Given the volume of challenges that investors face at the moment, it is very easy to build a bearish (negative) outlook for many different financial markets. At a high level, one could point towards being at a late phase of the economic cycle, the fact riskier assets have largely ignored this as they rise, policy makers lack the tools to stimulate activity if we move to a recession, and government bond markets are pessimistic. To add to this it’s hard to deny the risk from a geopolitical perspective, particularly in relation to the threat to global trade (and hence growth) emanating from a more protectionist US presidency.
Some of these factors are true. We are in one of the longest economic cycles in history in the US, with over a decade long expansion, and with the slowing in growth momentum the question of whether we are entering recession is on everyone’s minds. That said, economic cycles post financial crises do tend to be longer and shallower, and whilst bond markets are telling us a recession is on the cards, a variety of traditional factors don’t support this.
WHY WE DON’T BELIEVE A RECESSION IS LOOMING.Economic indicators point to a slowdown not a recessionDespite such challenges, there are a number of reasons why our view has not deteriorated – even with the recent strength in markets. We can deal with each of the threats individually and the best area to start is probably the economy and recession risk. It’s true that growth is slowing and the signals from both the inversion of most yield curves in the bond markets and negative yields across the globe are worrying, and should not be ignored. To counter this though, economic indicators still point to a slowdown over the coming 12 months, not a recession, and we don’t have the imbalances in the personal or corporate sector that are cause for material concern. The fundamentals (housing, jobs, and consumer confidence) only point to a slowdown, as are the Purchasing Managers’ Index (PMIs). Trade has deteriorated further, but the broader context remains intact.
Assessing the incentives and direction of travel for policy makers is always important, given their potential to manage the cycle and influence market volatility. On this note we are ‘relaxed’. From a monetary policy perspective, it has become increasingly clear this year that central bankers are intent on supporting the economy and lengthening this current cycle. The one area of doubt was the Federal Reserve, but the clear pivot by Powell to move to a more dovish stance has temporarily removed this risk. The major support is from a monetary perspective, but it’s also important to note that whilst additional fiscal stimulus in the US is less likely, global fiscal policy is less restrictive than it has been.
What is the ‘market’ telling us?Well this is where it becomes confusing at the moment. Bond markets and equity markets are sending a somewhat different message. The fact that most US yield curves are inverted and German bond yields are negative beyond a 15 year maturity is extreme to say the least, and means the bond markets are worried - history has proven that it’s often dangerous to ignore this. Rising equity markets and tight credit spreads, however, say the reverse. Whilst markets are important indicators, that isn’t always the case, as Paul Samuelson famously said “the stock market has forecast nine of the last five recessions”.
Our view is that whilst the bond market does concern us about the longer-term signals for growth, in reality the low bond yields for now still actually enable the economy to borrow at cheaper rates, and make the yield of riskier assets attractive. This ‘hunt for yield’ argument has been there for the best part of a decade and has further potential to support markets – so long as the economy holds up and cross asset volatility remains ‘under control’.
Another factor to consider is that whilst equity markets have continued to do well, we don’t have any clear signals that markets are overbought or investors’ positioning is excessive. We monitor this closely and this could be a driver of a more cautious stance at a later date.
Our approach to a balanced and diversified strategyGiven the risks outlined initially, and in spite of more constructive considerations on our macro outlook, we are not in a position where we are aggressively taking risks across portfolios. We maintain risk levels, but to become excessive here would be inappropriate – balance and diversification remain key pillars of our strategy.
We mentioned in our year-ahead outlook that we need to get used to a backdrop of lower returns and higher volatility and this requires a longer-term time frame for investing. This remains the case, but as detailed above, increased risk does not mean that you should automatically avoid risk taking. It’s all about seeking appropriate exposure at the right price, all the while deploying a balanced and diversified strategy.
Our current portfolio strategyAcross our multi asset portfolios there are a wide range of positions and strategies implemented to deliver capital growth in an attractive manner. Risk is managed effectively through both active management and diversification. Here we highlight a few key areas of recent developments:
Diversifying risk asset exposure - During the year whilst we maintained overall equity exposure levels, we raised the risk of our strategy by adding other asset classes with return potential. These included Emerging Market Debt, the Technology sector, and Small Cap equities.
Low exposure to traditional diversifiers/government bonds - We continue to be reluctant to add government bond exposure and maintain low allocations across portfolios. A primary driver here is due to our view that investment grade credit (that has a higher yield) continues to also carry somewhat similar diversification benefits to government securities. This is because we expect spreads to be stable, however, if this outlook changes we would be comfortable switching more exposure to government bonds, even at the current low yields.
Investing our cash into alternatives - With controlled exposure to equities and lower allocations to the traditional diversifiers, portfolios could easily be left with high cash balances that yield you basically nothing. Our approach this year has been to invest this cash into strategies that continue to provide the portfolio with return potential. We invest here into liquid alternatives and absolute return strategies, together with short-dated investment grade credit. These help further diversify the return potential, another example of how we seek to actively manage our strategies for clients.
If you would like to discuss any of the investment themes raised in this article do not hesitate to contact your usual Brown Shipley Adviser.
Toby Vaughan // Chief Investment OfficerToby joined Brown Shipley in October 2018. He has over 17 years’ experience in asset management and heads our Investment Office, as well as being a member of Brown Shipley’s Executive Committee.
