Too good to be bad: the misplaced focus on recession risks

Risk/reward balance in equities remains tilted towards the latter

Many investors are so focused on monitoring potential recession signals that they may overlook evidence to the contrary.

The world economy is not heading towards an imminent recession. It is instead exiting a temporary cyclical slowdown that began in mid-2018. Fiscal stimulus measures in China and more accommodative monetary policy in the US are having a positive impact and helping to steady the global economy. Leading economic indicators in both countries confirm this view, pointing to a pick-up in economic activity this quarter.

Even so, many investors remain on the sidelines. Some may still be wary after the hefty sell-off during the fourth quarter of 2018. Others may believe that the subsequent first-quarter rally across all major global indices was too good to be true and that a US recession lies ahead, with the recent inversion of the yield curve providing an apparent warning sign in this regard.

It is arguably not the time to be risk-averse.

It is arguably not the time to be risk-averse. Valuations have obviously got richer in the past few months. The risk/reward balance in equities remains tilted towards the latter — provided that the global economy does indeed work its way out of the mini cycle slowdown and major central banks keep interest rate hikes on hold.

That being said, one should not expect a return to the boom times of 2017. Any further gains in equity markets in coming months are unlikely to compare to the remarkable Q1 2019 performance. After all, the global economy is currently in the late stages of an extended economic cycle, and growth is likely to slow from its peak.

We expect global economic growth of 2.8 per cent this year compared with 3.2 per cent in 2018. Improvements in manufacturing indices in China and the US are a case in point. In China, the official Purchasing Managers’ Index (PMI) advanced to 50.5 in March, crossing the key 50 level back into expansion territory. In contrast, China’s PMI reached 52.4 in September 2017. In the US, an index of factory activity compiled by the Institute for Supply Management (ISM) also improved in March, rising to 55.3, which remains in the growth zone but is clearly lower than the reading of 60.8 achieved in September 2017. Together, the US and China account for more than half of global economic growth and thus provide a solid indication about the state of the global economy. The good news is we can expect moderate growth for the foreseeable future, and, crucially, tame inflation to go along with it. 

The good news is we can expect moderate growth for the foreseeable future, and, crucially, tame inflation to go along with it.

A world with central banks on hold provides a very good backdrop for financial markets just as growth starts to pick up once again. Risky assets, especially equities, should continue pushing upwards in the months to come. A recession will emerge at some point — it is a normal part of the economic cycle. But we see a low probability of a US recession within the next 12 months, not least because household leverage remains moderate.

There are of course risks that should be taken seriously.

There are of course risks that should be taken seriously. Global organisations such as the International Monetary Fund continue to scale back their expectations for global growth. Trade remains a key risk as the US and China have yet to resolve their differences and the US-European trade tensions may intensify. In addition, UK-EU relations remain uncertain as the two parties await a Brexit breakthrough. Finally, in late March the US yield curve inversion — viewed as a recession bellwether — unsettled investors.

Despite these uncertainties, it would be premature for investors to declare the end of the cycle.