It’s important to be patient as the business cycle matures
Owing to its size and influence around the world, what happens in the US economy has important implications for financial markets everywhere.
The 2008 financial crisis is a fading memory, and America is now enjoying one of the longest periods of economic growth in its history. Although the pace of this expansion appears to be slowing, there are few signs that the world’s largest economy is about to fall into recession any time soon.
The surge in economic growth in the middle of 2018, thanks in part to tax cuts, was offset by decelerating consumer spending towards the end of the year. Still, despite the ongoing trade dispute with China and a government shutdown at the start of 2019, conditions remain reasonably healthy.
Amid signs that the economy may be coming off the boil, the Federal Reserve (Fed) has recently ditched its guidance to investors suggesting that further interest rate hikes lie ahead. The central bank vowed to be “patient”, citing low inflation and recent economic turbulence as reasons not to raise rates. So far, this shift seems to have supported equities by assuaging any fears that the Fed would raise interest rates too aggressively and choke off growth.
Time to adjust portfolios
While we remain in favour of staying invested in equities, as the economic cycle matures, we believe it’s prudent to start adjusting portfolios in favour of higher-quality equities and those with more defensive characteristics — those that are less dependent on economic conditions for their performance. Within corporate bond markets, we prefer those with higher credit ratings.
We believe it’s premature to position for a recession. Even the most forward-looking leading economic indicators are yet to send a recessionary signal. They include, for example, the real (adjusted for inflation) growth rate of money supply, and the difference between one- and 10-year yields on US government bonds, or Treasuries.
This relationship, known in the parlance as the yield curve, inverted in late March (one-year surpassed 10-year yields). An inverted curve has been a harbinger of all of the last nine recessions, while sending just two false signals. However, investors must be careful. The length of time between inversion and recession is very inconsistent, and is always long.
In previous economic cycles, these leading indicators have sent signals many months before equity markets peaked. Therefore, any decision to shift portfolios too early could result in missing out on further stock market gains for a considerable period of time. At the same time, defensive sectors tend to outperform cyclicals after the warning lights start flashing and before equity markets peak.
However, as we explored in the previous issue of InvestmentInsights, some of today’s defensives may not be fit for tomorrow. For example, consumer staples face change as lowered barriers to entry give rise to challenger brands that use social media to target audiences cheaply and effectively.
Meanwhile, healthcare and pharmaceuticals usually enjoy relatively stable demand throughout the economic cycle but are currently facing increased scrutiny over pricing in the US, where rising healthcare costs are a hot political issue. Given the challenges traditional defensives face, investors must cast their nets more widely to find safe havens.
Figure 4: China's economic growth rate (%)
We use data that is timelier and less susceptible to manipulation by official statisticians to 'nowcast' the real underlying rate of economic activity in China.
Source: Datastream and Rathbones.
Global growth is slowing
We acknowledge that the pace of global economic growth is slowing and is likely to continue to do so. In China, industrial output has slowed and new home sales have fallen. Officials are easing policy by cutting taxes and increasing local government infrastructure investment. Yet the most reliable indicators of the true underlying rate of activity growth in China have not plunged (figure 4).
The US slowdown is largely cyclical, driven by higher interest rates, the fading impact of President Trump’s tax cuts and uncertainty over ongoing trade tensions with China. The budget can’t handle another fiscal splurge, while any monetary stimulus, should the Fed decide to lower rates, would take a long time to feed through into real activity.
There is plenty of weak data around, such as sales of cars and residential properties. Meanwhile, banks have been tightening their lending standards slightly, which could weigh on capital expenditure towards the end of the year. Yet on balance, these indicators suggest the probability of a recession in 2019 is very low. Personal income growth remains strong, there’s plenty of scope for the savings rate to decrease, and so the overall outlook for consumption looks fine (figure 5).
Figure 5: The US consumer is holding up
The overall outlook for personal consumption in the US looks fine, which is another reason why we believe the probability of a recession in 2019 is very low.
Source: Datastream and Rathbones.
Economic growth across the eurozone was robust in 2017 and early 2018 but has weakened recently. Italy fell into recession in the second half of 2018, and Germany suffered a quarter of negative growth. The European Central Bank (ECB) has reacted with a promise to keep interest rates at historically low levels for at least the rest of the year.
Conditions in the eurozone have been particularly poor, but leading economic indicators are consistent with weak growth rather than a recession. They include the European Commission’s economic sentiment index, the IFO business survey, the composite Purchasing Managers’ Index and the Belgian business confidence index (which tends to be a reliable gauge of internal eurozone demand).
Slowing industrial production weighed heavily on economic activity in the last three months of 2018, although January numbers were much improved in France, Spain and Italy. Employment growth is reasonably robust, wages are rising and household lending is increasing, which together should support consumer spending in 2019.
Although we think the current business cycle has further to run before falling into recession, we’re aware of the risks and remain cautious. The global economic slowdown is likely to leave growth at a level where equities can continue to outperform bonds or cash. Yet we should not ignore the slowdown, which can play a key role in how we position portfolios and adjust to the changing environment.