Still Navigating the Late-Stage Expansion
July 12, 2018
“One evil in old age is that as your time is come, you think every little illness is the beginning of the end.”—Sydney Smith, Letter, 1836
- Market volatility in 2018 reflects investor concern for the longevity of the expansion and shifting trade policy.
- Even when factoring in the potential impacts of recent trade policy changes, the likelihood of recession remains relatively low.
- Despite recent volatility, markets remain priced for an ongoing expansion, albeit with less room for upside and more room for downside.
- While forward-expected returns are muted by higher starting valuations, equities should still earn incremental returns over bonds.
- Investors should continue to position portfolios to participate in ongoing economic and profit growth while building in an appropriate degree of protection given the modest rise in risk.
Equity markets continue to oscillate throughout 2018, a meaningful contrast to the smooth returns of 2017 (Exhibit 1). Volatility in 2018 can generally be attributed to investor concern about the age of the bull market and economic expansion. Perhaps at this point, as Sydney Smith suggested in 1836, every issue that arises seems to cause jitters as to whether it could be the beginning of the cycle’s end.
Exhibit 1: Smooth Stock Market Returns in 2017, Volatility in 2018
Source: Glenmede, FactSet Data through 6/27/18
Data shown is the historical price of the S&P 500 Index. This represents past performance, which is not indicative of future results.
Issue du Jour: Trade Policy
The most recent issue to capture investor imagination is trade policy. In June 2018, Daimler AG, the parent company of Mercedes-Benz, became the first multinational to revise earnings guidance downward due to escalating trade tensions. Daimler claimed China’s import tax on U.S. autos would hurt exports to China from their U.S. manufacturing plants. Shares of the company fell 4.5% following the announcement. Could the Daimler situation foreshadow a more broad market response?
The amount of imports subject to tariffs has risen steadily this year as new levies have been announced and implemented. Exhibit 2 contextualizes the magnitude of implemented and pending tariffs as of June 20, relative to the overall U.S. economy. The original steel and aluminum tariffs, and the first round of tariffs on $50 billion of Chinese goods, amount to about 0.01% and 0.02% of U.S. gross domestic product, respectively. After China retaliated with a similar measure, Trump signaled his intention to enact another round of tariffs on $200 billion of Chinese goods. This, in addition to the proposed tariffs on European cars and auto parts, amounts to an additional 0.03% and 0.01% of GDP, respectively. Individually, these tariffs are not that meaningful; but cumulatively, they amount to nearly 0.1% of GDP.
Exhibit 2: U.S. Tariffs Impact Less than 0.1% of GDP So Far
Source: Glenmede, U.S. International Trade Commission Data as of 6/20/2018
Impact calculated as tariff rate multiplied by total imports as of 2017. Assumes a 20% tariff rate for potential tariff on European Union cars and parts. GDP impact estimated for 2018.
While the impact of trade policy on industries such as steel and autos may be pronounced, so far the overall economic impact is noticeable but limited. In fact, the drag on GDP from these combined measures will likely be less than the estimated 0.5% GDP boost provided by year-end tax reform. As a result, the tariffs announced to date are unlikely to change the 2018 economic growth story.
Recession Remains Unlikely
Even accounting for the expected impact of recent trade policy changes, the Glenmede Recession Model (Exhibit 3) suggests a relatively low likelihood of recession in the next 12 to 18 months. This low likelihood of recession results from the lack of accumulated economic excesses. Growth has been slow, businesses have remained hesitant to expand more aggressively and even consumers have exhibited restraint.
Exhibit 3: Glenmede Model Suggests Low Likelihood of Recession
Source: Glenmede Data as of 5/31/18
The Glenmede Recession Model is intended to provide an objective assessment of the probability of recession within the next 12 to 18 months. The model is based on a mix of various measures of economic excesses and forwardlooking economic indicators such as our own leading economic indicator (LEI). There can be no guarantee that these indicators will be accurate.
The 17% probability of recession, shown above, reflects some economic fragility and the possibility that outside events not explicitly considered by the model could derail the expansion. For example, it is possible that further escalation of the trade dispute between the U.S. and China or another trade partner could cause a more meaningful slowdown of growth than currently projected. While such events are not our base case assumption, it is important to acknowledge both their possibility and probability.
Market Returns Going Forward
So what should investors be expecting in terms of returns? Financial markets usually reward investors for assuming greater levels of risk. Exhibit 4 shows the typical risk curve where longer-term bonds earn more than cash as reward for bearing interest rate risk, and equities earn more than both bonds and cash due to their inherent economic and market risks.
Exhibit 4: The Typical Reward for Risk-Taking
However, markets are rarely typical, and the picture changed dramatically over the past decade (Exhibit 5). At the start of 2009, following the financial crisis, expected returns for equities were as much as 12% according to Glenmede’s Global Expected Returns Models2. By contrast, expected returns on cash were quite low given the Federal Reserve’s stimulative programs. In other words, there was a significant reward for investing in equities over cash and bonds. Expected returns on fixed income came down by 2013 as global central banks pursued their bond buying programs, but there still remained a decent amount of extra reward for owning stocks.
Exhibit 5: The Reward for Risk-Taking Has Changed Dramatically
1 Source: Glenmede, FactSet. Glenmede’s Global Expected Returns Model projects 10-year forward returns based on the assumption that valuations converge from a starting-point to a future fair value estimate based on target valuation parameters. Historical forward projections are similar 10-year forward projections based on data available at the time projections are made. Cash, stocks and bonds are represented by the Bloomberg Barclays U.S. Treasury Bellwethers, MSCI All Country World Index (MSCI ACWI) and the 10-year Treasury, respectively. MSCI ACWI is a representative index that includes all countries.
Since 2009, equity markets have also recovered from discounted valuations, reducing their forward expected returns. The end result has been a flatter but still upward-sloping risk curve (Exhibit 6). Equities still appear capable of producing long-term returns in excess of fixed income returns, which should still come in higher than returns on cash. However, the differences in expected returns between the three asset classes are more compressed, reducing the incremental return awarded to investors for accepting more risk.
Exhibit 6: There Is Still a [Smaller] Reward for Taking Risk
Strategy: Invest to Participate and Protect
What should investors do? With few of the excesses that normally signal the end of an expansion, an ongoing boost from recent fiscal policy changes and manageable impacts from trade policy, the economic expansion seems likely to continue. However, the reward for taking risk is now lower than is typically available to investors.
It is also possible the trade situation could deteriorate further, leading the economies and markets into a more difficult period. Investors should counterbalance this risk with the understanding that as long as destabilizing events do not materialize, markets can remain extended for prolonged periods. Exhibit 7 illustrates the longevity of the last two extended markets.
Exhibit 7: Markets Can Remain Extended for Prolonged Periods
Source: Glenmede, MSCI Data through 6/30/2018
Long-term fair value is based on normalized earnings, cash flows and book value using MSCI’s USA Index. Past performance is not indicative of future results. This is an unmanaged, total return index with dividends reinvested. One cannot invest directly in an index.
As a result, investors should maintain a full/neutral weight to equities to benefit from the likely ongoing expansion. At the same time, unable to perfectly predict the timing or cause of a downturn, investors should deploy defensive strategies within their equity allocations to build in some protection on the margin. Defensive equity strategies invest in portfolios of stocks or companies that are inherently more stable than the broad equity market and therefore experience smaller declines during difficult economic and market periods.
What Should Investors Do?
In addition, investors should employ equity strategies that favor smaller, more regional businesses and are more likely to be insulated from trade disruption. Further, there remain pockets of relative value, particularly in international markets such as Japan. Finally, alternatives such as absolute return or hedge funds, as well as fixed income, can be used where appropriate to balance out portfolio risk.
In short, investors should position portfolios to exhibit appropriate protection on the downside while also participating in the further upside from the ongoing expansion, which remains the more likely outcome.
2 See footnote 1.
3 See footnote 1.
4 See footnote 1.
This writing is intended to be an unconstrained review of matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. This document is not intended as a solicitation for the purchase or sale of any product or as an inducement to enter into a relationship with Glenmede. Alternative investments, such as private equity, are only available to investors who meet specific criteria and can bear certain specific risks, including those relating to illiquidity. Advice is provided in light of a client’s applicable circumstances and may differ substantially from this presentation. Glenmede’s affiliate, Glenmede Investment Management LP, may conduct certain research and offer products discussed herein. Opinions or projections herein are based on information available at the time of publication and may change thereafter. Information gathered from other sources is assumed to be reliable, but accuracy is not guaranteed. Outcomes (including performance) may differ materially from expectations herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss the applicability of any matter discussed herein with their Glenmede representative. Nothing herein is intended as legal advice or federal tax advice, and any references to taxes which may be contained in this communication are not intended to and cannot be used for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promotion, marketing or recommending to another party any transaction or matter addressed herein. You should consult your attorney regarding legal matters, as the law varies depending on facts and circumstances.