The sharp sell-offs in global equity markets, which commenced in October, have yet to find a convincing bottom. In December, equity market weakness was joined by strong rallies in duration fixed income and a further flattening of the US yield curve, suggesting that investors see an increased probability of a significant global economic slowdown, if not recession.
In what follows we take stock of recent market volatility and examine the prospects for 2019. Our conclusion is that although uncertainty remains high around matters such as trade conflict, the nature of Brexit, or broader geo-political issues, worries about the economic outlook are probably overdone. Nevertheless, against the backdrop of slowing economic and earnings growth, risks such as trade wars or hard Brexit now matter. That is the nature of ‘post-peak’. As a consequence, we believe even a relatively benign macroeconomic backdrop in 2019 will probably be accompanied by recurrent episodes of volatility. Jagged market price action, higher volatility and a greater dispersion of returns put the emphasis squarely on proper portfolio construction and risk control.
Given the near inversion of the US yield curve and recent de-rating of global equities, it is important to underscore why those market signals overstate the risk of recession in 2019.
It is commonly and accurately cited that an inverted yield curve has preceded every US post-war recession. However, the leads and lags can be long and variable. Moreover, a host of factors, including foreign central bank policy stances, changes in liquidity and risk preference, as well as regulatory changes have resulted in a structural increase in the demand for the ‘risk-free’ asset. All things equal, as the Fed lifts short rates, we believe the yield curve will flatten sooner and more than in previous cycles.
In our view, there are other reasons to question the leading indicator properties of the yield curve. Yield curves in other countries, such as the UK, have inverted many times in the past with little cyclical predictive power. In addition, in past cycles, when an inverted US yield curve correctly anticipated recession, other factors were at work. For example, credit spreads had widened sharply and real interest rates were strongly positive and rising.
That is not the case now. The US high yield spread over Treasuries today is roughly two thirds its average level in the run-up to the last three US recessions. The current real Fed Funds rate is barely positive, in contrast to an average level of two percentage points (or higher) prior to the last eight US recessions. Even the latest decline in the US S&P 500 index only takes it back to the levels seen in Q2 2018. In short, the yield curve may be tipping into ‘recession’ territory, but financial restraint is not significant.
Also, we do not believe most leading indicators point to anything remotely recession-like. The twin Institute for Supply Management (ISM) indices are at historically high, ‘boom-like’ levels. Jobless claims have come up from multi-decade lows, but as the November employment report showed, job creation is only slowing gradually and wage gains remain above 3%. Rising household income will continue to underpin consumer spending and support the rise in personal savings rates achieved in recent years.
There are undoubtedly soft spots in the US and elsewhere. Spending on US consumer durables - housing and autos - has peaked. Eurozone growth has failed to bounce back in 2018 and will probably turn in an unconvincing trend-like performance next year. China continues to slow despite credit easing. Other large emerging economies are struggling to get back on their feet.
Yet even if recession fears are overdone, investors cannot relax. While we believe the probability of economic recession next year remains low, the odds of earnings disappointment are not. In the US, 2019 earnings will face challenging base comparisons, following more than 20% profits growth this year. Earnings are also a leveraged play on the business cycle, so softer activity will drag down profits growth. Finally, as a number of US companies noted in the Q3 reporting season, cost pressures are mounting. Wages, interest expense, energy expense and even tariff ‘expense’ are crimping margins. US profit share in GDP, a reliable measure of aggregate corporate profit margins, has been trending lower for two years.
Unfortunately, with the sole exception of Japan, there is no reliable global replacement for lost US earnings momentum. Europe and emerging markets, including China, have failed over the past decade to deliver sustainably higher return on equity. Absent a sharp acceleration of their growth rates - which we believe is difficult to imagine - 2019 is likely to be another year of failed earnings delivery in much of the world.
A ‘post-peak’ world of slowing growth arrived in the second half of 2018. We believe it will probably define 2019 as well. The good news is that markets have begun to adjust. However, the asset allocation committee is sceptical that the adjustment is yet complete. Confidence has been shaken and will not be easily restored.
Even when the bottom occurs, we believe a decade-long era of investment outperformance, characterised by above-average returns in stocks, bonds and credit, accompanied by mostly below-average market volatility, is over. The bull market in bonds ended in mid-2016. In our view, the middle of 2018 marks a similar end to the best of the equity bull market.
Lower returns will be accompanied by more jagged market performance. Trends will give way to sawtooth patterns. Volatility will recur with greater frequency. The reason is simple. In a slower growth world, the margin for error is smaller. Yet the probability for error - trade conflict, a messy Brexit divorce, policy irresponsibility, geopolitical risk - does not seem to be receding.
Accordingly, we believe the onus shifts to effective portfolio diversification. In common parlance, the balanced 60:40 portfolio is no longer fit for purpose. Returns are lower, volatility higher and correlation less stable. Portfolio construction must shift to one of selective equity risk, based on exposure to companies with reliable earnings and business models (but not ‘value’), coupled with uncorrelated exposures to specialty credit and non-directional strategies. That is our preferred way to manage portfolios in 2019.