Although US equities have remained well supported so far this year, the same cannot be said in Europe and Emerging Markets.
As a result, global equities have remained broadly unchanged from their December 2017 levels. Add to that a yield on 10-year US Treasuries that has climbed above 3 per cent and an interest rate curve that is flirting with inversion, and investors have started questioning their equity allocation. While we acknowledge that the cycle is ageing, we believe it is too early to adopt an outright defensive stance.
The current economic cycle that started in the wake of the global financial crisis 10 years ago is on track to be one of the longest in history. For some investors this is enough to call for an imminent recession. We disagree. As we have argued many times in the past, cycles don’t die of old age. Outside of so-called bubbles bursting like the “dot-com” era in the late 1990s or the housing/credit boom in the 2000s, recessions tend to occur because interest rates have reached a level that has become punitive for the economy.
This level is unknown ex-ante and depends on many variables, including the strength of the labour market and its productivity. At this point, the neutral rate (ie the level at which interest rates neither stimulate nor penalise economic growth) is between 3 and 3.5 per cent. Historically, this rate has been higher but a combination of technological innovation and unfavourable demographics have pushed it lower in the last decade.
With the US Federal Funds rate currently at 2.25 per cent, the US Central Bank will remain on its hiking path for the time being. In fact, we expect another four to five interest rate increases by the end of 2019. This should bring us right in line with our estimated neutral rate.
As this progress continues, the spread between the yield on the two-year and 10-year US debt is anticipated to turn negative (ie the interest rate curve to invert) in the second half of next year. Investors are anticipating this inflection point, as historically it has been a relatively reliable indicator that a recession was on the horizon.
What has been less consistent though is the time it took between the curve inversion and the beginning of the following recession. Indeed, looking at the past seven cycles, investors had to wait between nine and 26 months before growth finally turned negative. Inversion and recession do not occur in tandem.
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Interestingly, the S&P 500 index has usually performed relatively well in this timeframe, returning on average around 9 per cent. In addition, when considering the six months leading to a yield curve inversion, performance has been equally solid. This is why it’s too early to go defensive. First, based on our forecast, the next recession is unlikely to happen within another 18 to 24 months. Second, equity markets tend to perform well in the six months leading to - and following - an inversion of the interest rate curve.
As such, the best course of action is to maintain exposure to equity markets. But that does not mean investors should not change anything in their portfolios. As the cycle ages, sector and stock leadership evolve. The most cyclical parts of the market tend to lag as market participants start anticipating the upcoming rollover in economic growth.
On the other hand, defensives and growth sectors tend to outperform as investors seek earnings visibility. Commodity-linked parts of the market also tend to do well as their returns are more linked to the price of the underlying commodity rather than to the health of the global economy. Similarly, on the fixed income side, gradually adding back duration to portfolios and moving up the quality spectrum are two very sensible moves.
Like any other, this cycle will end. However, the likelihood of a recession happening imminently is low. While we recommend investors start adjusting their portfolios as we enter the later stage of this economic cycle, we also remind them that the most consistent way to generate returns over the long term is to stay invested.
Julien Lafargue is executive director and European equities strategist at JP Morgan Private Bank
