Investors are facing a fork in the road

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This article was published 13/07/2019 (2298 days ago), so information in it may no longer be current.

The markets are at a crossroads and, in all likelihood, so is your portfolio.

With the start of July, the U.S. set a record for its longest economic expansion in modern history.

That’s the good news.

The bad news is the long bull market of strong returns in stocks is getting very old.

And economic growth is slowing.

Of course, a key player in the slowdown is trade strife, which creates uncertainty, and when businesses are uncertain, they spend less. As such they create fewer jobs, which means consumers have fewer dollars to spend.

All of this has led us to a situation in which central banks are talking about something that they haven’t in some time: lowering interest rates.

“It’s one of the biggest inflection points we’ve witnessed in the last 10 years,” says Frances Donald, chief economist and head of macroeconomic strategy for Manulife Asset Management.

“Unlike in the past when central banks have been very reactive to slower growth, it appears they’re much more proactive — that is, they’re cutting rates before the economy slows down.”

Stock markets have rallied a bit on the news, too, as they have at the prospect of China and the U.S. back at the bargaining table.

Markets are likely to get a few more boosts if central banks, including the Federal Reserve, actually do cut rates over the next few months. (The Bank of Canada, by the way, stated this past week it will hold its rate steady.)

At the same time, many investors have been pouring money into bonds, fearing the worst. As they buy up fixed income assets, bond prices rise and their yields fall. Typically, bonds do well when stocks do poorly, and the two rarely move in the same direction concurrently.

But here we are in an environment where both have moved — and may continue to move — up in price, at least for a brief time.

And that brings us to that fork in the road.

“Equities and bonds can both go up in price for awhile, but sooner or later one will be proven right,” says Craig Basinger, chief investment officer with Richardson GMP.

Right now, investors are mostly split on the direction of the market for the remainder of the year, says Shailesh Kshatriya, director of Canadian strategies for Russell Investments.

“There are two divergent paths we see that can take place over the next six to 12 months,” he says.

One involves the Fed cutting rates. The broad consensus is likely two cuts this year, for a total of 50 basis points — with the overnight rates falling from 2.5 per cent to two per cent. This would spark a bigger stock market rally — at least for a few months.

But the question is whether economic reality supports sentiment.

The tricky part here is that economic fundamentals like trade flows, investment and job growth now largely depend on what happens with U.S. and China trade negotiations, and the whims of U.S. President Donald Trump, whose tweets can quickly sour sentiment.

Every bit of negative news increasingly affects how businesses and consumers behave — obviously not in a good way. In turn, the economic numbers worsen, Basinger says.

It’s not the tariffs that are the trouble per se, he adds. It’s the perception.

“It changes people’s decision-making.”

Then again, the U.S. and China could strike a deal, and cause real economic numbers to improve. That’s the other path.

“But how much more upside is left in this long bull run —10 or 15 per cent?” Kshatriya says. The trouble is on “the downside, it could be more than 30 per cent.”

That asymmetry between outcomes is not in stock market investors’ favour, he adds.

Even if the market continues to provide positive returns — bolstered by rate cuts, which reduce the cost of lending and presumably encourage business and consumers to spend more (by borrowing) — Manulife’s Donald forecasts trouble is still likely to start next year, and a recession is certainly not out of the question.

After all, how long can economic expansion occur without a pullback?

Yet even if it does occur, Donald says it’s likely to be a “pothole recession”: two consecutive quarters (three-month periods; six months total) of negative GDP growth.

Investors with a long-term view could seize upon this kind of recession — which would likely lower stock prices significantly — as a buying moment. That’s not a bad outcome considering stocks are overpriced right now.

“But if you have a very short-term horizon, then you need to be aware that risk assets (like stocks) may struggle in the later half of this year and into 2020,” Donald says.

For that matter, most investors, Basinger adds, should be dialing back stock market exposure in their portfolios.

“We’ve certainly got a lot more cautious,” he says.

For the average investor who can’t pore over the financial facts and figures — and jump back and forth between bonds and stocks, and everywhere in between — Kshatriya suggests looking to professional managers running multi-asset funds.

Or at the very least, Basinger offers this basic, late-bull-market strategy.

“When markets get to all-time highs (as they have recently), taking some money off the table is extremely prudent.”