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The Long View: Equities Look Darkest Before the Dawn

First Quarter 2019

Key Takeaways
  • The equity and fixed income markets are sending contradictory messages about the direction of the economy, but we believe weakness priced into sovereign yields will abate. 
  • A yield curve inversion in March prompted a red signal in the ClearBridge Recession Risk Dashboard, however the overall signal remains in expansionary territory (green), which is a positive for equity investors. 
  • Signs of global economic weakness could portend increased volatility in the near term, but we continue to view any equity pullback as a long-term buying opportunity. 
Equities Look Darkest Before the Dawn

As we put the first quarter into the record books, there remains an obvious disconnect between global economic data and equity markets. Using the ClearBridge Recession Risk Dashboard as our compass, our last quarterly letter suggested that equity investors were overly discounting the odds of an impending U.S. recession, thus representing a good buying opportunity for long-term investors. Over the past several months, global equity indexes have sharply rebounded from the Christmas Eve lows and are nearly back to all-time highs. However, with economic data continuing to deteriorate, many investors remain confused about the path forward.

Equities vs. Fixed Income

One area of bifurcation exists between fixed income and equity markets. Specifically, while global
equity (and credit) markets have rebounded in recent months, sovereign yields remain under pressure. Many interpret this to mean fixed income investors do not believe that the global growth slowdown will abate anytime soon. For example, the U.S. 10-year Treasury is yielding just 2.5% and the 3-month vs. 10-year Treasury yield curve inverted for the first time in the current expansion two weeks ago, which resulted in a change of the Yield Curve indicator on the ClearBridge Recession Risk Dashboard to a red signal (Exhibit 1). A perception exists that bond markets tend to lead equities, and that fixed income investors are usually the first to leave the party before the cops arrive. But not all bond investors are leaving the party quite yet, with high-yield spreads narrowing substantially from their early January highs. Which asset class is telling the correct story about the path forward?


Exhibit 1: 3m10y Yield Curve

Data as of March 29, 2019. BPS = Basis Points, one hundredth of one percent. Source: Fed Reserve Bank of St. Louis, retrieved from FRED. Compiled:


Ultimately, we believe that sovereign yields will move higher, similar to what occurred three years ago. In February 2016, a durable bottom was formed in global equities, credit markets and commodities. However, sovereign yields continued to grind lower for several more months, before finally shifting course in June. We believe sovereign yields will once again lag riskier asset classes such as equities and credit.


"While we believe the yield curve is important, it works best in conjunction with an array of additional indicators."


One potential catalyst for higher yields could be the Fed. The March FOMC meeting minutes were noticeably more dovish, with the Fed communicating the conclusion of quantitative tightening in September and removing two rate hikes from their dot plot expectations. Taken together, these indicate a more accommodative stance and equity markets responded positively to the news. Such a shift in policy is not unprecedented, and the Fed historically has cut rates very quickly after the end of a tightening cycle (Exhibit 2). Surprisingly, the first cut has tended to occur less than five months after the final hike. While it remains to be seen if the December hike was the final one for this cycle, it wouldn’t be unusual for a cut to occur in the upcoming months.


Exhibit 2: History May Suggest a Cut

Data as of March 31, 2019. Source: FactSet.


With the yield curve one of the most widely followed economic indicators, the Fed is particularly sensitive to its inversion, as it generally indicates a policy mistake. While the curve is one of the better indicators, it is important to recognize that there are long and inconsistent lags between its inversion and the onset of a recession. For example, the yield curve first inverted in January 2006 during the last cycle, two years before the onset of the Great Recession. In fact, the S&P 500 rallied 21% to the October 2007 peak from the time the curve inverted. Due to the range of timeframes between historical yield curve inversions and recessions, the yield curve is not a top-three weighted variable in the ClearBridge Recession Risk Dashboard (Exhibit 3). While we believe the yield curve is important, it works best in conjunction with an array of additional indicators. Most importantly, the inversion of the yield curve by itself does not typically portend an immediate and sustained selloff in equity markets.


Exhibit 3: ClearBridge Recession Risk Dashboard

Data as of March 31, 2019. Source: BLS, Federal Reserve, Census Bureau, ISM, BEA, American Chemistry Council, American Trucking Association, Conference Board, and Bloomberg.


We believe investors are currently underappreciating the Fed’s review of its 2% inflation target. Over the decade-long bull market, inflation has met the Fed’s 2% target only twice (Exhibit 4). Some  suggest that the central bank should move toward targeting “average” 2% inflation over the medium term, or over a multiyear period. In simple terms, this would suggest that the Fed would become comfortable temporarily letting the economy run hot (i.e., inflation above 2%) to make up for the persistent shortfall of the last several years. The result of this would be looser policy. If this were to transpire, investors could push up yields to compensate them for the risk of higher inflation. This move could be one of several catalysts behind the aforementioned shift in sovereign yields becoming more in sync with commodities, equities and credit markets.


Exhibit 4: Fed Inflation Target

Data as of March 31, 2019. Source: Federal Reserve Bank of St. Louis. Personal Consumption Expenditures (PCE) excluding food and energy.


U.S. vs. Global Economy

Investors are also grappling with a divergence between U.S. and global economic data. U.S. data is expected to slow in the first quarter, and recent economic numbers such as the February jobs report and retail sales have been disappointing. However, a trough could be near, with housing appearing to have bottomed and consumer confidence rebounding from late 2018 lows. By contrast, the trough for the global economy appears to remain elusive, despite steps taken by global central banks and governments (specifically China) to stimulate their economies.

The domestic soft patch in the first quarter is likely a function of seasonality. Throughout the current cycle, first-quarter data has been weak, with the Bureau of Economic Analysis recently acknowledging challenges regarding how it adjusts the data for seasonal impacts. Further, the government shutdown, delayed tax refunds and consumer apprehension in light of market volatility are all likely to weigh on GDP in the near term (Exhibit 5). However, the good news is a rebound should materialize. While many believe the sugar high from the Tax Cuts and Jobs Act of 2017 has worn off, fiscal stimulus related to that bill (tax refund boost) is actually larger in 2019 than it was last year, as is the most recently authorized fiscal budget (Exhibit 6).


Exhibit 5: 1Q Has Disappointed

Data as of Dec. 31, 2018. Source: FactSet.



Exhibit 6: Fiscal Stimulus % of GDP

Data as of March 4, 2019. Source: Strategas Research Partners.


Looking abroad, economic data appears more concerning, with Chinese deleveraging efforts representing the epicenter. Global PMIs have declined in 10 of the last 12 months. This nearly matches the record from 2008 of 11 consecutive monthly declines for global PMIs  The good news is that while Chinese manufacturing data appears weak, Chinese services have held up much better. In keeping with the aim to diversify its economy, China has focused its stimulus on services. Much of these efforts, including tax cuts and government spending, support the domestic Chinese consumer. The government has also taken steps to shore-up the shadow banking system and unwind past manufacturing excesses. However, this does not mean the pain is over, and the Taiwanese Manufacturing PMI points to further weakness (Exhibit 7). Taiwan is the proverbial tip of the global economic spear given the country’s position at the very beginning of the supply chain. In fact, Taiwanese stocks have the greatest revenue exposure to China of any country. Therefore, their Manufacturing PMI New Orders component is a strong leading indicator, which suggests additional weakness is still to come.


Exhibit 7: Taiwanese Activity Leads the U.S.

Data as of March 31, 2019. Source: ISM - Institute for Supply Management, National Development Council, FactSet, Bloomberg, Cornerstone Macro.


Given the prospect of a sluggish global economy, we believe the coming quarter could see increased volatility compared to the quarter just completed. Unlike the fourth quarter of 2018, positioning and sentiment data do not appear to be at extreme offside levels, meaning any pullback is likely to be more muted than the volatility experienced late last year. As a reminder, the market has seen 17 pullbacks of 5% or more since March 2009, several of which were linked to global economic slowdowns. However, each of these has proven to be a buying opportunity for the long-term investor. While global economic data is not yet flashing the “all clear,” it is important to remember that the stock market is a forward-looking mechanism. As a result, equities typically begin to rally well before economic data and even corporate earnings recover. This dynamic played out in the 2016 global slowdown, with the market bottoming 10 months before global earnings revisions turned positive (Exhibit 8). Similar patterns emerged in 1998, 2003 and 2009.


Exhibit 8: Global Stocks Lead Earnings

Source: JP Morgan.


The markets have come a long way from the lows of last year and we believe there is more upside for equities in this cycle. However, it would not surprise us to see a pickup in volatility during the coming quarter given the likelihood of additional weak global economic data and falling earnings estimates. This reminds us of a saying: “It’s always darkest before the dawn.” With the ClearBridge Recession Risk Dashboard continuing to suggest expansion, we believe any weakness should be viewed as a long-term buying opportunity. As the economy enters the later stages of this cycle, risk management and a focus on quality become increasingly important characteristics for investors.

Jeffrey Schulze, CFA

Investment Strategist
15 Years experience
6 Years at ClearBridge

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