Quantitative modeling insights
Improvement for U.S. equities
The model for U.S. equities versus U.S. fixed income has moved into the positive range, up from neutral in our mid-year report. With low inflation and steady U.S. GDP growth, equities have increased in value. This stronger momentum translated into a greater signal in favor of risk assets, though we remain cautious.
EAA U.S. equity vs U.S. fixed income aggregate signal
Source: Russell Investments, as of September 15, 2017. Forecasting represents predictions of market prices and/or volume patterns utilizing 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 Business Cycle Index (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 a near-term U.S. recession is unlikely and we’re also unlikely to see accelerating economic growth in this aging cycle.
- Valuation: Our Fed model stayed flat and suggests the relative valuation between equities and fixed income assets is fair. Our dividend discount model continues to favor equities over fixed income.
- Sentiment: Equities continued to rise in the third quarter of 2017. Our momentum signal as of September 15, 2017, is stable and positive, but our contrarian long-term mean reversion signal is stable and negative for equity versus fixed income.
- Conclusion: This combination of positive value from the dividend discount model and positive momentum overcomes the contrarian signal to put us slightly in favor of U.S. equities.
Recession probabilities: Short-term risks building?
The BCI index, which estimates the probability of recession in the next 12 months, is almost 25% as of September 15, 2017. Though historically low, this marks a new high for this expansion since the 2008 recession. We conclude that a near-term U.S. recession is unlikely, but we should monitor this aging cycle.
BCI historical forecasted recession probabilities
Significantly reducing recession probabilities to what we observed two years ago would be difficult for the U.S. economy, in our view, given we’ve already had such a long expansion. The pace of job growth is still steady, but it is likely to moderate as we push towards full employment. There was a period of decreasing recession probabilities after the 2016 U.S. presidential election, where indicators reflected increased confidence in the U.S. economy. Some of that optimism has since dampened.
The slope of the yield curve is a proxy for future growth expectations and an inverted yield curve is a recession warning. While the yield curve flattened over the last two quarters, it is still far from inverting. 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. As a result, we would maintain a balanced risk portfolio and look for opportunities to buy market dips and sell the rallies.
Yield curve: Flattening, but hasn’t inverted yet
Source: Thomson Reuters Datastream, as of September 1, 2017.