Recessions, inverted yield curves, and Sharemarket returns

Fears of economic recession, particularly in the US, peaked over the final three months of 2018.

Nevertheless, talk of economic recession has now faded into the background after the US Federal Reserve hit the pause button to further interest rate increases in January of 2019. The Fed is not expected to raise interest rates again in 2019.

This is not to say that a recession will not occur, it will at some stage, just as night follows day. The economic/business cycle has not been conquered.

Nevertheless, the timing of the next recession is unknown. Take Australia for example, their last recession was over 28 years ago. New Zealand is over 9 years since their last recession.

With regards to the US, in July of this year the US economy will enter its longest period in history without incurring a recession. Their economy remains on a sound footing: interest rates remain low, the US consumer is confident, businesses are investing, the Government is increasing spending, and forward looking indicators of economic activity remain positive. Lastly, housing activity is likely to pick up over the second half of 2019.

 

What is a Recession?

A recession is defined as at least two consecutive quarters of declining economic growth. The US National Bureau of Economic Research (NBER) defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real gross domestic product (GDP), real income, employment, industrial production and wholesale-retail sales.”

 

A recent article by the Capital Group: Preparing for the next recession: 9 things you need to know provides a good overview of the ins-and-outs of economic recession.

 

The good news, as Capital highlight, recessions generally aren’t very long.

Capital undertook analysis of 10 US economic cycles since 1950. This analysis showed that recessions have lasted between eight and 18 months, with the average spanning about 11 months. Unfortunately New Zealand’s history is a little more chequered than the US.

Investors with a long-term investment horizon, should expect to experience a number recession over their investment horizon and therefore look through the full economic cycle. Fortunately, for most of us, we spend more time in economic expansion than in recession.

Capital note, “over the last 65 years, the U.S. has been in an official recession less than 15% of all months.”

The following graph highlights the average length, total growth, and returns from the average stock market return over the average recession and economic expansion.

Notably, “equity returns can even be positive over the full length of a contraction, since some of the strongest stock rallies have occurred during the late stages of a recession.”

The human cost of economic recession is provided in the form of jobs lost and this should not be forgotten.

 

Economic cycles Capital.jpg

 

From a sharemarket perspective, a bear market, defined as a 20% or more fall in value, usually overlaps with recessions.

Share markets tend to lead the economic cycle, given they are forward looking. Sharemarkets on average peak six months prior to the onset of a recession. They continue to fall during the early stages of a recession.

The recovery in sharemarkets often takes hold while the economy is still in recession (economic growth is still contracting).

The initial bounce in sharemarkets is often a period of strong performance and occurs before there is any hard evidence of a pickup in economic activity.

The following graph presents the above sequencing and overlapping nature of sharemarket returns and recessions.

Sharemarket returns and recession cycles.png

 

Having said all that, stock markets are not good predictors of economic recession i.e. a sharp fall in global sharemarket does not mean there will be an onset of global economic recession.

This is captured by the well know quote from Paul Samuelson: “The stock market has predicted nine of the last five recessions.”

 

Sharemarket Returns and Inverted Yield Curves

There has been a lot of discussion over the last twelve months about the implications of an inverted US yield curve. (An inverted yield curve is when longer-term interest rates (e.g. 10 years) are lower than shorter-term interest rates (e.g. 2 years or 3 months). A normal yield curve is when longer-term-interest rates are higher than shorter-term-interest rates.

Parts of the US yield curve are currently inverted, and this inversion has increased over recent days.

The significance of this is that prior to the last 7 US recessions the yield curve has inverted prior each time. An inverted yield curve has by and large been a good predictor of recession.

Nevertheless, not every time the yield curve inverts does a recession follow and on average the inversion of the yield curve occurs 12 months prior to a recession.

 

The following analysis undertaken by Wellington Management looks at the performance of the US sharemarket in relation to yield curves inversions.

The period of analysis is from the 1950s at which time the US Federal Reserve gained full, independent control over interest rates from the US Treasury. As Wellington note, “it was after this transition that the yield curve became an effective tool for gauging the impact of monetary policy on the economy and the prospect of a recession.”

Wellington present the following analysis and the Table below:

  • “As shown in the third column (of Table below), the S&P 500 peaked ahead of a yield-curve inversion only twice (1959 and 1973).
  • “The median time between inversion and peak equity returns was 17 months, and in several cases the market peaked almost two years or more after inversion.”
  • “Aggregate equity returns post-inversion have been partly dependent on the length of time between the initial inversion and the start of the recession.”
  • “Since returns tend to be negative right around the time a recession begins, the instances in which there was a shorter period between the initial inversion and the start of the recession were more likely to have a negative return.”

 

Just like there is a period of time between economic recession and an inverted yield curve, the sharemarket often peaks after the yield curves inverts.

Sharemarket returns and inverted yield curves.png

 

Back to the Capital article, for it also runs through a number of other recession related questions.

Of interest are:

What economic indicators can warn of a recession?

  • Capital outline some generally reliable signals worth watching closely, such as an inverted yield curve, corporate profits, unemployment, and leading economic indices.
  • Importantly it is appropriate to look at and consider several different economic indicators.

 

What Causes Recessions?

  • There are many reasons for a recession, chief amongst them are rising interest rates, particularly by Central Banks such as the US Federal Reserve and Reserve Bank of New Zealand, imbalances within an economy e.g. excess housing prices, high debt levels
  • Every economic cycle is unique, but anything that impacts on corporate profits or consumer spending, such as rising unemployment, are factors to consider.

 

Just remember is it notoriously difficult to predict economic recession and they are normally the result of a number of factors that have a cascading effect leading to an economic downturn.

 

The following Kiwi Investor Blog Posts maybe of interest to those wanting a better understanding of inverted yield curves, leading economic indicators, and historical performance of equity market corrections.

Recession predictability of inverted yield curves and other economic indicators to considered:

 

Analysis of Sharemarket corrections and market declines

 

Lastly the Capital article provides some suggestions as to how to position your portfolio for a recession. I think it is exceedingly difficult to finesse a portfolio in the expectations of a recession.

From my perspective, the following is most critical:

  • Maintain a long-term perspective;
  • Implement a balanced and broadly diversified portfolio. Portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits. True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration (movements in interest rate), economic growth, low volatility, value, and growth. Investors are compensated for being exposed to a range of different risks;
  • Know you risk tolerance: what level of volatility in capital are you prepared to handle without changing your mind;
  • Understand your risk capacity: the amount of risk you need to take in order to reach your financial goals;
  • Implement a goals-based investment approach, where success is measured on how you are tracking relative to your investment goals, rather than market index performances; and
  • Always maintain a high quality portfolio, with plenty of liquidity, and limit the level of turnover across the portfolio e.g. amount of trading (buying and selling)

 

A good advisor should be able to help you with the above and see you through bouts of sharemarket volatility, including a recession environment.

 

Happy investing.

 

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

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Pioneering work on yield-curve inversions and risk of economic recession

There is no doubt that global economic growth has slowed over the last six months. The Reserve Bank of New Zealand (RBNZ) highlighted rising global economic risks in its recent Policy statement. The RBNZ noted that economic growth has slowed in our major trading partners of Australia, China, and Europe.

Economic growth has also slowed in the US. Although US financial conditions have eased in recent months, they did tightened over the course of 2018.

The risk of a US recession has risen in recent months. Albeit calls of a US recession have been around for some time.

A recent article by Gary Shilling in Think Advisor captures the type of the analysis undertaken on the US economy over the last 18 months.

Leading economic indicators for the US have weakened. Nevertheless, they are not consistent with forecasting a looming recession, except perhaps one, an inverted yield curve which is discussed below.

Overall the US economy is in good health, with record low unemployment, growing incomes, high saving rates, strong household balance sheets, business investment is set to increase, as is Government spending.

 

As Shilling notes in his article, the US economy could go several ways e.g. economic growth rebounds over 2019, the US experiences a period of prolonged moderate economic growth without a recession, or the US experiences a classic economic cycle and tips into a recession at a later date due to the US Federal Reserve raising interest rates.

By Shilling’s count, there have been 12 occasions since World War 2 that the Fed raising interest rates has resulted in a recession. Presently, this would appear some time away  given the Fed has indicated it is unlikely to undertake further interest rate increases in 2019.

The later scenario is most consistent with the consensus view – it is a little early to call a US recession, yet the risks of a recession within the next 2-3 years are growing. For the time being the US continues to expand and will enter its longest period of economic expansion in modern history in July 2019. Recession will eventually be triggered by the Fed increasing interest rates resulting in a more “garden variety” recession.

 

And this leads to a key point in Shilling’s article, the word recession invokes images of a Global Financial Crisis (GFC) type outcome – not surprising given this was our last experience.

His expectations are that the next US recession will not be as severe as the GFC.

He has a similar view with respect to the next US “Bear” market (i.e. fall in value of greater than 20%).

I’ll leave it to him to explain:

“Recession” conjures up specters of 2007-2009, the most severe business downturn since the 1930s in which the S&P 500 Index plunged 57 percent from its peak to its trough. The Fed raised its target rate from 1 percent in June 2004 to 5.25 percent in June 2006, but the main event was the financial crisis spawned by the collapse in the vastly-inflated subprime mortgage market.

 Similarly, the central bank increased its policy rate from 4.75 percent in June 1999 to 6.5 percent in May 2000.  Still, the mild 2001 recession that followed was principally driven by the collapse in the late 1990s dot-com bubble that pushed the tech-laden Nasdaq Composite Index down by a whopping 78 percent.

The 1973-1975 recession, the second deepest since the 1930s, resulted from the collapse in the early 1970s inflation hedge buying of excess inventories. That deflated the S&P 500 by 48.2 percent. The federal funds rate hike from 9 percent in February 1974 to 13 percent in July of that year was a minor contributor.

The remaining eight post-World War II recessions were not the result of major financial or economic excesses, but just the normal late economic cycle business and investor overconfidence. The average drop in the S&P 500 was 21.2 percent.

 

In short, history shows that US sharemarkets drop by about 21% when the economy falls into recession, remembering the S&P 500 fell almost 20% during the last three months of 2018.

 

Inverted Yield Curve

As you will know, the slower economic growth has resulted in several Central Banks, with the RBNZ the latest, to turn more cautious on the outlook for economic growth and inflation. This list includes the US Federal Reserve, European Central Bank, and Reserve Bank of Australia.

This sudden change in direction of interest rate policy (Monetary Policy) has witnessed a flattening of yield curves (when longer-dated interest rates are at similar level to shorter-term interest rates).

In the US, the yield curve has become inverted, where longer-term interest rates are lower than shorter-term interest rates.

The inversion has primarily been due to the significant reduction in longer-term interest rates rather than the increase in shorter-term interest rates (inversions normally occur when short term interest rates are increased rapidly by Central Banks).

The significance of this is that prior to the last 7 US recessions the yield curve has inverted each time.

Nevertheless, not every time the yield curve inverts does a recession follow and on average the inversion of the yield curve occurs 12 months prior to a recession.

 

As you can imagine a lot has been written in recent weeks on the implications of a negative yield curve, I would like to highlight the following three articles, which pretty much sums up the current debate:

  1. A very recent interview with the person who undertook in 1986 the pioneering work on yield-curve inversions and their foreshadowing of economic downturns (RA-Conversations)
  2. Mohamed A. El Erain’s article of “Beware of Misreading Inverting Yield Curve “
  3. BCA LinkedIn Post, Yield Curve Inversions and S&P 500 Peaks, don’t get bogged down in the noise.

 

It would appear, that when it comes to the current inversion of the US yield curve, we have “Nothing to fear but fear itself” (Franklin D. Roosevelt). This is certainly the view of Mohamed A. El Erain.

 

I have blogged previously on the history of inverted yield curves and their predictive ability. Similar there is also a previous post on the anatomy of equity Bear markets.

 

Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement

Recent Market volatility and end of year market and economic forecasts

There are lots of economic and market forecasts at this time of the year. Many are easily accessed on the internet.

Does anyone care about these forecasts? Or do we place too much emphasis on these forecast? These topics are covered in a recent Institutional Investor article. Some good points are made.

 

The current market volatility is likely to be front of mind presently for many investors. Others may be seeing it as an opportunity.  What ever your view of 2019, a longer term perspective should always be maintained.

Either way, it has been a tough year to make money .

 

Most likely, your view of the current market volatility is closely tied to your forecast for 2019.

On this note, there are number of reasons to be “relaxed” about the current market volatility as outlined in the recent Think Advisor article.

 

Why should we be relaxed about the current bout of volatility? The most pertinent reasons from the article are as follows:

The US economy is still strong

US Economic growth accelerated in 2018 while the rest of world slowed. Global growth is expected to moderate in 2019 from the current pace in 2018.

Albeit, the US economy is still strong with unemployment at its lowest level since 1969, consumer and business confidence remains healthy, forward looking indicators are supportive of ongoing economic growth.

Although growth is slowing in Europe and China the environment remains supportive of ongoing economic expansion.

Global sharemarkets appear to have already adjusted for a more moderate level of global economic growth in 2019.

 

Stock Fundamentals are okay

Global corporate earnings are forecast grow over the next twelve months, supported by the economic backdrop outlined above.

As alluded to above, value has appeared in many global markets given recent declines.

 

Yield curve inversion

Markets are pre-occupied with the possibility of a US inverted yield curve. This appears overdone. Yield curve Inversion is when the yield (rate of interest) is lower on longer dated fixed interest securities compared to shorter dated securities. Under normal circumstance longer dated securities have a higher yield than shorter dated securities.

As highlighted previously  an inverted yield curve is a necessary but not sufficient pre-condition to recession. Not every yield curve inversion is followed by a recession .

There is also a considerable time lag between yield curve inversion and economic recession. A period of time in which sharemarkets have on average performed strongly.

Lastly, the traditional measure of yield curve inversion, 3 month yield vs 10 year yield, is not inverted!

 

Of the reasons provided in the article, the above are the most relevant and worthy of taking note of.

Nevertheless, global trade is a key source of the current market volatility and is likely to remain so for sometime.  Likewise it may take time for markets to gain comfort that global economic growth has stabilised at a lower rate of expansion. Therefore, continued market volatility is likely.

Alternatively, a pause in the US Federal Reserve raising short term interest rates would also likely provide a boost to global sharemarkets.

 

PIMCO, as recently reported, highlight that the risk of a recession in the US has climbed in 2019.

This prediction is made in the context that the US is nearing a decade long period of economic expansion, the longest period in its history without experiencing an economic recession (defined as two consecutive quarters of negative economic growth).

PIMCO note “The probability of a U.S. recession over the next 12 months has risen to about 30 percent recently and is thus higher than at any point in this nine-year-old expansion, Even so, the models are flashing orange rather than red.”

“The last few months have given us a sense of the types of risks that are out there, that both the economy and markets are going to face in 2019,” ….. “At a minimum, like we have seen this year, expect ongoing volatility and that’s true across all segments of the financial markets.”

 

Happy investing.

 

Please see my Disclosure Statement

  

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

It has been a tough Year to make Money

2018 has been a tough year in which to make money.

2018 is “The worst time to make money in the markets since 1972” according to a recent Bloomberg article.

“Things have not been this bad since Richard Nixon’s presidency”.

Research undertake by Ned Davis Research, who places markets into eight big asset classes, everything from bonds (Fixed Interest) to US and international stocks and commodities, not one of them is “on track to post a return this year of more than 5%, a phenomenon last observed in 1972”….

As they note, in terms of absolute loses, think Global Financial Crisis (GFC 2007/08), investors have incurred far worst returns in 2018, nevertheless, as far as breadth of asset classes failing to deliver upside returns, “2018 is starting to look historic.”

Nothing has worked this year.  Year to date: global equities are down, as are emerging markets, hedge fund indices, global commodities (even oil), International Credit, Global High Yield, US Fixed Interest, US Inflation Protected Bonds, while Global Aggregate Fixed Interest have eked out a small gain.  Investments into unlisted assets have been more rewarding.

 

“That’s all but unique in history. Normally when something falls, something else gains. Amid the financial catastrophe of 2008, Treasuries rallied (increased in value). In 1974, commodities were a bright spot. In 2002, it was REITs. In 2018, there’s nowhere to run.”

 

Outcomes are a little better if you are a New Zealand (NZ) based investor, Cash is on track to return around 2%, 6 month Term Deposits 3.5%, NZ Fixed Interest is up around 4%, and the NZ Sharemarket is currently up 3%.  Still they are all short of 5%.  Meanwhile the recent strength in the NZ dollar has detracted from offshore returns.

 

It has been a tough year, global equities reached all-time highs in January, fell heavily in February and March, only to recover up to October, with the US Sharemarket reaching a new historical high.

Since October yearly gains have been erased due to a number of factors, some, but not all, of these factors are briefly outlined below.

 

In short, as highlighted by a recent Barron’s article markets appear to be panicking over everything.

Recent market drivers in brief:

  • Primarily concern for Sharemarkets has been a reduction in global economic growth expectations. Global investor sentiment toward the pace of global economic growth in 2019 has become more cautious over recent months. Global sharemarkets have adjusted accordingly. Albeit, the sharmarket adjustment does appear to be overdone relative to the likely moderating in global growth in 2019, which has also  largely been anticipated.
  • Global Trade concerns continue to negatively impact global markets e.g. Australia and commodities, primarily the ongoing negotiations between the US and China are a source of market volatility and uncertainty.
  • Brexit more recently. The UK are going to have to pay a price for leaving the EU, why? too stop other countries ever considering leaving the EU as a viable option. Unfortunately, while Brexit is an important issue and will be a source of volatility, the negative consequences will largely sit with the UK rather than the rest of the world.
  • There has been considerable oil price volatility, the price of oil fell by over 20% in November.
  • There has also been uncertainty as to likely pace of increases in the Federal Funds Rate by the US Federal Reserve (US Central Bank).

 

Inverted Yield Curve

Lastly, markets have also latched onto the inversion of the US Yield curve.

Inversion is when the yield (rate of interest) is lower on longer dated fixed interest securities compared to shorter dated securities. Under normal circumstance longer dated securities have a higher yield than shorter dated securities.

An “inverted” yield curve has been useful, though not perfect, in predicting economic recession and equity bear markets (when sharemarkets fall in value of over 20%),

 

On this occasion the market has focused on the three year security versus the five year security.

Normally, the market focuses on the three month versus the 10 year security as the best predictor of economic recession.  For a further discussion see Risk of Economic Recession and Inverted Yield Curve and US Recession warning. An inverted yield curve is a necessary but not sufficient condition in predicting a recession, and there is often a lag.

 

As the Barron article highlights: “Since 1965, the three-year yield has been higher than the five-year on seven different occasions. In 1973, the stock market had already sunk into a recession. In the other six instances, the median distance to a recession was 25 months—or more than two years. The S&P 500 went on to gain a median 20% over the 24 months following such an inversion. “Historically, not only have returns tended to be very strong, but the bear market has generally been years away,”

 

Happy investing.

 

 

Please see my Disclosure Statement

 

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Balanced Bear Market

A “Balanced Bear” is when both equities and bonds sell off together.

As a result, a Balanced Fund, 60% invested in the stockmarket (equities) and 40% invested in fixed income (bonds), has a larger than normally expected period of underperformance – a Balanced Fund Bear Market.

During these periods the diversification benefits of bonds relative to equities disappears.

As you will know, historically if the stock market is selling off sharply, money is moving into fixed income. This drives up the price of fixed income securities helping to partially offset the negative returns from the stock market.  A Balance Fund can come through these periods of equity market uncertainty relatively unscathed.

In a Balance Bear, equities are falling in value and fixed income is also falling in value given interest rates are rising (noting as interest rates rise the price, and therefore value, of a fixed income security falls).

This type of market environment was evident in early 2018 and was a prominent feature of the market volatility in early October 2018.

 

The thesis of the Balanced Bear has been promoted by Goldman Sachs and their equity analyst Christian Mueller-Glissmann raised the idea on CNBC in February of this year.

Goldman Sachs have written extensively on the Balance bear using historical US financial market data.

Importantly, a Balanced Fund is now into its longest period of outperformance, reflecting the very strong record run in US equities since 2009 and that interest rates, albeit they have risen from their June 2016 lows, are still at historical lows and have provided solid returns over the longer time frames.  The same can be said about New Zealand “Balanced Funds”.

 

The Anatomy of equity bear markets is well documented, not so for a Balanced Fund bear market.

In this regards Goldman Sachs (GS) has undertaken a wealth of analysis.

 

Requirements for a Balanced Bear – usually a Balance Bear requires a material economic growth or inflation shock.

In this regard, the largest Balance Fund declines over the last 100 years have been in or around US recessions (economic growth shock).

Nevertheless, Goldman Sachs also found that the Balance Fund can have long periods of low real returns (i.e. after inflation) without a recession e.g. mid 40s and late 70s. These periods are associated with accelerating inflation.

 

Naturally, equities dominate the risk within a Balanced Fund, therefore large equity market declines e.g. Black Monday 1987 are associated with periods of underperformance of Balanced Funds.

Not surprisingly, most of the largest Balanced Fund falls in value have been during US recessions, but not all e.g. 1994 Bond market bubble collapsing, stagflation of 1970 (low economic growth and high inflation), 1970’s oil shock.  It is worth noting that the 1987 sharemarket crash was not associated with a US recession.

 

Also of note, the stagflation periods of the 1970’’s and 80’s are periods in which there were large falls in both equities and bonds.

 

Bond market bears – are usually triggered by Central Banks, such as the US Federal Reserve, raising short term interest rates in response to strong growth and an overheating of the economy.  Bond market bears have been less common in modern history given the introduction of inflation targets anchoring inflation expectations.

 

Equity markets can absorb rising interest rates up to the point that higher interest rates are beginning to restrict economic activity. An unanticipated increase in interest rates is negative for sharemarkets and will lead to higher levels of volatility e.g. 1994 or recent tapper tantrum of May 2013.

 

As noted in previous blogs, most equity bear markets have been during recessions…but not all.

Goldman Sachs makes this point as well, noting the majority of 60/40 drawdowns of more than 10% have been due to equity bear markets, often around recessions. They note it is very seldom the case that equities deliver positive returns during a 60/40 drawdown (they estimate only in c.5% of cases).

With regards to recessions, Goldman Sachs note that there have been 22 recessions since 1900 and 22 S&P 500 bear markets. However, not every bear market automatically coincided with a recession in the last 100 years – out of the 22 since 1900, 15 were around a recession – 7 due to other factors.

 

Also, high equity valuations don’t signal a bear market. Nevertheless, they do signal below average returns over the medium to longer term. Albeit, sharemarket bear markets are not associated with low valuations!

 

Therefore, assessing the risk of a US recession is critical at this juncture.  As covered in a recent Post the “warning signs” of recession are not present currently based on a number of US Recession warning indicators.

 

Lastly, as also noted in a previous Post it is very difficult to predict bear markets and the costs of trying to time markets is very expensive.  The maintenance of a truly diversified portfolio and portfolio tilting will likely deliver superior return outcomes over the longer term.

A more robust and truly diversified portfolio reduces portfolio volatility increasing the likelihood of investors reaching their investment goals.

 

It is a good time to reflect on the diversification of your portfolio at this time in the market cycle. As Goldman Sachs note, both equities and bonds appear expensive relative to the last 100 years.

In a Balanced Bear scenario there are very few places to hide.

  

Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement

US Recession Warning Indicators

As you will know the US economy is into its second longest period of economic expansion which commenced in June 2009.

Should the US economy continue to perform until July 2019, which appears likely, the US will enter its longest period of economic expansion. The longest expansion was 10 years, occurring during the tech expansion of the 1990s, the current expansion is nine years.

Similarly, the US sharemarket is into its longest bull market run, having not experienced a drop-in value of greater than 20% (bear market) since March 2009.

As a rule, sharemarkets generally enter bear markets in the event of a recession.

 

Nevertheless, while a recession is necessary, it is not sufficient for a sharemarket to enter a bear market.

Since 1957, the S&P 500, a measure of the US sharemarket:

  • three bear markets where “not” associated with a recession; and
  • three recessions happened without a bear market.

 

Statistically:

  • The average Bull Market period has lasted 8.8 years with an average cumulated total return of 461%.
  • The average Bear Market period lasted 1.3 years with an average loss of -41
  • Historically, and on average, equity markets tend not to peak until six – twelve months before the start of a recession.

 

Therefore, let’s look at some of the Recession indicators.

In a recent article by Brandywine, they ran through some of the key indicators for a US recession.

Federal Reserve Bank of Atlanta’s GDP Nowcast.

This measure is forecasting annualised economic growth of 4.4% in the third quarter of 2018. This follows actual annualised growth of 4.2% in the second quarter of 2018.

Actual US economic data is strong currently. Based on the following list:

  • US unemployment is 3.7%, its lowest since 1969
  • Consumer Confidence is at an 18 year high
  • US wages are growing at around 3%, the savings rate is close to 6%, leaving plenty of room for consumers to increase spending
  • Small business confidence is at all-time highs
  • Manufacturing and non-manufacturing surveys are at their best levels for some time (cycle highs)

 

Leading Indicators

The Conference Board’s Index of Leading Indicators, an index of 10 components that includes the likes of the ISM New Order Index, building permits, stock prices, and the Treasury yield curve.

The Conference Board’s Index is supportive of ongoing economic activity in the US.

 

Yield Curve

The shape of the yield curve, which is normally upward sloping, meaning longer term interest rates are higher than short term interest rates, has come in for close attention over the last six months. I wrote a about the prospect of a negative yield curve earlier in the year.

An inverted yield curve, where shorter term interest rates (e.g. 2 years) are higher than longer term interest rates (e.g. 10 years) has a pretty good record in predicting a recession, in 18 months’ time on average.

With the recent rise of longer dated interest rates the prospect of an inverted yield curve now looks less likely.

Albeit, with the US Federal Reserve is likely to raise short term interest rates again this year and another 3-4 times next year the shape of the yield curve requires on going monitoring.

Having said that, an inverted yield curve alone is not sufficient as a predictor of economic recession and needs to be considered in conjunction with a number of other factors.

 

Brandywine conclude, “what does a review of some well-known recession indicators tell us about the current—and future—state of the U.S. expansion? The information provided by the indicators is mixed, but favors the continuation of the current expansion. The leading indicators are telling us the economy should continue to expand well into next year—at least.”

In favour of ongoing economic expansion is low unemployment, rising wages, simulative financial conditions (e.g. low interest rates are supportive of ongoing growth, as are high equity prices), high savings rate of consumer and their low levels of debt. Lastly government spending and solid corporate profitability is supportive of economic activity over the medium term.

As a word of caution, ongoing US – China trade dispute could derail global growth. Other factors to consider are higher interest rates in combination with a higher oil price.

Noting, Equity markets generally don’t contract until interest rates have gone into restrictive territory. This also appears some time away but is a key factor to monitor.

Lastly, a combination of higher oil prices and higher interest rates is negative for economic growth.

 

I have used on average a lot in this Post, just remember: “A stream may have an average depth of five feet, but a traveler wading through it will not make it to the other side if its mid-point is 10 feet deep. Similarly, an overly volatile investing strategy may sink an investor before she gets to reap its anticipated rewards.”

 Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement

Trustees should be aware of the shocking cost of timing markets and what is the best solution

Cambridge Associates recently published a research report concluding it does not pay to be out of the market.

” Investors who take money out of the market too early stand to “risk substantial underperformance,”

Cambridge advised investors concerned about the length of the current bull market not to bail out of equity markets earlier than necessary in an attempt to avoid exposure to downturns.

This seems timely given current market volatility.

As the article notes, it is hard to time markets “because trying to time re-entry to get back into the markets at lower levels leads to substantially lower long-term returns, the researchers found. For example, the report showed that being out of the market for just the two best quarters since the turn of the last century cut cumulative real returns on U.K. equities by more than 50 percent.”

“That effect is even more profound in the United States, where sitting out the best two quarters cut cumulative real returns by more than two thirds, according to the report.”

“While no investor should be ignoring valuations, becoming too focused on timing an exit has substantial risks,” said Alex Koriath, head of Cambridge’s European pensions practice, in a statement accompanying the research. “The best periods for returns tend to be very concentrated, meaning that exiting at the wrong time could drag down cumulative returns significantly.”

 

This is a pertinent issue given the US sharemarket is into its longest bull market run in history. Also, of interest, historically on average, markets perform very strongly over the final stages of a bull market run. Lastly, bull markets tend to, more often than not, end six-twelve months prior to a recession. Noting, this is not always the case. Albeit, the consensus is not forecasting a recession in the US for some time. It appears, the probability of a US recession in the next couple of years is low.

The key forward looking indicators, such as shape of the yield curve, significant widening of high yield credit spreads, rising unemployment, and falling future manufacturing orders are not signalling a recession is on the horizon in the US. Please see my earlier posts History of Sharemarket corrections – An Anatomy of equity market corrections

 

What is the answer?

It is difficult to time markets. AQR came to a similar conclusion in a recent article. AQR argue the best form of defence is a truly diversified portfolio. I agree and this is a core focus of this Blog.

As we know equity markets have drawdowns, declines in value of over 20%. In the recent AQR article they estimate that there have been 11 episodes of 20% plus drawdowns since 1926, a little over once every 10 years! Bearing in mind the last major drawdown was in 2008 – 09.

The average peak to trough has been -33% and on average it has taken 27 months to get back to the pre-drawdown levels.

As AQR note, we cannot consistently forecast and avoid these severe down markets. In my mind, conceptually these drawdowns are the risk of investing in equities. With that risk, comes higher returns over the longer term relative to investing in other assets.

At the very least we can try and reduce our exposure by strategically tilting portfolios, as AQR says, “if market timing is a sin, we have advocated to “sin a little””.

 

I agree with the Cambridge Associates article to never be out of the market completely and with AQR to strategically tilting the portfolio. These tilts should primarily be based on value, be subject to a disciplined research process, and focused more on risk reduction rather than chasing returns. This approach provides the opportunity to add value over the medium to longer term.

 

Nevertheless, by far a better solution is to truly diversify and build a robust portfolio. This is core to adding value, portfolio tilting is a complementary means of adding value over the medium to long term relative to truly diversifying the portfolio.

True diversification in this sense is to add investment strategies that are lowly correlated with equities, while at the same time are expected to make money over time. Specifically, they help to mitigate the drawdowns of equities. For example, adding listed property and listed infrastructure to an equity portfolio is not providing true portfolio diversification.

In this sense truly “alternative” investment strategies need to be considered e.g. Alternative Risk premia and hedge fund type strategies. Private equity and unlisted assets are also diversifiers.

Again conceptually, there is a cost to diversifying. However, it is the closest thing in finance to a free lunch from a risk/return perspective i.e. true portfolio diversification results a more efficient portfolio. Most of the diversifying investment strategies have lower returns to equities. There are costs to diversification whether using an options strategy, holding cash, or investing in alternative investment strategies as a means to reduce sharp drawdowns in portfolios.

Nevertheless, a more diversified portfolio is a more robust portfolio, and offers a better risk return outcome.

Also, very few investor’s objectives require to be 100% invested in equities. For most investors a 100% allocation to equities is too volatile for them, which raises the risk that investors act suboptimal during periods of market drawdowns and heightened levels of market volatility i.e. sell at the bottom of the market

 

A more robust and truly diversified portfolio reduces portfolio volatility increasing the likelihood of investors reaching their investment goals.

 

As AQR note, diversification is not the same thing as a hedge. Uncorrelated means returns are influenced by other risks. They have different return drivers.

From this perspective, it is also worth noting that adding diversifying strategies to any portfolio means adding new risks. The diversifiers will have their own periods of underperformance, hopefully this will be at a different times to when other assets in the portfolio are also underperforming. Albeit, just because they have periods of underperformance does not mean they are not portfolio diversifiers.

AQR perform a series of model portfolios which highlight the benefits of adding truly diversifying strategies to a traditional portfolio of equities and fixed interest.

No argument there as far as I am concerned.

 

Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement

Risk of Economic Recession and an Inverted Yield Curve

There has been a lot of discussion recently about the prospect of an inverted US yield curve.  (An inverted yield curve is when longer-term interest rates (e.g. 10 years) are lower than shorter-term interest rates (e.g. 2 years or 3 months).  A normal yield curve is when longer-term-interest rates are higher than shorter-term-interest rates.

Historically an inverted yield curve is a powerful recession sign.  John Williams, who will take over the helm of the New York Federal Reserve Bank of New York in June, said earlier in the year a truly inverted yield curve “is a powerful signal of recessions” that has historically occurred (italics is mine).

The US yield curve spread (difference in yield) between the 2 year and 10 year US Treasury interest rates has recently reached its narrowest in over a decade.  Thus the heightened discussion.

As can be seen in the graph below the US Treasury yield curve inverted before the recessions of 2008, 2000, 1991, and 1981.

It should be noted that the US yield curve has not yet inverted and there is a lag between inversion and recession, on average of 1 to 2 years.  See graph below.  I am not sure I’d call the Yield Curve still “Bullish” all the same.

At the same time, the risk of recession does not currently appear to be a clear and present danger.

Much of the flattening of the current yield curve (i.e. shorter-term interest rates are close to longer-term interest rates) reflects that the US Federal Reserve has increased shorter-term interest rates by over 150 bpts over the last 2 years and longer-term interest rates remain depressed largely due to technical factors.  Albeit, the US 10 year Treasury bond recently trade above 3%, the first time since the start of 2014.  Therefore, the current shape of the US yield curve does make some sense.

Inverted yield curve.png

 

The picking of recession is obviously critical in determining the likely future performance of the sharemarket.

As a rule, sharemarkets generally enter bear markets, falls of greater than 20%, in the event of a recession.

Nevertheless, while a recession is necessary, it is not sufficient for a sharemarket to enter a bear market.

See the graph below, as it notes, since 1957, the S&P 500, a measure of the US sharemarket:

  • three bear markets where “not” associated with a recession; and
  • three recessions happened without a bear market.

bear market recessions.jpg

 

Statistically:

  1. The average Bull Market period has lasted 8.8 years with an average cumulated total return of 461%.
  2. The average Bear Market period lasted 1.3 years with an average loss of -41%
  3. Historically, and on average, equity markets tend not to peak until six months before the start of a recession.

The current US sharemarket bull market passed its 9 year anniversary in March 2018.  The accumulated return is over 300%.

 

Mind you, we have to be careful with averages, I like this quote:

“A stream may have an average depth of five feet, but a traveler wading through it will not make it to the other side if its mid-point is 10 feet deep. Similarly, an overly volatile investing strategy may sink an investor before she gets to reap its anticipated rewards.”

 

Assessing Recession Risk

Importantly, investors should not use the shape of the yield curve as a sole guide as to the likelihood of a recession.

The key forward looking indicators to monitor include an inverted yield curve, but also a significant widening of high yield credit spreads, rising unemployment, and falling future manufacturing orders.

Tightening of financial conditions is also a key indicator, particularly central banks raising interest rates (or reducing the size of their balance sheet as in the current environment) e.g. US Federal Reserve, but also tightening of lending conditions by the large lenders such as the commercial banks to consumers and more particularly businesses.

Lastly, equity market valuation is important.

Happy investing.

 

Please see my Disclosure Statement