It’s Not About Good or Bad, It’s About Better or Worse
We spent the last few days in Washington for one-on-one meetings with Investment Strategists from Schwab Institutional, Goldman Sachs, Blackrock and others.
The theme of our longtime friend and peer, Liz Ann Sonders, head strategist at Schwab, is that the direction of stocks is mostly about the trends, which we agree. This is because the markets are forward looking and reflect future growth expectations.
The “Leading Economic Indicators” are overall, very strong. However, recently a few of the underlying components are trending downward. Unemployment claims, new orders, interest rate spreads and the leading credit index are still strong, but the average workweek, building permits, and the stock market have worsened in recent months.
Dr. Janice Yellen
Once again, I had the great pleasure of meeting Dr. Janice Yellen, as well as learning about her current views since much has changed since our meeting in June. Dr. Yellen has several concerns surrounding Fed policy and the potential impact of tariffs, however she is not seeing other financial imbalances that are often associated with recessions. Most importantly, she believes that the current GDP growth rate is unsustainable, given the tight U.S. labor market. She noted that the White House has a target GDP growth rate of 3%, which she believes to be unrealistic. In her opinion, the trend sustainable growth rate should be about 2%, and that while next year may not be as good as 2018, it should be well above the trend rate, perhaps around 2.5%. She also believes that we cannot maintain the current level of growth with 3.7% unemployment, which she sees falling to 3.5% by year end.
She commented that with “real” interest rates close to zero (real interest rate represents the 2% Fed Funds Rate minus 2% inflation), monetary policy is still accommodative to growth. Regarding the pace of interest rate hikes, she noted that the Fed is raising rates at half the pace of the 2004 interest rate hike cycle.
Dr. Yellen’s greatest concern is the economy overheating. With the Schiller (cyclically-adjusted) Price-to-Earnings Ratio at 30, the market is the most expensive it has been since 2000. She discussed how banks are much stronger than they were before the financial crisis, but she is still concerned about the buildup of debt in U.S and non-US corporations. She believes that we could see a recession in 2020 but does not expect a deep one similar to the 2008 crisis.
Consistent Themes We Are Hearing From Strategists
- While many strategists viewed the recent pullback as just a temporary correction, they do see the growing risk of recession in late 2019 to mid-2020.
- Evidence of a cyclical peak is mounting. Most notably within corporate earnings and Purchasing Managers Index (PMI) data.
- Most have a cautious outlook on credit sectors including corporate bonds, senior loans and high yield bonds as we near the end of the cycle.
- Almost every strategist expressed concerns about the long-term effects of a trade war with China and the U.S. abandoning its global leadership role.
- While growth stocks have materially outperformed value stocks over the past 10 years, this trend is expected to reverse in coming months. In addition, large cap stocks should also outperform small cap stocks.
- Many of the differing views are centered around interest rate expectations. While Goldman Sachs sees 3 to 4 rate increases next year, Schwab’s head of fixed income, Kathy Jones, is only looking for two more hikes in 2019. Kathy also believes that treasury yields may peak soon, coinciding with the end of the Fed’s tightening cycle.
- Rowe Price believes we are not heading toward a recession right now, as corporate fundamentals remain strong and they do not see the typical imbalances associated with recessions, driven by overconfidence and asset bubbles. However, they also commented that the benefits of fiscal policy (i.e., spending bill, tax reform) will likely peak next year.
Our growing list of concerns leads us to believe that the second half of 2019 may be a tumultuous time for the markets as we approach an inevitable recession in 2020. Due to this outlook, we will likely continue to de-risk our models as we work our way through next year, rotating into higher quality and lower volatility equity and fixed income securities. There is little doubt that we are in the 4th quarter of this business cycle, and it is now time to begin preparing for what lies ahead.