Recent market volatility has yet again raised concern that an impending economic downturn might be on the horizon and has generated questions of whether the markets are telling us we are near the end of the cycle. While the recent volatility and pullback has not been pleasant, we do not believe the stock and bond market action is indicative of a sudden change in forward prospects for 2019.
Being late in the economic cycle is not the same as being near the end of the economic cycle. As we wrote in our last communication, we indicated that corporate earnings have remained consistently strong, yet the prices investors were willing to pay for those earnings (in forms of multiples) have been declining as geopolitical risks, inflation concerns, and short-term interest rates have all been increasing this year.
While the markets have been acting as if all the best days are behind us, a quick look at global economic data tells a slightly different story. Globally, more than 75% of world economies are still in expansionary territory, and while growth is slowing, it is still very positive.
Figure 1: Global Economic Activity Remains Positive
Volatility has affected the bond market as well, with longer term yields declining and the curve flattening over the past month. The yield curve is one of the many indicators we actively monitor regarding the probable trajectory of the economy. Historically, when short term interest rates near or exceed long term interest rates, it can signal a weakening economy that can point to an oncoming recession.
Figure 2: US Yield Curve Continues to Flatten
A deeper look into the causes of the shift has more to do with slowing global growth expectations and less about the outlook for US economic prospects. Why? As the Fed continues to raise short term rates to keep our domestic economy balanced between steady growth and moderate inflation, it also raises financing costs, increasing headwinds around the rest of the world, where economies are not currently as strong or advanced in their economic cycle. This dynamic has resulted in long term interest rates declining, while US short rates continue to climb.
Figure 3: Short Yields – Fe Policy has Diverged Significantly from the Rest of the World
The more bearish case is that the slowing global growth and increased financing costs will catch up with the US and lead us into recession. The more bullish case is that the US will continue its resilience as domestic fundamentals remain relatively strong and corporate earnings remain healthy.
Figure 4: No Signs of Recession Yet
Given the data, we remain in the camp that the probability of a recession here or abroad is low in the next 12 months, though we believe that volatility will continue to increase on recent concerns of global trade, geopolitical tensions and Fed policy.
Over the past month, we have been preparing for the challenging onset of the Winter months by de-risking and defensively positioning the portfolios. We have implemented tactical moves to reduce sensitivity to the equity markets and rising short term interest rates, while keeping a close eye on indicators that would suggest a downward shift in the fundamental outlook. Although obvious, Spring always follows Winter, which is when new growth occurs. Could China’s recent massive stimulus package be that catalyst in Spring of 2019? Time will tell, but even in these current volatile times, we are reluctant to bet too heavily against a backdrop of persistent positive economic fundamentals and extremely accommodative monetary policy.