By Thomas Jalics, Director of Asset Allocation, Fifth Third Bank
Published: November 1, 2019
The economic situation for businesses and investors is in an unpredictable place. Fast-changing dynamics around trade, corporate spending, and fiscal policy changes are contributing to the potential for a forthcoming recession to reshape markets in the U.S. and around the world.
So how soon could a recession begin? It’s increasingly clear that the U.S. economy is in a late-stage phase of its longest-running expansion in history. Slowed growth is expected worldwide in the months to come: The International Monetary Fund recently made a fifth straight cut to 2019’s global forecast, reaching the lowest projections since 2009.
That does not mean a recession is arriving in the coming days, however.
It’s Fifth Third’s point of view that an economic downturn is not immediately imminent. With a close eye on possible interest rate changes, our outlook calls for patience and discipline with portfolio strategies.
Note: The content in this article is based on Fifth Third’s current assessment of global markets and economic signals. It reflects the same ideas shared in conversations with Fifth Third clients, but does not constitute investment advice.
Forces at Play
Talks of a potential recession have been happening for years, as rising populist dynamics—and related events like the Brexit referendum and President Trump’s election—have influenced the global business and economic landscape.
The recent yield curve inversion in August 2019 made recession conversations even louder. (An inverted yield curve happens when interest rates are higher for short-term Treasury Bills than long-term Treasury Bonds.) An inversion of the 2-year/10-year yields has preceded every U.S. recession since 1955—making it a highly valuable warning signal.
However, it can also be a premature signal. The arrival of an inverted yield curve historically doesn’t say much about potential recession timing, since it sometimes happens months or years before the start of a downturn.
The last inversion before August 2019 took place in June 2007, for example, but was preceded by a first inversion in December 2005—well ahead of 2008/2009 market lows. Investors have historically benefited by maintaining existing risk posture for some time after an initial yield inversion, as it typically precedes a stock market peak by many quarters (creating return opportunities).
Market observers who recognize this have lessened their focus on the (now un-inverted) yield curve and turned it instead to the impact of trade tensions.
The U.S. has yet to reach a trade deal with China as of this writing, and uncertainty around tariffs is negatively affecting business confidence and financial conditions (according to recent Federal Reserve reports). In September 2019, domestic manufacturing activity dropped to a 10-year low and manufacturing production decreased 0.5 percent, influenced by the GM workers’ strike and other factors.
Business investment also contracted more sharply than expected in the most recently reported quarterly data. Protective spending strategies could accelerate the potential for a recession, as U.S. corporate debt-to-income ratios are near their all-time peaks. (Strong consumer spending and low unemployment have helped counter diminishing business confidence for some time. But retail sales fell in September—leading some economists to expect further deceleration in household spending.)
With so many factors at play in today’s economy, however, any predictions for timing of a recession would be little more than speculation. The key harbinger of a recession, in Fifth Third’s point of view, would be a choice by the Fed to raise interest rates in an effort to curb inflation in the face of slowing economic activity. Today, while economic output is slowing, inflation remains elusive, allowing the Fed to lower interest rates in an effort to spur economic growth.
After three interest-rate cuts this year, the current environment doesn’t call for that kind of tightening measure to take place right away. The American economy is resilient, and the strong levels of business spending over 2017-2018 may still ripple out in continued productivity momentum for another few quarters—helping keep inflation in check.
The timing for trade agreements and further policy changes remains uncertain, as well, but sudden movements seem unlikely in the current political landscape. Impeachment proceedings will absorb Congress for some time, making further U.S. tax cuts before 2020 a near impossibility. The ever-changing deadline for a Brexit deal also appears to be moving into early next year.
Sudden events aside, expecting the unexpected has become a de facto attitude in the current global landscape. As Pinelopi Goldberg, the World Bank’s chief economist, recently said: “Policy is supposed to remove instability, instead it is suppressing old certainties. No one knows what tomorrow will bring.”
Regardless, making long-term investment decisions based on what happens today or tomorrow is historically unwise.
Re-evaluating one’s asset mix near the end of an economic expansion period is important, but timing economic cycles is notoriously difficult. The combination of patience and a disciplined portfolio approach is warranted, as liquidating risk positions due to a looming recession can lead to significant losses: In 7 of the last 12 recessions, the S&P 500 has posted a positive total return between the peak and trough of the economy.
Exiting the market also creates a second decision to make: How soon do you get back in?
No one wants to be asking that question in the middle of a downturn. With unpredictability becoming the norm, staying the course of a portfolio strategy—while still watching for negative signals, with the help of expert partners—can help counter uncertainty.