25 Sep 2018
Much of Europe has enjoyed an unusually warm summer. But as the nights draw in and leaves turn brown, we know that winter is somewhere around the corner.
Like summers, economic expansions do not last forever. The US recovery is now the second longest on record. There is nothing to suggest it will end in the near future, so the broad prognosis for risk assets remains good. But we know that—like weather forecasters—economists struggle to precisely time a change in the outlook.
This report does not therefore seek to pinpoint the timing of the next global recession. Instead, it provides a number of strategies for investors who are looking to slowly turn the dial towards a more defensive portfolio. We discuss challenges in today’s bond markets and suggest that investors think carefully about which areas of the market will provide adequate protection. We highlight a number of other strategies that have served to shield portfolios in the past, when the snow, and stocks, start to fall.
As the US expansion approaches its 10th birthday, investors may wonder how much longer this expansion has to run.
While no two recessions are exactly the same, the playbook often runs as follows: unemployment falls; emboldened workers ask for higher pay; central banks hike rates to stem inflationary pressure; higher wages and rising interest costs squeeze profits, which leads to job shedding. Fearful of losing work, consumers rein in spending, demand falls and the recession takes hold.
This looks simple, so why are economists so notoriously bad at forecasting recessions? The reason is that economic relationships can change. Workers may not ask for more pay. Central banks may not slam on the brakes. And households and firms may keep spending despite higher interest rates if animal spirits are running high. All of these can extend the economic cycle. And, of course, the playbook might change entirely in the event of a financial crisis or geopolitical shock.
EXHIBIT 1: UNEMPLOYMENT RATES
Source: BLS, Eurostat, ONS, Thomson Reuters Datastream, J.P. Morgan Asset Management. Periods of “recession” are defined using US National Bureau of Economic Research (NBER) business cycle dates. Past performance is not a reliable indicator of current and future results. Data as of 31 August 2018.
It is hard to say where we sit in the current US economic cycle with any precision. The unemployment rate—at an almost fifty- year low—suggests the expansion is in its twilight years. However, a rise in productivity indicates that firms are managing to squeeze more out of their existing staff. And with wage growth remaining subdued there hasn’t yet been a squeeze on corporate profits. Even stripping out the effect of the corporate tax reduction, earnings for S&P 500 companies rose at a solid double-digit rate in the second quarter.
But the Federal Reserve is slowly lifting interest rates. This will be an increasing burden—particularly for the companies that have leveraged up in recent years. Higher interest rates may well start to bite just at the time when the almighty fiscal stimulus begins to fade.
The European economic cycle is less advanced. Having “double- dipped” with the sovereign crisis, unemployment is still relatively high in much of the region. There is ample spare capacity, which is keeping core inflation low. As a result the European Central Bank appears to have very little intention of lifting interest rates until at least the summer of 2019.
In the UK, the recovery was more aligned to that of the US until the uncertainty surrounding the Brexit referendum slowed the pace of activity. Despite the fact that unemployment is at a multi-decade low, the Bank of England seems for now, more hesitant about raising rates.
Although these economic cycles aren’t aligned, it seems likely that a downturn in the US would filter through to a global slowdown. Europe is still a very export-dependent region and relies on demand from the US consumer.
EXHIBIT 2: REAL DOMESTIC GDP
Source: BEA, Eurostat, Thomson Reuters Datastream, J.P. Morgan Asset Management. Real domestic GDP is total real GDP excluding the net exports component. Past performance is not a reliable indicator of current and future results. Data as of 31 August 2018.
Although it is hard to pinpoint the start date of the next recession, we can say with more conviction that the next equity market contraction is likely to be less severe than the close-to-50% corrections seen in the last two recessions.
There has been a tremendous regulatory drive to reduce the likelihood of another financial crisis. The financial system is better capitalised and more transparent, which should reduce the risk of contagion. A “traditional” recession—whereby corporate profits are eventually squeezed by rising interest costs and unit labour costs—seems most likely.
And equity market expectations of future growth are considerably more modest than they were ahead of the tech bust. In March 2000, the S&P 500 technology sector peaked with a price-to-earnings (P/E) ratio of 55x, and the stock market today have very high valuations, the tech sector as a whole now has a P/E ratio of 19x, and the S&P 500 multiple is broadly in line with its average of the past 25 years.
EXHIBIT 3: S&P 500 DECLINES FROM ALL-TIME HIGHS
Source: Bloomberg, NBER, Robert Shiller, Standard & Poor’s, J.P. Morgan Asset Management. Periods of “recession” are defined using US National Bureau of Economic Research (NBER) business cycle dates. Past performance is not a reliable indicator of current and future results. Data as of 31 August 2018.
With the US economy still booming and valuations looking reasonable, it isn’t obvious that any dramatic shift in portfolio allocation is required. Investors looking to time the market have rarely been rewarded for their efforts. But it seems wise to consider what assets can be added to a portfolio to increase resilience.
In times past, those looking to add ballast might have reached for a higher allocation to government bonds. This cushioned the losses to an overall portfolio as the equity market declined (see detailed table in Exhibit 5).
The difficulty we face this time around is that interest rates in much of the developed world are still near record lows. Consider a simple average of the US, eurozone and UK central bank policy rates. This measure fell from roughly 5.5% in 2000 to less than 2% in 2003, and then from 4.7% in 2007 to less than 0.5% in 2009. Given the current average of these policy rates is just 0.8%, there is clearly no room for a fall in interest rates of this magnitude.
EXHIBIT 4: AVERAGE CENTRAL BANK POLICY RATE
Source: Thomson Reuters Datastream, J.P. Morgan Asset Management. Calculated as the simple average of the US Federal funds rate, European Central Bank overnight deposit rate and UK Bank of England base rate. Bps is basis points. Past performance is not a reliable indicator of current and future results. Data as of 31 August 2018.
The US government bond market does offer some protection given rates have now risen. Indeed, if the US 10-year government bond yield fell from 2.9% to 1.5% that would produce a roughly 15% return.
It’s much less obvious where investors can find cover in European government bond markets. The German 10-year Bund yield is just 0.4%. Elsewhere in Europe, the expansion has not been strong enough for governments to repair their balance sheets. A near-term downturn could once again lead to questions about the ability of certain European governments to sustain high levels of debt. And if another economic downturn caused a further political shift towards the more radical policies advocated by populist parties, the market could question the “risk-free” nature of some government bonds. This could be an issue beyond the European periphery.
Investors should also be mindful of the potential risks in some other areas of fixed income. Corporate leverage has increased substantially, and almost half of the US investment grade index is now comprised of the lowest eligible grade (BBB) of bonds.
Put simply, investors considering running for the shelter of fixed income should consider very carefully which areas of the market will provide them with a solid roof.
With this in mind, and considering the experience of different asset classes and sectors in the past, we can summarise seven broad strategies that investors looking for a more defensive portfolio should consider:
There are few signs that either the US or global economy is about to fall into recession. But as US interest rates normalise and the fiscal stimulus fades the headwinds will mount. While a 50% correction in equity markets seems less of a risk, some investors—particularly those more sensitive to potential downside—may wish to consider what changes can be made to a portfolio to add resilience.
Traditionally, government bonds were considered the first line of defence. We question whether they will prove quite so useful this time around given there is limited scope for interest rates to be cut, particularly in Europe. Investors should think about how they can dynamically use fixed income and liquidity products, how they should alter the equity styles within their portfolios, and whether alternative strategies such as macro funds and equity long-short funds will serve as a better cushion in the coming years.
EXHIBIT 5: ASSET CLASS RETURNS DURING S&P 500 DRAWDOWNS
Karen Ward is Chief Market Strategist for EMEA for J.P. Morgan Asset Management.
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields is not a reliable indicator of current and future results.
J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued in the United Kingdom by JPMorgan Asset Management (UK) Limited, which is authorized and regulated by the Financial Conduct Authority, Registered in England No. 01161446. Registered address: 25 Bank Street, Canary Wharf, London E14 5JP.