“Whenever You Find Yourself on the Side of the Majority, it is Time to Pause and Reflect.”
In our last letter we noted that the length of our current economic expansion had moved into record territory, and it continues. However, now that we are 125 months into the longest expansion going back to 1854, investors are working hard to convince themselves that its demise must be imminent. We do not agree. So, is the economy’s glass half-empty or half-full?
“The Report of My Death Was an Exaggeration.”
A multitude of economic measures, polls and data points are published on a regular basis and are now receiving extra scrutiny for potential signs of weakness. Sluggish economic results outside of the U.S. are extrapolated onto our economy, as if they are inexorably linked. Indicators that have had some historical accuracy in forecasting are being taken as gospel. This all brings to mind the Mark Twain quote above regarding the state of his physical well-being. Meanwhile, our economy and stock market continue to march onward and upward, albeit more recently in stutter step. Year to date through the end of November, the S&P 500 has advanced almost 25% and is up 8% in the past three months.
The November Institute for Supply Management (ISM) Manufacturing Index indicated that U.S. factory activity contracted for the fourth consecutive month and was near the lowest level since the end of the last recession. Stocks reacted very negatively to this news, concluding that the global manufacturing recession had finally reached our shores. Credit the ongoing trade wars for much of the manufacturing malaise, as reflected by a large decline in the “new export orders” component of the index. However, a similar survey of manufacturers from IHS Markit signaled slight economic expansion during the same time period. We conclude that the data is mixed and our overall economy continues to grow, albeit at a slower rate.
The prior shock to the market was triggered when the yield curve “inverted” with short-term interest rates exceeding those of longer maturity bonds. This indicator has an enviable but imperfect track record predicting recessions. Of the last ten inversions, seven were followed by a recession 12-24 months later. A major difference this time is the existence of negative yields on $15 trillion in government debt globally. Although interest rates in the U.S. are low, they are not negative. As a result, U.S. bonds are more attractive on a relative basis, and significant amounts of foreign money have flowed into our market distorting/inverting the yield curve. The Federal Reserve has recently responded by lowering short-term interest rates, which reversed the yield curve inversion and returned it to upward sloping.
“It is Wiser to Find out Than Suppose.”
Global growth is slowing for a variety of reasons, some of which will impact our economy. In the U.S., the current expansion is powered by consumers, whose spending accounts for 70% of GDP. This is the area of the economy which deserves the most careful observation. Here at home, the consumer remains very healthy and the employment picture is strong. Unemployment is at a 50-year low, having steadily declined to 3.5%. Importantly, jobless claims are falling and nonfarm payrolls are rising as the growing economy continues to create new jobs. Wages have increased 3% in the latest year, a rate higher than inflation. Additionally, house prices are holding steady and measures of consumer confidence remain strong. These are the crucial factors supporting our economic well-being at this time.
Modern economies rely heavily on access to credit at reasonable prices. It is the oil that lubricates the gears of our economy. The lower interest rates we have today ease the burden of borrowing across the economy and help keep it running smoothly. That said, if a recession were quickly approaching, one of the earliest signs would be a significant widening of credit quality spreads, the difference in yields between government bonds and those of risky borrowers with similar maturities. Those spreads remain very tight today.
“Continuous Improvement is Better than Delayed Perfection.”
Adjusted for inflation and helped by the tax cuts, our economy grew 2.5% last year. That was a slightly higher rate of growth than the 2% average during the ten years since the last recession. This year the economy will likely grow just above 2% and next year that figure looks likely to be near 2%, bracketing the ten-year average. While slower than the recent past, those numbers still represent a healthy economy. It is also worth noting that during election years incumbent administrations are highly motivated to stimulate economic growth in order to enhance the chances of re-election.
There is a constant stream of economic data to analyze and digest. Data can be fast changing, contradictory and almost never all points in one direction. Psychology too plays an important role — people tend to spend more when they feel confident in the economy and the employment outlook. Noneconomic factors such as natural disasters or politics, for example, can also be impactful. Therefore, the risk of a recession is never zero and may be somewhat higher today than just a few months ago due to global slowing as well as trade wars and tariffs. While we do anticipate a somewhat slower rate of economic growth, as has occurred twice prior in this ten-year expansion period, we believe the odds of a recession in the near-term remain low.
“Don’t Wait. The Time Will Never be Just Right.”
Equities are still among the best investments. Interest rates are falling, inflation is subdued, earnings are growing and valuations are very reasonable. In short, there is no bubble to burst. However, investors are on edge. Each dose of unfavorable news, whether economic, political or global, can cause short-term turbulence for stocks and take time for markets to digest. During periods such as this, it is important to remember that it is the long view which remains most relevant and these intermittent storms too shall pass.
Holger Berndt, CFA Director of Research hberndt@rssic.com
