Alert but still not alarmed
The U.S. is in the second-longest economic expansion since the 1800s, and S&P500 performance generally has peaked six months before the onset of a recession. Given the age of the economic cycle, getting a clear read on recession risk is crucial. The Business Cycle Index (BCI) model, which uses a range of economic and financial variables to forecast the probability of recession, still indicates it's too early to go completely defensive.
Short-term (three-month) recession risks are very low, given the strong labour market, easy financial conditions, and strong economic growth. At the 12-month horizon, the model recommends that investors remain alert but not alarmed. We are closely monitoring the data, but until recession risk is especially elevated (i.e. probabilities are in the warning zone), we believe leaning out of risky assets at this point is premature. A key watchpoint for longer horizons is the slope of the yield curve, which is an input into the BCI model and a reliable leading indicator. The 10-year U.S. Treasury yield is determined by the term premium and the average expected short rate over the 10 years. When the 10-year yield falls below short-term yields, the market is pricing a growth slowdown in the future where the Fed is forced to cut rates. The yield curve hasn’t inverted yet, but has uncomfortably flattened. Continued flattening will put upward pressure on the model’s recession probabilities.
BCI model historical foretasted recession probabilities
* Source: Russell Investments, as of September 2018.
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.
Mom(entum) knows best
The past quarter has been dominated by a run up in the U.S. equity market. Our models focus on the trade-off between momentum (strong), current valuation levels (expensive) and how that trade-off compares to the attractiveness of the fixed income market. Our quantitative models continue to show a small preference for U.S. equities over U.S. fixed income. While late-cycle investing is inherently risky, we believe conditions are still in a “cautious-but-go-equities” zone.
EAA* U.S. equity vs. U.S. fixed income aggregate signal
Source: Russell Investments, as of September 2018.
Standard deviation is a measure of the dispersion of a set of data from its mean: more spread-apart data as a higher deviation.
* Enhanced Asset Allocation (EAA) is a capability that builds on a 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 SEP 500 Index and Bloomberg Barclays U. S. Aggregate Bond Index.
Within our cycle, value and sentiment investment framework we make the following overarching assessments based on our quantitative models.
- Business cycle: This is still strong though our tools tell us the risk of a recession is gradually increasing.
- Valuation: U.S. equities might be expensive in absolute terms but are less stretched relative to bond yields, according to our Fed model. Our dividend discount model has come down slightly in the third quarter but is still positive.
- Sentiment: Momentum has increased with the run-up in U.S. equities. This also means that our contrarian model that looks at long-term mean reversion has become more negative. On balance though, momentum wins out and we see an increase in our modeling signal as we move into the fourth quarter.
We are cautiously optimistic for the time being as 2019 approaches, but will continue to monitor valuations for signs that things have gone too far.
Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.
The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested.