With US stock bulls taking a breather, while the narrative of the country's late economic cycle status is gaining ground. That gives investors a big reason to consider their positions. 

An economic model by Schroder Investment Management indicates that the US economy is showing signs of slowing down. The fund house's US output gap model estimates the difference between the actual and potential output of the economy, using unemployment and capacity utilisation as variables.

Schroders' model, which it says has been proven right four times out of six in the past, is signalling change in the US business cycle for the first time in two years. And the UK fund house isn't the only one noting signs of an impending US slowdown.

“Equity markets seem oblivious to weak economic news and could see a rude awakening if the data does not get better,” said Kathleen Anderson, client portfolio manager at ClearBridge Investments, a Legg Mason unit.

A recession typically lags the corporate profit peak of earnings at US companies by about 43 months, according to Anderson. “Hence by that measure, the risks of recession are not imminent, but it is definitely on the radar,’ Anderson added, while calling US equities “elevated”. 

After a record close near April-end, the S&P 500 is down some 2%. It is still up more than 18% in the past two years. On average, markets have risen over 40% between a profit peak to recession, said Anderson. 

The potential for a US economic softening has widespread implications. “If something happens to the US, given the close linkages, other markets won’t be able to stay unaffected,” said Janet Li, Mercer’s wealth business leader for Asia.

She said that she has been advocating emerging market debt and equities over developed markets to clients since the beginning of the year. Clients have also been preferring multi-asset credit and absolute return credit over plain vanilla credit investments, Li added.

DEVELOPED APPEAL

The signs of US economic weakness comes as long-only pension and sovereign wealth funds in Asia continue look to invest more in developed markets, particularly the US, as they seek out better returns. A fast aging population in many of the near-developed economies in north Asia has in many ways set the clock clicking on the pension funds in these regions.

Higher volatility amidst trade salvos between the US and China and the upcoming US presidential election in 2020 means risk-averse long only funds would find staying invested in American stocks a tad uncomforting, says analysts. 

The risk is heightened as exposure to equities has been increasing at the portfolios of such investors. Equities made up for some 40% of portfolios on average in 2019 from 32% in 2017, according to the analysis of nearly $5 trillion of assets under management by Mercer. These assets belonged to government, corporate, and mandatory pension schemes across Latin America, the Middle East, Africa and Asia.

Among other asset classes, 46% on average was invested in fixed income with 10% invested in cash and other assets and 4% in alternatives. Also, average foreign exposure rose 49% from 45% with exposure to foreign fixed income rising to 23% from 16%, Mercer said.

“This shift was notable in Japan, South Korea, Malaysia and Taiwan as investors sought greater geographic diversification,” it said.

Li has been advocating that investors assess their risk appetite periodically to avoid “shocks.”

Her caution comes despite the US Federal Reserve attempting to calm rising worries by reiterating its preference for low interest rates.

Although the “slowdown phase” will be prolonged and not end in recession, “recession is a possibility, especially if policymakers don’t respond to the threat,” said Schroders. But with inflation low, “central banks have actually been able to step in a bit more quickly than otherwise,” said Piya Sachdeva, an economist at Schroders in London.

But the cost of capital for US companies could potentially rise, shaving corporate profits, said Anderson. She recommends looking for relative bargains in the energy sector in the US, especially when larger energy companies are looking to buy smaller players. Oilfield equipment makers may too be a good buy coming after large energy producers deferred capital expenditure for nearly four years.

Anderson says large, well-capitalised biotech stocks look attractive relative to the large pharmaceutical companies and the broader market. The sector remains largely “under-owned” by investors and with significant stashes of overseas cash, could be a driver of acquisitions, she said.

For the time being though, risks remain.

“In a multi-asset investment context, the slowdown phase is the worst for equities,” and unsupportive of risk-assets in general, said Schroders’ Sachdeva.