The meltdown in risk assets late last year culminated in a sharp retrenchment by investors accompanied by a stampede into safe-haven assets, most notably U.S. Treasury securities. Was the abrupt shift from risk-on to risk-off investing in October justified? How should investment portfolios be positioned for the year ahead? Do current underlying economic, financial, and policy conditions suggest that a recession is not imminent? Is the economic outlook for 2019 favorable for risk assets, most notably common stocks?
In this edition of Economic Commentary, Robert F. DeLucia, CFA and Consulting Economist for MEMBERS Capital Advisors, Inc., shares his perspectives on the critical factors that are likely to determine the direction of financial markets during the next year.
Q&A with Robert DeLucia
How can investors best gauge the current relationship between risk and return in world financial markets?
More than ever, investors must adopt a disciplined and balanced approach in making portfolio decisions. There is a long-held paradigm called the investment cycle that investors can use as a basic foundation and guide for making asset allocation decisions. Although it is far from precise, the investment cycle tends to unfold in a similar pattern from onset to maturity. In addition, valuation tools also provide investors with valuable signals in assessing prospective relative rates of return.
How is the investment cycle defined?
The investment cycle is shaped by the classic business cycle: As the economic cycle transitions from early recovery to expansion, mature expansion, and recession, financial markets react in a relatively systematic fashion. For example, the onset of recession always signals a new bear market in stocks and a new bull market in government bonds. Conversely, anticipation of the end of a recession (and early economic recovery) always triggers a new bull market in common stocks.
How far advanced is the current investment cycle?
The investment cycle has reached an advanced phase, but it’s far from ended. The current phase of the cycle will end — and a new phase begin — with the approach of the next recession. At that point, the cyclical bull market in common stocks will come to an end and a new bull market in government bonds will begin. However, my analysis of current underlying economic, financial, and policy conditions suggests that a recession is not imminent and that a period of further economic and profit growth lies ahead.
Could you be more specific regarding the end of the current investment cycle?
As 2018 unfolded, it became increasingly apparent that the current cycle was rapidly nearing an end. Economic growth had entered an accelerating phase and was running significantly above its long-term potential, reflecting an economy at full employment. Wage and price inflation were in a distinct rising trend, and bond yields spiked to the highest levels in nearly eight years.
Most worrisome was the thrust of monetary policy: The Federal Reserve’s rate-tightening cycle appeared to be on automatic pilot, with seemingly little regard for underlying economic trends or financial market conditions. In short, the economy was increasingly at risk of overheating, accompanied by a monetary squeeze, culminating in a classic boom/bust cycle. In addition, equity market valuations had reached the highest level in more than a decade in early October, while most investors were extremely bullish, a distinct negative from a contrarian perspective.
However, each of these worrisome forces shifted abruptly in the final months of last year. In retrospect, economic historians will come to view the fourth quarter of last year as a true game changer with respect to the economic and investment outlooks.
Could you explain what the term “game changer” means?
Incredibly, virtually all of the critical fundamental forces driving the business and investment cycles made a sudden and decisive 180-degree swing in direction during the final months of last year, transforming the investment outlook. The overarching implication is that underlying conditions now favor a risk-on rather than a risk-off investment stance, the most important of which include the following:
- Widespread weakness in incoming economic data implies slower growth in the coming months — but a possible extension of the current expansion cycle into 2021.
- Stabilization of inflationary pressures during the latter months of last year implies a slower than normal rise in the inflation rate in 2019. Inflationary expectations plunged within a period of only several months.
- An abrupt shift in rhetoric from various Federal Reserve officials from hawkish to dovish implies a slower pace of rate hikes this year.
- The plunge in market yields on U.S. Treasury bonds implies a period of lower borrowing costs for households, homeowners, and business firms.
- A drastic shift in investor sentiment from euphoria and greed to fear and risk aversion is positive for equity markets, from a contrarian perspective.
- An abrupt swing in the equity market valuation from expensive to cheap created an excellent buying opportunity for value-conscious investors.
- Market fears of an inflationary boom/bust cycle in the fall of last year quickly shifted to widespread fears of a recession in December. A study of history reveals that recessions have almost always occurred when least expected.
What are the most immediate investment implications?
This confluence of developments in the waning months of 2018 radically altered the investment outlook in three major respects, each of which supports a shift from risk-off to risk-on investment strategies:
- The combination of lower bond yields and inflation and a less restrictive monetary policy implies an extension of the economic expansion and deferral of the inevitable economic and profit recessions.
- The shift from overvaluation to undervaluation and shift from euphoria to extreme risk aversion have favorable implications for equity investors.
- A prolonging of the economic expansion should extend the current bull market in common stocks and the bear market in government bonds. Historically, the equity market has not reached its ultimate peak until three to six months prior to the onset of the next recession.
Could you summarize the 2019 outlook for financial markets?
I expect risk assets to outperform defensive safe-haven assets for most of this year. Specifically, US common stocks, non-US stocks, emerging market debt and equities, corporate bonds, industrial commodities, and crude oil should easily outperform US, German, and Japanese government bonds over the next six to nine months.
I also expect the exceptionally high correlation among these asset classes in recent weeks and months to persist for much of the year. Cyclical stock groups such as financials and industrials should also outperform defensive stock groups such as utilities and consumer staples. Finally, as a safe-haven asset, the US dollar is likely to weaken against the euro, consistent with broad weakness in low-risk assets.
This is a very bullish outlook. How long can this risk-on environment persist?
This favorable environment for risk assets will continue until the early signs of a recession become more palpable. The implication is that there exists a window of six to nine months for risk-on investing. However, looking beyond the short term, the investment environment should become increasingly challenging for investors, beginning in early 2020.
The outlook is complicated by various crosscurrents. On the one hand, a recession is highly unlikely over the next year. At the same time, the economic cycle is advanced and a recession appears inevitable within the next several years. The implication is that equity investors should gradually de-risk portfolios during the rising market that I anticipate over the remainder of this year in preparation for a more hostile environment in 2020 and 2021. Finally, it should be understood that the current bullish investment climate is different from those of previous oversold markets in recent years.
Could you explain the difference?
Similar to today, the equity market became significantly oversold and valuations became extremely attractive following the eurozone crisis in 2011 and the China/energy/commodity crisis in 2015. US equity prices plunged by 20% in 2011 and more than 15% in early 2016. Because each of these severe corrections occurred much earlier in the economic/investment cycle, the runway for the subsequent market rebound was much longer than exists today. Therefore, the current opportunity to purchase equities at very attractive valuations is likely to be relatively short-lived.
What is the most likely timing of the next recession, and what are the implications for world financial markets?
I have pushed back the most likely timing of recession from 2020 to 2021. Instead of a recession, I expect the current economic soft patch to resemble another mid-cycle slowdown, similar to those of 2011, 2013, and 2015. This forecast is predicated upon a slower-than-expected rise in inflation, a moderate pace of monetary tightening, a period of lower private borrowing costs, and a temporary slowdown in residential and nonresidential fixed investment. This scenario would be supportive of common stocks and corporate bonds at the expense of government bonds.
Why are you not fearful of an imminent recession?
Simply put, the typical catalysts for recession are not currently in place: rising inflation, aggressive monetary tightening, and elevated real interest rates. Importantly, there is very little evidence of physical excesses in housing, plant and equipment spending, and business inventories. Banks are in excellent health and credit problems are at a low level. Finally, recessions seldom occur when they are widely anticipated. The corollary is that recessions typically occur when they are least expected by investors, business executives, and the media.
What are the primary risks to the outlook?
There are several significant risks to the outlook that should be closely monitored. The most serious risk continues to be the ongoing trade tensions between China and the US and a failure to reach an agreement before too much economic damage has been inflicted on the world economy. Another risk is an unexpected escalation in wage costs, which would squeeze company profit margins and compel the Federal Reserve to tighten monetary conditions more aggressively.
A potential hard economic landing in China would almost certainly have a powerful negative ripple effect on emerging market economies, Europe, and Japan, triggering an outright decline in world trade. Finally, the continuation of the current turmoil and dysfunction in Washington would further undermine business confidence, with potentially negative implications for business hiring and capital investment.
Could you summarize the central themes pertaining to the investment cycle?
The investment cycle has reached an advanced phase but has somewhat longer to run. The central theme is that the extraordinary events of the past several months have prolonged the investment cycle by postponing the timing of recession from 2020 to 2021. A further brief extension of the business cycle means that the inevitable downturn in company earnings is also likely to be deferred, providing further support for the domestic equity market in the interim. Instead, the slowdown currently underway will likely end in a soft landing — another mid-cycle slowdown — rather than an outright recession.
However, sustained economic growth in 2019 and 2020 implies increased cyclical pressures on input costs, mainly labor, with negative longer-term implications for inflation, profit margins, and monetary conditions. Common stocks and corporate bonds should easily outperform government bonds in 2019 but will likely become increasingly vulnerable as 2020 unfolds. Consistent with financial market history, the investment cycle will end approximately six months prior to the next recession.
The only real certainty in the stock market is that it will fluctuate between up and down cycles. Help your clients better understand current conditions and navigate the inevitable highs and lows by exploring our quick-reference guide, Preparing for the Next Cycle. Click the button below now to access your copy of this valuable tool.
All opinions and commentaries expressed are those of the writer, Robert F. DeLucia, and do not necessarily reflect the opinions of CUNA Mutual Group, CBSI, or its management.