All-time highs and the fear of what comes next

The number three has a mystical quality to it. For some, it’s a charm; for others, it’s how bad things come.

It’s little wonder then that the bullish run in stocks continues to enthrall investors while spooking them at the very same time. Both Baby Boomers and Gen X’ers have been down this road before -- not once but twice. It started with the dot.com boom and bust of the late 1990s, followed by the subsequent rise in equity markets that ended in collapse in the Great Financial Crisis a decade ago.

In both instances, the fear of missing out drove share prices dangerously higher, only to see them plummet -- losing a staggering half of their value – while triggering a collective unease among investors about repeating the same process over again.   

Could this now be a case of third time unlucky? It may be beginning to look that way as many of these same investors seek the promise of new gains, but grapple with the prospect of another prolonged downturn as one of the best performing market cycles in history winds closer to its end, marked by increasing volatility. 

Nowhere is this growing uncertainty about what comes next more evident than in the turbulent swings that have marked both equity and bond markets over the past ten months.

The S&P 500 index, for example, is up 17% this year through June and has repeatedly hit all-time highs despite experiencing a significant pullback along the way. Meanwhile, the yield on 10-year U.S. treasuries has dropped 125 basis points since early November and recently fell below 2% as the appetite for safe haven assets has continued to grow.

While not unprecedented, the aggressive rally in both of these asset classes is unusual and highlights a growing divide about the state of the global economy, whereby equity investors seem far less worried about an imminent recession than do their bond counterparts. 

At issue is the degree to which economic data is truly weakening in the U.S., Europe and China at a time when unprecedented geopolitical risk is being relentlessly fueled by a hyped-up news cycle.

Case in point is the contentious trade negotiations between the United States and China.  Many investors had assumed this was a done deal earlier in the year, only to see talks break off between the world’s two biggest economies in the spring.

And while both countries recently agreed to resume talks and avoid escalating their multi-billion dollar tariff war, it’s unlikely an agreement will be reached soon, leaving markets hanging longer in the wind and susceptible to further turmoil in the near future.

But that’s not all. Investors must also contend with the potential for other trade frictions to intensify in the weeks ahead. This includes the threat of further tit-for-tat tariffs between the U.S. and European Union (EU,) as well as the chance of collapse in the United States-Mexico-Canada Agreement (USMCA), which, months after being agreed to in principle, has yet to be ratified.

Brexit, meanwhile, remains a challenge to the global economy as does the ongoing political dysfunction in Washington D.C. and, more recently, brewing tensions between the U.S. and Iran.

While politics and the politicians who play them will clearly have a role in the global economy’s health in coming months, the more important factor in staving off recession may be central bank policy.

In particular, the U.S. Federal Reserve’s next few moves will be critical in determining the fate of the U.S. economy and that of markets. The Fed’s decision to pause on further rate hikes in late December was a major catalyst for both stocks and bonds early on this year, but investors – and U.S. President Trump too  –  have grown impatient with this stance in recent weeks and, by some estimates, markets are now pricing in as many as four rate cuts by April 2020.

For his part, Fed chairman Jerome Powell has acknowledged one rate cut could be coming if economic conditions continue to weaken, but otherwise has remained reticent about discussing the possibility of further cuts.

Even so, it seems almost assured that he will announce a 25 basis point cut later this month and then an additional rate cut sometime later this year. In doing so, he should appease markets – if not all of his critics – and could give stocks another large boost in the weeks ahead.   

But if the Fed doesn’t cut as expected, it could result in just the opposite, tipping off another major selloff in the process, even if the reason for not cutting is a stronger economy than expected.

Conversely, equity markets might get just as spooked if the Fed cuts too much or too fast over the next few months. After all, the lower rates go, the more trouble the Fed believes the economy is in.

Needless to say, the current environment hangs in a precarious balance and is susceptible to both political and policy missteps that could derail the global economy and change the current trajectory of both equity and bond markets.

Given this backdrop, and the late stage of the cycle, investors have every right to be cautious but shouldn’t shy away from seeking opportunities while trying to keep risks in check.

From a portfolio perspective, we believe this can be achieved by taking a barbell approach that tempers exposure to equity and fixed income markets with a bulked-up cash allocation somewhere in the 5- to-7-percent range in a typical 60/40 asset mix. 

While some might consider this weighting too small given how much stocks and bonds have run of late, there are other, complementary ways to mitigate some of the downside that this could entail. Namely, some level of diversification into alternative asset classes or long/short strategies that provide returns with low correlation to both asset classes may be appropriate.   

Ultimately, we believe that those investors who take the time to build well-rounded portfolios will continue to benefit even when the current run in markets starts to lose its charm.

Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Ltd. He is a regular contributor to AGF Perspectives.