Geraldine Sundstrom, a managing director at PIMCO and portfolio manager who focuses on asset allocation strategies, keeps getting the same question from clients: “When is a recession going to come?”
At the 72nd CFA Institute Annual Conference, hosted by CFA Society of the UK, Sundstrom argued that we aren’t at the end of the economic cycle yet. As she sees it, we are late in the economic cycle, and she explained how investors can position their portfolios to take advantage of late-cycle growth while protecting against the risk of a recession.
What Keeps Us Up at Night
Sundstrom reviewed the usual culprits that could push the economy into recession, such as an overkill of monetary policy, oil shocks, an overheating economy, excess investment, or over-consumption. From her perspective, none of them seem likely to occur. “There is only one thing that keeps us up at night and could topple the economy into a big recession and that is a trade war,” Sundstrom said.
Sundstrom explained that there is a dichotomy in the markets that could explain the dynamics of fixed-income and equity prices. On one side are the “skeptics” in bond markets, pointing to signs that the global economy and trade are slowing; they believe that a trade war will tip us into recession. On the other side are the “believers” in equity markets, saying that the slowdown is behind us now that the U.S. Federal Reserve has removed its foot from the brake and China is using both monetary and fiscal stimulus to boost growth.
“There is a reason for views on both sides that are not necessarily wrong and they ebb and flow around the trade war and the risk of a possible recession,” Sundstrom said.
Sundstrom likened current trade tensions to a Cold War where discussions simmer and get hot or cold for a while. Neither country stands to gain from letting things boil over.
“In a Cold War situation, where you have two giant superpowers — the U.S. and China — who are both competing for economic, technological or digital supremacy, neither of these two athletes can afford to be sick or fall behind… or let the gap become too large,” she said.
Sundstrom explained that “Cold wars are very scary because there is an element of ‘mutually-assured destruction.’ But we know from game theory, these are some of the most stable systems because as soon as there’s a bit of weakness, all the power goes into trying to fill the gap or to giving a shot of adrenaline into this big competitor.”
“When you have the top two elite fighting for supremacy,” she said, “this is when records break and you have technological advances.”
Late Cycle Investing
Even though Sundstrom does not believe a recession is around the corner, she is increasing the overall quality of the positions in her portfolio to prepare for one down the road. “What quality means to us for countries and companies is that they have room to maneuver and to navigate higher volatility and potential adversity,” she said.
In fixed income, Sundstrom currently invests in securitized credits with collateral such as seasoned non-agency mortgages or short-dated AAA CLOs in Europe where she thinks the risk premium is too elevated.
Sundstrom also recommended overweighting investment-grade corporate bonds and, if investing in high yield, not going too far along in terms of ratings or or timing where you don’t have visibility of cash flows. “If you can combine a strong country/region with a strong credit within the region, you double your chances of being able to navigate rough waters,” she said.
For equities, Sundstrom likes companies in the U.S. and Japan that have a lot of cash on their balance sheets. She also prefers companies with strong business models, and she said that companies in Japan were especially underappreciated in this regard.
“We used to say companies with too much cash was a negative attribute,” she said. “But now, when you move to late cycle, you want to own companies that can buy back shares when prices become too low or maintain the dividends even with a downturn in their business cycle.”
Overall, Sundstrom recommended investing in high-quality equites, but she warned investors about factor drift, particularly migration among value, growth and quality factors, at this stage of the cycle. She also encouraged investors to make adjustments for the fact that we are in a disrupted world where quality is becoming more concentrated in certain sectors.
“The economic cycle is getting old and being dynamic is going to be key,” Sundstrom said. She recommended that investors keep emerging markets in mind, particularly China and Asia, where the maneuverability and quality factors are high.
Sundstrom also recommended taking advantage of episodic spikes in volatility. Her examples included going long (or short) emerging (or developed) market currencies to generate carry, or selling puts and buying calls to create asymmetric payout structures when equity markets are most fearful.
“When midnight strikes and Cinderella’s carriage turns into a big pumpkin, you’re going to have to do something. One way that you can help yourself better navigate the ‘recession moment’ is by investing in quality,” she advised.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image courtesy of Neil Walker