’ve heard there’s going to be a recession; I’ve decided not to participate.”
The dreaded “R” word – Recession – seems to be filling the financial news as of late. A couple weeks ago the interest rate on short-term bonds was for a brief couple of days even with and for a few hours here or there, higher than, the rate on long term bonds. All other things being equal, If you lend money you expect a higher rate of interest the longer it is going to take for you to be paid back on that loan. Since bonds are essentially loans, you would expect a 10 year bond to pay a higher rate than a one or two year bond. But sometimes the difference in these rates gets smaller, and sometimes they “invert” where the shorter rate is higher. This would be of little consequence if an “inverted yield curve” hadn’t been a perfect predictor of every recession since 1956. The problem with this predictor is twofold; first the time frame between the inversion and the recession has ranged from as short as seven months to as long as two years, so if you make radical changes now and the markets and economy keeps chugging along for two full years you could lose more upside short term than you make up by avoiding the downside later. Second, these indicators work until they don’t. The Federal Reserve seems to have made a dramatic about face in their policies, perhaps due to this indicator, and if they change course which then helps us avoid recession does that then disprove the indicator? This is a real chicken and the egg type argument for another time, but suffice it to say nobody really knows.
Here are a few news headlines for the past several weeks:
“A Recession is Coming, and Maybe a Bear Market Too.” Bloomberg, March 18, 2019.
“Global Recession Fears Overblown.” CNBC, March 28, 2019
“Bond Market Flashes Recession Warning.” NPR, March 22, 2019
“U.S. Recession Unlikely Says Former Federal Reserve Chair Janet Yellen.” South China Morning Post, March 25, 2019
“Recession, What Recession? CFO’s Expect Slowdown, Nothing More.” TheStreet.com, April 3, 2019
“Nobel Prize Winner Robert Shiller, ‘Greater Than Average Chance of Recession in the Next 18 Months’.” CNBC, March 19, 2019.
The last one is my favorite. Robert Shiller deserves a Nobel Prize for equivocation. So let me give you some of the reasons to think a recession is coming, and then I’ll give you some reasons to doubt one is coming – and then I’ll give you my opinion, which may only be slightly clearer than Profession Shiller’s.
As for reasons we might be headed for a recession. Well the aforementioned inversion of the yield curve is the most obvious. A pretty clear indicator that has been correct for over sixty years is nothing to sneeze at. People like to joke that economists have correctly predicted twenty of the last ten recessions, but the yield curve inversion unfortunately has a much better track record than that. However, it’s not the inverted curve itself that causes the recession it’s just an indicator one is coming. So if you’re looking for actual causes we can see those as well. Economic growth worldwide has slowed, the Organization for Economic Co-Operation and Development (OECD) compiles a list of leading indicators; that is things that tend to slow down before the overall economy, for 30 developed countries comprising more than 170 different statistics. Things like jobless claims, building permits and inventory levels. When this index is above 50 it’s considered expansionary; the index dropped below 50 late last year. The Purchasing Manager’s Index (PMI) which measures how much inventory business are buying is also down significantly, the job numbers have been lackluster the last few months and total global trade is down. Not to mention simply the time frame that we’ve been living in. Since the turn of the 20
h century we’ve never gone this long without a recession – if we make it to June we’ll have gone ten full years so it just feels like we’re due for one. Oh – and Great Britain seems determined to destroy itself economically by leaving the European Union in the worst, stupidest way possible.
We know recessions are part of the business cycle so we’re are not going to go forever without having one, but if you want reasons for us being at least several more years away we can find those as well. As for the yield curve, it is very flat – but it really hasn’t inverted. Short-term rates have not been lower than long-term rates for even a whole day. The market never closed for the day with the two year rate higher than the ten year rate, even if it bounced around that area for a few minutes here and there. When it comes to the obvious slowdown in trade and purchasing – there’s an explanation for that as well. Many businesses stocked up on inventory early last year when the tariff talk was at its height, buying twelve or eighteen months of inventory just in case these huge tariffs (there was talk of 50% or higher rates on Chinese goods) were put into place. With the ongoing negotiations between the U.S. and China those tariffs are on hold, and that overbought inventory is going to start to run out over the next few months. That is why in the headline above so many CFO’s are calling this a slow-down as they are still selling their goods at the retail end and know they’ll have to build back up their inventory pretty soon. As for the ten years since the last recession, well time is only one way to measure it. As far as years and months go this is the longest recovery we’ve ever had from an economic slowdown – but in terms of size it’s still far from the top. Based on the average growth rate coming out of recession since the end of WWII, over these past 117 months you would have expected the U.S. economy to have grown by over 40%. Instead it has grown by only about 22% from the Great Recession low. So which is it, do expansions typically last only about five years and we’ve gone two times too long? Or do expansions typically grow the economy by 40% and we’re only a little over half way there? Oh- and Great Britain isn’t really that important to the global economy anymore.
So what to do, what to do? I believe the chances are better than not that we will see a recession in the next six to eighteen months. If the Fed hadn’t reversed course the way it did, I would have been more confident and expected a recession on the shorter end of that range. However, even if we avoid a recession, which is defined as two consecutive quarters of negative economic growth, even a prolonged slowdown could have negative effects on the stock markets, and that’s what we’re paid to worry about. The stock price of the average stock vs. the earnings of that stock (called the P/E ratio) is currently very high. The markets aren’t priced for a recession, but they aren’t priced for anemic economic growth either – they’re priced for robust growth. Individually the price of a company’s stock can be wildly higher or lower than those averages and that price can be justified for that particular company. But when the whole market is overvalued, you have to worry. So at Keeling Financial we are doing two things to try and counter the possibility the markets have a deeper and more prolonged sell off than the quick dip we had in the fourth quarter of last year. First is what we always do, we overweight toward value companies (that is companies that have a lower overall P/E than the market) and smaller companies. These tend to be less volatile than the market as a whole and have proven to actually outperform over the long-term, (based on Nobel Prize winning research by Eugene Farma and others.) Secondly we are making some changes in the portfolios. Like most people in the investment world we believe in diversification to spread investment risk. But the correlation between different types of investments has tightened over time as it’s become so easy for people to invest in all types of companies all over the world. For example, in the 1980’s the correlation between the U.S. stock markets and the other “developed” markets (Europe, Japan, Australia etc.) was 50-60%, in other words those markets only moved together a little over half the time, that was a great diversifier. Today that correlation is closer to 75-80% - that still offers some diversification but not anywhere near as much as you’d expect based on the past.* So we are adding investments that either employ trading strategies or invest in asset classes that still offer significant non-correlation to our client’s other equity investments. These investments are not designed to “outperform” in fact if the markets continue to go up at the rate they have the last ten years they will under perform. But they can make money during a market correction and if no correction takes place, they can still go up – unlike if you just went to cash or tried to short the market, the first a move that rarely works and the second a move that can end in disaster.
If our current clients want more information on the specifics of those moves, we will of course discuss it at your reviews but feel free to give us a call in the meantime. For anyone else out there who may still be reading this newsletter but are not current clients, we’d be happy to discuss our investment philosophy, our core investment strategies, our ESG portfolios, and all the other services we provide under that money management umbrella – or for an hourly or “per engagement” fee. Enjoy the spring everybody and stay out of a recession.
Global equity investing: The benefits of diversification and sizing your portfolio
. Brian J. Scott, Kimberly A. Stockton, Scott J. Donaldson.
Vanguard, Feb. 2019