The US – the world’s largest economy – appears to be heading into a slowdown, according to analysis by Schroders, and history shows that these conditions have tended to lead to government bonds beating equities.
Concerns over the health of the US economy have been in place for some time and have heightened in recent weeks after the trade war between the country and China intensified with the threat of higher tariffs on each other’s exports.
The latest Bank of America Merrill Lynch Global Fund Manager Survey found that only 5 per cent of asset allocators are worried about a global recession in 2019 – but significantly more believe this could be a risk that emerges in 2020.
Fund managers’ views on when the next global recession will start
Source: Bank of America Merrill Lynch Global Fund Manager Survey, May 2019
Schroders, the global asset management house with assets under management of £421.4bn, has analysed whether the US economy looks likely to tip over into recession using its US output gap model. This model estimates the difference between the actual and potential output of the economy, using unemployment and capacity utilisation as variables.
The Schroders output gap model is currently signalling a change in the US business cycle for the first time in two years. It suggests the US economy is moving away from the ‘expansion’ phase and into ‘slowdown’ (the other two phases of the cycle are ‘recession’ and ‘recovery’).
Martin Arnold, an economist at Schroders, said: “The last slowdown period occurred during the global financial crisis and so this should be seen as a warning sign to US policymakers that a recession could be on the horizon.
“In our view, US growth has been supported by accommodative central bank policy and we expect that slowing US growth will force the Federal Reserve’s hand in cutting rates in 2020 to bolster activity.
“Although we feel that the slowdown phase will be prolonged and not end in recession, the balance of our scenario risks indicates that recession is a possibility, especially if policymakers don’t respond to the threat.”
Since the firm launched its output gap model in 1978, there have been six separate occasions when it has indicated the US economy was going into the slowdown stage of the cycle and four of these instances were followed by a recession.
The two periods of slowdown that did not result in recession eventually reverted to expansion. These occurred in early 1990, when the slowdown was a false signal, and in the final months of 1998, when it occurred in the middle, rather than at the end, of the cycle.
Performance of assets in different stages of the cycle
Source: Schroders
Arnold noted that the slowdown phase of the economic cycle has historically had “considerable implications” for the returns made by different asset classes. However, he added that past performance is not a guide to the future.
The table above shows the average performance of US equities, government bonds, high yield debt, investment grade bonds and commodities in the four stages of the cycle, going back to February 1978.
“During a slowdown phase in the output gap model, equity markets not only perform the worst compared to other phases of the business cycle but exhibit greater volatility,” the economist explained.
“During the slowdown phase, US equities have returned on average less than 5 per cent on an annual basis, with volatility of more than 15 per cent. Periods of slowdown are historically the only phase when sovereign bonds outperform equities.”
He also pointed out that government bonds outperformed investment grade corporate bonds in times of slowdown, while they in turn beat high yield credit.
In addition, the performance of these asset classes tends to reverse during the recession phase, with high yield credit outperforming both investment grade and sovereign bonds on average.
However, Arnold conceded that current slowdown phase “could be different”.
“The recovery from the global financial crisis was the longest and shallowest in history,” he said.
“With monetary policy remaining accommodative, there is the potential for the Fed to engineer a slowdown phase that is longer than average and which doesn’t end in recession – a period of so called ‘secular stagnation’.”
At the first look, such a period of weak growth could be considered undesirable. But the economist argued that if this period does not end in recession, then central bank policy could have finally smoothed growth and avoided the boom and bust cycle of the economy, which is an objective it has been trying to achieve for decades.
“Time will tell and investors will likely keep their fingers crossed,” Arnold concluded.