The pace of the current expansion has been exceptionally slow moving. We are in the tenth year of an expansion whose endurance has proven resilient. That leaves us late-cycle, but in an investment environment where pro-cyclical positioning continues to make sense.
It’s hard to find any asset class that I would categorize as inexpensive. That isn’t said as a negative. Valuations across equity and credit markets reflect sound fundamentals. We maintain our overweight to equities across portfolios. We also maintain our underweight to duration and core bonds.
We believe the market environment continues to favor stocks over bonds. But given that we are late-cycle (Figure 1), we want to ensure that we aren’t overreaching for risk. We added to our equity overweight in February as markets sold off. We trimmed back that overweight in June. Two-steps forward, one-step back.
Life During (Trade) War Time
There is a clear understanding that Washington is intent on addressing trade policy head-on. This isn’t simple political posturing ahead of midterm elections in the United States. It’s a policy priority. For now, investors seem to be readying themselves for a dash toward the year-end finish line. They remain confident that current tariff skirmishes won’t escalate into something far worse for the global economy. We'll see. The introduction of the U.S.-Mexico-Canada Agreement is a positive sign.
“No trade war and no trade peace” remains the market’s mantra. That is allowing investors to refocus on a macro environment that, while late-cycle, is durable. Investors recognize that for the next year, fiscal stimulus in the U.S. is locked in largely thanks to tax reform. The momentum from U.S. fiscal policy seems likely to dwarf the negative near-term economic impact of tariffs.
The synchronicity we saw in global growth at the beginning of this year is diverging, as is central bank monetary policy. That makes the outlook less certain. Still, the macro picture hasn’t really changed much over the past quarter. Growth remains above trend across major economies. However, growth has slowed from the fast pace of 2017, in particular across Europe and emerging markets (Figure 2). We expect the pace of global growth to slow further over the course of the next few years. As uninspiring as euro area growth may seem, we believe it remains above trend. We continue to see emerging economies under pressure.
The probability that the U.S. falls into recession over the next year remains quite low—I would say less than a 20% chance today. It’s possible that we don’t experience a recession over the next three years, but this would be unusual given the length of the cycle and key indicators we are watching.
As the current cycle extends—and the burst we’ve seen in fiscal stimulus from U.S. tax reform begins to fade—we expect tighter labor markets, declining operating margins, rising corporate interest expense and a decline in cyclical spending growth. We are watching the recent decline in residential housing investment as a potential indicator of a shift in the economic cycle ahead, as housing historically has been a useful leading indicator.
Markets are fixated on 2020 as the year the U.S. economy falls into recession. That supposed 20/20 vision may simply be an expectation of positive trends unwinding. Those same trends currently support the U.S. expansion. A lot can happen between now and 2020.
The U.S. economy saw a strong second-quarter bump of +2.9% in productivity, which is something we are keeping a close eye on. If sustained, it might allow the Fed to slow the pace of tightening ahead by mitigating capacity constraints and containing inflationary pressure. While this isn’t our base case, it would be good news for markets.
I will point out that the Conference Board’s leading index of economic indicators has managed to signal shifts in the U.S. economy with remarkable consistency. A year-over-year decline in that particular index has served as a useful barometer that the U.S. economy is moving closer to recession. Today, that index is at all-time highs and small business optimism remains strong (Figure 3). Steady as we go.
Mind the Gap
Central bank policy always matters, but I believe this is especially true for the year ahead. The Fed continues on its path of raising interest rates. The Fed’s “neutral rate” seems to be right around 3%. With the Fed’s September rate increase behind us, we are currently at a policy rate range of 2.00–2.25%. If the Fed continues to raise rates quarterly, we would get above “neutral” by the end of September 2019.
Jay Powell has proven to be a refreshingly direct speaker as Fed Chair–exactly what markets need. His emphasis on risk management and a balanced approach to rate increases is particularly important. The Fed’s decision to add press conferences to each policy meeting starting in 2019 provides optionality and may break down market expectations that the Fed will only hike rates on a quarterly basis. It may also add to market volatility.
Investors continue to wonder about the precision of a 3% target as the Fed’s long-term neutral policy rate. The Fed does as well, and Jay Powell has said as much. The “dot plot,” which the Fed uses to signal participants’ views on the Fed’s target rate, isn’t going away soon, but is likely to be increasingly downplayed. The challenges ahead for markets and policymakers only get greater from here.
With the Fed on track to continue to raise rates, we see greater monetary policy divergence ahead across developed market central banks. Mind the gap. Both the European Central Bank (ECB) and Bank of Japan (BoJ) should be on hold with regard to raising rates well into the second half of next year. That divergence should be supportive of risk assets—not all major central banks will be raising rates at once.
That said, the impact of the Fed’s tightening of liquidity is global. The U.S. dollar is on one side of +80% of global foreign exchange transactions and represents more than 60% of central bank reserves. With over $11 trillion in U.S. dollar credit to non-U.S., non-bank borrowers, the dollar remains the predominant global funding source. Rising U.S. rates and a well-supported dollar make dollar debt more expensive to repay for foreign borrowers.
Tail Risk in Emerging Markets
We continue to expect the negative pass-through effects of a stronger dollar, higher U.S. interest rates and combative U.S. trade policy to weigh further on emerging markets. My concern around EM has been the ability of Washington to roll out damaging trade policy. I don’t believe the current U.S. trade narrative is going away quickly.
Asia represents about 75% of the MSCI Emerging Markets Equity Index. China, Korea and Taiwan represent about 55% of that index. It has taken longer than I expected, but Washington seems intent on escalating trade-based protectionism. China appears to be ground zero. The negative knock-on effects across Asia, thanks to supply-chain links in relation to China, are real.
Not all emerging markets are created equal–that is already creating investment opportunity. However, we’ve seen significant investor-tourism in EM this year, as short-term money rushed in to chase last year’s returns. According to EPFR Global, EM equity markets have seen in excess of $30 billion of net inflows this year. Should investor confidence wane further, there is room for those inflows to reverse.
Investors continue to forecast sales and earnings growth next year across EM of about 8% and 12%, respectively. Slower economic growth, as well as rising interest rates and inflation across emerging economies have yet to be reflected in operating margins, not to mention top-line and earnings growth. That can weigh further on valuations. On a three-year basis, EM equity markets look interesting. Near term, tail risk is real.
Why Invest Anywhere but the U.S.?
The first half of this year was fairly unsatisfying for investors. Markets maintained the tailwinds of a solid macro environment and strong earnings. Yet an accelerating escalation of negative political and policy headlines continued to distract investors, weighing on animal spirits. Markets effectively went nowhere.
Market performance from July to September may reflect investor belief in a stabilization of trade tensions. But until this becomes clear, investors recognize that the U.S. serves as a safe harbor. Equity markets outside the U.S. have the most to prove to investors—near term, the U.S. has less to lose. Longer term, that remark isn’t as obvious. Across portfolios, our current equity overweight is in the U.S. That has not been a consensus market view until recently.
Should trade-tantrums shift to an environment that can encourage a series of regional trade-truces, equity markets outside the U.S. can play some catch-up. I think this is particularly the case for developed markets outside the U.S.
Investors have soured on European equities. As mentioned above, Europe continues to grow above trend. Inflation is not currently high enough to challenge policymakers. And deflation risk has abated. That should allow the ECB to end bond purchases by year-end. We are likely a year away from a policy rate hike from the ECB, and monetary policy in Europe remains accommodative. Earnings growth should remain in the high single digits. Those are all positives.
However, European politics are weighing on investor sentiment, particularly in Italy and Brexit negotiations. Risk of automobile tariffs from Washington remains in the background as well. As we get clarity around each of these issues, there may be relative upside for European equity markets ahead of us. Those markets deserve some catch-up.
We said in the second quarter that the European macro environment wasn’t as dire as forecast. The data has so far supported this view. While risks remain, we believe that the earnings and policy fears currently hanging over European investor sentiment today seem overblown.
Gradually or Instantly
The current bull market remains the most distrusted I’ve seen, as market volatility in October has again illustrated. This expansion’s slow-paced nature has kept investors on their toes and cautious for the most part. Had it not, valuations would likely be higher.
The current market cycle will end. And as obvious as it will seem with hindsight, it won’t be obvious as it is happening. Just look at how investors behaved during January’s rally and February’s sell-off— chasing after equity markets in January, only to sell after February’s correction. Mixing emotion and investing is perilous.
If provided with the right opportunities in the current market environment, we are happy to take advantage of them. We don’t want to be taking concentrated risk in markets, given that we are late-cycle and that markets, in general, are fully and fairly valued. Diversification matters most late-cycle.
Over the past few years, we made significant investments in our team, process and investment toolkit. At the same time, we have markedly increased our allocation to passive investments. I believe these targeted, low-cost investment vehicles continue to increase portfolio precision and ultimately lead to better outcomes.
We remain disciplined investors. You should continue to expect to see us rotating positioning as we move through the late innings of this cycle. That may mean adding core bonds and duration to portfolios before it seems obvious, and trimming allocations to credit and equity markets into market strength. We’ve done both this year.
Markets correct gradually or instantly. Instantly is a great deal more dramatic. Then it’s over and the course of investment action is generally clear: to add thoughtfully back to risk assets. A gradual correction can imply pockets of pullbacks, volatility and periods where markets offer benign returns. A gradual correction takes patience to weather. It certainly seems to characterize the market environment we find ourselves in. Pace matters. So does endurance.