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2019 Global Market Outlook: Mind The Gap

By

Jeffrey Kleintop

CFA, Senior Vice President, Chief Global Investment Strategist

Jeff specializes in analyzing international market trends and their financial implications. He's frequently cited in a range of national media outlets including The Wall Street Journal and The New York Times. He has an MBA from Pennsylvania State University.

December 10, 2018

Member for

2 years 4 months
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Submitted by Site Factory admin on Mon, 12/10/2018 - 12:41
2019 Global Market Outlook: Mind The Gap

Near-term indicators: Global growth is likely to slow in 2019 as the economic cycle nears a peak. Watch the gap between unemployment and inflation rates for major countries and the U.S. yield curve for signs of a peak in economic growth ahead of a potential recession.

Intermediate-term risks: International stocks may continue to see heightened volatility and could enter a bear market if key indicators continue on their current path. Consider reducing portfolio volatility by trimming historically more-volatile asset classes, such as emerging market stocks.

Long-term opportunities: Consider rebalancing back to long-term asset allocation targets. Historically, long-term asset class trends have tended to reverse in the year prior to global recessions and bear markets. This may begin to favor international over U.S. stocks, value over growth stocks, and large- over small-cap stocks as they start to close the wide relative performance gaps of the past 10 years.

Setting Expectations: Investors with time horizons beyond 3.5 years and a diversified portfolio may want to revisit their long-term plan and remind themselves that ups and downs are part of investing for the long-term.

Global economic growth may slow in 2019 as the economic cycle nears a peak, with increasing drag from worsening financial conditions combining with full employment and rising prices. Global stock markets may enter a bear market if leading indicators signal the gathering clouds of a global recession.

Borrowing the severe weather scale for storms and applying it to the global economy and markets, we aren’t forecasting “Recession Warning,” meaning a recession is here or imminent. A better term is “Recession Watch,” in which conditions are favorable to a recession if a number of risk factors (e.g., trade, interest rates, inflation) deteriorate.

Recession cartoon

For all the concerns about trade policy, Brexit and other issues, 2018's biggest stock market declines generally were driven by inflation and interest rate concerns. These are the indicators investors should watch most closely in 2019 as signals of intermediate-term risk in the global stock market. Fortunately, these indicators also point to opportunity, as they signal reversals in the long-term trends in relative performance among major asset classes. 

Investors should mind the gaps in 2019: 

  • The intermediate-term risk signaled when the gap in unemployment rate and inflation rate closes.
  • The intermediate-term risk signaled when the gap between 3-month and 10-year U.S. Treasury yields closes.
  • The long-term opportunity signaled by the above indicators that the gap in relative performance by U.S. and international stocks, growth and value stocks, and large and small cap stocks may begin to close.

Gap 1: unemployment and inflation rates

One indicator we are watching for signs of the potential for a recession and a deeper and prolonged decline in stocks is the gap between the unemployment rate and the inflation rate. This indicator suggests that the risks are rising.

History shows us that when the unemployment rate and the inflation rate converge to become the same number, a prolonged downturn for the economy and markets often followed. Why could this signal a peaking economy? After a recession as a new economic cycle is getting its start, unemployment tends to be high (since a lot of people have lost their jobs) and inflation tends to be low (since businesses are forced to cut prices to attract customers). This results in a wide gap between the unemployment rate and the inflation rate. As the economy improves, more people find jobs and companies are able to raise prices, causing the gap between these rates to narrow. When the gap narrows to zero and the unemployment rate and the inflation rate are the same number, it has acted as a sign the economy was overheating and nearing a peak. About a year after the gap closed, recessions have often occurred and were accompanied by bear markets for stocks. 

Let’s look at what this indicator is telling us about the prospects for some of the largest countries in the world: the United States, United Kingdom, Japan, Germany and Australia.

In the United States, the gap between the unemployment rate and the inflation rate (CPI) has closed ahead of each of the past three recessions in the U.S., as you can see in the chart below. At 1.2%, it is now getting close, but not there yet.

United States

Recessions vs Unemployment rate less inflation - US

Inflation measured by Consumer Price Index year-over-year % change.
Source: Charles Schwab, Bloomberg data as of 12/9/2018.

In the United Kingdom, the gap closed or narrowed to less than one percentage point ahead of recessions, as you can see in the chart below. At 1.7%, it is now also getting close.

United Kingdom

Recessions vs Unemployment rate less inflation - UK

Inflation measured by Consumer Price Index year-over-year % change.
Source: Charles Schwab, Bloomberg data as of 12/9/2018.

In Japan, the gap hasn’t always completely closed but did ahead of the latest recession in 2014, as you can see in the chart below. Currently at 0.9% it bears watching.

Japan

Recessions vs Unemployment rate less inflation - Japan

Inflation measured by Consumer Price Index year-over-year % change.
Source: Charles Schwab, Bloomberg data as of 12/9/2018.

In Germany, the gap between the unemployment rate and the inflation rate is best measured using the Producer Price Index (PPI) rather than the Consumer Price Index (CPI). Because Germany has the largest trade surplus of any country in the world, with nearly half of the country’s GDP coming from the production of exports, the PPI may be a better measure of prices. The reunification of Germany in the 1990s limits the comparable historical data we can look back to, but it is important to keep an eye on Europe’s largest economy. The gap in Germany has fallen to 1.8%, as you can see in the chart below.

Germany

Recessions vs Unemployment rate less inflation - Germany

Inflation measured by Producer Price Index year-over-year % change.
Source: Charles Schwab, Bloomberg data as of 12/9/2018.

Australia has not technically had a recession since 1991, thanks in part to its proximity to China. However, Australia did have just one quarter in 2000 and 2008 where GDP fell by about one half of one percentage point. We shaded those a different color in the chart below to note they weren’t technically recessions, but were periods of weakness for both the Australian economy and stock market that were signaled by the closing of the gap between the unemployment rate and inflation rate. At 3.2%, Australia is an outlier from the other countries we have presented, but it is worth noting how rapidly the gap closed from about 2-3% in prior periods.

Australia

Recessions vs Unemployment rate less inflation - Australia

Inflation measured by Consumer Price Index year-over-year % change.
Source: Charles Schwab, Bloomberg data as of 12/9/2018.

These gaps bear watching since they could close in the next 6-18 months. History tells us this could signal an overheating economy and a bear market for global stocks ahead of a global recession.

Gap 2: yields of 3-month and 10-year Treasuries

Whenever the yield on 3-month U.S. Treasuries rises above the 10-year yield, the yield curve is said to invert and debates reemerge about how effective this signal is at forecasting peaks in U.S. economic and stock market performance.  Less discussed is how useful a tool it has proven to be for signaling peaks in non-U.S. stock markets. This is especially important now that the gap between 3-month and 10-year yields in the U.S. has narrowed to 50 basis points, or half of one percentage point.

The U.S. yield curve: 50 years of signaling peaks in international stocks 

US Treasury yield curve vs MSCI EAFE

Weekly data since inception of MSCI EAFE Index at end of 1969.    Past performance is no guarantee of future performance.
Source: Charles Schwab, Bloomberg data as of 12/9/2018.

The six arrows in the above chart show the inversions of the U.S. yield curve ahead of the shaded areas that mark global recessions since 1969. Over the nearly 50 year period, the inversions came about one year before each global recession. More significantly, they came close to the cyclical peak in international stocks.

  • A.    Inversion in June 1973 was about 3 months after the stock market cyclical peak in March 1973. Stocks had already shed about -5% but were to lose a total of -46% in a bear market that ended in October 1974.
  • B.    Inversion in November 1978 was the same day as the stock market peak and stocks began a long sideways move in a narrow range that ended in 1980 with a loss of -7%.
  • C.    Inversion in October 1980 was the same day as the stock market cyclical peak, ahead of a -27% decline that ended in August 1982.
  • D.    Inversion in June 1989 was 6 months before the stock market cyclical peak in December 1989. Stocks rose another 15% before falling -32% in a bear market that ended in September 1990.
  • E.    Inversion in July 2000 was about 3 months after the March stock market cyclical peak. Stocks had barely started their decline with a -5% loss as the inversion took place, then proceeded to decline for more than two years with a loss of -50%.
  • F.    A bit of an outlier, the August 2006 inversion was about 14 months before the October 2007 stock market cyclical peak. This was a longer than usual lag as stocks continued to rise, but the global financial crisis soon followed, resulting in a -60% peak-to-trough loss.

While the yield curves of individual countries often do a better job of predicting recessions in their domestic economies, the U.S. yield curve does a better job of measuring global economic conditions that affect broad international stock markets. Why is the U.S. yield curve so much better at gauging global economic conditions? For one thing, the U.S. is the world’s largest economy and a major source of demand for global companies. In addition, the U.S. government bond market is the largest and most liquid in the world, which may mean it better reflects global conditions and is less susceptible to domestic influences than other countries’ bond markets. 

Whatever the reasons, the U.S. yield curve has done a remarkable job signaling peaks in international stocks. While there can be no guarantees it will always do just as well, the successful track record over the diverse political and economic environments over the past 50 years provides good reason to heed the warning. 

Gap 3: Performance gaps by geography, style and capitalization

In the past, long-term trends have often reversed in the later stages of the economic cycle. This makes rebalancing portfolios—trimming leaders and adding to laggards, and restoring the portfolio’s long-term strategic asset allocation particularly important in 2019. Three long-term trends that may reverse in coming years include the relative performance of: U.S. and international stocks, growth and value stocks, and small and large cap stocks.

There are no guarantees in life, but historically there have been regularly occurring cycles of performance. As you can see in the chart below, after 10 years of U.S. stock market outperformance of international stocks, the trend to again may be about to reverse due in part to the stage of the global economic cycle, the gap in valuations, and how wide the trend in relative performance has become. Note how the pattern reversed in 1971 ahead of the recession that began in 1973, in 1989 about a year before the 1990-91 recession and again in 2007 ahead of the 2008-09 recession.

U.S. and international stocks

MSCI EAFE against MSCI US vs MSCI US against MSCI EAFE

Source: Charles Schwab, Bloomberg data as of 12/9/2018.         Past Performance is no guarantee of future results.

We can see a similar cycle of performance between growth and value stocks in the chart below. Growth outperformed the late 1990s, then value from 2000 to 2007, then a return to growth leadership. Note how the pattern reversed in 2000 ahead of the 2001 recession and again in 2007 ahead of the 2008-09 recession. It may not be a bad idea to rebalance by style.

Growth and value stocks

MSCI Growth against MSCI Value vs MSCI Value against MSCI Growth

Source: Charles Schwab, Bloomberg data as of 12/9/2018.         Past Performance is no guarantee of future results.

The chart below shows the trend between large and small cap capitalization stocks. Small caps have been outperforming large caps since the bull market began in 2009. The trend may be stretched, given the gap in valuations and the tighter credit conditions that often develop near the end of the economic cycle.

Small and large cap stocks

MSCI Large Cap against MSCI Small Cap vs MSCI Small Cap against MSCI Large Cap

Source: Charles Schwab, Bloomberg data as of 12/9/2018.         Past Performance is no guarantee of future results.

Prepared investors should be thinking about rebalancing their portfolios back towards a balance in geography, style, and size as the later stages of the economic cycle have pushed trends to historical extremes.

Setting expectations

What usually happens when the cycle peaks so we can be prepared and know what to expect? While many investors may think back to the so-called “Great Recession” of 2008 as a baseline for what to expect, this may be misleading. The economic and market impact of the Great Recession was more akin to the Great Depression of the 1930s than a typical downturn. That was largely due to systemic vulnerabilities compounding the impact of the recession, which no longer appear to be as much of a problem (see our recent article on how today’s vulnerabilities to a crisis differ from those of the past).

The nearly 50 years of history for the MSCI World Index includes six global economic cycles and a wide range of environments that contain periods of geopolitical conflict and relative world peace, U.S.-led trade protectionism and broadening free-trade, high and low interest rates, and many other varied conditions. Excluding the 2008 “Great Recession”, looking at the past five “typical” recessions and bear markets, on average:

  • Stocks peak about six months ahead of the start of the recession. 
  • Stocks bottom about a year after the recession starts.
  • The global recession lasts just under one year.  
  • During the bear market, stocks fall a little over 20% from peak-to-trough (although this varies widely).
  • Stocks bottom about the same time the recession is ending (although recessions aren’t usually declared over until many months, and sometimes years, have passed and economists can pinpoint the end date).
  • After bottoming, stocks take about 3.5 years to return to near their prior peak.

The duration of the stock market decline and the length of time to recover the loss is the same whether the Great Recession of 2008 is included in the average or not. The only difference including 2008 recession data makes is a deeper average decline.

Losses have tended to happen quickly while the recovery has tended to take longer to complete. It is important to remember that over a long-term time horizon, these recessions and bear markets look like temporary dips on a rising path, as you can see in the chart below.

MSCI World Index total return since inception

MSCI World Index

Source: Charles Schwab, Bloomberg data as of 12/9/2018.        Past performance is no guarantee of future results.

Setting expectations is important to avoid surprises that might cause an investor to abandon their long-term plan. Investors may want to consider underweighting the most volatile asset classes such as emerging market stocks. Those with time horizons beyond 3.5 years and a diversified portfolio may want to revisit their long-term plan and remind themselves that ups and downs are part of investing for the long-term.

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