Synchronized Global Economic Slowdown

Investing Environment Review and Outlook – Volume 52

Synchronized Global Economic Slowdown

Last month we discussed the current mid-cycle economic slowdown and the mixed implications for equities as we transition out of the boom phase. In August, 77% of foreign purchasing managers indices declined, demonstrating this is not just a U.S. issue. Aside from the obvious supply bottlenecks and the Delta variant, other counter-trend forces include fading U.S. fiscal stimulus and contracting China bank lending. Historically, mid-cycle slowdowns were positive for equities since they extended the economic cycle by reducing inflation and delaying Fed tightening. This time, persistent supply chain and labor shortages are testing the Fed’s “transitory” concept by allowing inflation to remain elevated above their 2% target for longer than anticipated. Even our inflation outlook indicators remain high despite the drop in the economic outlook. The other challenge for equities is extended investor positioning, including some self-proclaimed fully invested bears.

This month we discuss diversification and some of our indicators like economic and inflation outlook, investor positioning, and volatility. Asset ratings are unchanged this month. The U.S. equities rating remains a neutral 3. Foreign Developed and Emerging Markets remain a bullish 4. Bonds and commodities remain a neutral 3 rating and gold remains a bullish 5.

Diversification and the Dollar

It is widely understood that portfolio diversification is one of the best risk control techniques by allocating investments across various financial instruments, industries, and other categories. A low correlation among investments reduces portfolio volatility since declines in one asset are potentially offset by rallies in others. Most investors understand the concept, but in practice it requires discipline to cut back on winners and add to weak performers, and in fact, there is a strong human tendency to do the opposite. At a time when U.S. equities have outperformed the world for over 10 years, many portfolios have significantly higher risk from a loss of diversification. To quote Leda Braga, Founder and CEO of Systematica Investments, from a recent interview, “Expected returns are forecasts, but diversification is for certain.” ¹If all portfolio pieces are appreciating together, upside returns are strong, but when the time comes, they will likely all decline together as well. The result will be a sharp drawdown for the portfolio, with only difficult options at that point. To avoid this outcome, this means checking, today that underperforming assets like foreign equities, gold, and cyclical group allocations are in line with targets. This rebalancing could also help address the significant risk of a long-term decline in the dollar, since these assets are negatively correlated to dollar moves. Unprecedented fiscal and monetary policy put the dollar at risk, yet this is off most investors’ radar.

¹Source: Capital Allocators Podcast, 9/9/21
This review and outlook report by Brenton Point Wealth Advisors LLC represents our views and beliefs regarding the current market outlook. Please also read the important disclosures at the end of this report.

Economic Outlook Lower: Mid-Cycle Slowdown

Our economic outlook indicators weakened further during August to a reading of 42.8. Supply chain disruptions, the Delta Variant, the reduction in Federal stimulus and contraction in China lending are all having an effect, and the ISM will likely follow lower. The Citi Economic Surprise Index shows downside surprises, also consistent with a mid-cycle slowdown.

Economic Outlook Lower: Mid-Cycle Slowdown Ahead

Economy Surprising to Downside: ISM Index Lower

Inflation Outlook Up

Inflation outlook indicators are down from their peak but remain elevated at 84.7. September expected headline CPI is 5.3% Y/Y down from 5.4% in August. Prior mid-cycle slowdowns were effective in bringing down the inflation outlook and inflation itself, but this year presents more complicated issues like supply chain disruptions and labor shortages which are driving up prices of both. The August decline in the ISM deliveries index may indicate a break in supply chain issues.

Inflation Outlook Extreme: 3-5% Inflation Ahead

ISM Deliveries Rolling Over: Possible Break in Supply Chain Issues

Strong Returns YTD through August: Flat Returns in September and October

The S&P 500 was up 21.6% through August, and 11% over the 200-day average. There were 7 prior years since 1950 when the S&P was 10% above the 200 Day average on September 1^st. On average those cases were flat through the end of November despite large gains through August like this year. The best prior case was 1958 up 18% through August then another 7% in September and October.

S&P 500 10% over 200 Day on Sept 1
7 Prior Cases Flat through November

Low Volatility in September

Equity volatility is low in the 10^th percentile historically with an average daily move of just 0.4%. It is hard to imagine the extreme 4.9% average daily moves in April 2020 and 4.5% in October 2008. All else equal, high volatility is positive for equities, followed by above-norm returns. Low volatility is less telling. For instance, of the 30 years since 1950 when volatility was below 0.5% on September 1^st, the average move in September and October was -0.2% with 57% higher. In all other years with higher volatility, the average return was 0.7% and 61% higher.

S&P 500 Volatility Low: Average Daily Move 0.4%/Day is 10th Percentile

Equity Investor Positioning Extreme: Risk for Equities

Equity investor positioning remains extreme with 5 of 10 investor groups extended. Individuals are the outliers in this group with neutral positioning. Historically, elevated investor positioning was more of a risk in the September to October time period, leading to overall flat returns with a risk of a 5-10% decline before November.

Equity Investor Positioning Extreme: 5 of 10 Groups Extreme

Summary

Indicators show a mid-cycle slowdown began in April, with mixed implications for equities and commodities. PMI’s for August show it has become a global synchronized slowdown, with multiple counter cycle forces. The elevated inflation indicators and investor positioning are a challenge for equities, particularly this time of year. With our ratings mostly neutral, we are watching our indicators closely for any changes for better or worse. We believe that patience will be rewarded with opportunities. Thank you for your support and please contact your advisor with any questions.

 

IMPORTANT DISCLOSURES

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Source of data and performance statistics: Bloomberg L.P. and Factset Research Systems Inc.
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