Why We Are Not Worried About Recession... Yet

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Why We’re Not Worried About Recession… Yet

The Economic Cycle

It is called an economic cycle for a reason. Short-term growth trends can only stay in place for so long. Eventually growth peaks and leads to a slowdown. The slowdown oftentimes leads to negative growth (recession), which could be mild or severe but also serves as a reset, and the cycle starts over as a recovery occurs. So where are we in the current cycle?

The current economic expansion is one of the longest in U.S. history, now 9+ years running, so one of the questions that seems to be making headlines daily is “when is the next recession?” Then, it is usually followed by investors asking “… and what do we do about it?” Let’s deal with each of these questions separately.

While it’s difficult to accurately predict the timing of the next recession, the following are 3 reasons we believe recessionary conditions may still be several quarters (or possibly years) away.

Source: Chart from Mr Shearing Economics, August 6, 2018.

1. Positive Yield Curve

The difference in yields between the 10-year U.S. Treasury and the 2-year is about 0.35%, or 35 basis points. The difference between the 10-year and the 3-month T-bill is about 0.90%. An inverted yield curve occurs when short-term interest rates exceed long-term rates, and as the chart below shows, each of the last 5 economic recessions have been preceded by an inverted yield curve. Further, when the curve does invert, recessions have tended to occur many months if not years later, so there should be plenty of time to make rational decisions when the time comes.

Source: Charles Schwab, Bloomberg, FactSet, as of June 29, 2018.

2. Leading Economic Indicators are Quite Strong

The past three recessions were preceded by LEI growth slowing and eventually becoming negative. That’s just not where we are currently.

Source: Charles Schwab, July 3, 2018.

3. Employment is Strong

Past recessions occurred as unemployment claims troughed and began rising. That isn’t happening currently.

Source: Charles Schwab, July 3, 2018.

Now, we are certainly aware that not all economic cycles act and react the same, and conditions can change with time, so we constantly try to assess the environment as it develops. We do believe, however, that while there will most likely be another recession at some point, current conditions and near-term expectations do not justify a recession occurring in the next few quarters at least.

Since earnings are what drive stock prices over the long-term, let’s add to the above what the current earnings picture looks like for stocks. Q2 earnings growth is coming in at about 24% y-y, and mid- to high-teens growth is expected the remainder of this year [i] . While roughly half of that EPS growth can be attributed to lower tax rates for corporations, it’s important to realize that Q2 revenue growth is expected to be +10%, followed by +7% in Q3 [ii] . These are healthy growth rates. Further, expectations for 6-7% EPS growth in the first half of 2019 is pretty healthy given the strong comparisons from this year.

Source: Zacks Investment Research, August 1, 2018.

To summarize, economic conditions do not lead us to believe that a recession is imminent, and the backdrop for owning stocks is solid.

When the next recession does develop, comparisons to the '08 - '09 recession are not likely reasonable. The previous recession was severe, because the financial system was at risk. Since then, Fed oversight and capital-based testing has been implemented, putting the U.S. banking system in much stronger shape than it has arguably been in for decades. As a result, we can foresee a diversified investment portfolio weathering recessionary conditions relatively well. Of course, working directly with your financial advisor along the way should help you avoid major surprises.

As always, thank you for letting us help you on your path to reaching your financial goals!

Gary Orf, CFA ^® | Chief Investment Officer | Renaissance Financial

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