News & Views: The Economy - What Now?

Guest Column by Chris Sheldon, Director of Investment Strategy, BNY Mellon

The following is an excerpt from BNY Mellon Wealth Management’s Investment Update. The Investment Update is a monthly economic and market commentary written by Chris Sheldon, BNY Mellon's Director of Investment Strategy. In this article, Chris discusses how the "green shoots" have taken hold and are now reflected in the markets. He also provides an overview of the firm’s current thinking and the resulting recommended investment allocation changes.

What Now?
Normally, three months seems like such a short time – a single spring season. But over the last 90 days, the world appears to have shifted on its axis. Just three short months ago, the questions on investors’ minds were: how bad? how deep? how long? how low? Dire predictions abounded. Six hundred on the S&P 500 loomed far closer than 1,000. Apocalyptic views of depression and nationalization were readily adopted. Predictions of any degree of market rise were sparse — and ridiculed.

During this challenging environment, we have used charts to show historical stock market performance after prior market bottoms, performance subsequent to dismal ten-year periods, and the importance of not selling at market bottoms. While important reminders and empirically sound, such charts undoubtedly can be viewed as arcane intellectual speculation and unrealistic. When we’ve heard from the media that “it’s different this time,” it is difficult to imagine upside potential. Yet, here we are again within spitting distance of 1,000 on the S&P 500. The question has shifted from “what’s next?” to “where do we go from here?”

This spring we were saying “less bad is the new good” to refer to economic data that, while still declining, was doing so at a slower rate. Indeed, the continuation of this trend has fueled the market rally and reduced the degree of risk aversion investors exhibited in early March. The employment report is a good example of this trend. A number that, in more normal times, would have been viewed as bleak was met with sighs of relief. Who would have predicted a year ago that “merely” 1.3 million jobs lost in the second quarter would be perceived as good news compared to the 2.1 million lost in the first?

Numerous other "green shoots" have taken hold and seem less likely to wither. Not only does the massive global stimulus appear to be working, but it may be working sooner than most economists and investors expected. Signs of diminishing negative economic forces, combined with improved credit markets, have reduced the appeal of the fear trade. Many of the asset classes that benefited from the flight to safety have underperformed recently, as investors have moved away from a maximum defensive position. As investors embraced some increase in portfolio risk, asset classes such as equities have benefited, while Treasury bond prices have declined with rising yields. At the same time, spreads have narrowed in municipal and high yield bonds and in other credit instruments at the cost of a fairly significant rise in Treasury yields.

Among fixed income investments, we continue to rate municipal bonds and investment grade taxable bonds as more attractive than cash and Treasury securities. With the recent rise in yields, Treasuries are much less overvalued than at the beginning of the year. While near-term yields may stabilize close to current levels, we believe that they likely will move higher over the next several years. A looming increase in issuance, improving economic growth and possible future inflation, combined with a larger deficit and weaker dollar, may put further upward pressure on rates.

What should investors who find themselves with too much cash and too little equity exposure do now? From a short-term perspective, it may be wise to exercise a degree of patience. Markets now better reflect the improved conditions we have described. Consolidation of recent gains in equities through a modest pullback is not surprising. Enduring frequent moderate corrections is a necessary part of long-term investing. We think it is unlikely that markets will continue to rise at the pace we have seen since early March. Over the short run, markets could be susceptible to an interruption in the “green shoots” improvements.

While equities typically move higher in anticipation of recovery, significant further short-term gains will require more investors to become convinced that the trend toward recovery will remain intact. Considerable cash remains on the sidelines. Better economic news and higher stock prices make it increasingly difficult for investors to justify maintaining significant cash positions in light of very low cash yields. Eventually, economic conditions will need to actually turn good, as opposed to less bad, to drive markets higher.

For long-term investors, we continue to believe that stocks will provide more attractive returns over the next ten years compared to the prior ten-year experience. Valuations remain attractive for equities, especially compared to other investment alternatives. Investors who are underweight in equities should consider rebalancing to their long-term targets.

At BNY Mellon, we have increased our suggested allocation to emerging market equities and commodities, based on early signs that many of the emerging countries, especially China, may benefit from local stimulus programs. Unlike past episodes, we believe that emerging economies actually may lead world recovery. After last year’s precipitous declines, we have been encouraged by the very strong run in emerging markets and the recent firming in commodity prices. Given these run-ups, a pause is plausible, but we see attractive current valuations and a compelling longer-term fundamental investment case.

The recent market experience is fresh in investors’ minds. Fortunately we endure such dramatic market conditions very infrequently. While the temptation to remain extremely defensive in portfolio positioning is great, the cost in terms of lower expected returns is very high. Short-term interest rates remain low. Therefore, the “cost” of safety remains high. We think investors will be better served by a diversified portfolio that balances the need to offer some degree of protection against extreme short-term declines, similar to those of 2008, with their long-term need to have some exposure to risky assets.

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