The S&P 500 is 4.5% from its all-time high. After a very scary December, where the market fell by -9%, global equities have posted an impressive comeback. The V-shaped reversal has silenced slow growth concerns and recession fears. All of this in only a few short months.
This has been accompanied by a major Fed policy change. In October 2018, shortly after Jerome Powell assumed the Chair of the Federal Reserve, Mr. Powell said that the Fed planned to continue its quantitative tightening schedule. This was the last thing market investors wanted to hear as global growth concerns mounted. Powell was supposed to be non-academic and more amenable to real-life market needs. Global markets responded to this news by rapidly selling off risk assets. A few days later, in response to the violent selloff, the Fed reiterated patience and completely changed their rhetoric.
Last week, the Federal Reserve decided to leave interest rates unchanged with no plans to raise for the rest of the year. This leaves the 2019 end-of-year target rate at 2.25%-2.50%. At this point, this hardly comes as a surprise as most economists and investors expected as much.
So now that the Federal Reserve is more accommodative, the market has posted an impressive rally. There has been a 20% rally since Christmas Eve. But when you take a look under the hood, all is not well. Very little has changed in 3-months. GDP growth rate has continued to slow. Both government and corporate debt levels have continued to skyrocket. And the most telling indicator is that the 10 Yr – 3 mos Treasury spread is below zero, signaling an inverted yield curve.
So the question arises; are we nearing a recession?
GDP Growth Rate
The U.S. economic growth rate has been slowing since Q2 2018. This ratcheting-down is the primary reason why we have been experiencing market volatility.
As this growth rate cycle continues to slow down, we increase the probability for more market corrections like the one we just witnessed. To be clear, we are experiencing an economic growth rate slowdown but not an economic contraction. We still have positive growth, it is only slowing. However, what is interesting is that since the 2008 GFC, slowdowns like this have resulted in stock markets selloffs.
Will the slowdown continue or reverse itself? Of course, we don’t know the answer to this. However, if we take a look at the Weekly Leading Index, it suggests that a slowdown might continue.
Corporate & Government Debt
The recent corporate tax cuts have proven to be a boon for U.S. stock investors. It is important to understand that tax cuts like this only bring forward future demand and does little to create sustainable productivity growth, especially when our government is running a massive deficit. We can only bring forward so much future demand like this via debt.
The United States just posted the largest-ever monthly budget deficit in February at $234B. We currently have $22T in total government debt. And this is in an environment when we are supposed to be economically strong. What is going to happen when we experience an economic slowdown or even a recession?
Corporate debt is also raising some eyebrows. Current corporate debt levels are at $9T, representing 46% of GDP, a record high. However, the increased corporate margins (due to economies of scale, operational efficiencies, the recent tax cut, and others) allow for companies to service their debt payments without too much strain. So as long as revenue continues to show strength and margins are wide, corporations should be fine. But when revenue falls (emphasis on when as this will happen at some point), this has the potential to be a very big problem. Margins will shrink and companies will find themselves struggling to pay their debts. Expense cuts will take place, including layoffs, and the unemployment rate will rise, thus beginning the cycle of slower economic output.
Though, this behavior seems to be the norm with business cycles. Corporations load up on debt during periods of growth and shrink this debt during busts, so this is not unusual. It likely only signals the end of an economic cycle.
Inverted Yield Curve
As stated earlier, the inverted yield curve has significant implications. Last week, the 10-yr and the 3-mo Treasury bond yields have inverted. This means that the 3 month Treasury bond is currently yielding more (2.46%) than the 10-year Treasury bond (2.43%).
An inverted yield curve means that investors are losing confidence in the underlying economy and it typically precedes a recession. When considering forward-looking indicators, the yield curve is one of the more reliable recession indicators, though it is not perfect. It has resulted in a false positive before (1966).
An inverted yield curve typically occurs 19 months before a recession. Therefore, this does not mean that we are entering into a recession today. It just simply means that we might be entering a recession within a year or two (emphasis on might).
However, this data also means that it doesn’t hurt to be cautious in this environment.
How We Are Positioned
I know this post sounds quite bearish. I am not advocating that you sell all of your stocks. Quite the opposite, really. Stocks are the single best investment for long-term investors. Period. I am simply saying that you should seriously consider if your portfolio is allocated correctly, given your risk tolerance and the current environment.
For many of you reading this, you know that we invest only in passive ETFs (passive management typically outperforms active management) and that we manage portfolio risk during business cycles. If you believe that you are not correctly positioned in this environment, please feel free to contact us. We would be more than happy to assist.