Asset classes: some laggards today, leaders tomorrow

INVESTORS should be fretting over the prospect that, if economic growth in the US slows, some of the asset classes that underperformed during the late cycle will be the outperformers in the slower growth cycle.

As is the case in the rest of the world, there is an ongoing debate in the US over where global markets are headed.

Although volatility has subsided, mainly because of dovish comments by the European Central Bank, the spread ratio of bullish and bearish sentiment in the US, as measured by Investors Intelligence in yardeni.com, is in neutral territory, and is the lowest since 2016. The uneasiness, or, should I say, nervousness stems from the uncertainty regarding the outlook for the US and the global economy.

The important question is what stage of the macroeconomic cycle has the global economy reached? In my framework, the global cycle consists of four stages: early cycle, late cycle, slowdown and recession.

An excellent indicator of the global macroeconomic cycle is the Institute of Supply Management’s Manufacturing Purchasing Managers’ Index (PMI). The US’s share of global gross domestic product is more than 22 percent, while North America’s total share is in the region of 25 percent. The US, therefore, has a major impact on the global economy. A PMI above 50 indicates that the manufacturing sector is expanding, while a reading below 50 points to a contraction.

In the early cycle of the upswing, the US PMI rises above 50 but stays below 55. When growth accelerates to reach the late cycle of the expansion, the PMI rises above 55 and remains elevated. When growth rate stalls, the PMI drops below 55 but stays above 50. When the PMI drops below 50, recessionary conditions are experienced.

The average asset class performance in the global macroeconomic cycle defined above makes for interesting reading.

I calculated the returns for the nine major asset classes – global consumer staple equities, global consumer discretionary equities, developed-market equities, emerging-market equities, gold, oil, metals and emerging-market currencies – in US dollar terms from 1995 to 2018.

In the current cycle, the US PMI had been above 55 since January last year, and the latest reading was 56.5. If we take into account that the US economy is at near full-employment levels, it is clear that its economy is in the late-cycle stage.

Above or below average

The oil price and metal prices are surging, while equities enjoyed a bumper 2017.

What is interesting is that, in the current cycle, the 31 percent rise in the oil price is nearing the average of 49 percent in late cycles; gold, at 15 percent, is approaching a 17 percent cycle average; emerging markets, at 35 percent, are higher than their 26 percent average; consumer staples, at 5.4 percent, are slightly below their 7.3 percent average; consumer discretionary equities, at 27 percent, are higher than average; metals, at 24 percent, are lower than their 34 percent cycle average; and developed-market equities, at 23 percent, are higher than their cycle average of 19 percent.

The derived emerging-market currency index, at 4 percent, is also higher than the 1 percent cycle average, and global bonds, at 7 percent, are slightly higher than their average of 6 percent.

What is bothering the markets is that, if the US PMI drops below 55, it will be an indication of a slowdown in growth. Given the average asset class performance since 1995, some of the asset classes that underperformed during the late cycle will be the outperformers in the slower growth cycle.

Consumer staples, global bonds and gold are likely to stand out, while metals, oil and emerging-market equities and currencies are likely to underperform. However, the average asset class performance during the slower growth shows that investors should prepare for lower returns.

It is virtually impossible to predict when the US economy will slow down, but when it does, asset prices will adjust without hesitation. It is not a question of if, but when.

This is not to say that recessionary conditions will follow the slowdown, because growth may accelerate again. A Black Swan event can overturn the apple cart, however.

It is virtually impossible to predict when the US economy will slow down, but when it does, asset prices will adjust without hesitation.