The Economy Is Flashing Warning Signs To Investors

The U.S. economy has been firing on all cylinders, propelled recently by massive tax cuts. The second quarter of 2018 saw U.S. GDP grow at a torrid 4.2% annualized pace, up from 2.2% in the first quarter, per the U.S. Bureau of Economic Analysis. However, economic expansions inevitably cease at some point, to be followed by recessionary contractions. 

Global asset manager Oppenheimer believes that the turning point has been passed, as they state in a recent report: "Global growth has peaked, and the deceleration in economic activity, while not severe, is broad-based. Our leading indicators suggest the United States is entering a slowdown regime, joining the deceleration experienced by Europe and emerging markets (EM)."  Their report recommends several strategies to investors, which are summarized in the table below.

Oppenheimer's Strategy For a Cooling Economy

  • U.S. equities: modest underweight. But overweight small cap and mid cap, overweight quality, underweight value.
  • International equities: modest underweight in Europe and emerging markets, as part of global equity underweight.
  • U.S. credit: underweight.
  • Emerging markets debt: do not hold.
  • Government bonds: overweight long duration U.S. and developed market sovereign debt.
  • Currencies: modest overweight in U.S. dollar, but hedged. Underweight euro and a few EM currencies. Overweight the yen.
  • Alternative investments: overweight event-linked bonds, and overweight MLPs vs. large cap U.S. equities.

Source: Oppenheimer

Significance For Investors' Portfolios

Other experts share this concern about the economy. The odds of a recession in 2019 are large and growing, according to a pair of veteran market watchers quoted by Barron's. They see interest rate hikes by the Federal Reserve and rising trade tensions as the main catalysts for a downturn. Meanwhile, Oppenheimer's reasoning behind some of their recommendations is outlined below.

Equities. "Our leading indicators suggest the U.S. economy is likely to slow over the next few quarters, after experiencing strong growth acceleration in the first half of the year," Oppenheimer says. They add, "We expect small caps and mid caps to outperform large caps, benefiting from domestic fiscal expansion, as long as credit markets remain stable, while being more insulated from weakening growth outside the U.S."

"Our leading indicators suggest the United States is entering a slowdown regime." -- Oppenheimer
 

Currencies. Weaker growth outside the U.S. makes U.S. equities relatively more attractive to investors right now. Net capital movement into the U.S. markets is bolstering the dollar. If foreign markets register positive economic surprises, that net capital flow to the U.S. will decrease, sending the dollar down.Bonds. At current levels of credit spreads between high yield debt and loans versus investment grade debt, Oppenheimer sees "limited upside" in corporate bonds. However, they are overweight in government bonds from the U.S. and other developed countries, specifically in longer maturities. They see slowing economic growth contributing to further flattening of the yield curve, "which should leave the long end of the yield curve less exposed to Fed rate hikes."

Alternative investments. Compared to tight credit spreads on conventional debt, Oppenheimer sees value in event-linked bonds, which pay off when natural disasters do not occur, or are less severe than anticipated. They saw that these bonds have "performed well" since the second quarter, with only "modest spread widening around Hurricane Florence."

JPMorgan has developed its own set of recommendations for investors, to prepare for the next recession. They believe, however, that a recession is unlikely to begin in the next 12 months, and warn that making big portfolio shifts too far in advance can be costly. (For more, see also: 4 Ways to Avoid Big Losses in the Next Recession: JPMorgan.)

Looking Ahead

Oppenheimer expects the Federal Reserve to continue increasing interest rates through at least the middle of 2019. However, they warn that "a dovish shift in Fed rhetoric" is the main risk to their strategy. A signal by the Fed that they will slow or halt their planned monetary tightening would extend the current market cycle, "provide substantial relief to risky assets, particularly in EM [emerging markets]," and weaken the dollar. (See also: 
The Impact of a Fed Interest Rate Hike.)

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