The U.S. economy is certainly maturing, and there are quite a few signs suggesting the same. However, investors tend to remain oblivion to this and invest in the same way that they have been doing for the past 10 years. Such investment patterns have historically resulted in massive losses to investors, but there seems to be no rush form investors’ end to get things right this time around at least. I believe this comes down to the human side of the investing process, and more often than not, we as investors tend to believe in all the good stories, and try to avoid negative stories about investing in equity markets.
In my opinion though, embracing a negative development regarding markets is not a bad thing in itself. Rather, it’s one of the key determinants of the performance of investor portfolios.
In this analysis, I try to provide more color on the current status of the U.S. economy, and provide a few guidelines as to how investors can better invest under the prevailing macro-economic conditions.
Is the economy really maturing?
The simple answer is a resounding YES!. It’s always better though to provide some proof of what I claim. In this segment of the analysis, I will present a few facts and opinions that prove the point made earlier; the U.S. economy is certainly maturing and nearing the end of the business cycle.
In my opinion, there are 2 key macro-economic level indicators which provide a clear understanding of the stage of the business cycle an economy is experiencing at any given point in time.
- Interest rates
- Inflation rate
If we start with interest rates in the U.S., it is no secret that rates have been rising since late 2015 consistently. As Quantitative Easing (QE) came to an end in 2015, the Fed settled for a more hawkish tone and continued to view the economy as heating, and reacted to this by raising the Federal Funds rate to cool down the heating economy.
Rising interest rates is one of the most-feared phenomenons by equity investors, understandably so, as equity market performance is negatively correlated with interest rates. As rates rise, borrowing costs rise in tandem and many companies give-up the growth plans that were supposed to be funded by assuming more debt. As such, the economic growth of an economy is expected to slowdown along with rate hikes, and this is exactly what has been happening for the best part of last 4 years in the U.S.
Rising rates is a sure sign of a maturing economy, as much as rate cuts are a sign of accelerated economic growth in the future.
As investors, we are now reaching a very interesting period as the Fed Chair Jerome Powell has remained dovish since last December. Even though we know that rates have been rising since late 2015, now the Fed is settled for a more patient stance and is expecting to hold on any rate hikes for at least another couple of months. This might sound promising to investors, but I only expect this patient stance of the Fed to short-live, and the FOMC will be keen to approve another rate hike as soon as economic growth in the U.S. starts accelerating once again and provides concerns to regulators.
A novice investor might wonder why regulators care so much about elevated levels of economic growth, so it’s important to understand that inflation levels rise to beyond controllable levels when an economy is growing at a faster clip than what the country can afford to. An unsustainable level of economic growth can elevate the price levels of goods and services artificially, and regulators often try to keep inflation at a pre-determined level. The best tool to keep inflation in check is monetary policies, and as such, fine-tuning headline interest rates has been one of the most adopted approaches to keep inflation in check.
Now that we talked about inflation already, we can have a look at how inflation rates have behaved recently.
Inflation rate has continued to rise over the last 5 years, and this has already prompted the Fed to take necessary actions to avoid an unnecessary hike. The recent decline in the inflation rate can be directly attributed to the recent decline we saw in economic activities arising from higher interest rates and the government shutdown in the U.S.
Even though the declining inflation rate has already prompted the Fed to be more cautious about planned Fed rate hikes in the future, I believe this provides a false sense of security for investors. Many investors have now forgotten that falling inflation levels and stable interest rates are seen at the beginning of economic recessions as well, as economic activities tend to decline considerably in comparison with the past.
All in all, the U.S. economy has grown at a stellar rate since the financial crisis, but it would be irrational to expect such economic growth in perpetuity.
What should you do as an investor when you realize that the U.S. economy is maturing?
I’m not going to suggest investors to pack up all the belongings and go into hiding when the economy is maturing and a recession looks more likely than ever. Rather, I’m going to suggest the total opposite. There’s no reason to panic, and it’s normal for economies to mature. Throughout the history, it has proven again and again that investors who hold on to their investments through thick and thin are going to make the most money from stock market investing.
However, this doesn’t mean that investors can hold on to their investment portfolio with stocks that are trading at rich valuation multiples and expect to see nice gains in the long-term. Investors need to realize the fact that valuations do matter, and riding the tide can give you attractive returns in the short-term, but such returns are not sustainable in the long-term.
As a first step, I believe investors need to do a thorough investigation of the valuation levels of stocks in the existing portfolio. Especially, I believe investors need to identify the sectors these companies represent.
Understandably, cyclical companies tend to perform poorly when a recession hits, as these companies rely on the overall economic growth to drive their company revenues and profits. Even though these stocks provide very attractive returns when economic growth rate remains at stellar levels, these stocks decline at a much faster rate than the broad market when the going gets stuff. As things stand at the moment, investors would be better off shredding the exposure to cyclical sectors such as consumer discretionary and luxury sector businesses.
Next, investors should place a special emphasis on identifying defensive stocks. Yes, you read me write. Defensive stocks! Defensive stocks are called so for a reason, and these stocks provide downside protection when economic growth slows down or when the economy enters a recession. Sectors such as utilities and consumer non-cyclical sectors are prime examples of defensive sectors.
As an investor, I believe it is very important to diversify into these sectors from now on, before it’s too late to consider this.
On the other hand, investors should place a special emphasis on investing in dividend paying stocks as well. Such stocks will continue to provide a steady income stream when capital appreciations are hard to find by, and these dividend distributions will offset any capital losses an investor might experience.
In this article, I’m not intending to discuss individual stocks that are looking very attractive to be included into any investor’s portfolio, but in my next article, I’m planning to list down a few dividend paying, defensive stocks that will improve the overall diversity of the portfolio and position the portfolio to perform better even if an economic recession hits the U.S. within the next 5 years.