Is a recession looming? Considerations for 2019

Are we heading into a recession?

From its record close on September 20 to hitting a 16-month low on December 24, the S&P 500 Index tumbled to within striking distance of a bear market (defined as a drop of 20% or greater). Stocks pulled away from the precipice with a dramatic rally on December 26 which is still going strong as the year started on a positive note - markets just got off its best start in 13 years!

Nevertheless, it’s very clear that investors are still concerned that the nearly 10-year-old bull market may be in jeopardy.

Below I am listing a couple of points which in my opinion should be kept in mind when looking at the markets this year:

a)  The US economy is not in a recession, and neither is Europe or Japan

The US is not in a recession and while its growth is slowing, its still very much robust. My view is that it is not (yet) the end of the cycle and markets have become way too pessimistic on this.

U.S. manufacturing activity has been firmly expanding for over 2 years, the unemployment rate is at its lowest level in almost 50 years, and the economy is growing meaningfully above its long-term potential. The U.S. consumer remains not just the key pillar of U.S. growth, but also the brightest spot for global growth. U.S. households are also benefiting from rising wages, large tax receipts and cheaper gasoline. The impact of higher interest-rate should mostly wear off by spring, leaving consumers with plenty of fire power as long as confidence remains elevated.

Recession or not, history shows us that significant equity market declines (and bear markets) can occur outside of recessions—1962, 1987, 1998, 2011, and 2015 are all examples.

As we can see from the diagram below (Vanguard Economic Outlook), the US has just entered its late stage of expansion.  The Eurozone, together with the UK, India and Japan are still in the middle stages of their expansion.

b) Inverted Yield Curve

A historical indicator of recessions has been the inversion of the yield curve. We have already seen this last year as US yields inverted for the first time since 2007 for a very short time but reverted subsequently afterwards. Historically however, recessions only follow a year or two after a prolonged (i.e. a couple of months) inverted yield curve.

c) Headwinds exist and should not be ignored

i) Monetary policy

Tighter monetary policy is driven by the shrinking of the U.S. FED balanced sheet known as quantitative tightening (QT). While FED may pause or stop rate hikes, QT is draining liquidity. In Europe we are now at the end of the balance sheet expansion. All in all, this means that collectively central banks are no longer supporting liquidity, but doing the opposite.

ii) Geopolitical risks

This is problematic as it creates uncertainty for business to make long term decisions. The US/China dispute remains the main hurdle and a major global concern. Last year we have seen an increase reference to tariffs during companies’ earnings announcements – this is expected to continue which ultimately is weighing on equity market sentiment.

Meanwhile, Europe remains snowed under by Brexit and Italian budget uncertainties which increase risk sentiment even more.

 

What’s the way forward?

In 2018 we saw the return of volatility in the markets which prompted the discussion about when a recession (and subsequent market decline) will occur.

Although the issues we faced last year are still with us, there is still a probability of a good market uptrend particularly following better news from the US/China trade front and central Banks slower policy tightening.

While analysts predict that a technical recession will not happen this year, last year should serve as a precursor of things to come and thus we must make sure we have our portfolio well placed to face any turmoil, whilst at the same time having the capability to gain from potential positive events.

 

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