About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
The last few days were another great reminder that just when we started to think that we had things figured out, there comes another curve ball.
First, last Wednesday we had the Fed's "hawkish cut," that is, the market got the 0.25% cut in rates that it was expecting. But it was followed by Fed Chairman Jerome Powell's "mid-cycle correction" theme, which the market viewed as hawkish (not the start of a new easing cycle). Then the very next day, the White House announced that a 10% tariff on the remaining $300 billion of Chinese imports will go into effect on September 1st.
And then on Sunday, China (apparently) devalued the Yuan by letting it fall through the important 7.0 dollar-Yuan exchange rate threshold, while at the same time announcing a buyer's strike on American soybeans. Allowing the Yuan to fall through 7.0 had been viewed as something of a nuclear option (devaluation means China’s exports become more competitive globally). So this latest development is stoking fears that the US and China are headed for a damaging, prolonged trade war. It also is confirming the market's sense that currencies are becoming the new frontier of global monetary and economic policy (also known as competitive devaluation).
The result? The S&P 500 is off 6% from its recent high (of 3,030) and the US 10-year Treasury yield has plunged to 1.77%. We have another bona fide "risk-off" episode this time against the backdrop of a slowing economy (even in the US but especially in Europe and China), slowing earnings growth, fears of a currency war as well as a trade war, and new lows for many key industrial commodities, all while the US stock market seems relatively expensive at a 16.5 forward price/earnings (P/E) ratio.
Some silver linings
But I think there are some silver linings. For one, bonds are benefiting from the plunge in interest rates (and equivalent gain in bond prices). Just last week, the Bloomberg Barclays US Aggregate Bond Index gained almost a full percent—a reminder that diversification among stocks and bonds works. If stocks remain under pressure because of the above factors of slowing growth, low inflation, and escalating trade tensions, then this dynamic of bond price gains offsetting some of the stock declines may well continue.
If US yields do what the rest of the investment-grade world has already done (go down), then some form of long duration exposure will go a long way to immunize against the risk of de-globalization. Imagine if the Fed's mid-cycle correction turns into a full easing cycle? With the Fed presumably having more room to cut than the European Central Bank or the Bank of Japan, the dollar could fall. That would once again make Treasuries attractive to own on a currency-hedged basis (using offsetting currency contracts to eliminate the impact of the movement in foreign currency prices), With Treasuries now yielding −0.6% less than German or Japanese bonds, that could lead to a major convergence between US and non-US investment-grade yields.
Remember that the bond market is extremely convex at these low yields. That means that a decline from 2% to 1% would create a much larger gain in a long-duration bond portfolio than say a move from 5% to 4%. Given the above, it’s hard to argue against the assertion that an appropriately diversified asset mix should be the cornerstone of every investor's portfolio.
Another silver lining is that credit spreads—the difference in yields between high and low-rated bonds—were stable during the market pullback. Generally speaking, large downward moves in stocks will come with a warning in the form of rising credit spreads, and that is not currently happening. If the credit cycle is still OK (as currently implied), then the economy at large should be OK as well.
Also, when we look at the progression of earnings estimates, we see that even though this supposed V-recovery is indeed starting to look more L-shaped, it still looks better than 2016 when we had an actual earnings contraction. Indeed, Q2 earnings season is turning out to be a strong one, with the initial −2.9% estimate now back up to zero. That’s a bounce very similar to Q1. With 387 companies reporting as of last week, the beat rate is 76% with an aggregate upside surprise of 5.46%.
A final silver lining is that while the forward P/E remains high at 16.5x currently, with the bond yield falling to 1.77%, that means that the equity risk premium (as defined by the earnings yield minus the bond yield) rose to a very generous 4.1% last week. It was a mere 2% not too long ago. It's an important reminder that P/E ratios should always be considered within the context of bond yields. In a low rate environment, the stock market may not be as expensive as it might look on the surface.
What's an investor to do?
For me it's always the same: First, have a plan in terms of having a diversified portfolio that balances risk and reward in the best way possible. Second, execute on that plan, and stay disciplined, patient, and diversified during the inevitable corrections. Third, rebalance as necessary.
With the US economy still in decent shape, driven in large part by a resilient consumer benefitting from low debt levels, low unemployment, and rising wages, I still do not see a US recession on the horizon anytime soon. And with the sharp decline in rates, maybe there will soon even be a boost coming from lower mortgage rates. The rest of the world economy is clearly doing worse, and that is certainly leading to some weakness in US corporate earnings, and current valuations do seem a bit too high given all the uncertainties around the trade picture. But over the long run, a well-diversified balanced portfolio should continue to deliver decent risk-adjusted returns for investors.
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