of the income part of your portfolio, but recognize that, if they tighten policy too quickly and that problem may get resolved, but it may create bigger problems for you in terms of economic growth and the equity part of the portfolio may correct significantly.
BRUCE LOVE: So it is a bit of a tricky situation for income and there’s certain strategies you can make. I guess, if income starts coming in, you’ve got another decision to make there, don’t you? And that’s rebalancing to take advantage of that.
KRISHNA MEMANI: Absolutely. So I think if rates start rising too quickly, your income problem may get resolved, but it may create another problem for you in the equity part of the portfolio where you may see somewhat of a drawdown, some correction. So it may not end up being as good as you expected.
BRUCE LOVE: Interesting. What’s the likelihood do you think, then, of tax reform next year?
KRISHNA MEMANI: I think it’s quite likely that we will see some form of tax reform. The real question is, what would be the magnitude of the reform? And I think there my expectations are relatively modest. We expect corporate tax rates to be lower than where they have been of late. Individual tax rates to be very modestly lower. Growth as a result to be modestly higher because of the fiscal stimulus that comes out of it. So we may get a one-time pop in the markets. But if the crucial purpose of tax reform was to revive the investment cycle and revive productivity, I don’t think that is going to materialize. And as a result, the growth trajectory will essentially be the same, except for the fiscal stimulus, that may generate maybe a couple of tenths of a percentage point in extra growth.
BRUCE LOVE: Interesting. Interesting. Well, in that case, if tax reform is enacted and, if that’s your view, then would your investment views change if tax review is enacted?
KRISHNA MEMANI: It will change materially. What it would mean is growth would be modestly higher. Equities will have a modestly higher return profile in 2018. But nothing like 2017. 2017 was coming off of a challenging 2015 and 2016. That is not going to be the case in 2018. So we will see a one-time pop after tax reform, but after that pop, things will basically be on the same path that they have been for a while.
BRUCE LOVE: It’s going to be a very fascinating year. In summary, Krishna, what do you think are the biggest economic issues that financial advisors will be facing for their clients in 2018?
KRISHNA MEMANI: Returns in 2018 are going to be far less than the returns in 2017. Preparing your clients for that expectation I think is going to be important. Secondly, growth in international arenas, in Europe, in emerging markets are going to be significantly better. Ensuring that your investors have a significant allocation into those markets I think is going to be important, as well.
And, finally, finding other sources of income away from just bonds I think is going to be important in 2018, as well.
BRUCE LOVE: Well, Krishna, thank you very much. With that, it’s goodbye from the Oppenheimer studios in New York. I’m Bruce Love with FA-IQ and with me today was Oppenheimer Funds CIO, Krishna Memani. Krishna, thanks so much for joining us today.
KRISHNA MEMANI: Thank you.
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