At the start of 2018, the in-vogue phrase was “Goldilocks economic conditions”. We were in a fairy tale environment that was not too hot and not too cold, combining sustainable economic growth with benign inflation. Needless to say, the bears have come back to the cottage and they’re making a racket that threatens to wake Goldilocks from her economic sweet dreams.
The loudest roar has been the US’s aggressive trade policy, as a war of words has developed into tit-for-tat tariffs between China and the US. The US is planning further escalation, with tariffs on a further $200bn of goods1. We are waiting to see whether China blinks first and concedes to US demands or whether the trade war ramps up and potentially spreads to other trading partners, leading to meaningful global economic damage.
The yield curve is getting close to inversion (exhibit 1 below), which has a remarkably strong track record of predicting recessions. In short, it tells you that people are more concerned about the near-term than the long-term.
Exhibit 1: US Government ten-year less two-year yield (Source Bloomberg). Data as of 30 June 2018
Finally, this bull market looks a bit long in the fang. It is the second-longest bull market in US history and, if it continues, will become the longest ever on August 22nd2.
It’s not all bad news.
That said, it should be pointed out that while the bears may be roaring, this has not yet been backed up by a painful bite. A resolution to the US-China trade tensions could still be found, and on average it takes 20 months after the yield curve has inverted before a recession begins3. And of course, just because a bull market is old does not mean that it is over.
However, sentiment in the market has turned, with defensives outperforming cyclicals in the last few months as investors look to derisk.
Historically the Conference Board index has been a strong lead indicator for the market peak. The 12-month pre- and post-peak relative performance of sectors is shown below:
Exhibit 2: World sector relative performance 12 months pre- and post a peak in the Conference Board Indicator (Source Morgan Stanley Research, Datastream). Data as of May 2018 encompassing 50 years of data.
It’s time to change strategy for a changing market.
The best performers tend to be oil and gas, basic resources and insurance – perhaps surprisingly, as these are often bucketed as more cyclical. It is worth noting that if Sino-US trade wars trigger the end of the cycle, it would be naïve to think that basic resources will hold up well. After this initial grouping, we see more traditional defensive sectors like food & beverages, healthcare and utilities.
The worst performers are tech, autos and media, all of which are quite cyclical. Tech has led the market upwards in the US, so is perhaps a consensus position that could unravel. It is worth noting that given the UK equity market’s large weighting in oil & gas, resources, healthcare and utilities it is a defensive index and tends to outperform other equity markets at the end of the cycle.
In summary, whilst we do not think the end of the cycle is nigh, it is worth considering positioning in case any of the bears’ roars turn to bites and our Goldilocks scenario is no more.
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