Stephen Dover, chief market strategist and head of Franklin Templeton Institute at Franklin Templeton, discusses the outlook for the US economy and investment opportunities after the recent extreme market turbulence and equity sell-off.

While markets appear to be in a tailspin over recent US economic data, it is too soon to conclude that the US is heading towards recession, according to Stephen Dover at California-based investment manager Franklin Templeton.

The US recession risk is clearly on the rise, as reflected by the sharp swing in market pricing. Rising jobless claims, a poor July employment report and signs that manufacturing may be contracting have changed the narrative. That said, Dover believes that other indicators are less worrisome, including the latest non-manufacturing Institute for Supply Management survey, the second-quarter US gross domestic product report, and anecdotal evidence from retailers.

It is too soon, in Dover’s view, to conclude that the United States is heading towards recession. His views are echoed by other wealth managers. After the annual inflation rate in the US fell to 2.9 per cent in July – below economists expectations of 3 per cent – Nicolas Sopel, head of macro research at Quintet Private Bank (parent of Brown Shipley), thinks the recession risks are overblown. Swiss private bank Lombard Odier also believes that the US economy and consumers are in relatively healthy shape, and sees limited recession risks. See more commentary here.

Marked by sharp declines in global equity indexes, bond yields and commodity prices, markets have been roiled. Dover remains cautious on global equities. Based on historical analysis of periods of economic deceleration, he believes that growth styles will outperform value, and that quality is also warranted. He is concerned about earnings' disappointments – above all for smaller-capitalisation stocks.

Non-US markets have been particularly hard-hit, with Japan’s Nikkei shedding over 12 per cent in its second-worst trading day in history – a reminder that it is almost impossible to diversify equity risk by region (or by sector or style) during major corrections or bear markets.  Opportunity will arise but, in his view, it is premature to step in at this point.

Global fixed income
In recent months, Dover has been a strong proponent of extending duration, particularly in US Treasuries. However, as 10-year Treasury yields have plunged to near 3.7 per cent, from near 4.5 per cent earlier this year, it makes sense to him to take some profit. Corporate spreads have not yet widened by as much as declines in equity prices might suggest are warranted, but selective engagement into higher-grade and even higher-yield issuers should eventually make sense.

“The outlook for non-US fixed income markets depends for US investors to a considerable extent on the outlook for the US dollar. The dollar has slumped against other major currencies in recent days, above all against the Japanese yen as carry trades have been unwound,” Dover said in a note. To a considerable extent that reflects expectations of significant Federal Reserve easing before the year end. He anticipates that the dollar will eventually stabilise and even recover, but that could take time. Therefore, for risk-averse, income-oriented investors, Dover believes that non-US fixed income investments offer poor risk/reward trade-offs.

Alternatives
For some time, Dover has been cautious about private equity, with a preference within that class for secondaries. The lack of visibility, particularly during periods of rising fundamental risk, makes him reiterate his caution. Private credit is slated to be more interesting, particularly if banks become even more reticent to lend. Pricing should improve. Over time, Dover believes that long-term investors should be rewarded by attractive discounts – especially true for investors putting new money to work in this environment. Above all, he emphasises the importance of manager selection. “Alpha dispersion” (the gap between top managers and the rest) is likely to increase significantly as a result of market dislocations, he continued.

Dover believes that the Fed will cut interest rates in September and thereafter. Sopel said this week that a 25 basis points cut into the Fed funds rate is more likely than a 50 bps one in September. "The US economy is still growing on the back of solid domestic demand. The recent weakness in the US labour data led investors to start questioning the longevity of the cycle itself and whether the Fed has held interest rates in restrictive territory for too long," Sopel added. David Goebel, investment strategist at UK wealth management firm Evelyn Partners also believes that there is little to suggest that the Fed would go for a 50 bps cut in September. He thinks that the original expectation of a 25 bps cut is still the most likely outcome. 

Dover emphasised how historically, equity markets have had positive returns in the year after the Fed starts cutting interest rates. This is true whether the economy has dipped into a recession or avoided one. The average return one year after the first rate cut in recessionary periods is 4.98 per cent, versus 16.66 per cent in non-recessionary periods. Drawdowns were magnified in recessionary periods after the first rate cut, with the average maximum drawdown being 20 per cent, versus 5 per cent in non-recessionary periods.

Dover highlighted how globally, there are no “white knights" in the event a recession unfolds. China has shown little inclination to repeat the kind of stimulus it offered 15 years ago during the global financial crisis. Europe and Japan are similarly unwilling or unable to offer “locomotive support” to the world economy. “A US election rules out quick fiscal action. Markets, therefore, may be slower to react to good news via Fed rate cuts, when they happen, in light of those global constraints,” he concluded.