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Late cycle stage should alert the wary investor
Though equities have rebounded sharply, weak manufacturing data suggests the next quarter could be more volatile, though any equity pullback is likely to be muted
Jeff Schulze 25 Apr 2019
Jeff Schulze
Jeff Schulze

Global equity indexes have sharply rebounded from the Christmas Eve lows and are nearly back to all-time highs. However, with economic data continuing to deteriorate, many investors remain confused about the path forward. Signs of global economic weakness could portend increased volatility in the near term, but any equity pullback is likely to be a long-term buying opportunity.

Risk management and a focus on quality is required as China, Taiwan point to economic uncertainty

Looking abroad, economic data appears more concerning than within the US, with Chinese deleveraging efforts representing the epicentre. Global Purchasing Manager Indexes (PMIs) have declined in 10 of the last 12 months. This nearly matches the record from 2008 of 11 consecutive monthly declines for global PMIs. The good news is that while Chinese manufacturing data appears weak, Chinese services have held up much better. In keeping with the aim to diversify its economy, China has focused its stimulus on services. Much of these efforts, including tax cuts and government spending, support the domestic Chinese consumer.

The government has also taken steps to shore up the shadow banking system and unwind past manufacturing excesses. However, this does not mean the pain is over, and the Taiwanese Manufacturing PMI points to further weakness. Taiwan is the proverbial tip of the global economic spear given the country’s position at the very beginning of the supply chain. In fact, Taiwanese stocks have the greatest revenue exposure to China of any country. Therefore, their Manufacturing PMI New Orders component is a strong leading indicator, which suggests additional weakness is still to come.

Bond investors not leaving the party yet

One area of bifurcation exists between fixed income and equity markets. Specifically, while global equity and credit markets have rebounded in recent months, sovereign yields remain under pressure. Many interpret this to mean fixed income investors do not believe that the global growth slowdown will abate anytime soon. A perception exists that bond markets tend to lead equities, and that fixed income investors are usually the first to leave the party before the cops arrive. But not all bond investors are leaving the party quite yet, with high-yield spreads narrowing substantially from their early January highs.

Ultimately, we believe that sovereign yields will move higher, similar to what occurred three years ago. In February 2016, a durable bottom was formed in global equities, credit markets and commodities. However, sovereign yields continued to grind lower for several more months, before finally shifting course in June. We believe sovereign yields will once again lag riskier asset classes such as equities and credit.

One potential catalyst for higher yields could be the Fed. The March FOMC meeting minutes were noticeably more dovish, with the Fed communicating the conclusion of quantitative tightening in September and removing two rate hikes from their dot plot expectations. Taken together, these indicate a more accommodative stance and equity markets responded positively to the news. Such a shift in policy is not unprecedented, and the Fed historically has cut rates very quickly after the end of a tightening cycle. Surprisingly, the first cut has tended to occur less than five months after the final hike. While it remains to be seen if the December hike was the final one for this cycle, it wouldn’t be unusual for a cut to occur in the upcoming months.

Don’t just focus on the yield curve

With the yield curve one of the most widely followed economic indicators, the Fed is particularly sensitive to its inversion, as it generally indicates a policy mistake. While the curve is one of the better indicators, it is important to recognize that there are long and inconsistent lags between its inversion and the onset of a recession. For example, the yield curve first inverted in January 2006 during the last cycle, two years before the onset of the Great Recession. In fact, the S&P 500 rallied 21% to the October 2007 peak from the time the curve inverted. While we believe the yield curve is important, it works best in conjunction with an array of additional indicators. Most importantly, the inversion of the yield curve by itself does not typically portend an immediate and sustained selloff in equity markets.

We believe investors are currently underappreciating the Fed’s review of its 2% inflation target. Over the decade-long bull market, inflation has met the Fed’s 2% target only twice. Some suggest that the central bank should move toward targeting “average” 2% inflation over the medium term, or over a multiyear period. In simple terms, this would suggest that the Fed would become comfortable temporarily letting the economy run hot (i.e., inflation above 2%) to make up for the persistent shortfall of the last several years.

Given the prospect of a sluggish global economy, we believe the coming quarter could see increased volatility compared to the quarter just completed. Unlike the fourth quarter of 2018, positioning and sentiment data do not appear to be at extreme offside levels, meaning any pullback is likely to be more muted than the volatility experienced late last year. The market has seen 17 pullbacks of 5% or more since March 2009, several of which were linked to global economic slowdowns.

However, each of these has proven to be a buying opportunity for the long-term investor. While global economic data is not yet flashing the “all clear,” it is important to remember that the stock market is a forward-looking mechanism. The markets have come a long way from the lows of last year and we believe there is more upside for equities in this cycle.  As a result, equities typically begin to rally well before economic data and even corporate earnings recover. As the economy enters the later stages of this cycle, risk management and a focus on quality become increasingly important characteristics for investors.

Jeff Schulze is investment strategist at ClearBridge Investments, an affiliate of Legg Mason

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