Eyes wide open

  By Guest Blogger Doug Rowat

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We’re bullish on equity markets.

And for good reason. First, it far more often pays to have a positive market view than a negative view because bear markets typically last only 1-2 years whereas bull markets last 8-9 years. All things being equal, the odds are heavily in your favour to be bullish. But aside from what market history tells us, we also view current market conditions favourably: corporations remain profitable with Q2 US earnings season playing out better than many expected, US GDP is poised to grow at a reasonable 2.3% this year, valuations are not overextended with the S&P 500, for example, trading at a price-to-earnings discount to its three-year average (18.9x vs 20.2x), the world is (mostly) a peaceful place with developed nations, in particular, not at war, and the world’s largest central bank, the Federal Reserve, has some capacity (and a clear willingness) to stabilize markets if the economic picture deteriorates further.

However, in recent months we’ve made small, but deliberate, changes to reduce volatility and give our clients’ portfolios a more conservative tilt. And, as always, we’ve continued to maintain an overall diversified mix of safer assets.

Why? Because you can’t be an effective portfolio manager and disregard risk. So, while our overall view is favourable, there are areas for concern. So, to prove that we aren’t Pollyannas blind to the market’s weak spots, below are a few of the items that keep us awake at night. (For the record, we aren’t mentioning the more obvious market risks such as the US-China trade war or a no-deal Brexit—these are a given.)

The Fed’s capacity to help the economy is no longer unlimited. The nine rate increases that the Fed made from 2015 to 2019 certainly gave it some freedom to begin to cut interest rates now, but the most recent tightening cycle brought interest rates nowhere near the levels of previous cycles. Each of the previous four cycles, for example, brought the Fed’s benchmark overnight rate above 5.00%, often above 6.00%. This latest tightening cycle peaked at only 2.50%, leaving the Fed significantly less ‘wiggle room’ for rate cuts. The Fed doesn’t have the capacity, for example, to lower rates 10 times—including numerous 50 basis-point cuts—as it did during the financial crisis. Basically, the Fed fired all its bullets during the last recession and, fortunately, killed it. However, this time around, the Fed has far less ammo. And while the Fed has also been steadily reducing its balance sheet, its total assets still stand at a lofty US$3.8 trillion—69% higher than asset levels at the end of 2009.

The Federal Reserve’s ‘peak rate’ ain’t what it used to be

Source: Bloomberg, Turner Investments.  A rate-hike cycle is defined as a period of multiple increases in the Federal funds benchmark rate. Any rate cut ends that cycle.

The US 10- and 2-year yield curve has inverted. We’ve heard the arguments that this time around this metric may not be as reliable a recession indicator as it’s been in the past; but let’s be honest, an inverted yield curve must be viewed as a concerning development. History tells us that such inversions are highly predictive of upcoming recessions, in fact, they’ve predicted every single one over the past 50 years. Why? Because the Fed often lowers interest rates to support a weakening economy. If this is the perception of the market, demand can get disproportionately weaker for short-term bonds (moving their yields higher) and stronger for long-term bonds (moving their yields lower). Simply put, if investors anticipate a weaker economy, they don’t want to hold short-term bonds that they’re soon going to have to roll into new bonds with lower yields.

There was one false-positive in the 1960s, but the inverted yield curve is now on a seven-consecutive-recession prediction streak. An inverted yield curve can’t be ignored.

The Inversion!

Source: Bloomberg, Turner Investments

US consumers are too confident. We know that consumer spending accounts for almost 70% of US GDP, so it can’t be bad that consumer confidence sits at elevated levels, right? Unfortunately, US consumers are notoriously poor at reading actual economic and market conditions. How consumers ‘feel’ is often an excellent contrary market indicator. When US consumers are euphoric (and it’s hard to view current confidence levels as anything but—see chart) then equity markets are often near their peak. Conversely, an extremely pessimistic consumer equates to a strong buy signal. However, it’s fair to say that the current message from the consumer is that markets are overbought.

Elevated consumer confidence often bad news for equity markets

Source: Bloomberg, Turner Investments

So, these are a few of the risks that, admittedly, make us highly uncomfortable. Ultimately though, we have to formulate an outlook and that outlook remains, as I’ve mentioned, positive.

However, it’s the awareness of risk that compels us to always maintain a balance of safer assets in client portfolios. Our positive outlook could be wrong and an undiversified portfolio will remind you very quickly just how painful being wrong can be.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.