For the most part, it’s been a good year for U.S. equities. We’ve so far seen only two down months in 2019―May and August. Both of these happened to coincide with escalating U.S.-China trade tensions. The ebbs and flows on this front are likely to remain a market-moving force and source of uncertainty for investors.
I’d like to tackle three more question marks that may have investors scratching their heads in the year’s final quarter:
1. Are the good times (nearly) gone for U.S. stocks in this cycle?
We don’t think so. We see similarities between the current moment and 2016: Investors are feeling uncertain about the economy, rates have dropped and a contentious U.S. election is brewing. We had an industrial recession then while the consumer was strong. We can check both of those boxes for 2019. One new dynamic: trade war.
In hindsight, 2016 was a classic mid-cycle slowdown. We think 2019 could be similar but acknowledge this time could be riskier simply because the cycle is older and the economy has less slack to offer a buffer. Yet we don’t see this as the end of the economic expansion―or equity gains. End of cycle is usually marked by spiking commodity prices, wages that are rising too quickly, and the Fed lifting rates to avert economic overheating. None of these are evident today. In fact, it’s just the opposite. One potential upshot: A continuation of slow growth and a stock market that can grind higher.
While we see little reason to call in life support on the current market and economic cycle, despite its advanced age, we do believe now it a good time to focus on quality in equities and aim to enhance portfolio resilience.
2. What is the yield curve telling equity investors?
Bond markets are sending mixed messages. Low yields (and high bond prices) are generally a sign of economic pessimism. Yet they normally come with a widening of spreads between lower- and higher-quality bonds. Not so today. The yield spread between U.S. Treasuries and riskier high yield bonds has been relatively contained, sitting below 4% throughout October. This compares to a 25-year average of 5%, and is well below levels seen during the 2001 tech bubble and 2008 financial crisis.
Brief yield curve inversions, such as the episode in August, could be more anomaly than omen. Part of the reason for the curve inversion could be less about the U.S. specifically and more a reaction to very low (even negative) yields globally. Even if the curve were sending ominous signals, it historically has been an imperfect timing indicator. Leading into the last five recessions, the 2- to 10-year curve was inverted for an average of 22 months before recession hit, according to research from Credit Suisse. And that interim period (between inversion and recession) has not necessarily been bad for equities. The study found U.S. stocks rose an average of 15%-16% in the 18 months following curve inversions, though the range of outcomes was wide at -11% to +30%.
3. Where should I look for income in a low-rate world?
Bonds historically have offered investors higher yields and lower realized volatility than stocks. Today is different, as shown in the charts below, making stocks an attractive income proposition.
Utilities and REITs, historically stable income providers and classic bond proxies, have high valuations today―consistent with higher bond prices. We prefer to seek income in less rate-sensitive areas of the market that also have potential to grow. Health care, for example, can see sustained growth from an aging population. The sector is further bolstered by consistent innovation and resilient spending to support it. We also see potential in U.S. banks, where stock prices are already reflecting a recession. That means any whiff of good news could see those prices get a lift.
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