Taking the Temperature: Just How “Sick” is Our Economy? And What Does It Mean for Your Investments?

By Michelle Connell, CFA | 9 min read

In this article:

  • Is it deja vu? 2019 vs. 2018
  • Why consumer confidence matters
  • History speaks for itself and typically repeats itself
  • How to protect your investments

Feeling a little deja vu? Is the patient sick and tired, or do these symptoms mean more? And, just how close are we to seeing a repeat of last year’s Q4 correction? If symptoms are a telling sign, we saw these same symptoms leading up to the 2018 correction¹.

  • Weakness in global manufacturing and elevated uncertainty as risk of trade war continues.
  • U.S. economic growth outpacing the rest of the world’s growth.
  • A strong dollar due to U.S. economic outperformance.
  • China’s slowdown has led to the depreciation of its currency. Thus, China has had less to spend and it has hurt the countries with which it does business.
  • A very high level of hedge funds have been betting against U.S. equities via short selling. This leaves U.S. equities vulnerable.

It’s Not All Deja Vu

Despite the numerous similarities, there are some differences in what we are seeing this year compared to this time last year. The biggest difference is that the Federal Reserve currently has an easing policy via rate cuts and quantitative measures. Last year, they were following a tightening policy. But will this fact alone be enough to keep consumers from losing confidence and keep them spending, or will it be too little too late? In fact, some economists think that the Fed’s easing really does not impact borrowing and spending.

Another difference we’re seeing compared to 2018 is that investors have been paring back on their equities in the hopes of holding onto their YTD returns. Their funds have been shifted to an overweight into bonds (a strange move indeed, considering most conservative bonds DO NOT pay anything). And it’s not only retail investors that are moving out of stocks. Institutional investors are getting defensive. For example, Barclays recently downgraded equities³ and stopped recommending loading up on stocks.

What is truly concerning is that investors hold little cash—as little as they did all the way back in 2007. What will happen when investors lose their confidence and decide to move into cash? Been there, done that. We know exactly what will happen: the equity balloon—and possibly the bond balloon—will pop!

Why Consumer Uncertainty Matters

Uncertainty plays a major role in global economies, not just in the U.S. Take a look at the cost of Brexit’s uncertainty on growth in the U.K., for example. Britain’s businesses are spending 6-14% less on capital goods-property, plant and equipment². Bank of England’s research reflects that global policy uncertainty has been on the rise since 2017, and continues to rise with the U.S.- China trade war. Bank of England believes the trade war will reduce both U.S. and China’s GDP by 1.8% over the next three years.

And, while global capital spending was surging in 2016-2017 at 8%, the current growth rate has dropped to ZERO as there are just too many unknowns in the world.

History Speaks for Itself

Historically, two key facts support the probability of a Q4 correction. 

First, since 1928, on average, the equity markets have experienced four 5% corrections each year. (See first chart below.) Some years these corrections have come in “pieces” (i.e. 5% and then another 15%.). YTD for 2019, we have had only two 5% corrections. If history is any indicator, we should expect another 10% before year’s end. (Disclaimer: Obviously, history does not always repeat itself.)

Second, since 1980, volatility has picked up during the last stages of the business cycle. While we may not know when this recovery will end, we do know that this economic recovery is long in the tooth. (And it is now the longest recovery on record). 

Image Source: J.P. Morgan

As indicated in the second chart above, you cannot time the market. Missing the last 10 days of investment performance in a year will cost you half of your year’s profits. Missing the best month of the year will take you from earning more than 7% to losing money.

Turbulence is coming. Investors must start thinking ahead unless they want to be heading for the exits with all the index funds and Exchange Traded Funds. It could get ugly for equities—and worse for bonds that have lower liquidity!

In summary, while the information above is ominous when considered as a whole, it does not tell us when the valuations of bonds and stocks will adjust to the lower expectations of the global economy and flat capital spending. If we know one thing for certain, investment markets are not rational. Investors sell when they realize that others are selling their positions, so they decide to do the same. The result is that more sellers than buyers are making transactions, and liquidity becomes an issue.

Take Action to Protect Your Investments

Don’t wait to take steps to protect your investments. Here’s what you can do:

  1. As companies report their 9/30 earnings, focus on their expectations for the fourth quarter and 2020.
  2. Watch manufacturing and consumer confidence numbers, especially as we approach the holidays. The consumer accounts for more than 70 percent of U.S. GDP and 30 percent of yearly retail sales are made during the holiday season.
  3. Gauge the tension levels for trade tariffs and impeachment. If the uncertainty and/or risks of these rise, investor confidence will decrease. The result will be that stocks will be sold and cash will be raised for safety.
  4. Evaluate your investment portfolio’s risk level and the allocations to each asset class. Are you overweight in some? Consider trimming. Hold no or little cash? Raise some cash to cover contingencies, as well as have money on hand to buy when things go on sale. 

Portia Capital Management can provide an analysis of your current portfolio and to receive suggestions to mitigate your risk. Contact us today.

Sources:

  1. J.P. Morgan Flows & Liquidity: How possible is a repeat of Q4 2018? By Nikolaos Panigirtzoglou. Sept. 27, 2019.
  2. Financial Times. Entrenched uncertainty is a global problem. By Gavyn Davies. Sept. 29, 2019.
  3. MarketWatch. Why one bank has stopped recommending loading up on stocks. By Steve Goldstein. Sept. 26, 2019.

About the Author

Michelle Connell, CFA is the President and Owner of Portia Capital Management, LLC and one of the highest-rated finance professors in the United States, currently serving as an adjunct professor at The University of Texas. Ms. Connell works with her students and private clients to understand the value of crafting a portfolio that includes conventional products as well as alternative assets, including private equity, private debt and real estate, and allows investment portfolio creation with greater downside protection and more consistent returns. 

Leave a Reply

Leave a Reply

Your email address will not be published. Required fields are marked *