JASON SWARTZ and MAYURESH KULKARNI: Investment options when equities signal recovery and bonds recession
We may miss out on a rally, but our work gives us sufficient comfort that our defensive positioning is justified
Risk and timing of US or global economic recessions continue to be debated in investment circles. While some global markets have been remarkably resilient recently, much of this recession debate has been informed by large market movements in equity and bond markets.
The two asset classes are sending conflicting signals. Equity markets suggest economic recovery, given that prices rallied strongly since the October 2022 lows. Bond markets suggest recession, given the deeply inverted yield curves.
This conundrum makes for a clear challenge for tactical asset allocation, as the risk of being wrong by being either too defensive or too aggressively positioned is high. An alternative approach to reading the tea leaves of global market performance is to build a cycle indicator that tracks the global economic cycle and gives insight into the effect of macroeconomic variables on the returns from different asset classes. The value of this approach lies in finding a simple yet predictable framework, given the relationships between an indicator and asset class returns.
Previous research on this topic is abundant. Some authors have employed variables such as currency exchange rates, output gaps (GDP growth relative to potential GDP), consumer price inflation and the slope of the interest rate yield curve to estimate the current phase of the economic cycle.
To cut through the noise, we built an objective framework to understand changes in the economic cycle and focus on the US economy as a proxy for the global cycle. Instead of thinking in binary terms, that is recession vs no recession, we classify the economic cycle into four phases: recession, reflation, recovery and overheat. Our definition of the recession phase is more aligned to an economic contractionary environment rather than the National Bureau of Economic Research’s definition of a US recession.
We employ an approach that considers the absolute level and the change of the indicator, and made use of data from the US ISM purchasing managers index (PMI) to determine which phase of the cycle we are in. If the PMI is low and falling this would be a recession; if the PMI is low and rising this would be a reflation. If the PMI is high and rising this would be a recovery. Finally, if the PMI is high and falling this would be called overheat.
The key benefit of the PMI is that it is a monthly indicator of economic activity based on a survey of purchasing managers at more than 300 manufacturing firms. The monthly nature of this indicator offers us a faster updating signal than most other macroeconomic variables, which update only quarterly. Our particular interest, given the phase of the cycle, is what this means for the subsequent six, nine and 12 month returns of different asset classes.
Our results, based on 65 years of returns data from global stocks, bonds and cash, suggest intuitively that bonds perform better in recessionary phases than stocks, but they also give us more insight into what happens in other phases. The table illustrates which asset classes outperform and which underperform in various phases.
Now that we’ve been able to assess that asset classes have an intuitive relationship with a global cycle indicator we ask ourselves: what does that imply in terms of building an outperforming portfolio? To test this we consider a naive global benchmark of 60% equities, 30% bonds and 10% cash. Based on the monthly PMI phase signal we tilt the portfolio away from this benchmark towards the asset classes that perform well in that phase and funded from asset classes that underperform. When tracking the performance of this active portfolio through time the results confirm that shifting between asset classes based on the cycle indicator can consistently outperform a global balanced benchmark.
The latest US PMI number is lower than 50 and it is rising. But the recent rise is not significant enough for our indicator to come out of the recessionary phase. This means it is still reflecting a weak manufacturing demand environment and typically a slowdown in corporate earnings and economic growth. Based on the indicator, we are in the recession phase and have been there since November 2022. Similar recessionary phases were in early 2001, late 2008, late 2015 and late 2019 — all periods in which investor risk appetite was poor. We have thus been tilting towards bonds and cash and away from equities within our multi-asset funds.
As with every systematic indicator there is a risk that the recommendations it offers may be incorrect, or alternatively too early or too late. As such it is quite plausible that the global cycle is now shifting from a recessionary phase to reflation (via a soft landing), which typically implies an equity bull market. While we acknowledge we could miss out on this rally, we are engaged in risk management strategies to mitigate this risk.
Ultimately, the work we have done in this area provides us with sufficient comfort that our investment outlook will play out, and our defensive positioning is justified.
• Swartz is portfolio manager, and Kulkarni investment analyst, at Old Mutual Investment Group.
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