Time To Sell Equities As UBS Raises A Recession Risk Red Flag
In the great scheme of the economic cycle one encounters recoveries, peaks, recessions and troughs. The natural rhythm of a free market economy means that recessions are an inescapable fact of life. We may be heading toward one now.
Along with periods of growth, when investors look for the high beta assets that can create excess return, or alpha it is the ensuing periods of decline that typically create the biggest headache for investors.
We have, over the past decade lived through a period of excessive monetary accommodation as the world’s leading central banks have sought to ward off an economic downturn. Indeed, it is the equity market that has been the principle beneficiary in the age of easy money.
On a long historical chart, I note the Dow Jones Industrials 30 has risen from a mere 6,437.90 at the start of March 2009 to 27,342.60 as of the start of July this year. That is a gain of 324.71% or an annualised growth rate of 15.42%.
Given such gains, and the steady increase in volatility over the past month that seems to coincide with every utterance from Donald Trump one might be tempted to cash in the gains.
Such a shift of mood has been given an aggressive nudge as Union Bank of Switzerland, (UBS), the world’s largest wealth manager. It has recommended investors pull out of equities for the first time since the darkest days of the Euro Zone crisis in 2012.
Those that take a bullish outlook on equities are a minority now as the consensus suggests that equity market rallies are unlikely to be sustained. One should note that the MSCI World Equity Index is hovering above its 200-day moving average and that is not an assured support level. The MSCI EM Equity Index slipped through its 200-dma at the end of July and is appears to be trending lower toward the October 2018 low.
The Dow Transport index has retreated to its mid-January low as has the broader Russell 2000 index. The key U.S. benchmark, the S&P 500 index is just 75 points way from its 200-dma. The statistics show that the likelihood of a 15-20% correction is rising. Any retreat of that scale would send reporters and journalists rushing to propose a bear market had arrived.
As already said, sentiment is fickle and can turn on a tweet, so be wary for whippy price action in a response to quick comments re U.S.- China trade restarting or on a breakthrough between the U.S. and Iran.
One must start asking why would a trade deal between the U.S. and China run on a schedule that suits Donald Trump’s re-election timetable? China may be willing to go another year in hope of negotiating with a Democrat from January 20, 2021.
To understand why there is such an urgency let me consider the nature of a recession. It is an extended period of a significant decline in economic activity. The accepted definition for economists is that two consecutive quarters of negative GDP growth is classified as a recession.
Recessions bring about faltering confidence on the part of consumers and businesses, weakening employment, falling real incomes, and declining levels of sales and production. Given an equity price reflects expected future earnings it is easy to see why such conditions would place this asset class squarely on the backfoot.
This implies that recessions lead to heightened risk aversion on the part of financial market investors and a flight to safety that is found is less risky assets.
The usual alternative would be the bond market, and yet one encounters all the major continental European government bond markets are being completely negative. The major exceptions are Italy and Spain that both have internal political problems.
The U.K. and the U.S. are often referred to as the “Anglo Saxon” markets and both are the only major liquid markets that have a positive yield at every maturity. The U.K. of course has the headache of Brexit to manage and in the U.S. the president appears to be at loggerheads with the head of his central bank. One could suggest Canada or Australia offer positive yields; however, both are markets where economic fortune is closely aligned with the commodity space; an asset class even more capricious than equities.
The lack of yield in so many markets is a direct result of central bank asset purchases giving investors a free ride for many years with backstop bid. Bank of America Merrill Lynch report that a record flow of funds was invested into fixed income funds than ever during the week of August 12. This is a gain of 25% i.e. almost $2 billion, on the previous record. It marked a second consecutive week of record inflows into bond funds.
The flow of funds reflects the key story as at Jackson Hole over the past weekend at the 2019 Economic Symposium. Fed Vice Chair Richard Clarida said on Friday, August 23 that the global economy has deteriorated in the past month.
“Obviously, the global economy has worsened since our July meeting, … The global economy is slowing and there’s powerful disinflationary pressures.”
One metric that could be signalling a gathering storm is the spread between the U.S. Treasury two- and 10-year notes. The current levels are T2 at 1.506% and the T10 at 1.545% i.e. they are inverted by 3.9 basis points.
This matters as yield curve inversion, especially in the U.S. is a reliable signal of a looming recession. The U.S. curve has inverted before each recession in the past 50 years. It offered a false signal only once in all that time, although the time-lag has varied.
One does not have to just act on what UBS is saying. The signal from both equities and bonds is clear. One may have days of success in buying heavily oversold equities, however, right now, that is not a sensible trade strategy to follow for anyone other than a hard core market professional.