Investing is never easy, and today, the task is made even harder by geopolitical tensions, local politics, regulations, and other outside influences. Investors need to understand what’s driving a company’s growth, but they also need to make sense of these seemingly extraneous risks and what they mean for their investments. Here we address five of the most pressing questions on your mind.
QUESTION 1: WHAT IMPACT WILL A TRADE WAR HAVE ON THE ECONOMY AND FINANCIAL MARKETS?
It seems new tariffs are being threatened or imposed almost every week, but their impact is a bit amorphous. To some economies, a trade war can be quite detrimental, while others, like the US, are not as directly affected. The announced tariffs, as of mid-July, affect about 30% of all imported goods, which means less than 4% of the overall US economy is impacted by these tariffs.
While the direct impact to the US economy would be small, the indirect impact, particularly related to business confidence and uncertainty, could be more meaningful and decidedly negative. This detrimental mix would likely result in lower capital spending and decreased hiring, in turn, dampening growth. Further, given the global nature of supply chains today, any interruption to the free flow of goods across borders would be negative for growth. It’s hard to pinpoint and measure the exact impact right now because the situation is fluid. Although we often say this, it seems applicable now more than ever: the situation warrants continual monitoring.
QUESTION 2: IS THE STOCK MARKET POISED FOR A BIG DECLINE?
Investors worry that these trade tensions, or a full-out trade war, will negatively impact the global equity markets. This, coupled with other risks—political uncertainty, rising rates, inflationary pressures, and market volatility—makes some investors fear the markets are headed sharply lower. A big decline is possible, as it always is, but for the market to tumble an extreme amount (i.e., 20%+), you have to assume a lot of bad news, in our opinion.
To help make our conclusion more tangible, we constructed a matrix that calculates returns for the S&P 500 over the next year, using earnings growth and changes in valuation as the most significant drivers of return (Display). Importantly, this matrix is not our forecast—for such short time periods, we are not that prescient. But the matrix does provide various possible scenarios to help us understand what needs to happen for the market to move up or down from current levels.
To experience steep market declines, both earnings growth, and the price-to-earnings multiple need to move significantly lower from current expectations. For example, to be down 28% over the next 12 months, earnings would have to fall 15%, and valuations would have to contract by three turns, from 17x to 14x.
It’s not inconceivable that such a negative scenario could happen, but history tells us it is not likely. Additionally, expectations for EPS growth are strong for the next 12 months, and today’s valuation is roughly in line with the market’s historical average. We agree that there are rising concerns that could impact the market, but US fundamentals remain robust, and such a negative near-term change is unlikely given the current landscape, in our opinion.
QUESTION 3: WHAT DOES THE FLATTENING YIELD CURVE MEAN?
Concern over a large pullback is, in part, due to increasing interest rates. Over the last few years, the Federal Reserve has been raising the Fed Funds target range, which normally causes all interest rates to rise. Interestingly, today, while short-term rates have risen, longer-term rates have not been moving up to the same degree, causing the curve to flatten.
It’s natural for the curve to flatten during a Fed tightening cycle. But fears of the curve inverting, where short-term rates are higher than long-term rates, are becoming more worrisome. That’s because inverted curves typically precede recessions. However, it is important to note that not all flat curves invert. That said, they do tend to be a good predictor of an economic contraction, but unfortunately are not predictive of when a contraction will occur.
Curves tend to invert when either short-term rates move too high and/or the market is worried about long-term growth. Today, though, may be different. US Treasury interest rates look relatively attractive compared with sovereign debt of other countries, inducing international buyers to purchase US bonds, somewhat anchoring longer-term US interest rates.
Fortunately, this influence is a supply/demand issue and not a result of lower growth expectations. So, we do not view this type of flattening as an imminent sign of the end of the cycle or a recession. But given the historical association of inverted curves with recessions, it would be imprudent to completely ignore the signal.
QUESTION 4: SHOULD I MOVE FROM BONDS TO CASH?
When interest rates rise, historically the short-term return on municipal bonds faces headwinds while the return on cash increases. This dichotomous return picture is causing investors to wonder if moving from bonds to cash makes sense. As often is the case, the answer is, “It depends.”
When deciding between cash or intermediate duration municipal bonds, the investor’s time horizon matters most. If the time horizon is short, then cash tends to be the prudent investment given that it rarely loses its principal value. But if the time horizon is longer, investing in munis often makes sense. The reason is simple: Over multiyear periods, the return on municipal bonds should be higher than cash, even as rates rise.
Despite the narrowing of returns, in a rising rate environment where hikes are generally well telegraphed by the Fed, munis have historically performed well. Today, we believe, is no different despite the higher cash yields on offer.
QUESTION 5: WHAT RISK IS UNDERAPPRECIATED?
One risk that we believe the market is taking for granted today is the potential for rising correlations between stocks and bonds (Display).
Prudent asset allocation is predicated on the belief that, on average, there is a low or negative correlation between stocks and bonds. But, there are times when the correlation moves positive, and meaningfully so. When the negative correlation breaks down, the diversification benefit from having both asset classes is significantly lower.
Using history as a guide, a positive correlation is more likely when rates are above 5%, which is above today’s rate. But deficit concerns, a spike in inflation, or the continuation of unwinding quantitative easing in the US could alone or in some combination be the catalyst that drives both stocks and bonds lower simultaneously.
This potential for rising correlations argues for greater asset class diversification, beyond just stocks and bonds. Real assets, such as commodities or real estate, and alternatives, such as hedge funds, private equity, or private credit, are generally lowly correlated with equity and bond markets. So, to reduce this risk, greater diversification, beyond just stocks and bonds, should be adopted.
PUTTING IT TOGETHER
The markets are always moving and changing, and many variables can pull them in any direction. The complexity of the markets should never be taken for granted. That’s why we continuously monitor and consider these and other factors that could impact the markets, and position our portfolios accordingly.
For more on trends in the economy, markets and asset allocation for long term investors, explore The Pulse, a Bernstein podcast series, and for additional thought leadership, check out the related blogs here.
The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.