This is now the longest expansion in post-war history, and the US equity market is at an all-time high. This makes investors jittery, searching the horizon for recession signs. But as the old saying goes, expansions don’t die of old age, and there has often been good money to be made in late cycle. This environment requires heightened discipline and a focus on asset allocation decisions, and the ability to move tactically to react to sharp shifts in sentiment.
As of the 29th October this year the S&P 500 index has returned 23 percent year to date. The MSCI World has delivered 21 percent. The Bloomberg Barclays Global Aggregate bond index has returned 6 percent. In short, by any standards this has been a great year so far: but anyone who spends time listening to financial market commentators or talking to other investors will tell you it hasn’t felt like it. Negative stories have dominated headlines, be it a US/China trade war, Brexit, manufacturing recession, and many have been ready to talk the market down. Positioning data suggests that many investors have been too cautious and missed some or all the market rally.
Those year to date numbers don’t tell anything like the full story. This has been a year of striking shifts in market performance and sentiment. After a very tough last quarter of 2018, the year began with the Fed pivot and improving fundamentals, leading to a sharp rally. Sentiment darkened in the second quarter as manufacturing data worsened, exacerbated an escalation in the trade war between the US & China, leading to a bumpy summer. Recession fears have been quick to arise at the slightest sign of data weakness, only to abate as scare stories in individual confidence measures or data points have been shown up as outliers. More recently, sentiment has picked up again as the manufacturing recession has passed its nadir.
Our macro view over the past 18 months has been consistent: we are in a low growth environment, where a combination of a relatively strong consumer and loose monetary policy can keep this expansion on the road. This doesn’t mean we are excessively bullish. Trend growth is low, inflation lackluster, demographics challenging in nearly all larger economies, and debt piles left over from the last crisis haven’t been dealt with. That said, consumer health and easy financial conditions suggest that the recession fears that have been driving many investors’ behavior in 2019 are overblown.
As we turn to 2020, our base case hasn’t significantly changed since the start of 2019. We do think that risks to the cycle have increased at the margin. A partial US-China deal or short-term truce won’t end the trade war or long-term battle for global hegemony, which we see as injecting a persistent political risk premium into markets. Manufacturing is fragile, and monetary policy can’t keep us going forever; there is a need for fiscal policy to join in, particularly in Europe, and there are significant political hurdles in the way. That said, we don’t see signs of large imbalances or inflation pressure that typically indicate recessions, and consumption, labor and housing markets are resilient. Credit growth in the eurozone is robust.
In conclusion, we believe the cycle will continue, and we are cautiously optimistic for risk assets into 2020. The challenges for investors are that we see sentiment-driven volatility continuing in this skittish late-cycle environment, and valuations are elevated, particularly in fixed income. These challenges call for a flexible and active approach underpinned by a robust macro process that can cope in nervous times for investors. Our process is built around four pillars of economic fundamentals, market sentiment, valuation, and monetary & fiscal policy, and we look at a broad, detailed but consistent set of indicators to understand how the macro outlook is evolving. The consistency of this approach allows us to see through the noise, which is particularly important late in the cycle.
What we can be certain of is that given valuations, income and growth are harder to find now than they were a few years ago. Our solution is to be active, using stock selection alpha to deliver performance and to tailor portfolios to the late-cycle environment. We also use active asset allocation to capture opportunities thrown up by volatility to add value or cushion the portfolio. We continue to like traditional sources of income such as high yield but think it’s important to widen the toolkit to include less common asset classes such as emerging market credit, financials debt, and alternatives. In a low return world, it’s essential to be nimble and flexible to avoid disappointing performance.
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RC
