One last try
Global growth is slowing and sentiment softening, while manufacturing continues to suffer as the trade war shows no sign of ending. For investors with a half-empty or half-full view, now is clearly a time to be selective across all assets.
We continue to receive mixed messages from macroeconomic data and markets, with the latter pricing in a recession across several gauges. At the same time, the late-cycle position we are in makes markets vulnerable to accidents that could come from any number of sources, including Trump’s unpredictable tweets, Brexit and the ongoing trade war.
Financial markets today are showing clear signs of anxiety around an imminent economic recession. The dollar index and gold, defensive investments, recently reached two-year highs. At the same time, US Treasury yields have plummeted this year. The decline has been most pronounced in long-term bonds, leading to curve flattening. Some parts of the curve have even inverted–historically a reliable harbinger of recession.
However, the yield-curve inversion this time around differs from those that preceded recessions in the past. The latest inversion has been driven by a fall in long-dated yields, as opposed to a spike in short-dated ones. This means investors expect interest rates to remain suppressed several years from now, which is more a reflection of the easy monetary policy that has been widely adopted over the last decade. Another difference this time around revolves around oil prices. In past instances of a recession following yield-curve inversion, oil prices were also at their peak growth rate, whereas today oil price growth is at near a three-year low.
At the same time macroeconomic data, while mixed, indicate that the current cycle has more room to run. The manufacturing sector has clearly suffered, both in terms of data and negative company earnings revisions. However, the services sector, which is a closer proxy to the real state of the economy, remains broadly stable. Meanwhile, the clearest short-term recession indicators – jobless claims and unemployment – are not flashing any warning signals. Indeed, unemployment in many major economies remains at historically low levels.
“The yield-curve inversion this time around differs from those that preceded recessions in the past.”
For these reasons, we do not believe a recession is around the corner. The manufacturing sector’s share of equity indices is significantly higher than its share of economic growth, so we could live in a low earnings growth world for a while. Instead, we are in a late-cycle economy, which makes us particularly vulnerable to any "accidents" that could come in the form any number of (geo)political surprises. We are therefore staying selective in equities, favouring companies with pricing power and dividend growers, and treating volatility as an asset class in itself.
In order for the current cycle to continue, economies need fiscal easing from governments. This need is punctuated by the broadly depleted state of central bankers’ toolkits, given that most major central banks have run out of ammunition and their ability to support the economy is diminishing. On this front, the UK government has planned extensive fiscal spending. We might also hope for Germany to loosen its purse strings, especially as pressure to address the climate crisis builds among German voters. For now, we are moving from underweight UK equities to neutral, because we now do not expect a recession, regardless of the Brexit outcome.