Economic data has been broadly underwhelming and leading indicators of growth continue to suggest a global economic slowdown is underway. Manufacturing purchasing managers’ indices have been declining for 18 months and JPMorgan’s global manufacturing PMI is now below 50 and at its lowest level since 2012 (Exhibit 1). Risks to the outlook include global trade frictions and upcoming deadlines with respect to Brexit and whether the U.S. government will raise the debt ceiling to avoid a potential government shutdown. While growth is indeed slowing and a number of risks exist, there are some signs that the current expansion can persist. U.S. consumption is holding up relatively well and non-manufacturing PMIs haven’t declined as much as their manufacturing counterparts. There is also evidence that productivity is improving and that the U.S. economy is capable of growing at a decent pace despite slowing employment gains.

Exhibit 1: Global purchasing managers' indices

Haver Analytics, RBC GAM

Central banks turn outright dovish

In response to slowing global growth and increased macro risks, major central banks recently voiced their intentions to deliver further policy accommodation. European Central Bank President Mario Draghi reiterated that he will do whatever it takes to stimulate inflation, suggesting a rate cut may be in the cards as soon as this week, and the Bank of England recently adopted a more dovish tone. In the U.S., Federal Reserve Chairman Jerome Powell hinted that the Fed was ready to act, opening the door for rate cuts as early as the next FOMC decision on July 31. There has been much debate as to whether the first cut would be 25 basis points or 50 basis points. We don’t think the backdrop in the U.S. calls for 50 basis points given that the unemployment rate is near a 50-year low and that inflation, as measured by the year-over-year change in the PCE price index, is only slightly below the 2.0% target. Investors anticipate more easing to follow the initial move with as much as 100 basis points in rate reductions priced in between now and the end of 2020 (Exhibit 2).

Exhibit 2: Implied fed funds rate

12-months futures contracts as of July 19, 2019

Source: Bloomberg, U.S. Federal Reserve, RBC GAM

Fixed-income valuation risk is acute

Government-bond yields declined in all major regions in the first half of 2019 as investors priced in slowing economic growth and central-bank easing. Credit spreads remain narrow and investments with attractive yields are becoming more difficult to find. In fact, the amount of negative-yielding debt has ballooned to over $13 trillion (Exhibit 3) and even yields on some “high-yield” bonds in Europe have slipped below zero. In this environment, there is a real risk of negative returns on bond investments and our models suggest valuation risk in sovereign fixed income in particular is elevated, especially outside of North America.

Exhibit 3: Barclays Global Aggregate Index

Market capitalization of negative-yielding debt

Source: Bloomberg, Barclays, RBC GAM

Equity rally pushes S&P 500 above fair value

Stocks have rallied since the beginning of June, supported by dovish central banks and a declining U.S. dollar. The S&P 500 led the global advance, rising nearly 10% from the start of June to a record high and nudging the index slightly above our estimate of fair value (Exhibit 4). Gains in non-U.S. equities have been less pronounced and other stock markets around the world remain at attractive distances below fair value.

Exhibit 4: S&P 500 equilibrium

Normalized earnings & valuations

Fair value estimates are for illustrative purposes only. Corrections are always a possibility and valuations will not limit the risk of damage from systemic shocks. It is not possible to invest directly in an unmanaged index. Source: RBC GAM

Earnings are critical to sustaining further advances in stocks

With the S&P 500 Index now above fair value, further gains will likely be paced by earnings growth. However, profit growth has stalled. Sixteen percent of S&P 500 companies have reported second-quarter results and, while about three-quarters have exceeded expectations, the aggregate earnings are still tracking flat growth for the quarter. Overall index earnings are being weighed down by the Energy and Materials sectors, as well as some large technology companies. However, the negative impact on earnings of declines in commodity prices may prove transitory and, looking ahead, analysts expect S&P 500 profits to re-accelerate in the fourth quarter (Exhibit 5).

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 – maintaining mild overweight stocks, underweight bonds

We expect the economy to continue growing, but recognize that the decade-long U.S. expansion is mature. While monetary stimulus can help growth, a 25 basis-point Fed cut is not substantial and rate cuts are generally consistent with the end of a growth phase. As a result, we maintain a cautiously optimistic stance in our asset mix. In fixed income, prospective returns are unattractive given the historically low or even negative starting point for yields and we therefore maintain an underweight position in bonds. In comparison, stocks offer much better upside potential, as long as the economy avoids recession and earnings growth resumes. That said, higher valuations in U.S. equities suggest our total-return expectations should be tempered. For these reasons we have only a small overweight position in stocks. Our current recommended asset mix for a global balanced investor is 57.5% equities (strategic: “neutral”: 55%), 40.0% bonds (strategic “neutral”: 43%) and 2.5% in cash.