Keep calm and rebalance into equities
The investment environment has not fundamentally changed since December. Then as now, the situation neither justifies being “all in” nor “all out”. Since the economic situation is worsening, a balanced portfolio of some type makes sense—this view rests on there being no clear evidence of a looming US recession and inevitable associated bear market for equities (at which point tin hats should be donned). In my view, that time has not yet come. So, with stocks down about -9% YTD (in the US and globally), investors should look to rebalance out of bonds or cash and into equities to maintain whatever “balance” they had before this sell-off.
This suggestion is based on our framework that connects the economic cycle and return on invested capital. The idea is that when the return on capital is above its cost, and the spread is either widening or stable at a wide margin, investors should be “all in” risk assets. That was generally the case from mid-2009 to mid-2013. Things began to change in mid-2013 when the return on capital started to slide, and at the same time the Federal Reserve began to retreat from its highly accommodative policy. Thus, based on our framework, the second half of this investment cycle began in mid-2013, and since then a balanced portfolio of some sort has been justified. It still is.
Recent data confirms the trend of a gradual deterioration, but does not yet indicate a recession is nigh. The US mining and energy sector continues to suffer severe pain. But the story elsewhere is less exciting. The shale bust has neither caused a financial crisis nor ushered in a consumption driven boom. Bank credit growth has been strong and stable, growing at 7-8% YoY since late 2014 (suggesting that the private sector was indeed ready to expand credit on its own, without more asset purchases by the Fed). Retail sales are growing at a real rate of about 2%, which is on the low end of their range since 2012 but still indicative of stable consumption.
Meanwhile, US manufacturing growth has slowed to a snails’ crawl—up just 0.8% YoY in December. This is mostly due to the emerging market slowdown and the uncompetitive US dollar. Add to those woes an elevated stock of inventories to work off and US manufacturing output may well decline YoY in the coming months. Worryingly, such an event most often occurs during recessions; but it can occur without recession.
It is a fools errand to rely on a single sector as a pointer to US recessions, but if pushed we’d opt for home construction as it provides an earlier signal of impending trouble. This is probably because the housing sector is unusually sensitive to interest rates (along with job and wage growth). It is thus quick to rebound after the Fed slashes rates, prone to overbuilding during booms, and then quick to correct as the cycle matures, interest rates rise and affordability falls. While the housing boom took pause after interest rates rose in 2013, it now looks to be back on track.
This makes sense as interest rates remain low, housing is decently affordable and the market is still undersupplied relative to household formation.
Better than relying on any single sector, we suggest looking at the return on capital for the entire US business sector. Such returns are deteriorating (as will likely be highlighted once again by this earnings season and 4Q15 national accounts data). However, return on capital remains well above the cost of capital (despite the recent Fed hike and the widening of spreads). As such, the situation remains consistent with a balanced portfolio. Keep calm, and rebalance into equities.