We trust you’ve all had a pleasant summer. As we head into autumn, the question on every investor’s mind seems to be when the longest running bull market in US history will end. For several quarters, we’ve advocated caution based on our view that equity valuations continue to be unreasonably high. We have, however, always kept Keynes’ adage in mind, that “The market can remain irrational longer than you can remain solvent”. Keynes learned this valuable lesson through his own experience trading currencies and investing on behalf of the King’s College endowment from 1921-1946. Many things have changed in the investment world since Keynes coined that phrase, but economic cycles have not. And just as it was during Keynes’ time, all bull markets eventually come to an end (sometimes abruptly) and usually with a recession.

When assessing the health of the economy, there are several indicators investors and economists monitor to gauge whether the business cycle is approaching a recession. Let’s consider them one by one:

• Consumer Confidence Index: This index published by The Conference Board measures economic optimism of US consumers via their spending/savings activities.  The Consumer Confidence Index dropped 9 points to 125 in September, with both consumers and businesses indicating conditions were not as good as they were earlier in the year, however levels are still fairly high. The same organization publishes a “CEO Confidence index” which also dropped 9 points to the lowest level in our decade long expansion, suggesting the corporate C-suite is showing more trepidation than consumers at the moment.
• Stock Prices: are considered a leading indicator of economic activity since valuations are based on future earnings. The S&P 500 reached an all time high in August (3007 points), we are now approx 4-5% below that high.
• Purchasing Managers Index: The Institute for Supply Management publishes an aggregate measure of the US manufacturing sector. This index dropped to 47.8% in September (from 49.1%). Any reading below 50 signals a contraction. A key measure of exports dropped to the lowest level (41%) seen in a decade. The corresponding measure for the services sector (the NMI) stands at 52.6%.
• Durable and manufactured goods orders: The US Census Bureau reported that durable goods orders increased by 0.2% in August, while shipments and inventories of durable goods rose marginally. New orders for manufactured goods dropped by 0.1% in August, shipments and inventories rose marginally. 
• Housing starts: The Census Bureau also reported that building permits rose 7.7% in August (seasonally adjusted). New residential construction is at the highest level it has been since 2007 (but well below the highs of 2005).  Some of this can be attributed to falling interest rates lowering the cost of capital.
• Weekly Hours: This measure estimates the number of paid hours worked by the hourly workforce. This indicator bottomed out at 33.7 hours in 2009, it reached a high of 34.6 hours in 2016. It is now close to that high, at 34.4.
• Global Trade: The WTO measures trade in goods and services across the world. Its most recent report indicates global trade in both goods and services has weakened in all regions this year. The softness is largely driven by unresolved trade disputes. The Global PMI stands at 47.5, which is the lowest level since 2012. 

Taken in aggregate, consumer confidence (the most forward looking measure) and the PMI indicate some softness in the economy. Global trade activity is weakening, which is also a negative sign. Other indicators signal low to moderate growth. The services sector appears to be growing, with exports and manufacturing showing no growth or mild contraction.

Interest Rates are also considered a leading indicator of economic activity. Lending for long periods of time carries greater risks than short term lending, and investors generally demand higher rates to lend for longer periods. When long term interest rates are higher than short-term rates, the “yield/rate curve” is considered to be normal. When long-term interest rates fall below short-term rates, it implies that bond investors believe rates will be lower in the medium-long term (i.e. the Fed will lower rates in response to a worsening economy). This is often called an “inverted yield curve”.

Many participants watch the “10 Yr – Fed Funds spread” to gauge the shape of the curve. This measures the difference between 10 Year interest rates and overnight Fed funds rates. When the overnight (1 day) interest rate is above the 10 Year rate, the spread is negative. The graph below shows a history of this rate spread. Every recession since 1960 (see shaded columns) has been preceded by a negative spread, i.e. an inverted yield curve.

Unemployment rates are the strongest single indicator that a recession has begun. Unemployment claims tend to rise almost exactly as the economy contracts.  Businesses know it’s expensive to hire and train staff, so managers often wait to reduce headcount until they’re certain markets are shrinking. When large numbers of workers are laid off, they change their consumption behavior, spending less. This change in behavior can become “contagious” as neighbors and former colleagues of the unemployed also retrench, reducing their own consumption in the face of economic uncertainty. This feedback loop in turn deepens the recession.

Overall, we believe there are significant risks of a recession ahead. If the unemployment rate rises, and the stock market slides further, that should be seen as a confirmation that the economy has begun contracting. We would then recommend very defensive positioning in client portfolios.

Our current recommendation to investors is to maintain caution and vigilance, rebalancing portfolios to be defensive and be prepared to act if conditions deteriorate further. 

Regards,

Subir Grewal, CFA, CFP                                                                     Louis Berger

Friends,

We hope you’ve had a good start to the summer.

The interest rate outlook has changed considerably since the beginning of the year. Investors entered  2019 with an expectation the Fed was likely to continue raising rates over the course of the year. However, recent comments from Fed officials have made rate hikes far less likely. There seem to be three factors influencing  this sudden shift in Fed policy. The first is gathering signs of a softening economic activity across the world (the IMF estimates countries representing 70% of the global economy will slowdown in 2019). The second is continuing uncertainty surrounding the US’s trade policies. The last is the political pressure being placed on the Fed, mainly expressed in the form of public statements and tweets from the president as we head into a presidential election next year. Rate cuts at this juncture would prolong the rally and the current economic expansion, aiding the administration’s prospects in 2020. Though other administrations have tried to coax the Fed, they’ve done so more quietly. We don’t know whether Fed officials will find Trump’s more public approach tougher to ignore. The bond market itself seems to be anticipating cuts, the yield curve is “inverted”, i.e. near-term rates are lower than those further out. This has historically been an accurate indicator of an upcoming recession.

As we begin the third quarter, the stock market remains close to all time highs, with the S&P 500 hovering at just under 3000 points. Despite some turbulence, stocks continue to be led by the technology sector, which is now over 26% of the S&P 500’s market capitalization. That factor has only been higher once, during the peak of the tech boom when it crested over 30%. The Nasdaq, which contains a large number of technology companies, is above 8000, an all-time high. However, there are some indications that the technology rise has run its course. This year has seen a steady spate of large technology IPOs for companies that have grown privately over the past ten years. This includes: Lyft, Uber, Slack and Pinterest among others.  Historically, such a spate of stock sales has been an indication that professional tech venture capital investors see the current price environment as a high-watermark, and an ideal time to exit investments that have grown in value for several years.

In general, the economy remains at very high levels of capacity utilization. Unemployment remains at a multi-decade low and wages rose swiftly in the past two quarters. The manufacturing and services sector remain at high levels, but growth in new orders has slowed. The purchasing managers indices for both manufacturing and services fell below 51 (a level of 50 indicates no growth). Anecdotal reports suggest the weakness is at least partly due to trade uncertainties. Consumer confidence also remains high, despite a sharp drop in May. 

Our general view remains that investors should exercise caution. We continue to recommend a defensive allocation with greater exposure to high quality bonds and lower exposure to risk assets.  

Regards,

Subir Grewal, CFA, CFP                                                                     Louis Berger

Dear Friends,

Spring is in the air. Subir’s younger daughter won’t step outside without checking to see what plants and trees have flowered. It is a special joy to be reminded of the resilience of life and the cycle of the seasons.

Back in the more quotidian world of markets, Q1 saw US equities rally sharply, recovering from the lows seen in December. Stocks remain below the highs of last summer. Part of this can be explained as a relief rally after a tough Q4. Year-end consumer spending was not as bad as feared. The government shutdown did eventually end and everyone apart from contractors was paid for time lost. Of course, time is a non-renewable resource and several weeks of human effort were lost.

A more influential factor spurring the rebound was the Federal Reserve reversing policy in early January, telegraphing a pause in interest rate hikes. The Fed appears to have been spooked by a confluence of factors including: the shutdown, Brexit, the Q4 correction, deterioration in hiring, and a softening of real-estate prices in several markets. Going into the year-end, we’d expected two rate hikes in 2019. It is now far less likely that this will happen. In our view, this weakens the Fed’s ability to act if we do enter another recession.

There is some speculation that the Fed’s back-tracking was a response to pressure from the White House. If that were the case, it would be a cause for concern. It’s clear to all concerned that the president would like to see an accommodating, low-interest rate policy heading into the 2020 election cycle. In that respect, this White House is no different from any other first-term administration. However, the nature of the President’s statements is somewhat unprecedented. The Fed is largely independent of the government and such attacks do present another test to our institutions. However, most market participants have been ignoring rhetoric coming out of the White House. As long as the Fed governors don’t let this affect policy, and chairman Powell can brush off the president’s frequent bromides, the White House’s statements are likely to have no impact on the market.

Looking beyond our shores, we still see an unsettled environment. The United Kingdom continues to lurch towards a break with the EU, without any firm plan in place. In our view, the UK’s exit from the EU system will have a significant economic impact, but it is unlikely to be extreme. We do not ascribe to the doomsday Brexit scenarios.

Further afield in Asia, we still see unsettled questions around trade with China impacting real economic activity. Companies continue to shift production out of China and into other South Asian countries. We believe these trade spats portend a major shift away from the post-war order. For over 70 years, we have seen free, global trade as the reigning orthodoxy for relations between nations. This is now being replaced by a more mercantilist stance in both the EU and US. The US response to the rise of Huawei and other 5G Chinese manufacturers underscores this. In Japan, the details of Charles Ghosn’s arrest suggest that Japanese officials moved out of fear a top-3 Japanese automaker would be absorbed into Renault.

If we are honest with ourselves, we will admit that various European countries, and Japan have always had a mercantilist trade policy supporting national champions. The US less so for most of the 20th century (outside of energy policy). That is clearly no longer the case, at least under this administration.

There are several reasons for this shift, the most significant is the clear rise of China under a semi-managed system. The development of an information-based services economy and the disruption of manufacturing industries through outsourcing is also part of the explanation. These momentous changes taken together have brought into question the 20th century orthodoxy of free-trade in goods/services as the only route to prosperity. Many in developed countries challenge these assumptions by pointing to declining living standards among the general population. They can also point to examples like China, which continues to keep much of its domestic economy closed and props up state-owned national champions. All this creates a more unpredictable investment climate, where we now have to consider the political links of major companies alongside their purely commercial prospects.

From an investment perspective, we continue to advise investors to maintain cautious allocations. Though markets have recovered from their December lows, the past 15 months have seen increased volatility and we expect that to continue going forward. As we enter the spring, we will remain watchful for long-term opportunities that arise from any further correction.

Regards,

Subir Grewal, CFA, CFP Louis Berger