Leading indicators of global growth have extended their decline and the majority of the world’s PMIs are now below 50 suggesting a broad-based deceleration in economic activity (Exhibit 1). Escalating trade tensions, slowing Chinese growth and uncertainty related to Brexit are all factors weighing on economies, but central banks are offering support in the form of monetary stimulus. We have lowered our economic growth forecasts slightly and, while we don’t see a recession over our one-year forecast horizon, we recognize that downside risks have increased.

U.S. business cycle is mature

The longest streak of uninterrupted U.S. growth is showing its age. Diminished economic slack and low unemployment rates suggest little room for upside surprise. Moreover, the U.S. yield curve, a reliable indicator of past recessions, is inverted and financial market volatility has appropriately increased against this backdrop (Exhibit 2). Overall, our assessment is that the U.S. expansion is in its later stages with an increasing possibility that the end of the cycle is near, although we still weight the probability below 50% for the year ahead.

Exhibit 1: Global purchasing managers’ indices

Source: Haver Analytics, RBC GAM

Central banks are now actively delivering monetary stimulus

Consistent with an end-of-cycle narrative is the fact that many global central banks are now actively cutting interest rates and/or have hinted that further monetary easing is forthcoming. The U.S. Federal Reserve cut interest rates by 25 basis points at the end of July as insurance against mounting trade tensions and slowing growth outside the U.S. We expect the Fed will deliver several more rate cuts over the year ahead. In Europe, the central bank hinted at pushing interest rates further into negative territory and possibility resuming quantitative easing. All this monetary stimulus should ultimately provide a boost to growth, but history suggests it could take some time before the impact from rate cuts is felt by the economy.

Exhibit 2: U.S. yield curve vs. VIX volatility

Source: Bloomberg, RBC GAM

Valuation risk in fixed income markets is elevated

Bond yields plummeted to record levels in the past quarter, reflecting slowing growth, increasing downside risk to the economy and dovish central banks. German bund yields of all maturities up to 30 years are now below zero and more than US$16 trillion of global fixed-income assets are trading with negative yields. The U.S. 30-year yield fell below 2.00% to its lowest level on record and the 10-year Treasury yield is approaching its 2016 low. Our global sovereign-bond composite situates yields at their lowest level ever relative to our modelled estimate of equilibrium and suggests valuation risk is elevated everywhere, particularly outside North America (Exhibit 3).

Exhibit 3: Global bond market composite

10-year government bond yields relative to eqilibrium

Source: RBC GAM

Stocks encounter challenges, but can deliver decent gains if recession is avoided

Equity markets encountered volatility following a strong start to the year and performance has been much more varied over the summer. Developed market equities have declined slightly but still feature double digit gains year to date. Increasing trade tensions appear to be taking a larger toll on emerging markets, however, with EM equities having erased year-to-date gains and are trading near their 2018 lows (Exhibit 4). According to our models, U.S. equities are hovering close to fair value but non-U.S. markets offer relatively attractive risk premiums.

Exhibit 4: Relative performance

Price levels, indexed to 100 at start of the chart

Source: MSCI, Bloomberg, RBC GAM

Shifting investor sentiment has been the main source of market volatility and renewed earnings growth is a pre-condition to higher prices. S&P 500 profits have seen little to no growth in 2019 as compared to the 20%+ gains from 2018 supported by tax cuts and stronger economic growth. Looking ahead, the consensus of analyst expectations indicates relatively flat earnings for the remainder of 2019, but a re-acceleration into 2020 (Exhibit 5). In an environment of low interest rates and inflation and reasonable valuations even moderate corporate profit growth should ultimately be sufficient to push stocks higher. However, should economies enter recession and/or the trade situation escalates into a full-blown trade war, both the profit pool and valuations would likely decline and lead to materially lower prices.

Exhibit 5: S&P 500 Index earnings per share

Quarterly earnings % change from same quarter in prior year

Source: Thomson Reuters, RBC GAM

Asset mix – trimming equity overweight/increasing cash reserve

Our base case is for the economy to continue expanding at a moderate pace but our scenario analysis places a higher-than-normal chance of recession and a bearish outcome for risk assets. We also recognize that bond yields are extremely low and that prospective returns in fixed income are quite unattractive. Equities continue to offer superior total-return potential versus bonds over the longer term and we continue to favour stocks over bonds in our asset mix. Recession odds are now higher than they have been at earlier points in the cycle, so we feel it is appropriate to move further along the path of de-risking our portfolios that we have been following as the cycle has matured. We lowered our equity weight by half a percentage point this quarter, placing the proceeds to cash. Our current recommended asset mix for a global balanced investor is 57.0% equities (strategic: “neutral”: 55%), 40.0% bonds (strategic “neutral”: 43%) and 3.0% in cash.