Takeaway 1: Rumors of recession may be exaggerated
RBC’s Chief US economist Tom Porcelli is not convinced that the US is heading for recession on the strength of the ISM Manufacturing Index slipping below breakeven for the first time since 2015. In reality, the manufacturing output in the US is just 10% and while a dip in the Institute for Supply Management’s index may indicate a contraction in manufacturing, services is the industry that will really tip a coming recession in America. And even within the Industrials sector, the numbers are not offering a clear-cut indication of problems.
“People [right now] are more willing to believe the negative than they are the positive,” said Porcelli.
“[For example], on a month-to-month basis, auto sales really haven't moved all that much from even just last year. But people are latching on to anything that they think sells the story of negativity. There's not a lot of overwhelmingly negative data points out there that are going to change my call on if a recession is happening any time in the near term.”
Takeaway 2: The ‘rock-solid’ consumer?
One of the reasons for Porcelli’s optimism on the near-term future is that consumers are still spending. But there are factors that could undercut that, including that consumers get spooked despite strong fundamentals.
“The consumer has been rock-solid, it is the pillar of strength in the United States,” said Porcelli. But he added that consumers are starting to respond to macroeconomic trends in new ways.
“The consumer seems to be paying more attention to what's happening from a trade policy perspective, this is very atypical. At the beginning of June, when Trump was going to go after Mexico from a trade perspective, it was very interesting that the weekly consumer confidence numbers actually dipped.”
According to Porcelli, the same thing happened again when they first announced the September 1st tariffs, consumer confidence dipped. For this reason, there’s a real danger that the US will talk itself into a recession by scaring the spenders. But even if that happens, there’s a massive difference between the consumer stepping to the side lines of their own accord versus the consumer stepping to the side lines because jobs are being destroyed.
Takeaway 3: Prepare for downside risk
There are bulls and bears and neutrals in the market right now, as equities zig and zag and prediction becomes harder.
“Right now, we've got a bunch of strategists who are really bullish, a bunch of strategists who are really bearish and a few people like me who are somewhere in the middle,” said Lori Calvasina, RBC’s Head of US Equity Strategy. “Where we are today is that we think equities are going to continue to zig and zag through year end.”
However, despite the difficulties in prognosis for the market, Calvasina thinks there’s increased risk of a growth scare hitting the market in the wake of the ongoing trade war.
“I think one of the reasons why the markets have been vulnerable [to bad news] is that we've been stretched from both the positioning perspective and a valuation perspective,” she said.
“What the data is telling me is that an unwind has started, it hasn't finished and I do think we're still in a phase where we're vulnerable to more bad news. And that to me was really the implication of the trade escalation at the end of August. I don't think we've really seen the full implications of that last shock to business confidence.
“We're not really hearing about it so much at this conference, but I do think we will start to hear about it a bit once the next reporting season rolls around starting in mid-October, so I think we have to keep an eye on that.”
Takeaway 4: Defense is the best offense
Calvasina recommends defensive tilts to portfolios for now, as markets digest continued policy risk from the trade war with China and the upcoming US election.
“We like REITs, we like utilities and we like consumer staples. And we did upgrade consumer staples last November, utilities this past May and we just recently took REITs up. Now we like a few things about these sectors – number one, they have high yield so we like the fact that the dividend yield component is there and they benefit from the Fed easing cycle,” she said. “Frankly we've also found that when ISM is trending lower, these sectors consistently outperform – that’s just been a very clear consistent trade since the financial crisis. So they are your ways to play defense in the market.”
Takeaway 5: Protection from policy
For the industrial sector, the head winds from the trade war with China are a concern, but the potential policies stemming from the US presidential election are unlikely to concern companies.
“When we think about the 2020 election, we can't really identify a big issue that will hit this sector and we cannot say that about any other cyclical or global growth sector. Energy and materials get hit by the Green New Deal if we get a Progressive Democrat in the White House. The TIMT Tech Regulation that Elizabeth Warren has been talking about would potentially touch three different sectors - communication services, consumer discretionary and tech itself. And obviously healthcare and financial have regulatory concerns that might develop,” said Calvasina.
Takeaway 6: Small but significant
Small cap companies have had a very difficult time in the last year and underperformed significantly. They simply don’t have the margins to deal with labor shortages, the trade war or escalating input costs. But smaller firms are now in a good position, because they’re already so stripped back.
“Valuations in small cap are the cheapest we've seen relative to large cap now since 2002, they're even deeper than what we saw in the middle of 2016 before you had the big Trump rally in space. We think if there is some sort of draw down before year end in any significant way, small caps just have less risk of an unwind at this point in time,” said Calvasina.
1. On September 18th, Lori downgraded consumer staples to market weight from overweight and upgraded industrials from market weight to overweight.
