Challenging the Predictions of Imminent Recession

October 6, 2019 – In the past months, the media has been preoccupied with talk of an impending U.S. recession. The reasons cited are numerous: the impeachment investigations, the longest-on-record economic expansion, the trade war with China, and poor manufacturing data–just to name a few. However, an imminent recession isn’t as likely as the press may make it seem. A recession is always a possibility, and will eventually come. If a recession is predicted long enough, the prediction is going to be right at some point. Making an economic or market prediction is easy. Assigning an accurate date to that prediction is the challenge.

We believe it is at least as likely that the expansion continues. The U.S. economy is still growing, inflation is very tame, monetary policy from the Federal Reserve is supportive, and employment is the best it has been in 50 years. The wild card is the trade deal with China. For the broad U.S. economy and U.S. financial markets, the impact of the dispute with China, until recently, has been much more psychological than material, with the exception of grain producing farms or other industries specifically targeted. However, the material impact has started to increase in the U.S., primarily from the indirect effect on the global economy. China’s economy is being hurt to a much greater extent than the U.S. Because of the large size of the Chinese economy, an economic downturn there affects Europe and Asia significantly. A global economic slowdown is the most probable consequence, which does affect U.S. markets.

Yet the risk regarding China trade seems to be asymmetric to the upside. The U.S. markets have priced in low expectations for a trade deal and, yet, the market is still growing. If there continues to be no deal, the economy is not headed for a cliff, but rather has an ongoing headwind. On the other hand, if the recession predictions happen to be correct, a real trade deal would likely be the catalyst to turn the economy back to expansion quickly, with the financial markets reacting to the upside immediately. It seems at this point the upside for the economy and markets from a real and substantive trade deal is disproportionately larger than the downside risk of a continued delay.

We continue to view the current U.S. stock market as slightly over valued. In contrast to the 9-month, year to date return in the table below, over the past 12 months which includes the steep decline last fall, the S&P 500 has gained a modest 4.25%. Earnings based on estimates for the quarter just ended are expected to be 3.7% below a year ago. That makes valuations higher and the overall market somewhat less attractive than this time last year. Even so, high quality U.S. stocks, in our view, are the most attractive investment with interest rates and economic growth still supportive, despite the earnings slow down.

In international markets there remains concerns over slowing global economic growth. Many foreign central banks have taken steps to boost growth by lowering interest rates, some of which were already negative. While more cautious and selective, we maintain an allocation to these markets for portfolio diversification.

Bonds have benefited from concern over slowing growth, along with low inflation, fueling an 10.3% rally in the benchmark U.S. Aggregate Bond index for the past 12 months. The 10-year Treasury ended the September with a yield of 1.67%, down from 2.00% at the end of June and lower by a full 1.00% for the year. Meanwhile, the 2-year Treasury yields are nearly the same at 1.65%. We continue to buy bonds to fulfil target allocations and are not anticipating significantly higher rates soon, adding to confidence in bond prices for the foreseeable future. With less than a tenth of a percentage point difference in the 2-Yr and 10-Yr yields, investors are not being rewarded for the added risk of longer-term bonds compared to short-term bonds. Similarly, accepting additional credit risk does not add proportionate return. We continue to use a conservative approach, monitoring interest rate risk and favoring shorter maturities and higher credit quality. When possible, we build core portfolios of individual municipal or taxable bonds and supplement with small allocations to specialty bond funds.

We diversify portfolios by including small positions in real estate and broad commodity indexes. Commodity indexes declined in the quarter on slowing global growth, while real estate surged on demand for income producing investment alternatives in this low-rate environment.

Although we provide an overview of many areas of the market, our focus when managing your portfolio is on your personal goal and an individualized strategy to reach that goal. We welcome your feedback and questions.