October was clearly a bad month for equity markets around the world, with the MSCI AC World index falling 6.9% in local currency terms. The key question is whether this is the start of something more pronounced or ‘just’ a correction. We think it is the latter.
"The yield curve in the US has predicted every recession going back to 1955"
It is unclear what the trigger was for the falls in October. Equity market performance had been unusual in the months leading up to the end of September. A large share of the rise in the world equity market related to US equities and a large share of the rise in US equities related to a small number of tech stocks, notably the so-called FAANGs (Facebook, Amazon, Apple, Netflix and Google). Such narrowness in markets is invariably unsustainable, and as the aforementioned stocks rose higher, the likelihood of a correction grew.
However, there have been other fault lines. The US tax cuts may have lifted investor confidence, particularly with respect to growth sectors such as tech, but it also provided a boost to the US economy at a stage when it was strengthening anyway. In other words, it caused the US economy to start to overheat. This led to a strong US dollar, which hurt emerging markets, as well as sharply rising long-term interest rates. The market behaviour throughout most of October may well have been a delayed reaction to both the strong dollar and higher interest rates.
Our framework for assessing financial markets and thus asset allocation – is based on business cycle analysis. Financial assets tend to exhibit particular behaviour in each of the four phases of the business cycle (recovery, expansion, peak and recession). Each of these four phases is characterised by underlying economic performance, for example, the recession phase is characterised by economic indicators that are low and falling, peak by indicators that are high and falling etc. As for the behaviour of various financial assets, equities tend to perform worst during the peak phase, commodities best during recovery etc. Thus, if one can identify the current phase of the business cycle, one can have an edge with respect to predicting markets and thus add value through asset allocation.
In the world of theory, the business cycle is portrayed as a regular ‘wave’. However, things are not so neat in the real world. Some phases can be longer than others, and economies can sometimes go backwards before resuming a forwards direction of travel. In other words, there is a material degree of uncertainty involved in identifying the phase of the business cycle. In addition, financial markets will not necessarily behave as they did in the past.
Our belief has been that the world economy entered an expansion phase around the end of last year. We thus moved our funds under management from overweight to underweight equities in the second half of last year and have continued to move them further underweight ever since. As the peak phase tends to see the worst performance from equities, we would like funds to be most underweight when it arrives, and so expect to continue to move further underweight over the coming 1-2 years.
It is monetary policy that provides the link between economic performance and the performance of financial assets such as equities and bonds. High real interest rates will cause business investment and consumer spending to fall, which in turn will affect corporate profitability. However, they will also lessen the attractiveness of so-called risky assets such as equities and credit. Cash competes with other financial assets for investors’ attention, and if real interest rates on cash are high, the yields on equities and credit become relatively less attractive.
Yield curves also provide a measure of monetary policy. When short-term interest rates are higher than long-term interest rates – known as an inverted yield curve – monetary policy is considered tight. Conversely, a steep yield curve in which short-term rates are lower than long-term rates is an indication of loose monetary policy. Indeed, according to research from the San Francisco Fed, the yield curve in the US has predicted every recession going back to 1955, and only once, in the mid-1960s gave a false reading – an inversion was followed by an economic slowdown but not an official recession.
The main aim of our analytical framework is to understand the monetary policy cycle in various countries and thus to be able to build up a view of aggregate global monetary policy. Most central banks around the world tend to have two goals of monetary policy: the promotion of maximum employment and price stability. Thus, assessing measures of inflation and employment conditions are key in determining the likely direction of monetary policy.
Where are we with respect to employment, inflation and monetary policy in various key countries? The first three charts below are the simple average of the unemployment rate, wage YoY% growth and consumer price index YoY% growth in the US, Europe, Japan and the UK.
It is clear that unemployment across the developed world is now very low in relation to the last four decades or so. This appears to be putting upward pressure on wages, which in turn is causing consumer prices to accelerate.
The fourth chart is the simple average of central bank policy rates in the same four jurisdictions. It is apparent that central banks have started to respond to rising inflationary pressures by increasing interest rates. The US may be ahead of other countries, having first raised interest rates in December 2015, but the UK has also now begun to raise rates. It may not be long before central banks in Europe and Japan indicate a tightening of policy in the months ahead. Indeed, the European Central Bank has stated that it will end its bond-buying program by the end of the year.
Although global liquidity conditions have tightened over the last 3 or so years, they are not yet tight. Thus, a global recession is not imminent. Yield curves, though generally flatter, are still positive (chart 5) suggesting that monetary policy at a global level is not yet acting as a restraint on growth.
As for equity market valuations, they are certainly richer than they were five or so years ago. However, they are not particularly stretched in relation to history (chart 6).
In sum, yield curves that are still positive and equity valuations that are not obviously expensive provide us with some comfort that markets still have some scope to produce positive total returns over the next 1-2 years, before finally succumbing to the usual pressures of tight monetary policy and imminent prospects of a recession. However, there will always be uncertainty with respect to such a prediction, and so we think it is prudent to begin reducing equity weights well in advance. If we are wrong, and a recession is closer than we thought, we will have already reduced. And, if the recession turns out to be further away than we anticipated, we can continue to remain defensively positioned or lower equity weights further.
We have been using the analogy of braking ahead of the bend rather than at the bend, and we make use of it again here. It is as good as impossible to time markets, thus gradual shifts in asset allocation are appropriate.
Published in Investment Letter, November 2018
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.