October’s relief rally — the best monthly returns in equities in four years — should have provided, well, relief. The trouble is that with positions washed out, sentiment fragile and macro data still mixed, few investors participated fully in the move, and many simply didn’t believe in it. We at J.P. Morgan Asset Management are not surprised by the lingering deficit in risk appetite and agree that a degree of caution remains warranted. After all, the third quarter was the worst three-month stretch for the S&P 500 since the same period in 2011.
Many commentators — bullish and bearish alike — appear very happy to call for a correction when they feel one is overdue, but nobody likes them when they finally turn up. So what comes next? In our view, either a continuation of the sharp rally in risky assets or a rapid deterioration into recession is equally implausible. Our best guess is a modestly higher, unconvincing grind into year-end, with stocks and bond yields slightly higher, commodities still weak and credit providing the best of the returns.
To put October’s market moves into context, the S&P 500 rose 8.3 percent, its best month since October 2011; U.S. high-yield spreads contracted 67 basis points and investment-grade by 10 basis points, the most since February; and emerging-markets equities rallied 6.8 percent, their strongest monthly showing since January 2012. By contrast, yields on the ten-year U.S. Treasury rose 11 basis points during the month — but only in the last two days of October, after the Federal Reserve reiterated that its December announcement will very much be a live meeting.
The negative correlation between stocks and bonds seems to be reasserting itself, but with the start of rate hikes still in play for December, many investors will continue to question how attractive bonds are as a portfolio hedge to stocks. The upshot is a continuation of the tempered risk appetite we’ve seen since the summer.
Even if October has left a lingering sense of “woulda, coulda, shoulda” for the many battered investors who merely watched the rebound from the sidelines, the relative calm has given welcome pause for reflection. We think there are four major factors that multiasset investors are now weighing:
• The risk of recession in developed markets, which we maintain is still very low.
• Liquidity, boosted meaningfully by the dovish remarks from European Central Bank president Mario Draghi and the rate cuts from China.
• Emerging-markets stabilization.
• Anticipated Fed policy moves in December.
The tightening of global financial conditions may have helped to trigger the correction over the summer, though aggregate financial conditions indexes remain well shy of recession levels. Emerging markets can, and probably will, continue to face slowing growth. They are unlikely to tip the world into recession, however, even if they continue to restrain the global manufacturing sector. Policy rates will adapt to prevailing economic conditions, and U.S. third-quarter real GDP at 1.5 percent was neither a surprise nor a comfortable backdrop against which to see rates higher. Focus must now shift to the U.S. jobs report, due tomorrow, for further clues as to whether the Fed will move in December. So, what of recession risk?
Most analysts and economists agree that a workout from excessive leverage, the overhang of excess capacity and the structural drag of an aging population are all contributing to a decline in U.S. growth. U.S. real GDP growth since the third quarter of 2009, the first quarter of positive growth after the financial crisis, has averaged 2.2 percent; by contrast, growth from the third quarter of 1985 to the end of 2007 averaged 3.1 percent. If we look in nominal terms — the type of growth consumers feel, rather than the type economists obsess about — the differential is starker still: 3.8 percent postcrisis, compared with 5.7 percent precrisis.
Well, there it is folks: the new normal. Not much fun, is it? However, to be clear, the U.S. isn’t in recession. Indeed, few if any of the usual recession indicators are anywhere near stressed levels. Delinquency levels, debt-to-income, capex-to-sales and jobless claims, to name but a few, are at comfortable levels. It is also true that the dynamism of an economy that is in midcycle on most metrics just isn’t there.
Perhaps this is not surprising. For instance, if we assume wages keep pace with nominal GDP over the long run, then the 2 percent difference in growth rates pre– and post–2008 financial crisis compounds to a 12 percent undershoot from 2009 to today. That’s about $5,600 a year by now for the average U.S. worker. Low energy prices, low mortgage costs and persistently low inflation are all helping to support personal consumption, which came in at more than 35 percent in each of the past two quarters. Though with inventories subtracting 1.4 percentage points and net trade flat in the third quarter, the overall picture on U.S. growth is lackluster.
Earnings growth in 2016 is likely to be positive, if unexciting. Woe betide those companies that miss earnings expectations, especially in fully valued consumer sectors. The upside risk to bond yields is probably limited, even if the Fed does raise rates in December. For bond yields, like equities, a grind upward looks more likely than a sharp jump.
We do expect sentiment to gradually repair. Once the inventory drag clears and the current contraction in manufacturing stabilizes, we anticipate some more encouraging headline GDP prints as the resilience of the consumer plays through. Nevertheless, we don’t feel compelled to chase assets today, preferring instead to build exposure in segments like credit, where valuations are more dislocated from fundamentals than they are in stocks. We maintain a moderately pro-risk view over the next 12 to 18 months.
Nevertheless, at this time our quantitative models, together with the greater level of uncertainty in the economy, lead us to take a somewhat derisked position. We have temporarily reduced our stock-bond position to neutral and have chosen to add risk instead in U.S. high-yield. We maintain a preference for developed-markets over emerging-markets but in reduced size. Within developed markets, we lean modestly to U.S. and euro zone equities. We are also overweight Australian bonds and underweight Canadian bonds, in a framework that leaves us neutral duration at the portfolio level.
As markets stabilize, our medium-term views will likely prevail once more. For the time being, though, we believe a degree of caution is the prudent course.
John Bilton is global head of multiasset strategy at J.P. Morgan Asset Management in London.
