Yesterday (15/08/2019), the yield curve inverted in the US and UK on an intraday basis which, combined with a slew of negative headlines, prompted profit taking in equities as investors grew nervous of recessions risks and looked to bank some of the strong gains enjoyed year to date. Economic growth rates have been slowing since the middle of last year, and, recently, some economies such as the UK and Germany have posted quarterly contractions in GDP. In this sense, the rising risk of recession is not new and the Manager has positioned portfolios with this in mind. The Manager has lowered the exposure to equities, providing it with dry powder to deploy should markets correct from here. Additionally, it has focused its equity investments on companies with lower sensitivity to stock market moves where the profit outlook is less dependent on the economic cycle. Its investments in property REITS and infrastructure are less sensitive to economic growth, and the companies in which the Manager invests are generally more defensive than the market. Additionally, while fixed income may not have the return potential of equities, these assets can appreciate even in times of market stress and counter act some of the volatility in equity markets.
While the prospect of a recession can be scary, investors should be careful not to act based on fear. Last December, the market started to price in a possible recession and fell 20%. Anyone who was shaken out of the market would have locked in those losses and missed out on the strong rally that we have seen this year. A great deal of harm can be done to long-term returns by selling out at the bottom.
It should also be noted that an inverted yield curve increases the risk of a recession, but does not guarantee one. If a recession were to follow, this could take anywhere from six to 24 months to manifest. Investors who were to sell now run the risk that markets calm down, Trump capitulates on his trade war, Brexit is resolved positively, and the economic data improves as the recent rate cuts and a return to quantitative easing drive the markets to new highs. Investors sitting on the side-lines can be out of the markets for long periods of times while missing out on returns, only to get back in when they can no longer stand missing out. The last two recessions combined an extremely over valued equity market in 2000 and a profligate and speculative banking system in 2009 with an economic slowdown. Valuations, while elevated are not extreme and the banking system in the US and the UK is far better capitalised. A recession without a banking crisis or valuation bubble has lower associated equity losses, and can be used by long-term investors to increase risk and pick up cheap assets. The Manager would expect to increase its equity exposure and take advantage of pull-backs in markets to cherry pick the most attractive assets and further improve long-term returns prospect.
Source: Philip Smeaton of Sanlam Private Wealth