Storm Clouds on the Market’s Horizon

Reiman Fall Finance Forum panelists anticipate economic slowdown will arrive sooner rather than later

This summer, the U.S. economic expansion eclipsed the 10-year mark, setting a record for continual growth. For the next 12­­–18 months, however, conditions are likely to be much more sobering, according to a panel of three investment professionals who spoke at the Daniels College of Business’s Reiman Fall Finance Forum Oct. 11.

With earnings growth slowing, the employment market faltering, corporations borrowing too much and consumer confidence fading, Dan Roberts said the economic cycle is near its peak. And since the financial markets react before the economy actually peaks, the executive managing director and head of global fixed income with MacKay Shields said a downturn is likely as the U.S. economy starts to pull back.

“It’s not the brightest picture in the world,” Roberts said. “But we all have to realize that you can’t have expansion forever.”

Joining Roberts in offering frank perspectives on the current state of the markets were Louis Llanes, founder and CEO of Wealthnet Investments, and Ric Martin, senior vice president and wealth advisor with Morgan Stanley.

Reiman Fall Finance Forum panelists

The cautionary tone was unanimous.

“Clearly, the data is not good,” Llanes said. “But we’re still at a historically low level of volatility and guess what? It’s going to get higher most likely.”

Roberts set the tone for the morning by explaining how the Federal Reserve historically starts cutting the federal funds rate and corporations start trimming payrolls just before a recession starts. Meanwhile, bond investors push yields, which move in the opposite direction of prices—lower—leading many to dig into poor-quality, high-yield issues for returns. Each of those steps has occurred this fall.

Meanwhile, a number of European nations are issuing government debt with negative yields, which constricts the likelihood of positive returns from international bonds as well.

“I would argue we’re in a bond bubble, globally,” Martin said. “And the problem with a bubble is that it lasts until it bursts.”

As for stocks, Martin said that the S&P 500 Index has essentially been treading water since the large corporate tax cut was implemented in January 2018, and added that falling interest rates have provided ballast for continued high valuations. In the coming quarters, though, he said that earnings will struggle to keep pace.

“The tax cut essentially front-loaded a few years of earnings growth in 2018, so the problem is that there is no way we can see additional earnings growth in 2019, and maybe not in 2020,” Martin said. “Plus, Morgan Stanley says that there’s a 50% chance of an economic recession next year. It’s been the longest economic recovery in history so yes, we’re going to have a recession at some point.”

Martin added that Morgan Stanley economists don’t anticipate the slowdown to be worse than a “garden variety recession,” which will allow smart companies to reduce excesses, restructure, cut costs and become more efficient. Meanwhile, he said that stocks may fall 20% from current levels, but will then be poised to outperform bonds for much of the next 10 years.

When faced with such prospects, Llanes said that investors should focus on what they can control, including:

1. Portfolio construction—taking an objective look at holdings to gauge risks and diversification levels is essential.
2. Proper planning—portfolios benefit from thinking about the role different assets play and taxation matters, as well as checks on emotions.
3. A systematic quantitative approach—relying on a process and checklist, instead of a narrative, which can erode when market stress arises, can help steady the nerves in rough patches.

“Thinking about our thinking at this point is important,” Llanes said. “The data is really important, but we’ve got to act.”

Of course, one looming unknown is the 2020 presidential election. Roberts, who worked in the Ronald Reagan administration and served as the chief of staff of the United States Joint Economic Committee in 1984–85, said he tells people that the election of a republican or democrat to the White House generally has little impact on the economy.

Until next year.

“The ideological split is so significant that it’s going to be different this time,” he said.