Banking

Will the US market face recession risk, or will the bull market remain for good?

From a macroeconomic perspective, while we have experienced a short period of market ebullience as the economic reopening and lifting of lockdowns instilled excitement across the US market, this is likely to fizzle out and give way to a period of slower, yet still robust economic and earnings growth in the months ahead.

However, these catalysts will still be powerful enough to elongate the bull market.

Many US investors may still be cautiously assessing the likelihood of recession risks, while some are patiently waiting for a period of market downturn to provide an opportunity to deploy cash.

Using the ClearBridge Recession Risk Dashboard (below), our analysis shows that all indicators are flashing green, signalling a strong recovery in the US economy. However, investors should tread carefully as much of this good news is already priced into the market, and potential risks of corrections still lie ahead.

Positive signals point to economic recovery, but volatility remains

Despite these clear positive strides towards recovery, market volatility remains elevated; investors are beginning to question what is causing this disconnect.

One factor keeping US equity markets rangebound is the Federal Reserve’s recent announcement of future rate hikes, which severely spooked the market. As the Fed moves towards its inflation-targeted framework, investors are continuing to try to discount its next steps, which could result in further fuelling of market volatility.

Secondly, another potential weight on the market is the fear of potential inflationary risks in the months ahead.

While bond investors are mostly comfortable that inflation will prove transitory, equity investors are much less optimistic.

Our analysis shows that price pressures remain stagnant and inflationary risk is much less prominent than expected. However, we believe that it will likely get worse before it gets better, further supporting our view that volatility is here to stay – at least in the near-term.

What’s next for US equity investors

With volatility on the agenda for the near future, and central bank intervention and inflation risk looming, US equity investors are looking for opportunities to capture the flourishing US market while mitigating downside risk.

History says: ‘Buy the Dip’; we say: ‘Don’t hold your breath’.

Investors should be cognisant that an old friend of equity investors has returned after a year-long absence: share repurchases.

Year to date, nearly $400bn in buybacks have been announced by S&P 500 companies. If this pace is maintained through year end, it would be the second-largest amount on record, behind 2018, when the Tax Cuts and Jobs Act’s repatriation of overseas earnings led to outsize return of capital to shareholders. While Fed stimulus will likely diminish in the latter half of this year, buybacks are just getting started, particularly given the excess cash reserves many companies have on their balance sheets.

Corporations are not the only ones rushing to purchase equities; investors are too.

Flows into global equities this year are on pace to reach $1.18trn, according to Bank of America Global Research’s 1 July The Flow Show report.

To put this in perspective, such an annual pace would be more than 1.5 times the total flows into the space during the last 20 years combined. This has pushed valuations higher, but combined with strong economic and earnings growth, equities may ultimately grow into current multiples.

With growth robust and interest rates low, the current backdrop marks a shift from the last cycle when both growth and rates were anaemic, signalling an expectation of higher economic activity on the horizon – and abundant investment opportunities.

From an investment perspective, US equity investors should be looking towards firms who are already benefiting from the current economic growth. These firms will likely choose to expand, backed by strong earnings which translates to excess cash that can be reinvested in the business.

Placing a laser focus on these corporations that are gearing for growth means investors can take advantage of economic progress, even if broader consumption begins to ebb. In tandem, this approach adds a layer of protection against potential inflationary risk as these corporates will continue their growth trajectory regardless of consumer behaviour.

Finally, this bodes well for long-term investors as riding out the patchy market with investments in firms with strong balance sheets and growth projections provides an opportunity to get in early and capitalise on profits later, particularly when consumer spending rebounds and stronger capital spending takes place in the years to come.

Jeff Schulze is investment strategist at ClearBridge Investments

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