“There are two kinds of people who lose a lot of money: those who know nothing, and those who know everything!” – Henry Kaufman

“In times when the US & global economies are slowing, and potentially headed for recession, portfolio diversification trumps all other risk reducing strategies, except knowing the future!” – Anonymous

Last quarter review

Jerome Powell, the Federal Reserve Chairman surprised many strategists and commentators, but pleased US and global equity markets when he announced at the March 20th policy-setting Federal Open Market Committee (FOMC) that the central bank will leave rates unchanged and scale back the Fed’s projected interest-rate increases this year to zero. On the basis that previously the market had anticipated at least two further interest rate increases in 2019, we can conclude that the central bank’s monetary stance has changed from hawkish to neutral, and potentially dovish.

Chairman Powell said, “The U.S. economy is in a good place, and we will continue to use our monetary policy tools to help keep it there. The jobs market is strong, showing healthier wage gains and prompting many people to join or remain in the workforce. The unemployment rate is near historic lows, and inflation remains near our 2 percent goal. We continue to expect that the American economy will grow at a solid pace in 2019, although likely slower than the very strong pace of 2018”

Jerome Powell observed how with the aid of fiscal stimulus (primarily the Trump tax cuts) and other tailwinds, US economic growth in 2018 at 3.1 percent real GDP, was the strongest year in more than a decade. He cautioned however that while the FOMC last September saw growth coming in at about 2.5 percent this year, subsequent data suggest growth is slowing.

Just two days after the FOMC announcement, the US Treasury yield curve inverted for the first time since 2007, sending US and global equity markets sharply into reverse. Wall Street stocks soon recovered to record the best quarter at the beginning of a year for decades, as the S&P 500 rose more than 13% to erase most of the losses sustained in the last quarter of 2018.

In the UK, despite the continuing Brexit political debacle, both the economy and the equity market appear to be in good shape. The latest GDP data show the economy growing at around 1.2% per annum, while the FTSE 100 index rose by more than 8% during the first quarter.

In contrast, the economic growth in most of the European Union economies is stagnant or declining, and some suspect Germany may already be in recession. Equity markets in Europe however rose on the coat tails of Wall Street, with the benchmark Euro Stoxx 50 rising more than 11%.

The best equity returns by far came from China where the Shanghai Composite rose an extraordinary 24% during the quarter. It has to be noted however that this is on the back of a previously long equity bear market in the Middle Kingdom, and there remains plenty of uncertainty about its economic future.

Investors in government debt also did well during the first quarter on the back of falling yields especially at the longer end of the respective yield curves, as many investors took profits on their equity investments and sought some diversification in less risky assets. The yields on benchmark ten-year government bonds in the US, UK and Germany, fell during the quarter to 2.41% (from 2.69%), 0.99% (1.27%) and -0.05% (0.25%) respectively.

1. GDP Data shown are to the 31st December 2018; Interest Rate, Equity & Bond Index Data are to the 31st March 2019; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.

Current Considerations

Two big developments that occurred during the first quarter of 2019 merit our focus when determining whether we should make any changes to the optimal risk adjusted investment portfolio. The first and most important is the US Treasury yield curve inversion on the 22nd March; a signal which has historically been extraordinarily successful in forecasting recessions in the American economy.

The second is the ongoing uncertainty surrounding the failed Brexit political negotiations. It is becoming more and more difficult (or arguably impossible) to predict which turn the surreal Brexit negotiations will take next, and we must recognise the very real possibility that this saga could take years to resolve!

Meanwhile, the US Treasury yield curve when plotted on a graph ordinarily slopes gently upwards from the y axis on the left towards the right the longer dated government bond maturities on the right, reflecting the normal economic logic that those who lend longer term should expect higher interest payments on their investments than those whom have lent the US government their money for shorter periods. Inversions occur when the yield on the benchmark ten year Treasury bond falls below that of shorter term bonds and bills, and while some market observers suggest the two year bond inversion is important, empirical studies including by economists at the Federal Reserve show it is the inversion of the three month bill that is all important.

There is an old joke in equity market circles that dates back to the eighties, namely “the stock market has predicted nine of the last five recessions, so any downturn should be taken with a pinch of salt unless economic fundamentals confirm the pessimism! However, Treasury yield curve inversions deserve our attention since this phenomenon has only predicted ten of the last nine recessions with its one false positive occurring in 1966.

On every one of the other nine occasions that the yield curve has inverted since 1953, recession arrived on cue! While this time could be different, it is extremely unlikely since as Mark Twain famously said, “while history does not repeat, it does rhyme”.

The earliest analysis of the correlation between the behavior of the yield curve and subsequent recessions was done by Dr. Reuben A Kessel, a Chicago University economist in a 1965 study titled “Cyclical Behavior of The Term Structure of Interest Rates.” Subsequent analysis by Campbell R Harvey at Duke University in 1986 confirmed Dr Reuben’s findings.

In June 1996 Professor Arturo Estrella and Frederic S. Mishkin, economists at the Federal Reserve Bank of New York published a paper titled “The Yield Curve as a Predictor of US Recessions”, which added further weight to the historical evidence on the predictive power of the yield curve. More recently, on the 27th August 2018, in a paper titled, “Information in the Yield Curve about Future Recessions”, exhaustive research going back more than half century by Michael D. Bauer and Thomas M. Mertens of the economic team at the San Francisco Federal Reserve, concluded, “The yield curve has been a reliable predictor of recessions, and the best summary measure is the spread between the ten-year and three-month yields.”

Data released by one of the leading institutional research houses, Economic Cycle Research Institute (ECRI) supports the case for slowing US and global economic growth, which could potentially lead to a full blown recession within the next year or so. Lakshman Achuthan, co-founder of ECRI explained in an interview he gave during March to Real Vision that, “you can have a deceleration in growth, like we’re having now. And it may resolve in a recession, or it may resolve in a so-called soft landing, where that bucket of coincident indicators, and the growth rate doesn’t go negative, and then it re accelerates.”

Encouragingly Lakshman believes that while the US economy is currently in a growth deceleration phase, it does not necessarily follow that it will result in a full blown recession, especially now the Fed has recognised the economy is slowing, and ceased its monetary tightening. ECRI ’s research identified some time ago that the inflation cycle had turned down again, and that perhaps more importantly the disinflationary trend had little to do with the volatile price action in oil.

ECRI’s observations on growth and inflation cycles, when combined with the Fed’s monetary tightening actions last year, go some way to explaining what happened in the equity markets in the last quarter of 2018, as Lakshman elaborates, “there’s an inflation cycle downturn. There’s a growth rate cycle downturn. And the Fed is saying it’s going to hike. And then the market tanked in December, and so it had to do an about- face. I don’t think its heart was really in it, but it had to do it because inflation is down- it’s not up- and the market was getting upset with the promise of more rate hikes.”

Then, surprise, surprise, the Fed does an about turn and goes dovish on monetary policy, and a V shaped recovery occurs on Wall Street as markets celebrate during the first quarter of 2019, but we probably should not get carried away, since as Lakshman warns , “I look at the leading indexes, and they’re still going down. There is not a cyclical upturn in these leading indicators yet for the US or abroad.”

ECRI has observed that most of the leading indicators that they monitor for economic growth have slowed or rolled over, including the leading services and non-financial services (where two thirds of Americans are employed) indicators, and the leading index of consumer spending growth. Unfortunately, ECRI who monitor the world’s twenty seven largest economies, observed that the slowdown was happening in most global economies including China and the constituents of the European Union.

Lakshman’s comments were made about a week before the US Treasury yield curve inverted, so unfortunately it now looks likely that the window of vulnerability leading to a full blown recession that he referred to, will be realised at some stage during the next eighteen months. While there will undoubtedly be further opportunity to make money in stocks, and the Wall Street melt-up could continue for a while yet, more and more investors will have a nervous eye on the exits, potentially making the likelihood of a sharp correction or crash much more likely before the economic recession is confirmed.

Forward Outlook

The worrying failure of the UK government to resolve negotiations surrounding the supposed Brexit departure from the European Union this quarter is a cause for concern. However regardless of the final outcome, and realistically it could take months or even years to resolve, we are convinced that the UK economy will continue to perform at least as well if not better than most EU member states.

It is the global implications of a likely forthcoming US economic recession that concerns us more going forward. We believe however there is still some way to go before this event occurs and that there remains significant potential for return in both UK and global equity markets at this time. As a precautionary measure, we are however, increasingly looking to rebalance portfolios towards a more defensive position as appropriate.

As we have noted in previous market views, deflation appears to still hold sway globally despite numerous attempts by the big four central banks over the past decade to generate inflation. Maybe if the latest craze of MMT (modern monetary theory) now sweeping parts of US political mainstream ever gains traction, we could once more face serious inflationary headwinds, but for now it seems continued deflation, largely driven by unprecedented government, corporate and personal debt will remain the dominant force.

The US Treasury yield curve has now inverted, and while expensive valuations in American stocks still have the potential to become even more expensive before this bull market is finally over, the clock is now definitely ticking towards a time when a bear market will take over to reflect the likelihood of a probable forthcoming recession. How deep or long that bear market and recession might last, we cannot know, but ideally we shall want to have minimal exposure to stocks and riskier assets during that time.

The same will course be true for the UK, and most other global equity markets, remembering the adage that when Wall Street sneezes, the rest of the world catches pneumonia! The good news is that provided the deflationary trend that has prevailed since the turn of the millennium remains in place during any forthcoming recession, there will be selective government debt (such as US Treasuries), and other high quality bond markets that will offer valuable and attractive lower risk and diversification alternatives during this time. Additionally, it is likely that we shall also find value in some of the other alternative asset classes, such as property, so ensuring a well-diversified portfolio will become key.

Monitoring and determining the macro picture including the likely direction of key indicators such as the dollar and Treasury yields will play a key role in advised portfolio asset allocations going forward. During the rest of 2019, we envisage gradually moving portfolios from a heavily biased equity exposure to a more defensive fixed income, property and other lower risk alternative investment options.

As always, investment risk is at the forefront of our advice and, whilst it often necessary to undertake adjustments in portfolio allocation in order to maintain individual preferences, we are confident that our advised portfolios remain well placed in meeting our client’s needs.

Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.

The Market View is a reflection of our in house assessment and views and is posted for client interest only. Please refer to our Terms of Use at the bottom of this page.