Does a yield curve inversion still signal an imminent recession, or is the U.S. still late in the cycle? This October in Boston, the Fixed-Income Management 2019 Conference will bring together researchers, analysts, portfolio managers, and top strategists to discuss the opportunities and risks of late cycle investing.
“When is a recession going to come?”
That’s the question Geraldine Sundstrom keeps getting from clients as a managing director and portfolio manager at PIMCO.
But Sundstrom, who focuses on asset allocation strategies, doesn’t believe we are at the end of the economic cycle just yet. We are late in the game though, she explained at the 72nd CFA Institute Annual Conference, hosted by CFA Society of the UK, and investors can position their portfolios to take advantage of late-cycle growth while protecting against the risk of a recession.
What Keeps Us Up at Night?
The usual culprits that could push the economy into recession — an overkill of monetary policy, an overheating economy, oil shocks, excess investment, and over-consumption — don’t seem seem likely from Sundstrom’s perspective. “There is only one thing that keeps us up at night and could topple the economy into a big recession,” she said. “That is a trade war.”
According to Sundstrom, there is a dichotomy in the markets that may explain the dynamics of fixed-income and equity prices. On one side are the “skeptics” in bond markets who point to signs that the global economy and trade are slowing. They believe that a trade war will tip us into recession. On the other side are the “believers” in equity markets who think the slowdown is behind us now that the US Federal Reserve has removed its foot from the brake and China has stepped on the gas with both monetary and fiscal stimulus.
“There is a reason for views on both sides that are not necessarily wrong, and they ebb and flow around the trade war and the risk of a possible recession,” Sundstrom said.
She likened current trade tensions to a cold war where discussions variously heat up and cool off. Neither country stands to gain from letting things boil over.
“In a cold war situation where you have two giant superpowers — the US and China — who are both competing for economic, technological or digital supremacy, neither of these two athletes can afford to be sick or fall behind . . . or let the gap become too large,” she said.
This creates tension and fear, but also spurs opportunity and innovation.
“Cold wars are very scary because there is an element of ‘mutually-assured destruction,’” she explained. “But we know from game theory, these are some of the most stable systems because as soon as there’s a bit of weakness, all the power goes into trying to fill the gap or to giving a shot of adrenaline into this big competitor.”
Indeed, there can be beneficial outgrowths of this sort of competition.
“When you have the top two elite fighting for supremacy,” she said, “this is when records break and you have technological advances.”
Though she doubts a recession is around the corner, Sundstrom is preparing for one down the road by increasing the overall quality of the positions in her portfolio. “What quality means to us for countries and companies is that they have room to maneuver and to navigate higher volatility and potential adversity,” she said.
In fixed income, Sundstrom currently invests in securitized credits with collateral, such as seasoned non-agency mortgages or short-dated AAA CLOs in Europe, where she thinks the risk premium is too elevated.
She also recommends overweighting investment-grade corporate bonds and, if investing in high yield, not going too far along in terms of ratings or timing where you don’t have visibility of cash flows. “If you can combine a strong country/region with a strong credit within the region, you double your chances of being able to navigate rough waters,” she said.
For equities, Sundstrom likes US and Japanese companies that have a lot of cash on their balance sheets. She also prefers firms with strong business models and believes companies in Japan are especially underappreciated in this regard.
“We used to say companies with too much cash was a negative attribute,” she said. “But now, when you move to late cycle, you want to own companies that can buy back shares when prices become too low or maintain the dividends even with a downturn.”
Overall, Sundstrom suggests investing in high-quality equities, but she warned investors about factor drift, particularly migration among value, growth, and quality factors, at this stage of the cycle. She also encourages investors to make adjustments for the fact that we are in a disrupted world where quality is becoming more concentrated in certain sectors. Investors should also keep emerging markets in mind, particularly China and Asia, where the maneuverability and quality factors are high.
“The economic cycle is getting old and being dynamic is going to be key,” Sundstrom said.
Episodic spikes in volatility are also worth taking advantage of, she says. Among her examples: going long (or short) emerging (or developed) market currencies to generate carry, or selling puts and buying calls to create asymmetric payout structures when equity markets are most fearful.
“When midnight strikes and Cinderella’s carriage turns into a big pumpkin, you’re going to have to do something,” she said. “One way that you can help yourself better navigate the ‘recession moment’ is by investing in quality.”
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image courtesy of Neil Walker
Continuing Education for CFA Institute Members