All Things Must Pass
The economy is at a crossroads. The world may be headed for a recession, as government bond yields are currently discounting; or the global economy will once again prove to be resilient, causing the equity bull market to revive. Every business cycle is different in its own way, but certain patterns have tended to repeat themselves over time. Business cycles refer to the regular cyclical pattern of economic boom (expansions) and bust (recessions). Recessions —a drop in GDP for at least two successive quarters— are characterized by falling output and employment; at the opposite end of the spectrum is an overheating economy, characterized by unsustainably rapid economic growth and rising inflation.
We are officially ten years into the current economic expansion; June 2009, was the technical end of the Great Recession and March 9, 2009, was the stock market’s bottom. Over the past year and a half, concerns have grown that we will likely see another recession and bear market soon, largely as a result of what was tightening monetary policy, a period with an inverted Yield Curve and the rhetoric and actions related to the U.S.-China trade war. Looking at the overall picture, we believe it seems very possible that we’ll avoid a recession in the coming year. The economy doesn’t seem to show any of the traditional signs of overheating, and the Fed and other Central Banks around the world seem committed to accommodative policies. The curve inversion might be more an indicator of extreme market nervousness at present, of increasing central banks action, skewed bond ownership, and of a global search for yield, rather than a sure sign that US is about to enter a recession.
So, it goes without saying that this is a crucial period for the capital markets, as the risk of economic sentiment cracking must be monitored given the steady drumbeat of negative trade and political developments. The principal risk is that weakness in manufacturing and trade around the world causes U.S. consumers to lose confidence and stop spending; that would be lethal for the U.S. and global economies. While current forward-looking indicators are still modestly upbeat, a significant cutback in U.S. hiring or sudden desire to boost savings over spending would end this current cycle. At a minimum, political developments are a negative and it is difficult to see an improvement in this area in the coming months, at best they may not deteriorate further. Fortunately, the timing of the deterioration in the political backdrop occurred when underlying nonmanufacturing economic conditions were in solid shape; we still place low odds on a recession.
At the time of this writing, the headlines are dominated by the impeachment inquiry of President Trump and the conflicts between the U.K. government, its judiciary and parliament. The threat of impeachment could delay progress in economic policies, including U.S./China trade talks, although perhaps Trump will try to divert attention by trying to strike trade deals, rather than continue the pattern of the past year of delays and setbacks. Still, the impeachment inquiry will reinforce uncertainty about the policy outlook for next year and the subsequent four years, given the sharp differences between the Republicans and Democrats. Surprisingly, the political drama in the U.K. matches developments in Washington. At best, we may have increased the odds of a Brexit delay, but uncertainty will continue to weigh on sentiment, pushing the U.K. economy closer to recession, with negative consequences for the euro area and global economy. A sudden and decisive conclusion to Brexit seems most unlikely. The biggest long-run economic threat, assuming a no-deal Brexit does not occur and U.S. impeachment proceedings turn into a slow-moving affair, is the U.S.’ shift to isolationism and protectionism. The evolution of trade policies will be critical for determining the direction of the capital markets.
We have been in a volatile trading range, held back by global trade and manufacturing weakness as well as political uncertainty, yet propped up by depressed borrowing rates. We believe that the global economy will continue to expand (likely, at a sluggish pace) over the next year or so and a recession is less likely in that time. However, the lingering trade war, the atypical U.S. election dynamics next year and the late-stage of the economic cycle that we are in, all argue for greater caution for the time being.
At the same time, we acknowledge that a recession will happen, whether this year, next year, or soon after. It is all part of the cycle. That said, there’s good reason to believe that when the next recession hits (and it will) the pain won’t be nearly as great as what people experienced in 2008. We always rely on our long-term asset allocation targets in our portfolios. We do not try to time investments, especially as one can’t know when a recession starts or ends until it is too late. Even in a deep recession like in 2008, investment values bounced back within two years. In smaller recessions they bounce back much more quickly. While recessions may be a regular part of the cycle, it’s important to remember: they too shall pass.