The United States is now in the second longest economic recovery on record. This recovery is currently six percentage points less than the average historic magnitude of recoveries. Based upon factors reviewed below, one could conclude a recession is unlikely until the third quarter of 2020. Typically, recessions are preceded by:
- Yield curve inversions: Normally precede a recession by an average of 11 months. According to Credit Suisse, “We would expect an inverted yield curve in mid-2019, implying recession in mid-2020.” This would include three rate hikes in 2018 and two more in 2019.
- Wage growth rising to 3.5%: This would hinder corporate profit margins and more importantly force the Federal Reserve Board into a tighter monetary policy. Full employment is anticipated to be reached in the United States when the unemployment rates reach 3.5%. Unemployment for the month of May (released June 1, 2018) hit 3.8%.
- Output gaps closing: Normally, a recession occurs 2.25 years after the output gap closes, implying the second quarter of 2020. The output gap is an economic measure of the difference between the actual output of an economy and its potential output. Potential output is the maximum amount of goods and services an economy can produce when it is most efficient – that is, at full capacity.
- A margin squeeze: Normally a recession occurs 2.7 years after corporate profit margins have peaked. Margins have not peaked as of yet. The eventual margin squeeze is likely to be caused by wage growth acceleration to 3.5% or over-investment, of which there are few signs so far.
- Deleveraging: 63% of the increase in global private-sector leverage since 2008 has come from China; however, according to CS analysts, there are few reasons for China to de-leverage just now. Also, in the U.S., free cash flow from corporations is still higher than total payouts: Recessions tend to occur two years after the corporate sector moves into a deficit scenario.
- Inventory cycles are much better managed and the Federal Reserve Board seems unlikely to risk a recession by raising the cost of debt financing too far.
Due to the factors mentioned above it is logical to remain overweight in equities. In the past 50 years, except for 1987, when the equity risk premium (ERP) hit a very low 1% (compared to the 5.1% current ERP), equities have never peaked more than 13 months ahead of a recession. De-risking typically only occurs in the six months before a recession.
One of the most frequent questions being asked now is, where are we in the economic cycle? According to Jamie Dimon, CEO of JP Morgan Chase & Co., “We’re probably in the sixth inning.” Moreover, building on the work of researchers at the Federal Reserve Bank of New York, probabilities of a recession at present have just a 10% likelihood.
Credit Suisse analysts have remained convinced, from research, that stocks remain favorable to bonds until the 10-year bond yield reaches 3.5%. As of this writing, the yield on the 10-year bond stood below 3%. Also, given the current rate of inflation, the net yield, after inflation, on the 10-year bond remains below 1%.
Regarding figure 25 below: Corporate profit is also a statistic reported quarterly by the Bureau of Economic Analysis (BEA) and summarizes the net income of corporations in the National Income and Product Accounts (NIPA). Corporate profit is the money left over after the corporation pays its expenses.
Thank you again for your continued long-term confidence and trust in all we do here at Vaughn Woods Financial Group to enhance the returns on your savings and investment portfolios. If you know others who could benefit from the ongoing monitoring and management energies of a professional manager please let us know.
Best Regards,
Vaughn Woods CFP, MBA
Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/ VWA00228
Bloomberg, June 1, 2018, Michelle Davis, Credit Suisse, May 25, 2018, Global Equity Strategy, Definitions by Investopedia