Rumblings of Recession
Observing nature can provide some insight into how forces and elements interact with one another to create various phenomena. For example, large earthquakes are often preceded by smaller earthquake swarms. The July 2019 earthquake in Ridgecrest, California was preceded by a large number of quakes that rose in severity leading up to the final magnitude 7.1 event.1 Those earlier smaller seismic shocks led local experts to warn of the potential for the larger event prior to its occurrence.
Though human constructs largely based in psychology and math, financial markets have many commonalities with the natural world. One is that historic calamitous market events have often been preceded by a variety of different indicators that the prudent market participant should pay attention to when considering future investment potential. Also, like the natural world, no one piece of information on its own is likely to be the only variable of importance in any forecasting model.
In the earthquake example, the number of quakes isn’t the only piece of information that matters; the relative strength and proximity to a fault line are also thought to be important predictors of future seismic activity as well. In the last 365 days, 17,922 largely meaningless small earthquakes have occurred in California (as of August 19, 2019), but only the Ridgecrest quake was of significant size.2 Discerning relevant quake activity from insignificant events must be a real challenge for seismologists. Like those responsible for the government’s early warning systems, being a successful investor takes a certain level of discipline and patience to sort meaningful information from the data noise.
As with natural disasters, it is important to take some precautionary steps, like stocking up on emergency supplies, to prepare for and avoid panicking when a crisis inevitably hits. Paying attention to various market data points can help provide early warning signs and enable some preparation for financial disasters, as well.
Early Warning Signs
At 121 months, the current U.S. business expansionary period is now the longest on record. Since 1854, the average expansionary period is 40 months long. Old expansion age is not necessarily a predictor of future recession, but it is definitely worth noting when a statistic is at some level of extremity. Looking globally, it can be seen that it is possible for expansions to last much longer. For instance, Australia is currently on its 27th year of economic expansion (over 324 months).3 Thus the current U.S. expansion’s age can be discounted as a real threat, while still remaining a point of interest since it has been an abnormally long time since a recession has occurred in the United States.
Source: Investor Caution in Order as U.S. Economy, Markets Climb Higher. (July 22, 2019). Eaton Vance.
Of greater importance is manufacturing and services data that provide evidence of either a shrinking or growing economy. This is something to worry about as, especially in international economies, a trend towards economic slowing exists in both manufacturing and service industries. In the table below, scores above 50 represent economic expansion and scores below 50 represent contraction. While the U.S. scores remain above 50, there is a definite downward trend in the data for major European and Asian countries. Services (i.e. non-manufacturing areas like technology and health care) remain a relative global bright spot, though slowing appears evident there as well. The main takeaway here is that slowing levels of growth, if not outright contraction, raise the risk of future economic recession on a global scale.
Source: Market Outlook Slides. (August 6, 2019). DWS.
Another early warning sign is delinquency rates on consumer loans (mortgages, student loans, credit cards, etc.). Generally during good economic times with strong employment levels, the average person becomes optimistic about the future, which creates a tendency for the general population to overextend itself via various types of debt. Eventually the servicing (payments) on this debt becomes overly burdensome and delinquency rates (the ratio of people who can no longer meet their ongoing payments) begin to rise. As the chart below demonstrates, since at least 1965, there has been a strong relationship between delinquency rates, future unemployment levels and future economic recession. In the three most recent examples, recession has followed a spike in delinquency rates within one to five years of the lowest level’s occurrence. Let it be noted that delinquency rates have spiked quite sharply in recent years. However, considering the longer end of the lagged effect time-frame (five years), this is obviously not something to panic about, but instead to be aware of in the context of other data points.
Source: Slok, T. (July 2019). Global outlook: The Fed is Right: Global Factors Threatening Us Expansion. Deutsche Bank Research.
Another significant recessionary rumbling is the inversion of the treasury yield curve, which your CWM team has written on and spoken of extensively over the last year, and has more recently been grabbing major news headlines. Yield curve inversion implies that shorter-dated debt carries a higher interest payment than longer-term debt. This is a major sign of economic dislocation, as logically it should be more expensive to borrow for longer time-frames. Longer-dated debt with lower interest payments than those of shorter-term debt implies that major bond purchasers are expecting rates to be lower in the future and are interested in locking in higher income payments for longer time periods now. Lower rates are typically a result of more accommodative Federal Reserve interest rate policy, which is typically associated with weaker economic environments (like recession) and highly correlated with lower stock valuations. Thus it can be said the major bond buyers, like pension funds and others, are demonstrating a concern about the economy and market’s future by buying longer-term debt to a point that it pushes long-term rates below short-term rates. The graphic below shows how dramatically the yield curve has changed since December 2013 with the short end of the curve (left side) now higher than most of the long end of the curve (right side).
Source: Kelly, D. et. al. (August 15, 2019). Guide to the Markets. J.P. Morgan Asset Management.
Inversions have a strong history of predicting economic recession and recessions are not good for stock prices. The chart below shows the last three times the two-year to 10-year treasury yield inverted. The 1988 event was relatively benign from a market standpoint, but valuations were also much lower than they are today (more on that later).
Source: Smith, N. (January 2, 2019). Yield Curve Tells the Fed to Hold on Rates. Bloomberg.
Recession is not guaranteed just because an inversion has occurred (no recession in 1965, for example), nor is a near-term market sell-off necessarily imminent. Despite the negative history, markets generally rise after inversion first occurs for an average of 7.4 months, for an average gain of 9.52% before rolling over.
Source: Bank of America Merrill Lynch Global Research, Bloomberg, Global Financial Data.
While it is true that markets typically still rise after an inversion first occurs, it is also true that stock markets have dropped sharply and relatively soon after, as well. Looking at the last seven inversion events, only the 1988 inversion wasn’t followed by market loss. On average, markets bottom 14.85 months after the first inversion occurs for an average loss of 24.48%.
Source: CWM, MarketWatch, and Yahoo! Finance.
What the above factors, and others, suggest is that the risk of economic recession and the potential for a market calamity have increased. The New York Federal Reserve (NYFR) seems to agree, as it places recession risk at over 30% and rising. It’s worth noting that the last three times the NYFR put recession probability at greater than 30%, a recession did indeed follow. The earthquake warning alarms are ringing. Now is the time to prepare, just in case a negative market event does occur.
Source: National Bureau of Economic Research. Slok, T. (July 2019). Global outlook: The Fed is Right: Global Factors Threatening Us Expansion. Deutsche Bank Research.
The CWM Outlook: Reasons for Caution, Not Panic
Other areas of interest that space (and reader attentions spans) do not allow for greater discussion, but are worth noting, include:
- A potential hard Brexit (the United Kingdom leaving the European Union without a mutually agreed upon exit treaty) in October and the potential for other European countries to follow suit.
- The potential for a European economic recession (with or without Brexit occurring).
- The ongoing U.S. trade war with China.
- The large amounts of negative yielding debt across the globe.
- A large number of other significant geopolitical issues.
Despite all these worrisome issues, the U.S. economy and stock market can only be described as resilient. The table below shows the date of the most recent stock market high for each of the largest 20 economies in the world (G-20). The only stock market in the world to post a new record high since January of 2018 is the United States. The stock market in Italy hasn’t seen a new high level since 2009! (Note: GFC stands for Great Financial Crisis, a.k.a. the 2008 market crash). Even with all of the headline worries and political drama, the U.S. marketplace has provided strong investment returns in recent years, whereas major foreign markets have not.
Source: Ludolph, K. (July 23, 2019). Crescat Capital Quarterly Investor Letter. Crescat Capital.
U.S. markets have been outperforming global markets and there has also been a relatively low amount of volatility (standard deviation) in recent years compared to historical trends. It is worth noting that periods of low volatility are often followed by periods of higher volatility (i.e. violent asset price movement). Your CWM team is concerned about the rising chance of violent earthquake-like volatility in the market’s future.
Source: Taking Measure of the Markets. (2019). Virtus Mutual Funds.
When assessing the warning signs of rising market risk, your CWM team looks for clusters of negative data in four main factor groups: Valuation, Market Momentum, Investor Behavior, and Interest Rate data. These factor groups continue to be a mixed bag of information, with valuation posing the biggest warning sign, along with partial yield curve inversion. However, still positive long-term price momentum and very low interest rates (i.e. borrowing costs) are supportive of markets.
Valuation is a big concern because a core CWM philosophy is “expensive things are dangerous.” Equity markets are currently valued in the top quintile (top 20%) of historic valuations going back to 1928, as measured by Shiller CAPE (one of the many types of valuation metrics). The max drawdown (the worst top to bottom sell-off) from similar past levels of valuation has seen losses as great as 51% of value. Ouch!
Source: Taking Measure of the Markets. (2019). Virtus Mutual Funds.
Considering the above, it should be no great shock that the CWM forward-looking market estimates are negative at the moment. The interval graph below shows a fairly sharp change from earlier this year (when your CWM team was much more optimistic) with the biggest difference being a result of the partial yield curve inversion (starting in March) and higher asset valuations, which have occurred due to sharply higher stock markets in 2019. As mentioned above, inversion can be historically tied to economic recession and market calamity. Along with high valuations, inversion has a significant downside effect on the forward outlook. Positive market outcomes are not impossible, but downside risks have become pronounced.
Source: Arford, M. (August 19, 2019). CWM Two Year Asset Intervals. CWM.
The above is not a reason to panic, but it is a call to employ some prudent risk management tactics. CWM clients can expect that if markets begin to meaningfully deteriorate, your advisory team will take action to reduce portfolio risk exposure. For now, the best course of action appears to be to sit on one’s hands and see how things develop.
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P.S. If you can believe it, this baby girl turned 1 already!
1 Recent Earthquakes Near California, United States. (August 19, 2019). Earthquake Track.
2 Epstein, K. and Eunjung Cha, A. (July 6, 2019). California Had Its Largest Earthquake In Years — Then An Even Bigger One Hit. The Washington Post.
3 Australia Holds World Record for Longest Period of Growth Among Developed Economies. (November 28, 2018). Australian Trade and Investment Commission.
This article has been prepared and distributed for informational purposes only and is not a solicitation or an offer to buy any security or investment or to participate in any trading strategy. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a financial professional. Past performance is no guarantee of future results.
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