We're enjoying the longest bull market in history - well in the US at least - yet 2018 has been a very challenging year for investing. So which part of the economic cycle are we in and where should we be investing?
Tough questions! Following a great year for stock investors in 2017, American stocks are still up YTD in 2018 despite a sharp correction at the start of the year. But other markets are struggling. Asia and Emerging Markets are not doing so well and most notably China entered a bear market recently (though has recovered a little since). Much of the world is still suffering from the 2008 GFC and of the major regions of the world, it's only really the US that has recovered. The US economy is very strong and has recovered well. But has it peaked? In my opinion , no not yet. But it's certainly coming to a top at some point in the next 1-2 years. Already there is some stress on earnings growth, and we know there are likely hikes to interest rates by the Fed still to come. What then for stock markets? Often bear markets start before a recession is actually seen. So is the US economy entering the late business cycle phase.
In short I believe it is coming there. That does not mean that there are not stock market returns still to be had. For starters, it is not clear that we actually are at the late cycle phase. Tech until the past week or so is still doing well and earnings are still very strong, though yes as mentioned above, there has been some pressure on some corporate earnings recently. Fidelity produced a good info graphic in 2016 stating that the US is showing a mixture of mid and late cycle features...
I believe we are still seeing mixed signals. Either way we are not deep into late cycle characteristics, and therefore I do not believe we are on the brink of seeing a recession. In other words, the music hasn't stopped yet and there are still plenty of chairs to be had! We just need to be mindful that there are less chairs left in the room, and start to position ourselves accordingly. Typically, when the economy hits late cycle, earnings growth slows, inflation rises, the Fed is tightening and the yield curve flattens. Some corporate earnings are starting to miss analyst expectations, but i wouldn't say they are slowing just yet - largely thanks to the tax cuts Trump brought in. Q1 2018 saw earning growth up 24% versus the same period in 2017. Other reasons suggesting we're a way away from the bear market, is that real inflation is still not over 2%. When the yield curve does flatten, historically we have around 19 months until a recession hits. Also small business optimism still hasn't peaked, and when that happens, historically it takes 3 years until we see a recession.
Overseas markets are at a very different phase though. The USD has also been strengthening as a result of widening policy divergence between the Fed and ECB. The strong dollar has hurt Emerging Markets a lot. I expect the USD to peak middle of 2019. By then the Fed will be nearer the end of the interest rate cycle. That could be good for emerging market equities. There is a very clear negative correlation between USD strength and EM stocks (see below graph courtesy of Canaccord Genuity Wealth Management). What is also clear though, is that we are not yet at that tipping point.
So if EM equity isn't quite yet ready to show a resurgence, what do we invest in? Continue with the US? Well, the backdrop of strong economic data and all I've highlighted below, should hopefully indicate more US equity returns to come. The key driver will be when the Fed rate hike path is clear. And it is not yet. The Fed will keep rate increases, the USD will keep strengthening and financial conditions will not stop tightening. As long as US earnings growth continues, the market should still continue upwards. China is slowing, sure, but far from crisis point. The main problems in other countries have been spearheaded this year by Turkey, Argentina and Venezuela - not exactly systemic to the global economy! The trade war of course is a wild card, and there are still short term hazards with Brexit and other European problems (eg Italy), and also the US mid-terms.
So where to invest today? I did some historical research, summarised below, and I think we should be rotating away from tech and high growth stocks, moving to more defensive positions. If we are indeed in or approaching the late business cycle, we should be considering certain sectors like Healthcare, Consumer Staples, Materials and Energy.
Consumer Staples is the stand out sector historically for late cycle investing. This should be something to consider adding positions too. Largely unloved sector in the past few years and healthcare stocks still offer value versus the general market. Telecoms too could be interesting given the mix up of some of the official sectors, with stocks like Alphabet being added to a new telecoms sector mix. ETFs will help boost flows here due to the herd mentality of their very nature. Also, the oil price is more stable than over the past 10 years, and energy stocks still haven't really fully recovered despite many years of cost cutting and revamping the business model. Oil majors offer attractive dividends too - Shell has a current dividend yield of 5.33% has never cut its dividend since WWII! It is well covered with cash too. Other majors like BP (5.48%) and Exxon Mobil (3.89%) offer attractive dividends.
On this, dividend stocks should be more attractive at this point than growth plays. The late cycle is great for these types of companies. Also, similarly, Value should be considered over Growth. Just look at this chart, also courtesy of Canaccord Genuity Wealth Management...
Today therefore represents the best mismatch in relative pricing of Value versus Growth. Time to rotate I think!
Either way, yes there are some headwinds and yes it's not at the easy growth phase we've enjoyed in the past. But there are still plenty of opportunities! As always, please feel free to contact me on Linkedin or on ianpryor@ippfa.com for any thoughts and questions.
Author: Ian Pryor
Please note these are my own thoughts, and not necessarily the house view of IPP Financial Advisers Pte Ltd, a Licensed Financial Adviser, or whom I am an Appointed Representative. I publicly disclose my own personal investments, and these can be viewed here at any time here.