Take A Deep Breath: Uncertainty Can Lead to Opportunity

When the markets are unsettled and uncertain, as they seem now, what’s your typical response? Maybe you feel anxious and focus on the short term, analyzing a single media headline or piece of data, hoping to time the next market top or the end of the business cycle. Or perhaps you pause and take a deep breath (or more than one), using this respite to focus on the longer-term. To be clear, we almost always endorse pausing and breathing, and here’s why. With a longer-term view, you are more likely to see some of the fundamental trends that are being driven by the engine of the U.S. economy—and that engine is the consumer. The consumer represents approximately 70% of the U.S. economy, and it’s a major reason the U.S. continues to break away from the rest of the world in terms of growth, equity market performance, innovation, and small-business enterprise and entrepreneurship. This is why we remain bullish, at least from our perspective, in the medium and long term and expect the market uncertainty to lead to potential opportunities.

Having said this, we also believe that the U.S. is not immune to outside influences, such as a major slowdown in China, a recession in Germany, deflationary forces popping up again in Japan, or geopolitical uncertainties such as Brexit. Clearly, the world economy has been slowing, led by a major industrial slump, which has been centered around weak auto manufacturing. The bond markets, especially the U.S. Treasury curve (along with the UK’s and Germany’s), have been telling us this. Policy makers, led by the Federal Reserve (Fed), do not need to save risk assets by cutting rates, in our view. “Right-sizing” the curve with more assertive action would be consistent with their words from earlier this year, when Chair Powell said, “we are listening to the markets,” and, more recently, when a Fed communication announced that the Fed “will act as appropriate to keep the expansion going.”

It’s important, in our view, to get ahead of a sharper slowdown, particularly one that is off-shore and less controllable, given the uncertainty over the trade war with China and the weakness in the European industrial base. Business confidence needs to remain at attractive levels to maintain the expansion. When the cost of capital in the short-term is above the return on capital in the longer-term (in other words, an inverted yield curve), it can delay capital investment, lending velocity, and hiring plans, and as a result, dent confidence, which ultimately can cause nominal growth to fall below trend levels. If this transition mechanism lasts longer than expected, it is possible for recession to occur. This is why, in addition to more clarity on trade, it is important to right-size the curve, in our opinion. The inversion of the yield curve between the 2-year and 10-year portion of the Treasury yield curve that recently occurred in August is not an insignificant event. We should not dismiss the messages that are being sent. It is important, however, to understand that this can occur due to a major move lower in longer-dated yields, as demand for high duration assets increases and inflation expectations drop; or it can happen if rates at the short end are heading higher to stop inflation in its tracks. In addition, an inversion can happen quickly (as we experienced in mid-1998), allowing risk assets to rally. We will be closely reviewing the communication coming out of the Fed’s Jackson Hole meeting, scheduled for August 22-24, looking for any clues that can help us assess the shape of the curve in the months to come.

However, current conditions are not all about monetary policy or the action by the Fed. We also believe there are structural forces at work. They include aging demographics, the global search for yield in long duration assets, the significant drop in supply of government fixed income assets, and hyper global competition and on-line price displacement. Other forces include the rise of the gigabyte economy (a digital economy), the transition to more service-based economies overseas, and the long “technology (trade/tariff war)” battle between the U.S. and China, which is still in its infancy. All of this has a material impact on corporate fundamentals such as cash flow, operating leverage, revenues and earnings, and the cost of capital. This is what ultimately drives the longer term level of growth in the broader economy. We still view most of this dynamic as a healthy one for the consumer and one that benefits the U.S. more than the rest of the world, given the strength of U.S. household balance sheets, real income growth, and the early stages of the innovation cycle.

In summary, there are a number of mixed signals currently out there, from macro data to the yield curve, to negative yields in Europe, to geopolitics and ongoing developments with the trade war with China. And, yes, growth is slowing more than originally expected, overseas. However, the strength of the consumer in the U.S., the potential for more assertive action by policy makers, and the positive impact from the still early days of the innovation cycle are signals to keep us bullish in the long run.

We believe it is important to let the shorter-term, high emotion, thinly traded markets settle down before increasing equity exposure all at once. Once volatility begins to stabilize, we believe long term investors may have an opportunity to add well-diversified exposure at attractive prices across U.S. equity markets and specifically in key industry groups in Technology, Healthcare, Industrials, and Financials. We expect this opportunity to present itself prior to the next Fed meeting in mid-September, during the third quarter earnings season and, potentially, at a moment’s notice given the uncertain timing of trade headlines. Having investment strategies ready during market pull-backs is imperative, particularly in more uncertain times such as this.

Follow the 7Cs for more clues on the health of the global investment environment: China; Credit; Claims; Curve; Central Banks; Confidence; and Contagion (geopolitical development).

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Chris Hyzy is Managing Director and Chief Investment Officer for the Global Wealth & Investment Management ("GWIM") division of Bank of America Corporation ("BofA Corp."), which includes Merrill and Bank of America Private Bank (formerly U.S. Trust).

The Chief Investment Office, which provides investment strategies, due diligence, portfolio construction guidance and wealth management solutions for GWIM clients, is part of the Investment Solutions Group (“ISG”) of GWIM, a division of BofA Corp. Merrill Lynch, Pierce, Fenner & Smith Incorporated (also referred to as “MLPF&S” or “Merrill”) makes available certain investment products sponsored, managed, distributed or provided by companies that are affiliates BofA Corp. MLPF&S is a registered broker-dealer, registered investment adviser and Member SIPC. Bank of America Private Bank is a division of Bank of America, N.A., Member FDIC. Both are wholly-owned subsidiaries of BofA Corp.

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