By Jeff Korzenik, Chief Investment Strategist for Fifth Third Bank
- Though cautious earlier in the year, our view on U.S. markets and the broader economy is now more positive than the consensus.
- Improvements in productivity offer more room for economic growth.
- Investors wary of a recession should watch three key signals for warning signs—yield curve, credit spreads and purchase manager confidence surveys.
Earlier this year—before volatility returned with a vengeance—my colleagues and I cautioned investors that the days of easy equity returns had likely passed.
Yet, that hardly means game over.
While investors must remain vigilant, the consensus view may have swung too far toward the side of pessimism. From where I sit—700 miles from Wall Street, incidentally—continued strength in the underlying economy could drive still higher returns for select U.S. equities.
This view is supported by a few factors, including a strong outlook for the U.S. consumer, increases in capital expenditures, and a pickup in productivity.
After nine years of economic growth and rising stock prices, there’s little question that this cycle is entering the late innings of expansion: Earnings improvements are baked into most valuations and—as inflation edges higher—rising interest rates are a real concern.
Over the course of this economic cycle, falling unemployment did not directly translate to rising wages. Recently, the tight supply of labor in the market has begun to push wages modestly higher. While this can lead to wage inflation, it may also give rise to greater consumer spending—and, therefore, economic growth.
At the same time, we believe the long-term impact of U.S. tax reform isn’t fully appreciated.
After all, lower marginal rates for corporations and the ability to immediately deduct capital expenditures are strong incentive for corporations to invest in better equipment, technology and property. Such spending not only offers an immediate bump for the economy, it is an essential ingredient for productivity growth.
Indeed, the promise of improving productivity is one reason we think this cycle still has room to run. Technology isn’t simply benefitting the manufacturing sector; it’s also giving rise to innovations in other sectors, from kiosks that streamline ordering in fast-food restaurants to software that is automating back-end functions in finance.
Further, quit rates—that is, when employees voluntarily leave their jobs—recently reached a 17-year high. This is the natural result of a tightening labor market, but it can also lead individuals to seek out and take positions in which they can be more productive. What’s more, the largest cohort of the workforce—millennials—are entering the period of their economic lives in which they’ll likely be increasingly productive.
Three Key Signals to Watch
Investors looking for clues about when the end is near would be wise not to focus on any single indicator. At Fifth Third Bank, we follow three: The yield curve, credit spreads, and purchasing manager surveys.
The yield curve should come as no surprise. The relationship between short- and long-term rates is a longstanding harbinger of market tops. Typically, the yield on the 10-year Treasury is significantly steeper than that of the two-year Treasury. When those two invert—as some economists expect to happen in 2019—a recession may be near.
One caveat: This gauge may be distorted given the unusual rate environment—i.e. negative rates abroad—we’ve seen in recent years.
As for credit spreads, yields for higher risk assets, such as high-yield bonds, are typically higher than Treasury counterparts. And the difference in this gap can often be indicative of market sentiment. Which is to say, when the spread narrows, it suggests that investors are comfortable taking on more credit risk—usually because they believe the economy is improving. When it widens, it can signal investors see weakness ahead.
Finally, we look at changes in corporate conditions assessment—specifically the Institute of Supply Management (ISM) Manufacturers Purchasing Managers Index: A rising index is a bullish sign; a decline signals a recession may be looming. The latest survey, released in early July, found that—though managers are concerned over the implications of a possible trade war—the index itself is holding steady.
In sum, we believe we’re in the eighth inning of this cycle—but the ninth could stretch out longer than the consensus currently expects.
So, with all of this in mind, how should investors play this market?
Our model portfolio continues to be heavy on U.S. equities—with a recent shift toward smaller domestically-oriented companies.
Our position includes a cautionary note, however: Participating in a late-cycle market requires vigilance for signs of the end as well as a willingness to shift into a more defensive stance quickly.
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