The inversion of the yield curve sent investors panicking last week, but this is just the tip of the iceberg when it comes to what has given the asset management community cause for concern recently.
“On the back of worsening trade rhetoric the week before, with the Chinese currency seemingly being used as a weapon for the first time in the dispute, we also saw the situation in Hong Kong deteriorating to the extent that the Chinese military have moved a step closer to intervening,” said Andrew Merricks, manager of the 8AM Focussed fund.
“The risk of a hard Brexit is [also] increasing as parliamentary figures try to avoid a default no-deal exit on October 31st.”
In addition, he pointed to “the Argentine stock market falling by an eye-watering 48 per cent in one day in dollar terms as their reform-minded President was trounced by his left-wing rival in primary elections”, and a collapse in Italy’s coalition government.
The manager added: “Well that was a lively week!”
Yet despite these headwinds, Merricks believes it may still be too early for investors to head for the exit.
Here he reveals why.
An inverted yield curve doesn’t come with a time limit
“An inverted yield curve, though consistently a good forecaster of recessions, is not so good when it comes to telling us when the recession will arrive,” Merricks explained.
The yield curve depicts the relationship between interest rates of the US government’s short- and long-term debt. Its normally ascending slope means that more volatile, long-term bonds have higher yields than their short-term counterparts; when it inverts, the opposite is true.
Every time the yield curve has inverted since 1960, it has been a strong signal for an impending recession.
Source: BCA Research
However, Merricks pointed out, an inverted yield curve is just one indicator investors need to watch out for.
“When it is in conjunction with others, you can probably narrow the arrival time down from the next 18 to 24 months to the next six or nine,” Merricks said. “We’re probably not in the latter stage yet.”
The ECB looks set to lend a helping hand
At its July meeting, European Central Bank (ECB) policymakers said they may intervene to prop up the eurozone economy. Uninspiring economic data released since then means a fresh stimulus package is now more likely.
“One of the key reasons why the yield curve is where it is is because of the ultra-dovish policy emanating from just about every central bank in the world right now,” Merricks added.
Measures from the ECB are likely to include a combination of a rate cuts, asset purchases, changes in guidance on interest rates, and support for banks through partial relief from the ECB’s negative interest rate.
There is no alternative to stocks
With bonds yields so low and central banks due to ease further, Merricks argued there is currently no alternative to stocks for investors seeking a positive return over the medium to longer term.
He pointed to the chart below, showing that global aggregate bond yields below 2 per cent are generally supportive of equities, just as yields at 2.5 per cent have been triggers for market sell-offs.
“We’ve gone significantly lower than 2 per cent in the past week,” he said. “It feels like a floor is being reached.”
Source: BCA Research
The yield curve may no longer be a reliable predictor of recessions
“It may be significant that each of the recessionary periods highlighted in the first chart occurred before the Great Financial Crisis of 2008 – an event that arguably changed the world from an economic perspective,” Merricks continued.
QE [quantitative easing] has pushed bond premia into negative territory, something he said had not happened in the 50 years before 2008.
“So, can we translate rules founded in one area to another?”
He quoted Peter Berezin of BCAB Research, who said: “Today, the US 10-year term premium stands at -1.2 per cent. In late 1994, when the yield curve almost inverted, the term premium was 1.9 per cent. Had the US term premium of the mid-1990s been anywhere close to present levels, the yield curve surely would have inverted, causing yield curve-obsessed investors to miss out on the biggest equity bull market in history.”
An upturn in manufacturing activity is due
The global manufacturing cycle typically tends to last three years: 18 months rising and 18 months falling, Merricks said.
“The last down-leg began in early 2018, so one can expect that, absent a serious decline in trade war relations, an upturn in manufacturing activities is becoming due,” he added. “The decline in global growth could be bottoming.”
Donald Trump backtracks
Merricks said tweets from the US president saying tariffs would have to wait until after Christmas showed an awareness that a recession before the elections of November 2020 would in all likelihood sank his dreams of a second term.
At the same time, the manager pointed out China won’t necessarily want to inflame the trade war any further and could afford to wait until after the election to see who it will be dealing with at that time.
As for how his team is handling this whole situation, Merricks said: “We’re old enough (and hopefully wise enough) not to get carried away with any surges of optimism that may burst out of the global gloom.
“Having our own money invested in the fund ensures we’re aligned with our investors in terms of acceptable risks.”
Earlier this month, “as things turned a little ugly”, the team sold its tactical Japanese holdings to raise some cash, and to boost its gold position to 15 per cent of the portfolio.
It has also exited oil, “for now, until the next flare-up between US and Iran”, and reduced its exposure to robotics, one of its longest held themes. “We’re confident that we’ll return to this before too long, but a cautious footing seems sensible,” Merricks said.
In light of the six reasons given above, the team is poised to “dip its toes back into the equity waters a little sooner than anticipated”, he added. “We’ll see how the next week or two develops.”
Source: FE Trustnet
The one FE Crown-rated £10.5m 8AM Focussed fund has returned 31.05 per cent since its 2013 launch, compared with 46.37 per cent for its IA Flexible Investment sector. It has an ongoing charges figure (OCF) of 2.06 per cent.