Investors are becoming increasingly sensitive to any hints of an economic slowdown as the economy enters a late-cycle phase. The upshot for investors: a need for extra diligence in balancing risk and reward. We see U.S. government bonds playing a bigger role as portfolio ballast and have upgraded our view to neutral.
A U.S. recession is not imminent, in our view, yet trade-related uncertainty and fears of a slowdown are challenging for risk assets. Recent inversion in parts of the U.S. Treasury yield curve has some investors worried. They point to historical incidents when curve inversion has foreshadowed recessions. We caution against that view. Our analysis would put recession probabilities as low for 2019 but rising to just above 50% by the end of 2021. We find equities have historically done well in late-cycle slowdowns. This includes even the calendar year preceding an economic downturn, as shown in the chart. Equity performance generally deteriorated as recession drew nearer, with U.S. Treasuries taking the lead as investors turned to perceived “safe havens.” History may not repeat. The averages mask a wide range of market outcomes around recessions given differences in starting valuations and the character of each downturn. Yet history often can be informative.
Renewed focus on portfolio ballast
Still-easy monetary policy, few signs of economic overheating and a lack of elevated financial vulnerabilities point to ongoing economic expansion. Yet the U.S. economy is entering a late-cycle phase, and the likelihood of temporary risk-off events is higher with elevated uncertainty. Trade frictions and a U.S.-China battle for supremacy in the tech sector hang over markets. We see trade risks more fully reflected in asset prices than a year ago, but expect the twists and turns of trade talks to cause bouts of anxiety. And we worry about European political risks in the medium term against a weak growth backdrop. Read more in our 2019 Global investment outlook.
As a result, we see U.S. government bonds playing a greater role in portfolios. For one, they can help cushion against any late-cycle selloffs of risk assets. In addition, the Federal Reserve’s policy path may create a relatively benign environment for Treasuries. We see the Fed pausing its rate-hiking cycle at some point in 2019 to assess the effects of slowing economic growth and tightening financial conditions.
We prefer short- to medium-term bonds. Higher yields and a flatter curve as a result of the Fed’s rate increases over the past three years have made shorter maturities an attractive source of income for U.S. dollar-based investors. Short- to medium-dated Treasuries now offer nearly the same yield as the benchmark 10-year Treasury, we find. Core European government bonds (such as German bunds) appear less attractive, as the European Central Bank’s still-easy monetary policy pins down their yields at low levels.
Rising risks call for carefully balancing risk and reward: exposures to government debt as a portfolio buffer, twinned with high-conviction allocations to assets that offer attractive risk/return prospects such as EM equities. We prefer stocks over bonds, but our conviction is tempered. In equities, we prefer quality—free cash flow, sustainable growth and clean balance sheets. We favor up-in-quality credit. We steer away from areas with limited upside but hefty downside risk, such as European stocks.