First, the bad news
First, the bad news
In the US, jobs growth has slowed. Income growth is trending lower. Manufacturing peaked in 2018. Tense trade negotiations are taking place on multiple fronts. Inflationary pressures are low. Corporate credit has ballooned. But corporate credit quality has collapsed. US Treasury bond market are pricing rate cuts. Other developed market central banks have already cut rates. The global economy is edging closer to recession. That is the bad news. Global equity markets have seemingly taken this in their stride. A rally in the first week of June largely reversed the small sell-off in May. But that isn’t the good news. The good news is there is time to prepare. Right now, we think embracing dynamism and reviewing defensive exposures are the most pressing preparations for investors.
The US is edging towards recession
Economic growth probably peaked in 2018. GDP measured by expenditure suggests robust growth through Q1 2019. But GDP measured by income – theoretically equivalent – has trended lower. It is currently below 2%. Manufacturing surveys have also trended lower (Figure 1).
Figure 1: Manufacturing surveys suggest growth may have already peaked
The May US payrolls report should also act as a wake-up call. The report was soft and recent jobs growth was revised lower. The yield curve, a leading indicator for jobs growth (Figure 2), suggests worse may be to come.
Figure 2: Volatility spiked suddenly in May following Presidential Tweets
We think a recession could be driven by deteriorating credit quality in the US. Recently, the US investment grade index’s credit quality deteriorated to the point that BBB rated credit – the lowest investment grade – dominated the index. There could be other causes of recession. But whatever the cause, the odds of a recession in the next year are increasing (Figure 3). And if there is a US recession, it will be a global recession.
Figure 3: The NY Fed model of recession probability is higher than in July 2007
Bond markets are pricing cuts, but not enough
World bond markets agree with the gloomy outlook (Figure 4). In the US, three rate cuts are priced with better than 50% probability by end-2019. In Australia, the RBA has already cut. We expect QE will be required in both markets.
Figure 4: Government bond yields have declined as the outlook as deteriorated
Equity markets have rallied in early June as yields declined. Equity investors may be expecting global central banks to engineer a soft landing for the slowing economy. But soft landings are rare. Typically, as rate cuts are priced in and implemented, the yield curve steepens. This coincides with a decrease in corporate profits and increases in equity and credit risk premia. The combination tends to drive a violent re-rating lower in equity and credit prices.
What actions can be taken?
The good news is, investors can prepare for these downside risks. Now is the time to implement appropriate, repeatable, fundamentals based dynamic asset allocation. Having a clear sense of potential risk-adjusted returns over the medium-term is important. This process removes the temptation to try and time market movements. Now is also the time to build exposure to real defensive assets. That means moving up the capital structure and focusing on the highest grade credit available. Developed market sovereign bonds still offer good risk-adjusted returns, despite low starting yields. High yield credit, lower quality loans and hybrids are likely to suffer equity like drawdowns and capital losses. We cannot stress enough that we expect these instruments are unlikely to provide defensiveness to investment portfolios.
First, the bad news. The risks to the economy are skewed to the downside. Many asset valuations are stretched. Potential returns are skewed to the downside as a result. The good news is, there is still time to prepare. The recent economic trends are a call to action to implement appropriate, repeatable dynamic asset allocation processes. Reviewing defensive asset exposure is an important part of that process. Failing to act could result in considerable drawdowns or loss of capital. Contact Oreana Financial Services or your affiliated Advisor to find out how we can assist with managing your wealth.
Data sources: Bloomberg LP, Oreana Financial Services
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