Testing times ahead
The US economy continued to improve over the quarter, with strong jobs and wages growth, together with very optimistic survey results from both consumers and small businesses.
On many occasions we have commented on how markets look stretched, based on valuations, pointing to a low return outlook over the next three years. The other side of this coin is that markets are also more vulnerable to shocks — the more stretched valuations are, the greater the likely downside shift if markets are confronted with negative news. It is therefore prudent to scan the horizon for likely shocks that may destabilise markets. The most damaging of shocks would be a US recession. A typical shock will see greed turn to fear, and often leads to a 20%-plus fall in equity markets, like the European shock in 2011.
However, while terrible at the time, markets generally recover in a year or so. However a recession, while seeing a move from greed to fear, also sees a sharp deterioration in corporate fundamentals, often leading to a 50% fall and the recovery can take five years or more.
Unsurprisingly, we spend a great deal of time determining the risk of recession. Our modelling has found there are generally three phases leading into a recession. First, the economy begins to see signs of overheating — goods and labour markets are tight and inflation pressures start to build. This generally occurs one to two years before a recession. Then, the central bank responds by raising interest rates and draining liquidity out of the system. Policy becomes tight, and with a lag of six to 12 months, this leads to a recession. The last leg to fall is when we start to see it in activity, with investment and employment falling and consumers beginning to rein in on their spending. At the moment will only see signs of the first phase, which puts the probability of the US recession high, out past a year. Equity markets generally lead the cycle by six months, suggesting recession risk is not a near-term problem for markets.
More near-term risks are ones we have been discussing for a while now: rising US inflation and President Trump’s tariff war with China. We first commented on the risk of rising inflation in the US late last year. Our analysis was based on the non-linear relationship between the unemployment rate and inflation: i.e. the unemployment rate has little impact on inflation until it falls below a tipping point. The prime example of this phenomenon was the 1960s where the falling of the unemployment rate from 7% to 4% had little effect on inflation, but once it fell below 4%, inflation began to rise sharply. Once again, the unemployment rate is below 4% and inflation has begun to rise. As markets do not expect a further rise in inflation, should that happen it would be a significant shock, and would lead to a sharp rise in volatility.
We have argued that the path of least resistance is for a continued escalation in the US’s trade war with China. The mid-term elections will be won by the party that can energise its base, as voting is not compulsory, and President Trump is using the trade dispute with China to rally his supporters. So far, markets have not reacted much to the trade dispute, either assuming it will be resolved soon or will have only a minor impact on the strong US economy. While most analysis points to a modest impact from rising tariffs, it generally assumes it will be spread out. However, we think it will be concentrated in a short period of time, as supply lines get disrupted, and this will have a negative impact on business confidence. Also, with the political momentum for further escalation, we think it might take a reaction from markets to short-circuit this. So far, we have been right on the politics, but not on the markets. However, with significant tariffs having only just been implemented, we think the impact is still to be realised.
Diversified portfolios are most vulnerable in the lead in to recession, which our indicators suggest is unlikely in the near future. However, valuations are stretched, suggesting markets are primed for a very positive environment, and that the margin for safety is low. We see a couple of near-term potential shocks, and therefore believe our defensiveness will pay off and opportunities will present themselves – and as we have shown in the past, we will be quick to avail ourselves of them when they do.
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