- The Fed’s post-recession policy experiment was mostly successful
- S&P 500 Index earnings growth has accelerated, marking the end of an earnings recession
- Equities tend to have better risk-return profile than fixed income in a pro-cyclical environment
Exiting the Great Recession in 2009, the global economy entered a period of pioneering monetary stimulus meant to fight deflation and to restore pre-crisis growth rates. The amount of stimulus from central banks around the world was unprecedented, and investors feared a number of possible negative unintended outcomes — with runaway inflation perhaps the most prominent — as a result of all the paper being pumped into the economies. Because this had never been attempted before, there was no investment playbook. Around the globe, investors were in uncharted waters.
Over the past eight years since the recession ended, we can retrospectively attest that the “easy money” experiment was mostly effective in its intended objectives. Although the federal funds rate remained at 0% for the majority of the past eight years, we did not experience runaway inflation and the market, as defined by the S&P 500 Index, returned 248%, or 18% annualized, from March 2009 through December 2016.
The 2015 earnings recession required new strategy tilts
For all of 2015 and through the first half of 2016, the S&P 500 underwent an earnings recession as the companies that make up the index, in sum, experienced negative annual earnings growth. Earnings recessions are more frequent than economic recessions, and navigating them requires proper asset allocation. The main strategy in the earnings recession investment playbook is to be defensive. For example, we believe investors should overweight fixed income relative to equities. Within equities, growth-style companies should be an overweight relative to value-style companies because the greater earnings visibility of growth stocks makes them more attractive in an uncertain environment. Investors also typically fear that an earnings recession signals the last innings of a cycle, and therefore embrace large-cap stocks, which then tend to outperform small caps.
In the earnings recession of 2015-16, fixed income outperformed equities.
Turn to a pro-cyclical posture for a normalizing market
Since mid-2016, we have been in a markedly different investing environment. Beginning in July of last year, earnings growth, GDP growth, and inflation expectations have all accelerated and the yield curve has steepened. In addition, the perceived policy boost from the election of Donald Trump enhanced pro-business optimism. As a result of these shifting dynamics, the FOMC decided to raise interest rates in March of this year, and the market is pricing in multiple additional hikes going forward, as regulators “normalize” the market.
Maneuvering in a pro-cyclical environment
Similar to the recent earnings recession environment, the pro-cyclical, rising-rate environment that we have entered has a playbook with historical precedent. In this market, research indicates that equities could provide a better risk-return profile than fixed income. Within equities, value should provide a better opportunity than growth thanks to a stronger pace of earnings and to accelerating economic growth. Put simply, investors are much more willing to invest in a company that will be growing earnings 10%-15% with a PE of 15X (Value) rather than investing in a company that is growing earnings 15%-20% with a P/E of 70X (Growth). Small-cap stocks have historically outperformed large caps in pro-cyclical environments as well.
Meet the new normal, same as the old normal
Investors did not have a playbook for the immediate months and years that followed the Great Recession. However, as the bull market that began in March 2009 has aged, opportunities to employ strategies consistent with similar previous cycles are evident. In 2015 and the first half of 2016, while earnings growth was negative, investors had the opportunity to pursue defensive strategies. As earnings growth continues to accelerate into 2017, and the FOMC continues to “normalize” the environment with additional rate hikes, it is time for investors to tilt portfolios appropriately.
Invest in the market you see, not the one you want to see.