image

The Odds for a US Recession


  • The current is the fourth-longest US economic expansion period with 84 months of growth.
  • Investment spending has been declining for the last 4 quarters.
  • Recession forecasts indicate increased chances in the medium term.

Introduction 

The scariest word for any investor is the word recession. A recession arises when there is negative economic growth for two consecutive quarters. No economic growth makes it difficult for businesses to grow as people tend to spend less and save until better times come around. This creates a spiral as less spending forces companies to lay off employees and further cuts investments. If prolonged economic hardships persist, governments intervene with quantitative easing or with other projects to get the economy going again. A recession has an immediate negative impact on financial markets as investors become more risk averse and seek security above all.

1 figure gdp declines and stock market
Figure 1: S&P 500 and recession signals in the last 10 years. Source: Yahoo Finance and author.

Even a simple quarterly GDP decline ignites fear in the markets and influences a decline. In the long term there is nothing to worry about as recessions are normal parts of economic cycles, but some decisions related to individual investing goals can be made based on the probability of a future US recession in order to minimize risks.

2 figure economic cycle
Figure 2: Economic cycle. Source: mrshearingeconomics.

Current Situation

The current situation is odd as the quantitative easing that is supposed to turn around an economy is still going on with low interest rates. Usually governments stimulate the economy until growth is reached, but since the financial crisis governments have kept stimulating economies in order to prevent any recession signs. This artificial environment creates fears that if a recession should occur governments would not have any fire power to help the economy as interest rates are already at historic lows and liquidity is not an issue. This limited government potential action is what scares investors as there would not be any short term backup in case of a recession.

The last US recession ended in June 2009 which puts the current economic growth period at 83 months or almost 7 years. Based on data from 1949 from the National Bureau of Economic Research (NBER), average US economic expansions last for 58.4 months and contractions for 11.1 months. As the current expansion cycle is already two years over the average, economic laws will eventually kick in.

3 figure 4thlongest expansion
Figure 3: Current US expansion is the fourth-longest to date. Source: Bloomberg.

Modest growth or stagnation is forecasted for the next few years as employment is reaching its full potential and any unplanned macroeconomic shocks might influence a recession. The 0.5% economic growth in Q1 2016 certainly has not helped. Investment spending is a forecasting indicator as it shows when full potential spending has been reached due to satisfied demand. As targeted levels of capacity are reached, companies begin to limit investments and return more capital to shareholders. Gross private domestic business investments have been declining for 4 quarters and the below chart shows how this is a good recession indicator.

4 figure domestic investments
Figure 4: Gross domestic private investment: Domestic business. Source: Federal Reserve Bank Economic Research (FRED).

In two previous occasions, as investments slowed down, recessions appeared. Morgan Stanley gives a 30% chance to a recession occurring in the next two years and while Deutsche Bank gives a 50% chance in the next four years. Jim Rogers is more pessimistic and forecasts a certain US recession in the next year, Bank of America gives a 50% chance in the next year while JP Morgan is almost certain with a 92% chance of a recession occurring in the next four years.

5 figure recession probability
Figure 5: Probability of recession from a multivariate regression model. Source: JP Morgan.

Meaning for Investors

Except for the fact that a recession has a negative impact on financial markets, there are some other factors that have never been there historically and distort forecasts. The first interesting indicator is the comparison of the FED’s balance sheet and the S&P 500.

6 figure fed balance sheet and S&P 500
Figure 6: Correlation between FED’s balance sheet and S&P 500. Source: FRED.

The correlation is 90% in the last 7 years and shows how the increased liquidity supplied by the FED had a positive effect on financial markets as low interest rates increased corporate profits. The conclusion here is that if signs of a recession arise and the FED is limited in using easing methods like lower interest rates, the stock market decline is probably going to be fast, impactful and could easily create panic as the case was in August 2015 and January 2016.

According to the above, a recession is inevitable as the natural economic forces are bound to come to life sooner or later. It would be better to be later than sooner, but such events are impossible to time due to the many factors influencing and the FED’s ability to artificially alter the natural course of economic cycles. Unfortunately, the more artificial a situation is the more painful will be the return to long term balance.

Conclusion and Investing Strategies

The above economic situation has to be put into a risk reward perspective. A 50% chance of a recession means that a stock portfolio has a 50% chance of falling by 25% or more in a short time as markets usually anticipate recessions. With the current S&P 500 dividend yield of 2.13%, investors might analyze their risk and reward position.

Also a strategy has to be related to individual investing goals. Investing a large lump sum in the market at this point should be very risky while slowly taking the accumulated unrealized profits of the 7-year bull market might not be crazy. The market already gave investors two warnings with sharp declines in August 2015 and January 2016 followed by recoveries due to the FED’s action in August and commodities recovering in January. On the other hand, starting investors with small monthly investment amounts should be in the best position as a recession will enable them to buy investments at cheaper prices and therefore give better opportunities to their long term portfolio growth. For senior investors, a more cash oriented portfolio might be better as the risks outweigh the returns in the short term.

 

Previous
Next