Insights
Neutral on US stocks due to the inverted yield curve and high valuation.
Positive on US bonds as the Fed expected to lower rates amid disinflation.
Neutral on US real assets as interest rates and inflation expectations decline.
Neutral on USD cash as interest rates currently high but expected to decline.
Neutral on the US economy as leading economic indicators little changed.
Federal Reserve under pressure to lower rates as economic activity slows.
US leading economic indicators signaling an economic slowdown in progress.
US leading economic indicators most similar to May 1998 conditions.
NY Fed 12-month recession probability elevated at 30% based on yield curve.
2019 yield curve inversion indicative of possible recession in 2020-2022 period.
An inverted yield curve has preceded the last six recessions by about 1-2 years.
Inflation expectations have declined as Core PCE remains below 2% Fed target.
Labor market activity showing a slowdown in new jobs and wage growth.
Financial markets have remained resilient as equities stay near record highs.
Fed futures are predicting two interest rate cuts in the second half of 2019.
US equity valuation well above historical average indicating lower future returns.
US equity market overvalued relative to EAFE and emerging markets.
We are neutral on US stocks as economic growth slows down, the Treasury yield curve inverts, and equity market valuations appear to be historically very high. The Treasury yield curve inverted around May 2019 suggesting elevated US recession risks going into the 2020-2022 period. We are positive on US bonds as the Federal Reserve turns dovish. Falling interest rates are a tailwind for US bonds as bond prices rise in response. We are neutral on US real assets as real estate values benefit from lower interest rates and gold prices increase. However, below-forecast Core PCE inflation and declining inflation expectations suggest slower growth in real asset values. We are neutral on USD cash as the asset class benefits from the currently high short-term interest rates and falling inflation expectations. However, cash returns are likely to decline going forward assuming the Federal Reserve initiates a rate cut cycle.
We have a neutral outlook on the US economy as leading economic indicators point to a slowdown in economic growth. Our analysis of leading economic indicators found that current conditions in the Leading Economic Index are most similar to mid-1998. A global growth slowdown occurred during 1998 on account of the 1997 Asian financial crisis, the 1998 Russian default crisis, and the collapse of Long Term Capital Management. However, the stock market gained for another year and a half as the so-called Dot-com bubble progressed.
A slowdown phase can be followed either by a recession or a resumption of the late upswing business cycle phase depending on actions taken by policymakers and prevailing economic conditions. Recession risks are elevated but not inevitable as growth has only slowed and could pick back up like it did after the 1998 slowdown if given a positive surprise. A positive surprise could come in the form of a comprehensive US-China trade deal coupled with central bank easing. The Federal Reserve Bank of New York's probability of recession within the next 12 months predicted by the ten-year minus three-month Treasury spread is currently about 30% with a 70% probability the economic expansion continues in some form.
Our Federal Open Market Committee (FOMC) cheat sheet indicates pressure for the Federal Reserve to lower interest rates as labor market activity slows down. Nonfarm payrolls declined in May to just 75,000 new jobs created according to the Bureau of Labor Statistics. Inflation has also slowed with the Core PCE inflation rate dropping to 1.50% from 1.80% six months ago. However, financial markets show a significant improvement from six months ago with equity markets at record highs, and low credit spreads signaling low credit risk. We believe these observations suggest net pressure for the Federal Reserve to lower interest rates primarily due to weakness in the labor market and disinflation despite the positive trends in financial markets. The Fed Funds futures market is pricing in two interest rate cuts for the second half of 2019 with a 99% implied probability of the first interest rate cut occurring at the July 31 FOMC meeting. There is a 75% implied probability of a second interest rate cut at the September 18 FOMC meeting. See Appendix 1 to view economic indicators in detail.
Future US equity market returns are likely to be much lower than average over the next decade. We observe the Total Return Cyclically Adjusted Price-Earnings Ratio (TR CAPE) to currently be above 95.43% of all observations going back to 1881, which implies a particularly high equity market valuation. A regression of future ten-year US equity market returns (based on S&P 1500 Composite) against the natural log of TR CAPE forecasts a real return of just 1.69% (+/- 7.03%) annualized over the next decade with 95% confidence. An expected 1.69% real return contrasts to the historical average real return of 6.47% from 1881-2019. These data points suggest the possibility of a significantly overvalued US equity market. However, periods of overvaluation can persist for longer than is thought rational, which makes market timing a difficult task. Equity investors may find better valuations in international equity markets, which have significantly underperformed the US over the last decade. These include possibly overweighting the developed and emerging equity markets relative to the US. See Appendix 2 to view more statistical analysis of historical US equity market valuations.
Appendix 1: Federal Open Market Committee (FOMC) Cheat Sheet of Economic Indicators
Appendix 2: Statistical Analysis of US Equity Market Valuation Based on S&P 1500 Composite Index
Disclosure
The information and opinions herein are for general information use only. NR Capital Management does not guarantee their accuracy or completeness, nor does NR Capital Management assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Past performance does not guarantee future results.