This month, I write about our funds’ current (tactical) asset allocation positioning in the context of my macro outlook and market views.
"The argument about the death of the Phillips Curve has a dangerous ‘this time is different’ feel to it"
With reference to Chart 1, we have been reducing equity targets gradually and progressively since mid-2016 (the spike in equity targets in December relates to the listing of AJ Bell and it being transferred to UK equities). The first year or so of reductions brought targets down to neutral in relation to each fund’s respective strategic asset allocation.
The last 18 months have seen funds moving more and more underweight. Given my macro outlook as described below, I expect we will continue to reduce equity targets for another year or so, then to begin to increase them at the beginning of 2021. Economies and markets however are uncertain, so the precise timing of these changes will no doubt change.
2018 was looking all fine and dandy up until the beginning of October. Equity markets, though having been driven by a small number of tech stocks in the US, were ahead for the year. Rising bond yields reflected robust economic growth, as did the rising oil price. Furthermore, although there had been many angry words spoken by Presidents Trump and Xi on the subject of global trade, it had always seemed that compromise was not too far away.
Then, kaboom! October saw equity markets fall sharply, and while in November they stabilised somewhat, there was a resumption of the declines in December. 2018 as a whole was left in tatters.
I believe that much of the behaviour of financial markets in 2018 can be traced to Trump’s tax cuts that were signed into law in December 2017. Despite them clearly favouring the wealthy, they were embraced widely – the attitude of poorer Americans to income and wealth inequality never ceases to amaze me! Although growth appeared to be slowing elsewhere, the tax cuts provided a thoroughly unnecessary boost to the US economy. Indeed, famed economist Nouriel Roubini described the cuts as the first expansion stage fiscal boost outside of wartime!
Emboldened by his success at having pushed through a campaign promise, Trump then set his sights on China and its alleged unfair trade practices. The reaction to this was less positive, and markets in February and March were weak.
How does all this link together?
The tax cuts provided a big boost to the US economy. Despite the trade related wobble in February and March, the economic strength was positive both for the US equity market and the dollar. In particular, investor exuberance focused on a small number of stocks, the FAANGs (Facebook, Apple, Amazon, Netflix and Google). However, both the dollar strength and the trade frictions were negative for emerging economies and their financial markets. Weakness in EM equity, debt and currency markets for much of 2018 was pronounced.
At the beginning of October, investors may have woken up to the fact that the rise in the FAANGs was unsustainable, and also that the tax cuts, rather than being a good thing, may simply have led to overheating, thus bringing forward the end of the cycle. Thus, the last three months of the year saw equity markets, the oil price and safe haven bond yields all fall sharply.
Yield curve flattening, particularly in the US, sparked concerns that the next recession was closer than many had previously believed. Optimism about trade talks turned to pessimism, with the arrest in Canada of Chinese government linked company Huawei’s CFO coming shortly after the positive remarks made by Trump at the G20 summit in Argentina.
Closer to home, Brexit related anxiety caused additional problems for UK financial markets. In December, Prime Minister May faced a no-confidence vote brought by hardliners in her party. She won, but her position was weakened.
My framework for thinking about the outlook for financial markets and thus asset allocation is based on business cycle analysis. Specifically, research by David Blitz and Pim van Vliet at Robeco, drawing on 50 years of data, found that asset classes performed distinctively in each phase of the business cycle. For example, equities perform best during recession phase and worst during peak. Commodities on the other hand perform best during recovery and worst during recession.
Although Blitz and van Vliet used various economic indicators to define the business cycle, the most important one in my view is employment. The percentage of its workforce that a country employs at any one time is a key measure of economic success or, indeed, failure. The unemployment rate also tends to go up and down in a fairly regular pattern that, while not describing the beautiful sine wave presented in text books, is a good, and simple, representation of the business cycle.
Tightness or otherwise in labour markets is particularly important because it has a significant influence on wage pressures and thus inflation in the broad economy. It is stable inflation that central banks are keen to promote on the basis that over time this helps maximise employment. They do this by adjusting monetary policy, but it is monetary policy that has the biggest influence on financial markets, both directly and indirectly.
Take equities.
The direct influence of tight monetary policy is to dampen economic growth and thus corporate profits. However, there is also an indirect influence. Equities and other financial assets compete for attention with each other. Cash becomes more attractive when central banks increase interest rates, and there is a commensurate decrease in equities’ attractiveness.
This is particularly the case in the peak phase, as a central bank responds to an overheating economy. Investors begin to move out of equities into cash, and also to anticipate the impact of the inevitable recession on corporate profits. The result? A bear market.
The bull market is essentially the reverse of this, though equities tend to be strongest during the recession phase when interest rates get slashed and investors anticipate the recovery in the economy and thus corporate profits. Lower interest rates of course also make cash less attractive in relation to other asset classes.
This all sounds easy, but the reality is that there is a lot of randomness and uncertainty in financial markets. Where one can find pattern among the randomness, it is over the medium to long term rather than the shorter term.
Moreover, while one can use business cycle analysis and the aforementioned research to make predictions over the next 2-3 years, there is a very good chance they will not pan out as expected.
Chart 2 below is simply Chart 1 overlaid with my estimate for the positioning of the current global business cycle. Note that we went underweight as the global economy moved from recovery phase – when equity markets returns are expected to be decent – to the expansion phase – when returns are expected to begin to falter (as indeed they have).
I expect our funds to be maximum underweight by around the start of the peak phase, the phase in which bear markets generally reside. Then I expect we will increase targets fairly rapidly – bear markets are shorter than bull markets – such that the funds are maximum overweight when the recession, and thus the start of the next bull market, begins.
My own expectation has for some time been that we would see a global downturn in 2021 which would be preceded by a bear market starting in 2020. However, I was aware that things could happen sooner than this, which is why we began reducing the equity exposure of our funds well over a year ago – conversely, I also knew that things could happen later and so was also ready and indeed remain ready to stay defensive for longer.
The question is, was 2018 the start of the next bear market?
My premise for believing that the downturn would come in 2021 has been that global monetary policy is still very loose and thus would not be tight for at least another year or so. Even in the US, where the business cycle is most advanced, monetary policy has only recently stopped being ‘accommodative’ – according to Fed governor Jay Powell, monetary policy is nearing ‘neutral’ and it remains unclear at what point it will become restrictive.
Furthermore, there may be a self-fulfilling element to the recent rise in growth concerns, so it is very possible that the Fed could put on hold future interest rate increases.
That said, global unemployment is now at 40-year lows, with the US and the UK nudging at the half century mark. Although some argue that the relationship between unemployment and inflation – known as the Phillips Curve – may not be as strong as previously, it seems inevitable that at some point the tightness in labour markets will spill over into consumer price inflation (see Chart 3). And anyway, the argument about the death of the Phillips Curve has a dangerous ‘this time is different’ feel to it.
However, we are living in a world in which deflationary pressures persist, and in which any inflationary pressures that do rise above the surface are being met with powerful negative feedback effects, the fall in equity markets in the fourth quarter last year being a case in point.
Much has been made recently of the flattening of the yield curve in the US. An inverted yield curve, particularly in the US, has been a very reliable recession indicator, having preceded every recession since World War II and not once giving a false signal. The yield curve, though close to being inverted, is still positive, and it may take some time for it to make a firm move into negative territory (see Chart 4).
Furthermore, although the headline unemployment rate is now very low in the US, this may be hiding some underlying weakness. The US participation rate – the workforce as a percentage of working age population – fell sharply after the last downturn and has never really recovered (see Chart 5). Some of this will have been due to demographics associated with an ageing population, but some will also have been due to people giving up looking for work. If the economy can remain reasonably firm, disaffected workers may be enticed back, allowing growth to continue but wage pressures to remain subdued.
However, any such effect would likely be minimal, serving only to postpone the inevitable.
In summary, I do not think the world economy has yet overheated as is usual before a recession. Inflation pressures have certainly risen but they remain relatively low (see Chart 3). And they will have weakened as a result of the recent falls in equity markets and concerns about growth. I would not be surprised to see central banks change tack and put on hold any plans to tighten monetary policy further.
This would argue for some sort of recovery in equity markets this year, rather than continued falls that would strongly suggest a bear market was underway. Such a scenario would also be bearish for safe haven bonds, while the oil price could also stage a recovery.
However, I could be wrong, which is why we started reducing our equity exposure some time ago and why we will continue to do so.
Published in Investment Letter, February 2019
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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