The pause that refreshes

Global central banks have turned dovish, China stimulus is stronger than expected and trade-war tensions are easing. The cycle is becoming slightly more supportive for equities, but it’s late in the cycle, so we see the upside as limited.


The S&P 500® Index missed official bear market1 status by a whisker in late 2018, falling 19.8% between September 20 and December 24. It has since rebounded 18% (as of March 12), but the volatility highlights how skittish investors have become.

Markets are caught between the incoming data pointing to slower global growth and forward-looking factors that suggest improvement later in the year. We think a modest improvement in global cycle conditions is likely. This would be led by the U.S. Federal Reserve’s shift to a more dovish outlook and China’s moves toward policy stimulus. It will also be helped by rebounds from a series of one-off events that have constrained global growth. These include the recovery in European automobile production after the collapse caused by the European Union’s new emissions regime, a series of natural disasters that affected output in Japan and the recovery in U.S. output following the 35-day federal government shutdown in January.

It also seems likely that U.S./China trade tensions are heading for a form of détente, which will lift a constraint on global trade and business confidence.

The window of opportunity for equity markets looks limited, however. Capacity pressure is growing in the U.S. with the unemployment rate below 4%. Wage growth is already threatening corporate profit margins. It will eventually find its way into inflation and bring the Fed back into action. We expect a Fed funds rate hike late in the year, followed by another two hikes in 2020. This would take Fed policy into slightly restrictive territory, creating the risk of a recession either in late 2020 or during 2021.

Goldilocks2 seems to have returned for now and history tells us that global equities can continue to rally late in the cycle, even as the Fed tightens. We also know, however, that the less costly late-cycle mistake is to be defensive early rather than chase the last rally. We’re comfortable with a market weight allocation to equities as the first quarter wraps up. With inflation pressures gradually building, we prefer to reduce long-duration bond exposure.

Loose lips sink markets

Novice Fed chair Jay Powell received a crash course in the pitfalls of unscripted commentary last October. His remark that interest rates were “a long way from neutral” gave the impression he was planning many more rate hikes. This helped trigger the late-2018 market correction. The subsequent dovish messaging in early 2019 has been one of the key factors behind the market rebound.

The chart above shows the dramatic change in market views around the Fed’s decisions. Fed futures show where investors think the Fed funds rate is heading. In early November, this market was expecting the Fed to lift rates a further three times by the end of 2019. As of mid-March, Fed futures are now pricing in a 30% probability of a rate cut by the end of 2019 and a 70% probability of an easing by the end of 2020.

Our view is that the Fed futures market has over-reacted to some soft data and dovish Fed announcements. The U.S. economy is slowing as last year’s fiscal stimulus winds down. Gross domestic product (GDP) growth of 2.9% in 2018 was unsustainably strong. We’re expecting a slowdown to around 2.2% this year, a rate that is still well above the trend 1.8% growth rate. This means that price pressures should build, bringing the Fed back into action later in the year.

China getting more stimulus

China’s economy continues to slow. The chart below shows that the manufacturing purchasing managers’ index (PMI) moved below the break-even level of 50 in December. The PMI index is being led lower by a dramatic decline in export orders as the effects of the trade dispute are felt.

The positive outcome is that the downturn is pushing authorities toward more aggressive policy stimulus measures. Data early in the year is always challenging to interpret due to the distortions caused by the timing of the Chinese lunar new year. Looking through the noise, there appears to have been a strong lift in bank lending and the broader total social financing measure over January and February. 

Chinese authorities have announced a broad range of tax cuts, and it’s likely that local government spending on infrastructure projects will be ramped up over the next few months.

China responded to its last two economic downturns, in 2009 and 2015, with massive fiscal and credit stimulus. The response this time is unlikely to be as large given the concerns about high debt levels and financial stability.

Even so, stimulus measures are underway, which should provide support to both China and the global economy in the coming months.

Asset class preferences

Our cycle, value and sentiment investment process points to a broadly neutral view on global equities as of March 21, 2019.

  • We have an underweight preference for U.S. equities, mostly driven by expensive valuation. The cycle has improved slightly with the Fed pause on rate hikes.
  • We’re more positive on non-U.S. developed equities. Valuation in Japan and Europe is reasonable. Japan should benefit from an improving China outlook. Europe has fiscal stimulus and the potential for strong earnings-per-share growth in its largest sector, financials.
  • We like the value offered by emerging markets equities. It is a beneficiary of a Fed rate hike pause, China stimulus and a potential thaw in the trade war.
  • High yield credit is expensive and losing cycle support, which is typical late in the cycle, when profit growth slows and there are concerns about defaults.
  • For government bonds, U.S. Treasuries offer reasonable value. Our models give a fair-value yield of 2.7% for the 10-year U.S. bond.
  • German, Japanese and UK bonds are very expensive, with yields well below fair value. The cycle is a headwind for all bond markets as inflation pressures slowly build.
  • We like real assets. Real estate investment trusts (REITs) are slightly cheap, while global listed infrastructure (GLI) and commodities are around fair value. Commodities typically benefit from late-cycle support as inflation pressures build. We expect GLI will benefit from its European focus as the region rebounds. Rising Treasury yields, however, are a headwind for REITs globally.
  • The Japanese yen is our preferred currency. It’s significantly undervalued, can get cycle support as over-pessimistic growth expectations are revised higher and has contrarian sentiment support from large short positions by market speculators. The euro and British pound sterling are undervalued. The recovery in European economic indicators should support the euro. Sterling will be volatile around the Brexit negotiations but should rebound if a deal is agreed with Europe. It has more upside potential than the euro.

1 A bear market is a condition in which stock prices fall 20 percent or more from recent highs amid widespread pessimism and negative investor sentiment.

2 Goldilocks defines an economy that is not too hot or cold; in other words, one that sustains moderate economic growth and has low inflation, which allows a market-friendly monetary policy.

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