Between the Fed’s sudden pause on raising interest rates and a dramatic market turnaround since Christmas Eve, we think it’s important to provide a framework for our view going forward. Here, we seek to explain our nuanced view, in part by juxtaposing it against an outright bullish and an outright bearish one.

 

  1. The Fed pause has extended the runway for both how long the business cycle can last and how far risk assets (like stocks and high yield bonds) can rally.
  2. We think the probability has fallen for a U.S. recession in 2020, which is why we are more positive on risk assets than we were a few months ago.
  3. Despite this, we need to remember that the recent Fed pause did not “reset” where we are in the cycle. It is still late in the cycle, and we still expect slowing growth. As such, we continue to suggest reducing risk overweights (i.e., equity and high yield) on strength, adding to longer duration fixed income positions, and building liquidity to take advantage of tactical trading opportunities that might present themselves.

In other words, we should still prepare for the eventual end of the cycle, even if we are not predicting its imminent end. Of course, our view is just one of the millions that make up markets. As an exercise, we tried to come up with arguments for much more bullish and bearish views than ours. Check it out:

 

  1. Markets are telling you that bulls have it right. The S&P 500 is up +11.1% year-to-date. The Russell 2000 is up +16.8%. A look under the hood also confirms this optimistic atmosphere: Cyclical sectors like Industrials (+18.1%) and Technology (+14.0%) are leading the S&P 500 higher, while safe havens (or more defensive sectors) like Utilities (+7.0%) and Healthcare (+5.8%) have lagged. Cha-ching!
  2. But, evidence for bulls goes beyond the price action—it’s also apparent in corporate profits. Take the Industrials sector, for example. Changes in expectations for future earnings (earnings revisions) seem to have bottomed after collapsing in the second half of 2018. It is hard to make a bearish case when one of the most cyclically levered sectors is experiencing positive revisions. Why the sudden turnaround? It could be because China is finding a floor. Credit growth, which is often seen as a leading indicator for future growth in China, has ticked up recently for the first time in almost two years. Stimulus from China should help stabilize growth and could rejuvenate global industrial activity. Cha-ching!
  3. Trade war fears are also receding. Most indications point to a détente between Trump and Xi Jinping before the spring. Chinese equity markets, which perhaps suffered the most during last year’s rise in tensions, have clawed their way back to where they were before the trade war escalated in May 2018. A U.S.-China trade agreement would bring more certainty and allow executives to make swifter decisions on how to design supply chains, potentially offering a boost for earnings and stock markets. Cha-ching!
  4. Equity valuations don’t seem demanding. Take valuations like the price-to-earnings ratio (P/E), for example, which shows how much investors are willing to pay for each dollar of earnings. The next 12-month P/E ratio on the S&P 500 is currently just above 16x, which is in line with historical averages and low relative to the 18.5x we saw in January of last year. In fact, you would have to go back to before President Trump was elected to find a forward P/E multiple that low. Cha-Ching!

U.S. cyclicals outperforming defensives - Line chart showing price index for cyclical/defensive stocks from January 2018 to February 2019. The line starts at 100, peaks from January through March 2018, then declines from April 2018 to May 2018, increases again through June, and then steadily declines through December 2018. From December through February, the line has seen an uptick to levels higher than those in January 2018.

  1. Let’s start with the Fed. The futures market is telling us that we’ve seen the last of rate increases in this cycle. In three of the last four rate hike cycles, the final Fed rate hike was followed by a recession in about 12–18 months. Yikes.
  2. Another thing on the Fed. It might sound obvious, but the Fed stopped hiking for a reason! Instead of focusing on the two hikes we didn’t get (thanks to the recent pause), maybe we should be paying more attention to the impact of the nine hikes that have happened. Interest-rate-sensitive sectors like Autos and Housing have suffered in the wake of higher borrowing costs. Crucially, housing tends to be a leading economic indicator, and it has been an accurate forecaster of the labor market (which tends to lag). Recent underperformance of the Housing sector suggests that one could expect the unemployment rate to rise over the next year and a half. Yikes.
  3. And it’s not just housing. Broader economic data has been off the mark too, with more data releases missing expectations than beating them. This is usually associated with trouble in risk assets. Yikes.
  4. Global growth is also slowing. The orange line in the chart below is the global manufacturing PMI, which peaked in early 2018 and is now hovering just above 50 (a reading below 50 would suggest contraction). Note how closely this correlates with global earnings revisions. If the global PMI continues to falter, one could expect weakness in corporate earnings ahead. Yikes.

Line chart shows global manufacturing PMI and Net earnings revisions from 2003 through 2019. The lines have moved in tandem through this time period. They reached highs in 2005, 2011 and 2018, and the lowest point was seen in 2009. The chart specifically highlights the decline in the line from 2018 to currently in 2019.

Clearly, there are lots of different views, and plenty of ammunition for both devout bulls and fervent bears. But our view falls somewhere in the middle.

While we do not believe we have an indefinite “all clear” for risk assets like stocks and high yield bonds, risks to the downside have been mitigated in the near term by a Fed that is on hold instead of marching steadily toward a recession. We think this creates a tactical window of opportunity in risk assets.

At the same time, the Fed pause also allows long-term investors to continue to reduce risk on strength. It is still late cycle, and the window of opportunity described above may actually sow the seeds of its own demise, as economic growth and strong markets give the Fed cover to sneak in another hike or two later on. What the Fed giveth, the Fed taketh away.

Our best advice to clients is to continue preparing for the inevitable end of the cycle, even if it not immediately imminent.