A recurring topic in our Research Notes in 2016 has been the importance of being prepared for market volatility against a backdrop of slow economic growth and relatively full valuations. Slow economic growth makes investors more anxious and liable to react to every zig and zag in economic data, fearing a recession might be just around the corner. As we’ve noted before, this can be compared to turbulence when flying. At 36,000 feet, turbulence is just a minor disruption, while at low altitudes—when the ground is much closer—even the most seasoned of air travelers likely will take notice. In a sense, the same is true for gross domestic product (GDP). It takes less of a slowdown to enter recessionary territory in a low-growth world than in a more robust economic environment.
The most recent bout of volatility came in June following the outcome of the United Kingdom’s (UK) referendum on its membership in the European Union (EU), known as “Brexit.” Rising investor complacency likely played a meaningful role in the sharp reaction to the vote to leave the EU. Heading into the vote, the number of investors who were “neutral” on equities reached the highest level since 1990, according to the American Association of Individual Investors sentiment survey. The UK vote sent the British pound into freefall, put downward pressure on yields, and roiled markets for two days. However, the FTSE 100 never even reached February lows in local terms, and the market has recovered strongly since. Elsewhere, many U.S. indices have hit new highs, and numerous other indices in local terms are at their highest level in over a year.
Investor complacency has quickly returned close to the levels that preceded the Brexit referendum. However, it is important not to confuse complacency with speculation. A complacent environment is marked by a lack of fear of potential threats to stock prices; a speculative market is fueled by the view that prices can only go higher, leading to a world where valuations detach from reality. By most measures, equity markets today are far from speculative territory. Take for example mutual fund flows and initial public offering (IPO) market activity. Investors have actually been pulling money out of equity funds consistently for over a year now, and the IPO market has been very tame by historical measures, including both the number of stocks going public as well as their first day returns. All in all we do not see a lot of excessive speculation that needs to be wrung out of the stock market.
When this sentiment backdrop is combined with valuation indicators, which are middle of the road at best, it should not be surprising that equity exposure in our multi-asset class portfolios (managed from a top-down perspective) had declined to slightly below midpoint in recent months.
We believe we will continue to see bouts of market volatility that should include buying opportunities. The backdrop for top-line growth for U.S. companies in particular should improve, as much of the dollar’s strength has been grandfathered in and wage growth is picking up, potentially fueling spending growth. Consumption has been the only meaningful contributor to growth for the last few quarters. At close to 70% of GDP, the consumer has the power to surprise us and affect the upside or downside of our slow economic growth base case. Overall, we believe that the consumer has more potential to surprise on the upside than the downside today. For more on the U.S. consumer, please review our latest feature article Checking in on the Consumer: Do Consumers Have the Capacity and Willingness to Drive the Economy? as well as our chartbook this month.
Beyond a healthier consumer, investment spending is likely to contribute modestly to economic growth based on recent developments. Industrial production was disappointing in the first half of the year, but recent manufacturing purchasing managers’ index (PMI) readings have moved back into expansion territory. Non-residential fixed investment spending is unlikely to be a further drag on GDP growth if oil prices at least stabilize moving forward, as year-over-year comparisons will start to improve (recall that oil and gas related activity was a major detractor from investment spending in recent quarters). Residential fixed investment was strong in the first quarter of 2016 and is likely to continue to contribute to growth, as housing supply remains low and the pace of new homes being built has lagged prior recoveries. An improvement in the rate of household formations could also contribute to residential fixed investment growth.
At the end of the day, we maintain our slow growth economic outlook. However, the return of investor complacency, combined with rather full equity valuations, has led us to decrease the recommended equity exposure toward neutral in our multi-asset class portfolios. We remain slightly overweight to developed international and emerging markets, but these positions have decreased meaningfully over the past few months. A near-term market correction would give us the opportunity to increase our exposure again as long as our economic indicators continue to signal that the market is favorable for owning equities.
Over the past year and a half, we have sought to use market volatility to our advantage by 1) reducing equity exposure in our multi-asset class portfolios during periods of very low volatility and elevated complacency; and 2) using periods of high volatility and near-term investor fear to increase equity exposure during market corrections. We believe this strategy is appropriate so long as the economic environment remains supportive of equities. Therefore, it is important to continue to factor in new information, but also keep the larger picture in mind.