The risk of shunning US equities now

Since the fourth quarter of 2018, market sentiment has swung significantly. A reversal of the Federal Reserve’s interest rate stance in January, as well as other central banks embarking on an easing path, have fuelled a strong run in equity markets. The collapse of trade talks between the US and China, in May, ratcheted up market volatility - despite a temporary truce in June alleviating some of the tension. Most recently, the retirement of John Bolton from President Trump’s inner policymaking circle could be a harbinger of a more conciliatory tone going forward – an underappreciated positive for markets.

The apprehensions earlier this summer have seen more investors become increasingly concerned about an imminent market crash, with many looking for safe havens to protect their wealth. Since mid-2018, this rush to safety can be seen in in the capital outflows from equity funds to fixed income and money market funds (see Fig. 1).

Fig. 1: Estimated net flows of open-ended and exchange traded funds world-wide¹

In particular, for the year ended 31 August 2019, US equity large cap growth funds posted roughly USD61.3 billion worth of net outflows, according to figures from Morningstar². This is despite the S&P 500 index reaching all-time highs, and the US consumer continuing to be resilient, underpinned by a low unemployment rate.

One widely discussed force behind such outflows is the fear of an impending US recession, which we argue is a remote possibility at this juncture.

Fanning the fears is the higher yield of the US 3-month bills over the 10-year Treasury bonds. This aspect of the inverted yield curve is represented by the 10Y-3M yield spread falling into negative territory (see the red line in the black circle in Fig. 2).

Fig. 2: US yield curve slopes and recessions³

Upon closer inspection, however, the 10Y-2Y (the yellow line) has only recently inverted, and importantly, longer term measures of the yield curve, such as the 30Y point, still exhibit a relative ‘perkiness’ – albeit the entire rate spectrum is lower than many would have previously expected. This, at first glance, is actually better than it looks, in so far as the recent sharp fall in long and short end rates allow for lower mortgage and other rates that will likely help home sales and fuel refinancing, thus putting more money into the hands of consumers.

This economy is far from being on its last legs!

A further factor to consider in relation to the yield curve – is that the lag between inversion and actual recession onset can be both long and variable. The onset of any subsequent bear market tends, in recent cycles, to be beyond the immediate investment horizon of most professional investors – meaning that there are often outsized positive gains to be made, for those with the courage of their convictions.

On a more comforting note, credit spreads imply that investors are assigning a low probability to a recession. US corporate spreads are currently sitting below their historical averages (see the black circles in Fig. 3). Put simply, lenders require less interest to compensate for financial risks, reflecting their confidence in the borrowers’ businesses.

Fig. 3: Credit spreads are below historical averages⁴

Considering all of this, if the Fed stays proactive and cuts interest rates, a recession could become a relatively distant possibility. As a result, investors who are now eschewing equities will risk heavily missing out on the growth opportunities.

With sweeping corporate tax cuts and banking deregulation firmly in place, the US economy should remain in good shape. The missing link would seem to be at least a partial resolution to the trade war uncertainty – something we can likely look forward to in advance of President Trump’s bid for re-election in 2020.

Whilst a near term recession does seem unlikely, a key question now is how long the current expansion can be extended. Key factors will be:

• The 2020 US presidential election
• A US-China trade deal
• The Federal Reserve policy

If President Donald Trump wins a second term, his enacted policies, together with the recently passed budget deal to raise fiscal budget caps and the nation’s borrowing limit, will sail through to 2021 onwards, and thereby provide more support for a longer expansion.

In addition, a successful trade deal with China will also play a role in maintaining the current expansion. With a US-China trade deal in place, a healing process can begin to buoy the global economy. Without a deal, American consumers and manufacturers will be hurt by the extension of even more tariffs to and from China. The jury is still out.

Weighing all of this up holistically, market valuations are easily justified given lower interest rates, and that corporate earnings can continue to grow by a good amount. Fig. 4 shows that the S&P 500 index is only trading at 17 times forward price-to-earnings (P/E), which is within the fair-value range of recent years.

Fig. 4: US equities (S&P 500) trade in a comfortable zone (forward price-to-earnings)⁵

P/E multiples typically swell in Fed easing phases. This, coupled with mid-single digit earnings growth, can easily justify an expectation of good returns. Add in a dividend and buyback yield of (combined) almost 4% - and one could be forgiven for starting to feel really quite bullish.

Of course, risks abound however - and visibility remains lower than at similar points in previous cycles. The Multi Asset Solutions team in Singapore remains alert to the various risks. Whilst we remain vigilant, and alert for ‘sell triggers’, US equities remain a core overweight from a multi asset perspective, pending ongoing assessment of the global macro key drivers.