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Are we “slow walking” into a recession?  Time will tell…

Michael R. Bacci, CFP

BACCI INESTMENTS GROUP, INC

3140 Stillwater Drive, Suite A

Prescott, AZ  86305

928-445-2598

July 15, 2019

 

For several years now (based on economic models and trends), the majority thinking among several leading economists and business leaders has been that the U.S. will experience a pronounced economic slowdown in early to mid 2020.  Many feel that this slowdown will lead to a recession.  A recent survey1 of corporate CFO’s (Chief Financial Officers) reads that near 50% of those polled feel that a recession will take place in 2020, if not earlier.

 

Since the Fall of 2018, economic data can now be seen as providing a pattern which at the very least indicates an expected reduction in corporate earnings and slowdown of overall economic activity.  As of late (Since the Spring of 2019), this data has accelerated to where manufacturing in the U.S. has declined dramatically in all sectors of the country, and is on track to low levels not seen since right before the Great Recession started in 2007.   Some are already making the call that we are in a manufacturing recession and that this slowdown in manufacturing is spreading to other business sectors in the overall economy.

  

Historically a recession has been defined (generally) as a period of negative economic growth in the Gross Domestic Product (GDP – the measure of all transactions of goods and services in a country for specified period) of the U.S. for at least two consecutive quarters (six months or more).  Although the first quarter of 2019 reported Gross Domestic Product (GDP) 3.2%, it is widely expected that 2nd quarter GDP will be around 1.5% or even less.   

 

As of the beginning of July 2019, the still intact economic expansion has been certified as the longest period of economic expansion (121 months) since records have been kept.  This expansion has been impressive not only in its duration, but in the amount of gains in the stock markets.  Since the bottom of the stock market crash of 2009, the S&P 500 index has gained over 300%. 

 

Having provided professional investment advice to clients for over 20 years now, I have seen many trends.  The most alarming trend at this time is the very high level of stock valuations compared to the declining rate of economic activity (economic fundamentals).  We saw this phenomenon start in 2007 before the meltdown into the Great Recession.  Stock markets were accelerating, and the economy was slowing, and there was obviously a bubble in housing prices which was unsustainable.  Housing prices in 2007 had reached levels where average purchaser wages and average retirement income levels could not continue to enable consumer to afford home prices. In short, everything was overvalued and there was not an economic engine strong enough to keep things moving in a sustainable and fundamentally supported fashion….then recession hit, and because of the level of excess in asset prices, the recession hit hard.  It is appearing as though we may have reached these price levels again.  Housing prices are near or above the peak of the housing boom of 2006. 

 

 

When assessing the current housing market, my feeling is that consumers are more educated with the fact that housing prices do not continue to go up indefinitely. Consumers who are aware of this are not rushing out to buy houses at these extended price levels, as they either can’t afford the prices or they assume a home purchase will be a much better investment if they wait for a downturn.  Because of the extreme effects of the Great Recession, many feel that renting is a much more flexible approach to housing than owning an asset which A) may be worth much less for an extended period, and B) should they lose their job, they are allowed mobility in their search for employment. 

 

It is now being reported that for the last 12 months the housing market it is showing a slowing trajectory across all regions of the United States.2 

 

To combat the potential of an economic slowdown, the Federal Reserve may begin to lower interest rates as early as this month (July 2019).   Generally the intent of lowering interest rates is to entice consumers and business to continue to purchase goods and services through financing (mortgages, business loans, car loans, credit cards, etc.).  This can cause near term optimism, especially in the stock markets because of the hope of increased future economic activity.  A point to consider though is that it generally takes 12 months or longer to see the economic effects from when the Fed lowers interest rates to when it helps the economy.  In addition, lowering interest rates between ¼ to ½ percent only saves the average home purchaser less than $15 a month per $100,000 of mortgage.  To get a real economic effect, the Fed will need to lower interest rates substantially more than what is currently being considered, and even then it will take an extended period to see any effects. 

 

Next to strong economic fundamentals, consumer and business confidence in future strength of economic growth is paramount to a sustainable economic expansion.   The Fed may lower interest rates to not only provide direct stimulus to the economy in the form of less expensive financing, but lowering interest rates may also add an element of positive psychology which they hope will keep investor and consumer confidence at healthy levels.  But if investor and consumer sentiment changes before any real effect are seen by lower interest rates, an economic slow-down may become a self-fulfilling prophecy and the markets and economy may experience a pronounced slow-down despite of the Federal Reserve’s efforts to stimulate economic growth. 

 

Currently, investors in the stock market are hoping that a return to an ultra-low interest rate environment will continue to drive economic growth, and therefore are continuing to drive stock indexes to higher and higher levels.  But with declining housing and manufacturing sectors….where is the driver of the economy going to come from?  For sustained growth, a stock market ultimately needs sustained economic activity, not just hope.

Lastly, the “wealth effect” is slowing.  The “wealth effect” is when investors, consumers, and corporations feel more wealthy because of higher investment account balances (higher stock and property values), and therefore spend their money more freely which helps keeps an economy moving.  We are now seeing reversing trends where many are not only spending less, but are looking to protect what they have made during the last 10 years.         

 

This may be attributed to their memory of the Great Recession and its dramatically negative impact on so many areas of economy.  The risk tolerance threshold for investors over the last 18 months has become much thinner and less tolerant,  as we saw during 4 stock market corrections during this same period.

 

If the economic data trend continues on a declining trajectory, much higher stock market volatility may return and the potential for exaggerated declines in asset prices may take hold.  If we lead into a declared recession market declines may become pronounced.  History tells us that declines in the S&P 500 Index during recessionary periods has averaged between -25% to -55%.3   Recessions during the last 20 years from “super cycle” economic growth (Technology Boom to Bust and Housing Boom to Bust) have averaged greater than -50% in a decline in the S&P 500 Index. 

 

During late stage market cycles such as the period we may be in now, those who retain ownership in stock investments should assess their risk tolerance of going through periods of heightened and prolonged market volatility and declining stock prices.

 

If an investors does not have a high enough risk tolerance for large near term market declines, and does not feel that they wish to commit to a long term stock investment time horizon (at least 5 years), then having a discussion of a defensive investment strategy may be in order.   In addition, investors with a higher risk tolerance may wish to look into investment strategies which may take advantage of market opportunities that may arise during times of economic distress.

 

During the past several months I have had these conversations with clients and continue to be here to listen and to advise on all of these market possibilities.

 

Michael R. Bacci, CFP

 

 

Current risks to the investment markets and economic growth:

 

  1. An acceleration in a trade war with China.
  2. The potential of armed conflict with Iran.
  3. High Oil prices.
  4. Slowing economic growth in U.S. manufacturing sector
  5. Slowing economic growth in U.S. housing market
  6. A reversing (downward) trend over last several months in the amount of newly hired non-farm related jobs.
  7. Economic slowing in China
  8. Economic slowing in Europe with potential for recession in European Union.
  9. A disorderly exit of Great Britain leaving the European Union (Brexit).
  10. A reduction in corporate stock buybacks as companies prefer liquidity to buying their own stock due to economic uncertainty. https://www.wsj.com/articles/decline-in-share-buybacks-deals-blow-to-stock-market-11562063438.
  11. Very high levels of corporate debt due to excessive borrowing at very low interest rates over the past 10 years.
  12. Very high inflation adjusted stock valuations when compared with earnings growth and company fundamentals.  https://www.multpl.com/shiller-pe
  13. Potential for impeachment proceedings of President Trump, as early as this Fall. (politics aside, impeachment proceedings of any President have the potential to cause uncertainty risks for markets).

 

Disclosure:  The content of this article is solely the work and opinion of Michael R. Bacci, CFP and does not represent in any way the views of Royal Alliance Associates, Inc. or any of its affiliated companies. 

 

Any mention of past market or investment performance is not a guarantee of future performance.

 

References:                            

1) CBS News:  06/12/2019:  Nearly half of U.S. financial chiefs expect economic recession within one year:

https://www.cbsnews.com/news/nearly-half-of-u-s-financial-chiefs-expect-economic-recession-within-a-year/

2) CNBC:  07/02/19:  Housing is providing another in a line of troubling signs pointing to an economic downturn

https://www.cnbc.com/2019/07/02/home-sales-point-to-recession-in-late-2019-or-2020-fed-economist-says.html

3) 11 historical bear markets:  From Great Depression to Great Recession.

http://www.nbcnews.com/id/37740147/ns/business-stocks_and_economy/t/historic-bear-markets/#.XRz7hehKiUl

 

 

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