With global recession brewing, equities rally may be nearing an end
Equity markets worldwide have risen more than in dollar terms in 2019, but best returns are often achieved in the last few years and months before a recession
Some of the best equity returns can often be achieved in the last few years and months before a recession. Of course, staying invested late in the cycle is not without risks – the biggest being overstaying your welcome.
Towards the end of 2018, it was feared that the global economy was slipping towards recession. This led to a sharp sell-off in global equities. In the eurozone, economic activity has slowed sharply from its 2017 peak. The UK economy is still constrained by Brexit concern, while in China growth continues to slow as trade friction impacts already slowing growth. The US is the only major economy that remains fairly resilient thanks in part to the fiscal stimulus in late 2017, which provided a temporary boost to earnings and GDP. This helped stretch out the business cycle, while the consumer sector is also benefiting from full employment and rising wages.
The first half of 2019 saw an impressive recovery in risk assets, with the global equity market rising more than 16% in dollar terms. This was due largely to the US Federal Reserve and other central banks becoming more accommodative to offset the weakening economic conditions. In 2018, the Fed raised interest rates four times, but now it appears that a cycle of rate cutting has ensued, which should extend the current economic cycle.
Nevertheless, we believe we’re late in the cycle – the difficult question is always how late. The easing monetary conditions have not materially impacted the global economy yet, but may increase excesses in the financial system. In addition, there is concern that central banks do not have much firepower left to fight the next recession as interest rates are already very low.
SA has its own idiosyncrasies, and while it will be impacted by whatever happens globally, in particular monetary conditions, there has been such a poor economic environment locally that if we could just get a bit of policy right and start creating some confidence for consumers and corporates, we could potentially be countercyclical.
After the strong global equity market rally this year valuations though not excessive are no longer cheap. However, with continuing monetary easing there are potentially still reasonable returns available. The risk is that monetary easing may overstimulate the US economy, which is already at full employment, resulting in a sharp tightening in financial conditions leading to a recession. Investors should consider gradually reducing exposure to global equity markets and within the equity category consider moving exposure away from growth investments to value-based investments or managers.
Some cash on hand will probably reduce portfolio volatility while providing the opportunity to buy cheap assets in the event of a market sell-off. Investors could also reduce exposure to global bonds and consider some inflation-linked assets. In the absence of the protection historically provided by bonds, investing with good hedge fund managers to increase asset dispersion may prove beneficial.
In the late part of the economic cycle inflation often starts coming through as the economy starts to overheat and there are not enough resources available for the increased demand – be that commodities or labour. As a result, in addition to equities real assets that can offer protection against inflation tend to do well.
However, as inflation rises interest rates are also likely to rise as lenders need compensation for the decline in purchasing power of future interest and principal repayments. Therefore bonds, notably fixed rate bonds, are negatively impacted by inflation as yields rise and therefore prices decrease. The longer-dated the income stream, the more negatively the asset will be impacted as the income stream is being discounted for a longer period. For example, a one percentage point interest rate rise will have a much larger impact on a 100-year bond than a two-year bond. Similarly, if you’re invested in companies where you’re paying a high price for future earnings growth in 10 or 15 years, those earnings will be discounted more aggressively. So, as interest rates rise and the economic outlook becomes more uncertain the valuations of high growth companies will tend to be more negatively affected than, for example, well run companies with a strong asset underpin. This is the part of the cycle where value investors generally outperform growth investors.
As the economy turns down there is generally increased dispersion in returns between and within asset classes. Since the global financial crisis momentum has been the order of the day; assets have risen and fallen together, driven largely by monetary conditions. As a result, investors haven’t been as discerning about their assets. A momentum driven environment is difficult for active managers, which is why there has been such a big move towards indexation, or passive investing. This changes as the economy slows and poorer quality assets start to show their true colours. For example, if a business has been largely using debt-fuelled acquisitions to grow earnings, and its earnings start to disappoint, suddenly no-one wants to own that company.
Globally, because of the low interest rate environment prevailing for some time, particularly in the US, companies have increased borrowings materially, often to buy back their own shares. This has had the impact of artificially increasing company earnings while also increasing corporate leverage. This raises red flags for future earnings growth as well as the corporate debt market, especially in a rising interest rate environment.
Another important consideration late in the cycle is to reduce leverage. Increasing your portfolio’s cash holdings has a similar impact to ensuring that the companies you’ve invested in have a strong cash base – this provides flexibility when there is a market sell-off and the opportunity to buy assets cheaply.
For a long period now bonds have been a great diversifier for equities, providing protection during equity sell-offs. However, that’s because the global economy has been in a very low inflation environment. If an era of high inflation returns bonds won’t provide protection. In addition, interest rates are coming off a very low base so there is limited room for interest rates to fall from current levels.
• Hatty is SA chief investment officer for Stonehage Fleming.