Asset markets rebounded strongly in the first half of 2019, following a poor 2018. Global equities led the way, rising more than 10 percent, but bonds (particularly riskier bonds) also performed well. Oil has rallied and gold recently broke out into a six-year high. The strong first-half performance has made some investors cautious on the outlook for global equities, given slowing economic growth and inflation, continued US-China trade tensions and sustained decline in bond yields.
The key question we face today is whether the equity market rally will extend through the second half of the year and into 2020. The answer depends most likely on whether the current growth slowdown will lead to a recession over the coming year. We believe there is a relatively low probability of a US recession over the next 6-12 months, thanks to the decisively dovish turn in monetary policy by global central banks and China’s fiscal and monetary stimulus.
Let’s explore this linkage between policy and markets in some more depth.
With the Fed likely getting ready to start cutting rates for the first time in more than 10 years, comparing the current situation to the previous four Fed easing cycles may help us determine whether we are witnessing a temporary soft patch in the economy (as in 1995 and 1998) or the precursor to a recession and an equity bear market (2001 and 2007).
Long-term factors signal rally has room to run
Of the six factors we look at for US markets (equity market valuation, unemployment rate, monetary policy setting, inflation expectations, geopolitics and financial excesses), only two (unemployment rate and geopolitics) are flashing red today, while the rest are either supportive or neutral for risk assets. While this may not appear to present a compelling case for equities, it is significantly better than in 2001 and 2007 (when five and four factors were negative, respectively).
Geopolitics is clearly an area of concern. While it is difficult to quantify such risks and factor them into decision-making, they argue for a less aggressive investment stance than would otherwise be the case. In our view, trade tensions are a symptom of the shift from a US-centric world order to a more multipolar one amid China’s rising economic, military and political power. To what degree the US accepts China’s increased role in global affairs will be key to the evolution of US-China tensions in the coming years.
The tightening job market is another area of risk. The US unemployment rate is lower than in the run-up to either the 2001 or 2007 recessions. While this is good from a socio-economic perspective, it shows the US economy may be getting close to full capacity, which could raise price pressures. However, productivity gains have largely offset wage growth over the past year, warding off inflation pressures. Inflation expectations have actually been falling this year. This should allow the Fed to cut rates to offset slowing growth, without having to worry about inflationary consequences, at least for now.
Meanwhile, there are hardly any signs of significant financial excesses akin to the 2001 dot-com boom or the 2007 US real estate market bubble. Although concerns have been expressed about US banks’ exposure to student loans and the increased reliance of sub-investment grade issuers on floating rate debt (many of which offer investors little recourse in the event of a default), these exposures appear to be insufficient to trigger the end of the cycle.
Short-term outlook more mixed
While the medium-term picture looks reasonably constructive, shorter-term factors are more nuanced. Event risks today are elevated, similar to the run-up to the 1995 and 1998 episodes (linked to Latin America’s “tequila” crisis and Russia’s debt crisis, leading to the collapse of the Long Term Capital Management hedge fund, respectively). However, one can argue that today’s trade risks are more manageable than prior concerns about debt dynamics.
Meanwhile, indicators based on chart patterns, market diversity and seasonality are flashing amber. Global equity markets have recently tested key resistance levels, which may be tough to break in the short term. Market diversity has fallen (representing widespread bullish views) and is getting closer to levels suggesting an imminent reversal. The seasonally weak summer period, during which equities tend to underperform, still has three months left to run.
On the positive side, earnings and economic expectations are currently more supportive than prior to previous midcycle and end-of-cycle interest rate cuts by the Fed. While business confidence has taken a hit in recent months due to global trade uncertainty, an indicator of US manufacturing activity suggests the industrial sector is experiencing a slowdown rather than an outright contraction.
Prefer risky assets, despite possible short-term volatility
On the whole, the current situation appears similar to 1995 and 1998, implying the Fed’s “insurance”-like interest rate cuts has a strong chance of extending the current economic cycle. This would warrant a continued preference for risk assets on a 6-12 month horizon, although the short-term warning signs suggest the road ahead is unlikely to be smooth. We would likely need to see signs of a revival in inflation pressures and/or financial excesses before considering dialing back risk in investment allocations.
Within equities, US stocks have the highest likelihood of outperforming their peers as earnings continue to expand, strong cash positions support share buybacks and looser monetary policies boost investor sentiment. In debt markets, emerging market US dollar-denominated government bonds are likely to outperform other bonds amid slightly cheap valuations and an intensified search for yield. A weaker US dollar should encourage flows into emerging market assets.
Last, but not the least, the prospect for short-term volatility, global central banks’ focus on reviving inflation expectations and a weaker US dollar should continue to support gold prices. We believe this is a good asset to include as a hedge in investment allocations.
By Steve Brice
Steven Brice is chief investment strategist at Standard Chartered Private Bank. -- Ed.