When the Federal Reserve ended its zero interest rate policy in December financial markets welcomed the move, believing it to be a sign of confidence in the US economy.
But sentiment has turned very quickly, with investors now questioning whether the Fed’s move was a mistake and whether the recent disappointing economic data suggests a risk of a recession.
But is the US really heading into a recession? And has the US economy dramatically changed since the Fed ended its zero rate policy?
The Institute of Supply Management purchasing managers’ index registered a score of 49.5 for February. Compared with 48.2 in January this showed welcome improvement but also represented the fifth straight monthly score below the 50 per cent mark, which divides future economic contraction and growth.
“History shows that where manufacturing goes services eventually tend to follow, so a real slowdown in the industrial side of the US economy could finally hit the rest,” says AJ Bell investment director Russ Mould.
JP Morgan chief marketing strategist for EMEA and Europe Stephanie Flanders says it is important to “very closely” monitor the US economic situation because a potential recession would “seriously change things” around in the market.
“Absent a pick-up in consumption and further weakening in the US dollar, we continue to see a rising risk of earnings recession in the US.”
She says: “We need to get a better sense of how much of a slowdown there is going to be in the US. We don’t see a recession but that is something that is weighing on the markets.
“But if you see commodity markets stabilise as well as the oil price and the situation in China stabilise, that would be a catalyst for the market to go into another direction.”
At a company level, the past two quarters of earnings have resulted in negative earnings growth for US firms, as a recent JP Morgan Chase report points out, explaining this is a clear historic indicator of an imminent recession.
According to the report, in the past 115 years, consecutive quarters of negative earnings growth have been followed by a recession 81 per cent of the time.
“Absent a pick-up in consumption and further weakening in the US dollar, we continue to see a rising risk of earnings recession in the US,” the report says.
“This suggests that in order to avoid the end of the current corporate profit cycle we may need a fresh injection of some form of stimulus.”
However, of all the possible indicators Mould says “the most worrying” one currently is the inventory-to-sales ratio.
He says: “At 1.39, this stands at its highest level since 2009. Most ‘normal’ recessions are simply caused by overproduction and firms having to pull back on output until stocks of unsold product decline to their traditional levels, so this indicator is flashing red.”
The Federal Reserve Bank of New York uses the yield curve and the spread between the interest rates on the 10-year Treasury note and the three-month Treasury bills as “a valuable forecasting tool” to predict a recession.
The bank argues the indicator is “simple to use” and “significantly outperforms other financial and macroeconomic indicators” in predicting recessions two to six quarters ahead.
The model currently says there is a less than 1 per cent probability of a recession over that period.
Architas senior investment manager Nathan Sweeney acknowledges the economic slowdown but says the US consumer sector will be the key driver of economic growth, as it makes up two thirds of the country’s GDP. In particular, he cites the car and truck sales for February, which saw an annualised selling rate of 17.9m, up 11 per cent from last year.
Sweeney adds that the US Q4 GDP was revised upwards to 1 per cent at the last reading, from a preliminary 0.7 per cent, failing to signal an impending recession.
However, some fund managers are more skeptical of the positive data.
The latest Bank of America Merrill Lynch survey shows that fund managers believe the biggest tail risk facing markets is a US recession rather than the Chinese slowdown, with 27 per cent of managers selecting it as their top risk.
Fund manager buying behaviour also reflects their caution. Looking to the most crowded trades, fund managers are pouring into the US dollar and buying into tech giants Facebook, Amazon, Netflix and Google, while shorting oil and emerging markets.
The shifts in portfolios reflect fund managers’ need for capital preservation, with moves into cash, utilities, bonds and telecoms and out of banks and equity markets.
Fidelity Solutions portfolio manager in the multi-asset team Kevin O’Nolan says he remains neutral on US equities although company earnings are under downward pressure from a stronger dollar and lower oil prices.
He says: “We used the recent sell-off to add tactically to US equities on the back of market weakness. Within US equities, we are positive on the technology sector, which benefits from the strong consumer backdrop and an increase in corporate technology spending.”
Jeff Rottinghaus, portfolio manager of the T. Rowe Price US Large Cap Equity fund, which returned 9.38 per cent over the past year compared with a 4.04 per cent return for the benchmark, says he does not see much free cashflow growth, as fundamentals are not looking “overly solid”.
He says: “It would not surprise us if the market traded sideways to down over the course of 2016. This is why we remain overweight in utilities and consumer staples. These sectors offer a degree of safety and also offer attractive capital return characteristics.”
But despite US equities being out of favour for some, investors are not perturbed. North America was the second best-selling region for equity funds in January with net retail sales of £230m in the month, the highest since July 2013, according to Investment Association figures.
Premier Global Alpha Growth fund manager Jake Robbins says there are “plenty of reasons” to believe earnings could surprise positively especially in the consumer and financials sectors, which he believes could be a strong performer over the rest of the year.
Threadneedle American fund manager Nadia Grant says in low, albeit positive rates, it is important to focus on secular growth companies with little dependence on the macroeconomic environment.
“Some current themes we favour include the growth of the internet, ecommerce, cloud computing, medical innovation and the replacement of cash transactions by credit cards,” she says. “We also see some selected cyclical opportunities, which include the US housing market, regional banks exhibiting good loan growth and beneficiaries of lower oil prices such as domestic airline stocks.”
US companies’ dividend payouts are also expected to exceed $1.17trn in 2016, an increase of 3.3 per cent from 2015, according to the latest Henderson Global Investors dividend index.
This is an area Neptune US Income fund manager James Hackman is focusing on. He is sticking to companies that are converting profits into cash and returning it to investors in the form of a growing dividend.
Despite not believing a recession is on its way, BlackRock Global Multi-Asset Income fund co manager Justin Christofel says it is now imperative to take a conservative investment approach, with a more positive look at “cheaper” fixed income.
Christofel has reduced equity market risk over the past six months in favour of higher quality credit.
He says: “As we reduced exposure to equities we tactically built up cash to protect capital and reduce volatility. We also added high- quality government bond exposure as a tail hedge. Eighteen months ago, the average high-yield bond was trading at well above the par amount you would be paid at maturity. At that time, we had an all-time low allocation in our strategy. Today, you can selectively buy better quality high-yield bonds at yields of 6 per cent to 9 per cent.”
Looking ahead, fund managers say they will keep monitoring the next move from the Fed on interest rates. Interest rate futures markets forecast the Fed will hold rates through the end of 2016, with an increase coming in the first quarter of 2017.
In February, Fed chair Janet Yellen did not rule out an interest rate increase in March but she expressed more concern about the inflation outlook, which suggests that the US central bank will be in no hurry to hike rates.
Hackman says: “We are hawkish on rates relative to the market because the Fed is acutely aware of the risks of not hiking whilst the labour market is improving and wages are growing. By deferring the inevitable, they would only have to raise rates more sharply later, increasing the chance of a recession.”