Is it time to cash out of the stock markets? How investors should react to signs of a coming downturn

Patrik Schowitz says the US is in the late phase of its economic cycle, leaving investors wondering when a downturn will come. However, this phase can last years and the decline is likely to be gradual, giving them opportunities to get out in time

PUBLISHED : Friday, 29 June, 2018, 4:03pm
UPDATED : Friday, 29 June, 2018, 10:30pm

It’s easy to blame the current noise and volatility in financial markets on the brewing trade spat between the United States and a range of countries, most notably China. But scratch a little beneath the surface and there is a bigger underlying worry: the economic cycle is undeniably getting very long in the tooth. How much longer can it run?

Most of this discussion in financial markets anchors around the US economy. As maddeningly as this US-centred approach can often feel to investors in Asia, there’s good reason for it. Since the second world war, only the US economy has been big and interconnected enough to drag down the world economy with it, when it goes into recession (that is, shrinks for at least two quarters).

It has now been almost nine years since the start of this US economic expansion, making it the second-longest on record. And, as the saying goes: when the US sneezes, the rest of the world catches a cold. True, it is quite likely that the Chinese economy is now big enough to have that clout, but since we have not yet seen a real recession in China, no one can know for sure.

Of course, the worries about trade and recession are linked. As it gets later in its cycle, an economy becomes more vulnerable to damaging events. As interest rates rise and business and consumers increasingly get stretched, the economy runs out of shock absorbers. And an escalating trade war could conceivably be just such a shock. Although, to tip the US and global economy into recession, current tensions would have to grow into something much bigger than currently looks likely. Growth is still far too robust for that.

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All of this matters to investors since – with only very few exceptions – global bear markets in equities (usually roughly defined as drops of more than 20 per cent) are caused by economic recessions and, conversely, a recession is inevitably accompanied by a downturn in equities. So when it gets “late” in the cycle, it is sensible for investors to be increasingly on the lookout for signs of an imminent economic downturn so they can reduce risk in their portfolios in good time.

However, there is also an opportunity cost to cashing out too early that has to be weighed against the benefits of staying invested. Historically, equity market gains in the last year before a bear market starts have been very significant. Over the past 50 years in the US, these last-year returns have often been in excess of 20 per cent and never less than 10 per cent.

And, when equity markets do peak at the beginning of a new bear market, they very rarely collapse overnight. Instead, at first, they usually decline fairly gradually for a few months. In other words, there is usually time to get out and there is no need to time the market perfectly.

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Of course, this is all easier said than done. Markets can be volatile and it is hard to know whether any given stock market drop is “the one”. That is why professional investors spend so much time analysing the macroeconomy and watching for recession risks.

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As long as economic confidence remains, any given twitch in the market is unlikely to signal the start of something more serious. And while it is clearly “late cycle” in the US economy, investors also need to remember that this phase can often last many years.

For now, economic fundamentals and growth still look pretty robust and there’s no increased likelihood of a US (or global) recession on the horizon over the next year or so, trade spats and gradually rising interest rates notwithstanding. It’s slowly getting late, but it’s still too early for investors to go home.

Patrik Schowitz is a global multi-asset strategist at J.P. Morgan Asset Management