The following is a portion of the most recent research bulletin of the Morgan Stanley Smith Barney Global Investment Committee. To read the bulletin in its entirety, click here.
The risk of recession in the US and the rest of the developed world has grown significantly in recent weeks, so we are adopting an overweight position in safe havens and an underweight position in risk assets. This is the most significant change to our tactical asset allocation in more than two years, as we are decisively moving to bearish from bullish.
The primary source of the recent financial market distress—with, we think, more to come—has been a combination of policy inaction and ineptness in the US and Europe. In August, the Morgan Stanley Global Economics team issued a report that stated developed economies were moving “dangerously close” to recession but maintained a base case that a recession was not yet probable (see Morgan Stanley Global Economics:
Dangerously Close to Recession, Aug. 17, 2011). More recently, the Economic Cycle Research Institute (ECRI), an independent research institution, warned that the US economy is on track for a recession. The ECRI has successfully called each of the last four US recessions with no false alarms.
To summarize the evidence pointing to a US recession, the ECRI US Leading Diffusion Index shows the proportion of components in all of its leading indexes that have weakened over a six-month span (see Chart 1).
As the chart shows, in more than six decades this index has declined to current levels only once without a recession transpiring. Even that exception involved a near recession in 1966 and 1967, and it included a 22% price decline in the Standard & Poor's 500 Index in 1966. Historically, the average decline during recession related bear markets is about 30%.
As of Oct. 5, the S&P 500 is 16% below its three-year closing price high, reached on April 29. The index is also 61% above its March 2009 bottom closing price. As for Europe, the GDP growth outlook was not robust before the latest round of sovereign debt deliberations. With further fiscal policy tightening in the offing and policy missteps by the European Central Bank, we expect Europe will soon be in recession.
Equities
If history is any guide, a recession will pose significant challenges to equity market performance until investors start to anticipate the end of the economic downturn. Still, performance would likely vary, to some degree, across regions. For instance, we would expect growth to continue in the emerging market (EM) economies as EM monetary policy tightening runs its course; indeed, central banks in Russia, Brazil and Turkey have recently eased. Thus, we continue to overweight EM equities, for which valuations remain attractive.
Moreover, our risk-of-recession call is largely confined to the big developed market (DM) economies—the US and Europe. At the global level, we still would expect GDP growth to be positive. Within DM equities, we favor the US over Europe and Japan where headwinds appear structural as well as cyclical.
Within US equities, we continue to favor large-cap stocks. Large-cap stocks typically outperform during adverse
market conditions and still have a relative valuationadvantage as compared with history.
At the style level, we continue to favor growth stocks over value stocks. During the periods of decelerating corporate earnings that accompany recessionary episodes, growth stocks—companies that have the ability to deliver relatively stable earnings growth regardless of the economic backdrop or those expected to post above average earnings growth—typically hold up better. In addition, value stocks continue to appear somewhat expensive relative to growth stocks on an historical basis.
Commodities
As part of our effort to scale back exposure to risk assets, we are adopting a slight underweight tactical allocation to commodities. We believe it is prudent to reduce exposure to this economically sensitive asset class in light of the increased risk of recession.
REITs
Another asset class with close ties to the economic cycle is real estate investment trusts (REITs). From the equity market bottom in March 2009 through September 2011, the FTSE EPRA/NAREIT Global Index, our benchmark, increased by some 120%, making it among the top-performing asset classes over this period. However, in light of coming GDP growth challenges, we believe it is judicious to reduce exposure. Moreover, from a valuation perspective, REIT yields are not, by historical standards, particularly compelling relative to investment-grade corporate bond yields.
Managed Futures
As an asset class, managed futures have low historical correlations to other asset classes, providing a considerable degree of portfolio diversification. We believe good risk management begins with portfolio diversification, but it doesn't have to end there. Because managed futures have historically performed well during periods of adverse equity markets, we are adopting a tactical overweight allocation.
Cash and Fixed Income
Given a recessionary backdrop, the attributes we prioritize have shifted. It remains hard to make a compelling valuation case for cash, short-duration fixed income and DM sovereign debt at a time when most of these yields fall short of inflation and appear expensive relative to equities and other risk assets.
However, the rate of inflation is likely to decline in a recessionary environment; moreover, defensive properties of these asset classes should provide ballast to a diversified portfolio during a turbulent period, so we have increased our exposure. Accordingly, we are now overweight cash and short-duration debt and less underweight to DM sovereign debt. We are also prioritizing safety and quality over wide spreads by reducing our exposure to high yield corporate bonds and emerging market debt, while increasing our already overweight exposure to investment-grade bonds.
Conclusion
In aggregate, we are now underweight risk assets—equities, REITs, commodities, high yield bonds and emerging market debt. Conversely, we are overweight safe havens—cash, short-duration debt, investment-grade bonds and managed futures. In sum, the economic cycle has turned against maintaining a “risk on” position. We are now risk off.
*The MSSB Global Investment Committee includes: Chief Investment Officer, David M. Darst;Chief Investment Strategist, Kevin Flanagan; Chief Fixed Income Strategist Jonathan Mackay; Senior Fixed Income Strategist, Charles Reinhard; Deputy Chief Investment Officer, Douglas Schindewolf, Director of Asset Allocation.
