It’s safe to say investors have enjoyed a positive 2019, so far. Equity markets have remained relatively calm and bond markets have returned four times the annual expected return in just six months. But with several key nations including Germany, UK, Canada, South Korea, China and Japan predicting weaker economic conditions, and growth in the US economy looking set to slow from 4% to 1.5% over the next 12 months, should we be concerned, or is this the opportunity we’ve been waiting for?
Slowdown or meltdown?
A slowing economy doesn’t have to give cause for concern. Indeed, we would be equally troubled if growth continued to accelerate at the rate it has done over the last few years. Slower economic growth means that sales growth is harder to come by, but good businesses still have investment opportunities to bring new products on stream and can deploy technology to drive increased earnings through productivity improvements. And the good news is that current economic conditions support this with borrowing costs (interest rates) still at very low levels.
The Federal Reserve (Fed), however, is nervous this slowdown could be deep-seated, leading to a global recession. And there are good reasons for their concerns:
Investors are getting a better return on short-term debt (bonds) than on long-term debt of the same credit quality, which has historically been a predictor of recession
The US has been riding high on tax and capex incentives, but the positive effect of these inducements will soon run their course
Job creation is likely to slow now that the unemployment rate is so low, which will squeeze corporate margins as businesses compete for talent.
As a result, the Fed has backed away from increasing interest rates, and there is now talk of reducing them for the first time in over 10 years. It seems their commitment to avoiding a recession supersedes their desire to reduce the debt incurred by quantitative easing, and an accommodative monetary policy wins the day, again.
“We continue to see excellent investment opportunity in strong businesses, and we’re confident those businesses are well-positioned to weather an economic slowdown. We’re also ready to take advantage of any opportunities that might arise from future uncertainty.” -Philip Smeaton, Chief Investment Officer
While we expect continued but slower economic growth, we recognise the risk that a slowdown could evolve into a recession, and we’re also concerned that the Fed’s change in policy could result in them losing control of inflation. We therefore continue to invest where we think there is growth opportunity coupled with protection from rising inflation. And we maintain a defensive position that means we can capitalise on opportunities created through volatility, should they arise.
Investment view: when gilts and equities don’t agree on the outlook
Investing in gilts (government backed bonds) is traditionally an insurance policy against falling equity markets. As one goes down, the other goes up, and vice versa. But this year, something strange has happened. While equities have performed well and recovered their losses from the end of last year, bonds have also delivered for investors. In other words, our insurance policy has paid out, but we’ve not made a claim.
As Chart 1 shows, despite the UK ten-year bond yielding only 1.27% at the start of the year, government bonds have since returned over 5%; around four times the annual expected return in six months. Corporate bonds and high yield bonds have returned even more, though these bonds pay higher rates of interest to compensate for credit risk.
So, what does this mean, and what is the outlook as a result? The bond market is currently screaming that economies have a growth problem down the road, while equity markets are confident that this will not impact corporate earnings. We must be even more selective at this point in the cycle as slowing growth increases the risk that corporates miss earnings targets. Having conviction that the companies you invest in can deliver is more important than ever.