2019

October 2019: your client asks... are we heading for recession?

This monthly series looks at the economic and market issues making headlines, and provides straightforward answers to investors' questions. This month: will the global slowdown turn into a recession?

28 Oct 2019

Are we likely to have a recession?

Whatever the near and longer-term outcomes of Brexit, there is a lot of uncertainty about economic prospects at home and around the world. One sign of investor anxiety is the strong performance of “safe haven” assets. These assets, such as gold and government bonds, tend to do well when investors fear the outlook is deteriorating.

We see indisputable signs of a slowdown, which we think stem largely from the ongoing trade disagreement between the world’s two giant economies of China and US.

However, we don’t think a recession is imminent.

For now, economic weakness is focused in manufacturing sectors, which are more dependent on international trade and more sensitive to changes in global demand. Other areas of activity – such as services and consumption – are still holding up. And in the US, which sets the pace of global activity, services and consumption account for a much larger share of the economy than manufacturing.

Much depends on the development of the US-China trade war. If it escalates, there is a significant risk that weakness in industrial sectors will spill over into the broader economy. But it is also possible that a meaningful agreement between the US and China – rather than a short-term ceasefire – could restore momentum to global growth. With interest rates still very low in much of the developed world, this could keep the current cycle going for even longer.

And if the economic backdrop is unpromising, will stock markets fall?

Stock markets overall are not cheap. Based on our data, global shares trade at just over 16 times their expected earnings over the next year. That is near the highest level we have seen since 2004 and around 8% above the average since then.

But that’s not the whole story.

Certain sectors and countries trade at what appear to be elevated multiples relative to history. Others command much more modest ratings. This isn’t a market that is “irrationally exuberant” – its one in which nervous investors are sticking to those areas of activity that they know are doing well.

Investors are paying very high multiples for more defensive stocks, such as consumer staples, which they expect to prove relatively resilient in a slowdown. The same is true for fast-growing companies that should be able to increase sales whatever happens in the broader economy. By contrast, sectors that are highly exposed to the ups and downs of the business cycle – such as energy companies and financial firms – trade at much lower valuations. The disconnect is now at the widest it has been in many years.

This is one factor which explains why different stock markets also trade at very different valuation multiples. The US, which is home to technology giants such as Amazon, trades at a significantly higher multiple than the UK market, for instance, which is much more dependent on the fortunes of commodity producers and banks (see chart below). 

Another factor to bear in mind is that while some stock markets may look expensive relative to history (on a share price/earnings basis), there can be good reasons why they might be more highly valued than usual. This could mean they are not as expensive as they look.

One reason is profitability. When companies are generating high profits, they are better placed to cope with a tougher economy and invest in new business opportunities. Put slightly differently, they combine lower risk and higher growth – both of which support higher P/E valuations. US companies, in particular, find themselves in this situation today.

Inflation is another supportive factor. Valuations tend to be highest when inflation is low and stable, as is the case today. This is because companies have scope to increase prices without seeing their costs spiral out of control.

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