After the Brexit market sell-off at the end of June, the stock market indexes rallied to all-time highs, and yields sank to all-time lows as bond prices rose. What does this divergence mean?
In her bimonthly check-in, Lisa Emsbo-Mattingly, Fidelity’s director of asset allocation research, discusses Brexit implications, the latest on the U.S. cyclical economic outlook, the potential investment ramifications of the concurrent rallies in the stock and bond markets—and the importance of a diversified investment strategy.
|Q:||What does Brexit mean for the global economy, going forward?|
Emsbo-Mattingly: Brexit, the U.K.’s vote to leave the European Union, was a referendum on globalization, and a rejection of it, albeit by a very slim margin. I think it should be a wake-up call for policymakers. Globalization has had a big impact over the last 20 to 30 years. It has improved efficiency and productivity. It has raised corporate profits and kept inflation in check, and it has helped pull hundreds of millions of people out of poverty. But there are also negative consequences to globalization, and policymakers have tended to ignore the losing side.
As the world economy grows more slowly, I think the voices of people who have lost out because of globalization are going to become a larger part of the conversation. I think Brexit should signal to policymakers that they should think long and hard about who the winners and losers of their policies are, and remember that the advanced economies are democracies, in which the voters should have a voice in how things are decided.
|Q:||What does deglobalization mean for markets and economies?|
Emsbo-Mattingly: Deglobalization—a reversal of globalization—could reduce economic growth rates around the world. It also could affect inflation: You might see more old-fashioned inflation, in which prices rise because of barriers to certain markets or inefficient distribution of goods.
We might also see a little less correlation between markets. Today, markets in the United States, Europe and Asia, tend to react similarly to major market developments. From a stock picker’s perspective, less correlation means increased opportunity—but you need a deeper understanding of what’s happening in various economies, as well as of policy developments in these countries.
|Q:||The other big political story is the U.S. election. What impact do you think it’s having on markets and the economy?|
Emsbo-Mattingly: When candidates propose policies that are off the beaten path, it tends to raise the level of uncertainty in the markets. Heightened uncertainty could create more market volatility than we’re accustomed to, just as Brexit did. Those political factors are contributing to an outlook that is a little more muddled than normal.
That muddled outlook actually is fairly typical of the late phase of the economic cycle. In the late cycle, the upward momentum that a country has been enjoying for a number of years starts to taper off, and market performance becomes more difficult to read. That seems to be what we’re seeing now in the United States.
|Q:||Have we fully entered the late part of the economic cycle?|
Emsbo-Mattingly: We seem to be trading places between the middle and late phases of the cycle. We’re seeing several typically late-cycle characteristics: There’s been a clear slowdown in productivity; labor costs are up; hiring has slowed somewhat; profit margins are under pressure; and earnings have come down, in aggregate.
On the other hand, we’re still seeing a number of typically mid-cycle trends. In the late cycle you usually consistently see the Federal Reserve raising interest rates, but for now the Fed has backed off rate hikes. The residential housing market is still moving in the right direction, and the negative inventory cycle we had been seeing in the housing market seems to have stabilized.
So it feels a bit like we’re swinging back and forth between the mid cycle and the late cycle. I do think the United States is heading into the late cycle, in large part because the upward momentum in the job market has started to slow. The slowdown likely can be attributed to two factors: Earnings are slowing, and employees are starting to command more money. When you combine those trends, companies may be less inclined to hire new heads.
|Q:||How are the markets reflecting the transition toward a late-cycle economy?|
Emsbo-Mattingly: Typically in the late cycle, a narrative that has been percolating for years really starts to come into its own, and becomes a sort of groupthink. The current groupthink seems to be that rates are going to stay low for a long time, and there will be low growth and little to no inflation, so the higher the yield of an investment, the more attractive it is.
You can see this now, with the money flowing into what we call the bond proxies; that is, high dividend-yielding stocks. These stocks are trading at valuations that are unprecedented, which is a little concerning. At the same time that these stocks present extreme valuations, many of the companies’ earnings are actually falling. I’m seeing some parallels with the tech bubble: People buy stocks because they’re rising, and then the stocks gain more in the short term so people feel more comfortable with them and invest still more. I’m skeptical this will end well. I think the most important thing for investors to remember about these stocks is that they are not bonds. They may have high yields, but they are fundamentally different securities than bonds, and they have the potential to drop in value very quickly.
|Q:||Both the stock and bond markets have performed well recently. What are the markets telling us?|
Emsbo-Mattingly: It’s unclear. Stock indexes are at all-time highs, but bonds’ gains suggest pessimism about growth and inflation. Which is right? It’s hard to say. But what it does say to me is that this is an especially risky time to overload any one type of investment. Maybe the prevailing narrative behind the bond proxies is right, and we’re in for another year, or even five years, of a no-growth, deflationary environment. But maybe it’s wrong—in fact, over the last three months headline inflation was running at a 3.4% annual rate, with core inflation at 2.3%. So I think this is an especially important time to have a well-diversified portfolio—one that includes investments that are likely to benefit in either scenario.
Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
Diversification and asset allocation do not ensure a profit or guarantee against loss.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917