Keeping it positive
Our model for U.S. equities versus U.S. fixed income continued to stay in the positive range in the past few months. We still see low inflation and decent GDP growth which are good conditions for equities. While we have seen them increase in value, we’d be cautious of expensive valuations and a flattening yield curve.
EAA U.S. equity vs U.S. fixed income aggregate signal
Source: Russell Investments, as of November 15, 2017. Forecasting represents predictions of market prices and/or volume patterns utilising varying analytical data. It is not representative of a projection of the stock market, or of any specific investment. Enhanced Asset Allocation (EAA) is a capability that builds on Strategic Asset Allocation (SAA) by incorporating views from Russell Investments’ proprietary asset class valuation models. EAA is based on the concept that sizable market movements away from long-term average valuations create opportunities for incremental returns. The EAA Equity-Fixed Income Aggregate Signal is based on the S&P 500 Index and Bloomberg Barclays U.S. Aggregate Bond Index.
Within our cycle, value and sentiment (CVS) investment framework we make the following overarching assessments based on our quantitative models
- Business cycle: The BCI model uses a range of economic and financial variables to estimate the strength of the U.S. economy and forecast the probability of an upcoming recession. We conclude as unlikely the following two scenarios: a near-term U.S. recession, or accelerating economic growth in this aging cycle.
- Valuation: Our Fed model declined but stays near fair value for equities and fixed income assets. Our dividend discount model continues to see equities as a worthwhile investment.
- Sentiment: Equities have continued to grow in the last few months. Our momentum signal grew slightly and has been stable and positive. Our contrarian long-term mean reversion signal is stable and negative for equity versus fixed income.
This combination of positive value from the dividend discount model and positive momentum overcomes the contrarian signal to put us slightly in favour of U.S. equities.
Recession probabilities: Alert but not alarmed
The U.S. is now in the third-longest economic expansion since the 1800s. Given recessions are damaging to equity markets as well as the expensiveness of the S&P 500 index, having a clear read on recession risk is crucial for navigating investments. The BCI model uses a range of economic and financial variables to estimate the strength of the U.S. economy and to forecast the probability of recession. As of November 25, 2017, the BCI index estimates that the probability of a U.S. recession in the next 12 months is around 25%— a level which signals caution, but not an outright warning. We conclude that a near-term U.S. recession is unlikely, but we should monitor this aging cycle.
BCI historical forecasted recession probabilities
Source: Russell Investments, as of October 31, 2017.
There are two major watchpoints with regards to the BCI model. The first is the labour market. Headline unemployment in November 2017 is 4.1%, the lowest since December 2000, and well below what the Fed estimates as sustainable. We expect the pace of job growth will moderate as the labour market overheats further, which will raise the BCI model’s recession probabilities. Separately, an overheated labour market puts us at risk for a potential policy mistake: in a tight labour market, companies compete for a scarce pool of workers and tend to bid up wages. In response to higher inflation, the Fed could raise interest rates too aggressively, restrict growth, and unintentionally start a recession. In the last nine economic cycles, an overheated labour market preceded a recession by two or three years on average.
The second watch point is the U.S. yield curve. The slope of the yield curve is a proxy for future growth expectations and an input to the BCI model. In the last five cycles, an inverted yield preceded a recession by 10 to 32 months. The current yield curve is far from inverted, but has uncomfortably flattened. As the Federal Reserve continues to tighten monetary policy, the short end of the yield curve will likely face upward pressure, potentially flattening the slope even more.
Yield curve: Uncomfortably flattening
Source: Thomson Reuters Datastream, as of November 11, 2017.
Overall, we think the U.S. economy is still on a path of moderate growth with low probability of recession over the next year, but risks are building at the three-year horizon. In our view, investors should maintain a balanced risk portfolio and look for opportunities to buy the dips and sell the rallies.