Adriaan Pask | Managing portfolios as the US market enters the twilight zone

There are concerning signs that the US economy is cooling. The impact of this on investors will be profound, especially considering that the US was virtually the sole area of meaningful market growth over the past decade. Whereto if the US is on the brink of a recession?

US equity markets have been outperforming the rest of the MSCI index since 2009, and has tallied up a 277% outperformance spread over that period. It is both the longest and largest US outperformance cycle in more than 50 years.

However, a slowdown in consumer spending, slowing manufacturing activity, an inverted yield curve, and forward-looking indicators that are signalling large scale bankruptcies, are just a few of the signs that point to a setting sun in the US. On 22 June this year the yield curve was still inverted with short rates (3-month Treasury yield) at 5.29% and the 10-year rate at 3.78%.  The message that the yield curve is broadcasting is tougher monetary policy combined with a weaker medium-term growth outlook, and it does not bode well.

Add to this the lofty analyst earnings expectations, and consequently also valuations, and we start to see the time has come to move beyond what has worked in the past 10 years and start approaching the new environment differently. Consensus analyst forecasts remain stubbornly high despite evidence that earnings momentum is receding and a surge in interest rates – which, while remaining unchanged by the Fed after the last FOMC meeting, will reportedly likely increase again. The “invest US, ignore the rest” approach that worked in the previous decade, will not work over the coming decade. As they say, trees don’t grow to the sky.

Only one problem: US markets fill the global investment landscape with irony. US recessions fears? Conventional wisdom states that you should opt for safe-haven assets like US Treasuries and developed market stocks – US mega caps anyone? Also, invest in gold, and the US dollar. Avoid emerging markets and commodities, which are dependent on US economic growth as performance drivers, they say. Recently, we again saw the consequences of this typical narrative play out as investors started to prepare for the looming US recession. This of course just further inflates the already ambitious valuations of some of these asset classes.

But why not think beyond the recession? After all, recessions and bear market declines come and go far more frequently than anyone would like to remember. In fact, history shows that investors should expect a bear market more frequently than every four years. Over a 50-year investment horizon you would historically have experienced no fewer than 14 bear markets. Dare I say that recessions and bear markets are perhaps normal?

So what really matters? What are the more fundamental trends when you look through the multiple recessions you are likely to face over decades of investing?

Things that come to mind are the structural underinvestment in commodity output, and the realities of a massive US debt burden that is hovering at a 129% debt-to-GDP ratio at higher interest rate levels, while we are about to see pressure building on the GDP side of that equation...

Underinvestment in the commodity space is not something that turns around overnight. Bringing new capacity on board takes years. The US debt burden is also not something that will unwind quickly, it will take years of fiscal control and discipline.

Is the best approach to avoid commodity producing emerging markets when there are global growth scares, even when many of these assets are eye-wateringly cheap and through-the-cycle supply looks constrained? If US markets don’t deliver, who will? Where is the global investor capital (that is currently in the US) going to find a new home? My guess: emerging markets. What is the impact of this likely to be on the US dollar? It’s unlikely to be positive, especially so if you consider that we are likely at a near peak in interest rates. Any interest rate softening will put pressure on the dollar.

Source: PSG Wealth

Long story short, what investors seem to be favouring and shunning during this twilight period is diametrically opposed to the longer-term risks and opportunities. In the context of a long-term investment horizon this twilight period is a very brief moment, and investing long term not only offers a far better probability of being successful, but is also likely to have a more meaningful impact when it comes to successfully building wealth in the long-run. Inflection points can be fantastic opportunities for investors, if they can navigate them successfully, and that requires some disciplined long-term investing and sound advice.