Investment Discipline Required!
As temperatures slowly drop, risks to the economic outlook heat up. New data confirms the global slowdown has begun to infect the United States economy, with manufacturing weakness spilling over to services as the future of the trade war with China remains unclear. Recent problems in the functioning of the overnight lending markets, reminiscent of the early stages of the financial crisis of 2008, have required the Federal Reserve’s intervention. Political sclerosis is also emerging with the United Kingdom hurtling toward a “hard,” potentially disruptive, exit from the European Union after more than three years of unsuccessful negotiations. Back home, headlines report possible impeachment proceedings against President Trump as talks of an impending recession grow.
Amid dimming prospects for growth, interest rates have collapsed. The U.S. yield curve has lost its positive slope, and bond markets are pricing in greater potential for the Fed to commit a policy mistake by keeping interest rates too high. A sustained and significant inversion of the yield curve—which has yet to occur—is a reliable leading indicator of a significant downturn 12-months hence. Bond markets expect the Fed to cut short-term interest rates two more times before the end of the year to provide the economy with the boost it needs to combat the lingering trade war. Globally, the supply of debt trading on negative interest rates has surged to more than $15 trillion, up from $6 trillion just a year ago. Former Fed Chairman Alan Greenspan has mused it is “only a matter of time” before negative interest rates wash up on U.S. shores.
Though President Trump has advocated for swifter rate cuts, current Fed Chairman Jerome Powell is aware of the limitations of monetary policy. A decade of easy money and financial repression in the wake of the Financial Crisis has led to deflation—not inflation. Even in Europe, the tide seems to have turned away from textbook experimentation with negative interest rates as their adverse impact on the banking system becomes clear. Christine Lagarde, who will assume leadership of the European Central Bank on November 1, has spoken at length about the need for fiscal policy to do more of the heavy lifting to stimulate the economy since persistently low and negative interest rates will give central banks few options to combat the next sustained downturn.
It is tempting to conclude we are overdue a recession given this cycle’s age. We have now enjoyed the longest period of uninterrupted economic growth since records began in the 1850s. Yet it is imperative to remember that economic cycles do not die of old age. Instead, they end when speculative excesses burst through restrictive policy conditions, typically when the Fed raises interest rates to contain inflation. In addition to it being the longest expansion on record, this has also been the most gradual. As a result, inflation remains stubbornly low even as the labor market continues to be strong, with the unemployment rate recently touching a 50-year low. These conditions give the Fed room to maneuver as it seeks to fulfill its mandate of price stability and full employment while corporate profits continue to grow.
In fact, all of the capital market indicators we monitor stop short of predicting a recession.
Given the apparent storm clouds gathering around a slowing global economy, many are surprised by the strong returns of stock markets this year, as U.S. markets continue to hover near record highs first reached early last fall. Moreover, even though strong fixed income returns should be expected if the equity market anticipates slower economic growth, the magnitude of fixed income gains year-to-date surpasses historical norms. Growing economic concern after a strong period of public market returns is tempting many to try to time markets by raising cash while finding reasons not to commit capital in a diversified way, or to chase exotic, illiquid private market investments in search of higher expected returns.
With this backdrop, our message is clear: now is precisely the time to maintain investment discipline.
Fundamentally, stock market valuations relative to bonds have improved slightly as dividend and earnings yields now exceed interest rates. The yield curve would have to invert more dramatically and sustainably with significant negative earnings revisions for our process to lead us to reduce equity exposure. Additionally, there are few signs of the euphoric sentiment which often characterizes the end of a long bull market. In contrast, investors have treated several of this year’s class of initial public offerings (IPOs) with skepticism, marking down their excessive private market valuations after their public market debuts.
Selectivity is key as this bull market matures. With market volatility rising from abnormally low levels and performance dispersion across securities and asset classes widening, a tailwind is occurring for active management both within and across assets classes.
In total, there is no shortage of reasons to be skeptical and concerned about the economic outlook, particularly as political noise mounts and the equity bull market forges ahead. But our models indicate that equities, relative to bonds, have already priced in these concerns. Media headlines are likely to become even more shrill as we approach the presidential elections next year, leading to increased market volatility. This is why it is ever more important to approach investments through an unemotional, disciplined process.
 The Fed acted quickly to quell disruption in money market funds by making more reserves available for banks to fix the plumbing underlying the credit system.
 The travails of WeWork, a company mired in marginal corporate governance practices, has been the portrait of this phenomenon.
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