Acute threat: a looming U.S. recession
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The threat of a U.S. recession will add to a number of looming issues contributing to heightened financial market and economic complexities and uncertainties in 2020.
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While some of the latest economic data suggest that growth in the U.S. economy remains steady, some key market and economic indicators are more consistent with a downturn, like the inverted yield curve.
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The health of the U.S. consumer is likely to hold the key to the health of the U.S. economy and the potential timing of a U.S. recession.
In addition to the financial market distortions, debt overhangs and democratic challenges to getting ahead financially over the long term, lies the increasingly real potential for a U.S. recession in the near term. The reason an economic downturn is important is because of its immediate and acute effects on households, particularly as it relates to its potential to derail life transitions as emergency savings are put to the test, opportunities to get ahead are stalled by lending and labor market tightness and financial market volatility further complicate aforementioned retirement insecurity.
The making of an economic downturn
What is a recession? On the one hand, a commonly cited definition of a recession is two consecutive quarterly declines in GDP growth. The National Bureau of Economic Research, a highly regarded business cycle dating group, on the other hand, broadly defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales".
Put in simpler terms, a recession is a crisis of confidence experienced by businesses and consumers that is preceded by a set of events or circumstances (inflation shock, financial market disruption, war, social unrest) leading to a broad slowdown in economic activity. More than ten years have passed since the U.S. experienced its last recession and comes at a time when downturns tend to happen once every 5-7 years[1]. Does this mean that a recession is imminent?
[1] National Bureau of Economic Research, Business Cycle Dating, December 2019
Figure 1: Yield curve inversions lead recessions by 18-24 months
What the recession indicators are saying
While some of the latest economic data suggest that growth in the U.S. economy remains steady, some key market and economic indicators are more consistent with a downturn, like the inverted yield curve. More specifically, the spread, or difference between the yield on 10-year and 3-month U.S. Treasurys is historically consistent with a recession beginning 18 to 24 months after the spread turns negative.
Using history as our guide, an inversion of the yield curve in 2019 suggests that the risk of a recession is likely to increase in mid-to-late 2020. Nevertheless, no one measure can accurately predict a downturn in the economy and so it is important to look to other economic indicators for more confirmation of a likely downturn.
Figure 2: U.S. business confidence in decline on trade uncertainties
To be sure, measures of business and household sentiment are another statistically significant indicator of a potential recession. And lately, business confidence in the U.S. and globally has weakened from its peak in 2018. This comes as the positive effects of the U.S. Tax Cuts and Jobs Act have faded, and the U.S. has raised tariffs on important economic and trading partners like Canada, Mexico, China and Europe.
At the same time, China’s credit-fueled growth continues to slow, putting downward pressure on economic activity at home and among its important trading partners, including the U.S. Taken together, these and other financial market complexities and geopolitical uncertainties are contributing to a greater level of caution among business leaders.
This is important because as businesses lose confidence, they tend to cut back on discretionary spending activity like replacing aging equipment, expanding facilities or adding new jobs. At the same time, businesses tend to pare back on the amount of inventory held in storerooms, putting downward pressure on factory orders and manufacturing activity. Indeed, recent surveys of corporate executives suggest plans to curb capital expenditure and hiring activity in the coming year as corporate earnings growth are expected to slow.[2]
[2] Duke Fuqua School of Business, “Duke CFO Global Business Outlook”, September 2019
Figure 3: Economic growth forecasts downwardly revised
A slowdown is coming, consumers may hold the key
Recession or not, economists have ratcheted down their expectations of global growth and largely expect economic activity to weaken in 2020. Most notably, the International Monetary Fund in October 2019 published revisions to its World Economic Outlook that suggest global GDP growth will slow to levels not seen since the 2008-2009 global financial crisis. And while slower economic growth does not necessarily portend a recession, it does increase an economy’s susceptibility to a downturn, particularly at a time when a few recession indicators are flashing amber.
One factor underpinning positive economic growth and arguably staving off an economic downturn has been the resilience of household spending. U.S. retail spending growth has largely surprised to the upside in 2019. And this followed a rebound in global equity markets and the prospect of falling interest rates earlier in the year, which likely buoyed household sentiment and underpinned household consumption in major economies. A key question today, however, is whether this virtuous trend in spending can continue amidst a host of uncertainties, particularly as elections and trade uncertainties loom in 2020.
Moreover, the buoyancy of consumer sentiment is likely to remain tied to developments in the business sector. As business uncertainties grow, employers are likely to further curb hiring activity. This means that the current slowing pace of job gains is likely to be exacerbated by falling sentiment, making it harder for some people to find work and leaving others worried about their own job prospects and potentially feeding into a cycle of falling discretionary spending and hiring activity.
Either way, with government spending constrained and business spending expected to slow, a decline in household spending could tip the U.S. economy into a recession, leading to a period of heightened economic and financial market volatility and challenging households’ ability to get ahead financially.
In our final post in this series, we discuss how households can get ahead, financially, despite growing financial market and economic complexities and uncertainties.
This post is an excerpt from our report, Getting Ahead Financially in 2020. You can download this report in its entirety by visiting franklinmadisonadvisors.com.
Important Disclosures
Broadview Macro Research is a division of Franklin Madison Advisors, Inc (“FMA”). The commentary provided on this website is limited to the dissemination of general information pertaining to Franklin Madison Advisors’ investment advisory services and general economic market conditions and are subject to change without notice. The information contained herein is not intended to be personal legal, investment or tax advice or a solicitation to buy or sell any security or engage in a particular investment strategy. For additional information about FMA, including fees and services, please contact FMA or refer to the Investment Adviser public disclosures.
Franklin Madison Advisors, Inc., is registered investment adviser firm with its registration and principal place of business in the Commonwealth of Pennsylvania. Registration of an investment adviser does not imply a certain level of skill or training. FMA is in compliance with the current notice filing requirements imposed upon registered investment advisers by those states in which FMA maintains clients. FMA may only transact business in those states in which it is notice filed or qualifies for an exemption or exclusion from notice filing requirements. Any subsequent, direct communication by FMA with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For additional information about FMA, including fees and services, please contact FMA or refer to the Investment Adviser Public disclosures. Please read the disclosure statement carefully before you invest or send money.
To learn more, visit us at http://www.franklinmadisonadvisors.com
Brace for more uncertainties in 2020
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An undercurrent of seemingly benign financial market and political developments are poised to move both prepared and unprepared households further away from their financial goals in the coming years.
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These issues include monetary policy-related financial market distortions, a drag from excessive global debt and the rise of geopolitical uncertainties.
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Households attempting to financially prepare for the future will need to contend with financial market distortions that induce greater risk taking, debt constrained growth that lead to increasingly more expensive investment options and weaker economic activity and political developments that have the potential to batter financial assets.
An undercurrent of seemingly benign financial market and political developments are poised to move both prepared and unprepared households further away from their financial goals in the coming years. Contributing to this outlook includes the fact that the global economic ties that had in recent years contributed to higher standards of living for millions of people globally are at risk of unwinding with the rise of populist politics and social unrest. At the same time, policy responses are forcing some savers into riskier investments and creating unsustainable excesses in debt and equity markets.
How financial market distortions make it easier to lose money
Central banks, in a bid to reverse slower economic growth and weak inflation, have maintained unconventional monetary policies since the height of the Global Financial Crisis. Doing so has nevertheless led to certain distortions in the global financial system, like extremely low interest rates (negative in places like Europe and Japan), excess liquidity in some corners of the financial system and liquidity shortages in others.
And these policies aren’t likely to go away anytime soon as gross domestic product (GDP) and inflation in the U.S., Europe, Japan and China remain weak, prompting policymakers to remain committed to unconventional monetary policies for the long term.
Figure 1: Major government bond yields remain in decline
This has two important implications for both savers and retirees when it comes to asset accumulation and distribution strategies. First, lower central bank interest rates have put downward pressure on traditional fixed income asset yields. What this means is that individuals and institutions setting aside funds to meet long term obligations will either need to put away more money today to boost saving levels or allocate their savings to high yielding (and often riskier) financial assets to generate higher investment growth rates.
There is no such thing as a free lunch and so the cost associated with higher returns is either the increased time need for more investment due diligence on riskier assets or the need for greater investor risk tolerance for inevitable swings in market prices. Either way, these central bank policies have effectively made it easier for unprepared savers to lose money by incentivizing higher allocations riskier investments.
Figure 2: A notch above junk: BBB rated corporate bonds a key market risk
At the same time, the number of firms rated as financially risky has increased as lower borrowing costs provide a support to otherwise structurally uncompetitive firms. Typically, rising interest rates late in the business cycle has the natural effect of weeding out weak firms as revenues typical with selling goods and services dry up and increased borrowing becomes prohibitive. Yet, lower rated firms have been given an artificial lifeline as central banks maintain extremely accommodative policies, keeping borrowing costs lower than usual.
Further, lower rates have pushed up valuations of riskier investments like stocks even as corporate earnings growth has weakened recently. The implications here is that valuations for some stocks and bonds, particularly those of lower quality issues, may become susceptible to outsized price swings when political or economic concerns inevitably lead to bouts of increased market volatility. Lower interest rates have also contributed to a notable rise in the amount of debt outstanding globally.
Figure 3: A rise in global debt will challenge growth for years to come
Debt and when a rising tide does not lift all ships
According to the Institute for International Finance, total public and private debt outstanding globally was $246 trillion at the start of 2019, which is 50% higher compared to a decade ago and nearly three times the annual output of the global economy. At some point this debt must be paid back, which becomes increasingly problematic and a rising source of financial market volatility when economic growth rates for major global economies are expected to remain subdued in the near term.
Closer to home, the cost to service debt is actually below where they were prior to the Great Recession in the U.S. Yet, lower interest rates have created an incentive for households to borrow more money, pushing up the value of non-financial assets like home prices and contributed to the ballooning cost of education, crowding out other discretionary spending and in some cases making important life transitions harder to attain.
And while lower interest rates have reduced government debt service costs, Washington has only increased debt-fueled deficit spending and hindering its ability to invest in important growth-oriented infrastructure projects. Taken together, what this means is that households and governments alike increasingly remain constrained in their ability to spend on growth-oriented ventures as balance sheets remain hampered by ballooning debt piles.
Therefore, potential economic growth rates (and rates of corporate earnings growth) are likely to remain subdued in the coming year, further challenging firms’ ability to service growing stockpiles of debt and potentially leading savers to buy investments at a time when asset prices are becoming more expensive and economic and market risks are increasing.
Figure 4: A rise in global policy uncertainties has challenged growth
Reasons to be worried: geopolitics and Main Street uncertainty
And if low interest rates and a debt overhang didn’t already complicate financial strategies for preparing for the future, a rise in geopolitical tensions has contributed to a rise in economic and financial market concerns. This comes as the U.S.’s Trade War with Canada, Mexico, the European Union and China has led to higher prices paid for goods by some households and a simultaneous decline in business confidence. What’s more, the unclear outcome of the 2020 U.S. presidential election is likely to intensify political uncertainties that markets, businesses and households have already contended with in the past year.
From a trade policy perspective, leaders on both sides of the political aisle remain energized to address economic issues caused by past trade policies, particularly as it relates to the U.S.’s seemingly unbalanced relationship with China. And so, the implication here is that while a partial trade deal between the U.S. and China may be secured at some point, tensions between the U.S. and China are likely to remain elevated for years to come irrespective of the 2020 election outcome.
Meanwhile, some U.S. presidential candidates have proposed tax and spend policies that are likely unfavorable for some families and complicate long-term estate planning considerations. Moreover, financial markets – abhorring uncertainty – are likely to become increasingly choppy heading into the 2020 U.S. elections as the potential for notable shifts in trade or economic policies brought about by shifts in the executive or legislative branches are likely to buffet risk asset prices and dampen near term business and consumer confidence.
Taken together, households attempting to financially prepare for the future will need to contend with financial market distortions that induce greater risk taking, debt constrained growth that lead to increasingly more expensive investment options and weaker economic activity and political developments that have the potential to batter financial assets.
Above all, these developments have the potential to raise the risks of a U.S. recession which we cover in our next post.
This post is an excerpt from our report, Getting Ahead Financially in 2020. You can download this report in its entirety by visiting franklinmadisonadvisors.com.
Important Disclosures
Broadview Macro Research is a division of Franklin Madison Advisors, Inc (“FMA”). The commentary provided on this website is limited to the dissemination of general information pertaining to Franklin Madison Advisors’ investment advisory services and general economic market conditions and are subject to change without notice. The information contained herein is not intended to be personal legal, investment or tax advice or a solicitation to buy or sell any security or engage in a particular investment strategy. For additional information about FMA, including fees and services, please contact FMA or refer to the Investment Adviser public disclosures.
Franklin Madison Advisors, Inc., is registered investment adviser firm with its registration and principal place of business in the Commonwealth of Pennsylvania. Registration of an investment adviser does not imply a certain level of skill or training. FMA is in compliance with the current notice filing requirements imposed upon registered investment advisers by those states in which FMA maintains clients. FMA may only transact business in those states in which it is notice filed or qualifies for an exemption or exclusion from notice filing requirements. Any subsequent, direct communication by FMA with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For additional information about FMA, including fees and services, please contact FMA or refer to the Investment Adviser Public disclosures. Please read the disclosure statement carefully before you invest or send money.
To learn more, visit us at http://www.franklinmadisonadvisors.com
Let the good times roll: the beginning of the end?
Stock market prices continued to grind higher as economic data releases surprised to the upside this week. Indeed, a host of indicators suggest to some that growth in the U.S. may in fact be improving after a softer showing in 2019 which has supported a rally in risk assets not just in the U.S. but globally this year. A key question for investors and savers now, however, is whether the good times are just getting started or the data mark the beginning of the end of good economic times.
We have argued that 2020 is likely to mark the beginning of the end for U.S. economic buoyancy and financial market resilience. Indeed, longer term indicators point to a rising risk of economic and market disappointment this year with recession related risks remaining elevated and not decreasing even as Fed policymakers would otherwise like people to believe.
What this means is that households should increasingly prepare for higher levels of economic and market volatility in 2020. This includes taking efforts to increase net positive cash flows, building up emergency reserves, rebalancing investment risk exposures and generating cash in investment portfolios to cover an extended period of retirement living expenses as market volatility increases.
Figure 1: Market momentum near 2-year high
Why so glum?
Key data releases hailed by the financial markets this week included seemingly robust retail sales and housing market data. The reports pointed to generally better than expected activity in December and capped a strong finish to an otherwise lackluster year for both sectors. Indeed, government data showed that December retail sales grew at its fastest year-over-year pace (+5.8%) since August 2018. This compares to a meager 1.6% rate in December 2018 and contrasts a period of general economic malaise in the fourth quarter of 2018.
Similarly, reports on building permits, housing starts, mortgage applications and builder confidence all trended higher in the month of December, pointing to a rebound in housing market activity. Building permits, for example, were up 11.4% year-over-year at the end of the fourth quarter of 2019 compared to a decline of -1.8% in 2018. What’s more, builder sentiment rose to its highest level in over 20 years as mortgage rates remained low all the while December UofM Michigan Consumer Sentiment rose to its highest level since May 2019. Taken together, these developments have given financial markets a reason to keep pushing higher this year.
To be sure, market participants have been heartened by the seemingly positive economic data and the S&P 500 is now up over 3% in January, making new all-time highs in 10 out of the first 12 trading days of the year. Year-to-date, riskier international equities are in some cases outpacing the U.S. with China up 5%, Mexico up 6% and Turkey up 7.3%. These developments come even after the threat of war between Iran and the U.S. and ongoing impeachment proceedings on Capitol Hill. So why are we so pessimistic on the market and economic outlook?
Figure 2: Stretched equity market valuations
No so fast...
While it is tempting to extrapolate positive near-term developments into the future, the truth is that cyclical factors that we track suggest that economic and market conditions may be more fragile than the recent historical data suggest. Take, for example, the latest labor market data. While December payrolls bested estimates, the trend in new job growth remains biased to the downside. This is evidenced in the latest nonfarm job openings data, an important leading indicator of labor market developments. To be sure, the rate of employers putting out ads to hire new workers declined -10.8% in November and is on track for their worst rolling 12-month pace of growth since 2017.
This is important because, if labor market conditions continue to deteriorate, and business sentiment weakens as our projections suggest, then growth in the U.S. economy is likely to remain weak in the first half of 2020. Such a development would put downward pressure on corporate revenues, leading to earnings disappointments in the year and giving market participants a reason to step back from their expensive positions in stocks. What’s more, a continued decline in labor market conditions, weaker economic sentiment and increased financial system instability could lead to a rising risk of a U.S. recession in 2020.
Figure 3: Labor market conditions waning
Juicing the markets
To be sure, equity prices have been on a tear since the Federal Reserve quietly restarted its asset purchase program, increasing the size of its balance sheet by 11% since August 2019 even as Chairman Powell asserts that the Fed has not restarted quantitative easing (QE). Better near-term economic data aside, this form of money printing has arguably boosted risk asset prices all the while corporate earnings growth has slowed and the economic outlook remains weak.
The effect of central bank supported rising prices and stagnant earnings growth has contributed to stretched valuations in the equity market. In other words, U.S. stocks, as measured by the S&P 500 are now more expensive than they have been in the past two years when measured by its trailing and forward-looking P/E ratio. And these stretched valuation measures have also been showing up in other parts of the equity market, particularly in the growth style of large, mid and small cap U.S. stocks as a whole.
Figure 4: Recession risks remain elevated
Preparing for economic and market uncertainties
The fact that risk asset prices continue to push higher even as geopolitical risks linger and economic fundamentals remain subdued has given us reason for pause. To be sure, we believe that the current rally in risk assets has more to do with the Fed’s unsustainable easy money policies which could set the stage for a pullback in prices this year. While central bank asset purchases have been supportive of lower borrowing rates and provided a near-term boost to housing market sentiment, we are hard pressed to find positive catalysts that would support a sharp economic rebound this year and hence underpin the financial market rally.
In fact, we believe that global easy money policies have contributed to systemic excesses, and are providing a lifeline to firms that otherwise should no longer be in business. History has shown that such excesses do not continue in perpetuity, and when combined with our latest business cycle work, suggest that risk of an economic downturn and heightened market volatility is likely to increase this year. Taken together, we believe that recent market exuberance could be marking the beginning of the end to this economic and market cycle.
With the economic outlook set to weaken this year and financial market volatility likely on the rise, we recommend households take some constructive steps to remain prepared for the unexpected. First, we recommend households take a step back and reevaluate the vision and purpose for their money as they look ahead into 2020 and beyond and determine whether their plans are in alignment with current economic and market conditions.
Next, we recommend preparing for rising uncertainties by increasing net cash flows by reducing discretionary spending and finding ways to refinance debts given today’s lower interest rate environment. We also suggest reevaluating big ticket spending decisions, topping off emergency savings and ensuring employer-matching contributions are maxed out. We believe that these steps will better prepare households for unexpected life events, particularly as labor market conditions show signs of weakening in the coming months.
For investors oriented towards asset growth, we recommend maintaining a diversified investment exposure and stepping back from riskier investments. Further, households would be best served by ensuring that aggregate portfolio holdings across all investment accounts are in alignment with their long-term goals. This includes rebalancing portfolios to target allocations and trimming winning positions to raise cash to keep as dry powder for when market volatility creates favorable buying opportunities.
Finally, for households taking distributions from investment, we recommend rebalancing accounts to long-term investment objectives and reduce unnecessary risk taking. Further, we recommend ensuring that cash positions are adequate to meet 6-12 months of living expenses. This is intended to avoid forced selling at depressed prices when market volatility increases.
Figure 5: Preparing for the unexpected