A widely used Latin phrase in Europe, “Quo Vadis?” (Where are you going?), is a very timely question as we head into the final quarter of 2019. The long running bull market in both equities and fixed income continues to chug along with U.S. equities up +20% (S&P 500 Index) through mid-October and a 60/40 split of international equities and bonds up +13%. Yet the financial press keeps its focus on a flat and slightly inverted yield curve which has been a past predictor of pending recessions. Are we seeing the final months of positive returns in equities and markets in general?
Our assessment of economic conditions suggest that we remain in a very solid operating environment for continued economic growth with upside returns for equities and other asset classes.
Though economic growth is slowing in both the U.S. and China, the two largest global economies, 95% of global economies are still reporting positive economic growth. In the U.S., corporate earnings season has just begun for the third quarter, and the major U.S. banks (J.P. Morgan, Citibank, and Bank America) all reported healthy growth in the quarter beating analyst expectations. In fact, forecast corporate earnings in the U.S. for 2020 is +10.2% compared with 2019.
U.S. Households continue to save (7.7% savings rate) and consumer confidence remains high, supported in part by historically low default rates among corporate borrowers (1%). Forecast GDP growth in the U.S. for 2020 is still in the 2% range with inflation remaining stable and liquidity still accommodative. Finally, the global outlook for interest rates remains soft with the Federal Reserve still likely to ease rates for the near future.
Therefore, we do not see a compelling argument that the economic cycle will turn in the next 12 – 18 months. However, there are some vulnerabilities worth noting.
The flat yield curve in the U.S. when looking at the yield differential between 2yr and 10 yr U.S. Treasuries is worth monitoring, and should its modest inversion increase in severity, expect macro-economic forecasts to turn increasingly cautious. It is worth noting that when past inversions correctly predicted a future recession, the time lapse has been as long as three years.
Tariffs and continued uncertainty around trade policy have the ability to impact growth and inject short term volatility. President Trump’s daily tweet average of 10.5 times also has the ability to infuse episodic volatility into the markets. Tight labor markets have the potential to impact corporate margins which is another point of vulnerability. Finally, the nature of trading, with increased high frequency related trade volumes (+243% in trading volume over the past few years) and 23% of daily trading volume in U.S. equities in the final 30 minutes of market trading, is itself a point of vulnerability.
The primary financial risk factors that could signal imbalances in the macro economic environment are government debt, housing, commercial real estate, consumer credit, business credit, equity valuation, consumer confidence, and corporate debt levels. Except for the level of government debt, all risk factors remain well within the metrics reported before the 2008 financial crisis suggesting that US economic growth remains viable in the near term.
Equity valuations, while justified by underlying earnings and margins, are high and suggest future moderating returns. Yet declines in P/E multiples last year were the fourth greatest decline in the past 60 years. Credit spreads on the other hand certainly suggest late cycle conditions but signs of increasing defaults have not materialized.
Quo Vadis? What is the bottom line from our vantage point?
The only prudent approach to investing in liquid public markets, given all the macro economic factors and geo-political trends, is to diversity across assets classes and focus on a targeted level of aggregate portfolio risk or volatility. We remain in a positive investment environment though market moves can come quickly and sharply. While picking solid individual stocks can produce good results over time, diversifying your investments across equity sectors, geographic regions, and asset classes is well suited for the current market conditions and achieving longer-term financial objectives.