Note that due to reader requests, I’ve decided to break up my weekly portfolio updates into three parts: commentary, economic update, watch lists/best stocks to buy now. This is to avoid excessively long articles and maximize the utility to my readers.
This week’s commentary explains why you should ignore stock prices and focus on three far more important things instead.
Note that I offer these weekly economic updates purely because I believe that investors should always take a holistic “big picture view” of the world. That means knowing the state of the economy and what the short- and medium-term recession risks likely are. However, as I’ll explain later in this article (recession risk section), macroeconomic analysis has historically proven to be a terrible tool for stock market timing (SPY) (DIA) (QQQ). Which is why I only offer these analyses so that readers will likely be able to see a recession coming about a year or so away.
That will hopefully allow you the time to prepare yourself emotionally and financially for the downturn. It will also hopefully allow you to adjust your portfolio’s capital allocation to a more defensive stance, such as with defensive sectors, or potentially greater allocation to bonds (for lower risk-tolerant investors).
Growing Global Recession Fears…
On Friday the market was once more rocked by worries over slowing global growth, this time from China. That sent stocks down to a fresh correction low, 11.3% from their September 20th record high.
(Source: Advisor Perspectives)
According to the latest economic data, November retail sales in China grew at the weakest pace since 2003. Worse still, industrial output rose at the slowest rate in nearly three years, indicating that the trade war with the US is really starting to bite. In fact, China’s manufacturing sector is now on the verge of contracting, and the weakest it’s been since June of 2016.
(Source: Bloomberg) – above 50 indicates growth
Meanwhile, the news from Europe is also bad. According to Reuters, the EU is “expanding at the slowest pace in over four years as new order growth all but dried up, hurt by trade tensions and violent protests in France.”
And in Germany, Europe’s economic growth engine, GDP growth in Q3 shrank by 0.2% QoQ, though was still up 1.1% YoY. That’s the first negative QoQ quarter since 2015.
“The slight decline in GDP compared to the previous quarter was mainly due to foreign trade developments: provisional calculations show there were fewer exports, but more imports in the third quarter than in the second. ” – Destatis office
Meanwhile, Brexit continues to be a hot mess, with the UK racing to come up with some kind of trade deal before it officially exits the EU on March 29th.
Japan too, continues to struggle with staving off a recession. After QoQ GDP fell in Q1 the country just reported -1.2% QoQ growth in Q3. That was below already bearish expectations of -1.0% growth.
And with US economic growth forecasts now falling steadily, and the IMF recently downgrading its forecast for global growth next year, many investors are worried that a global trade war may tip the world into a recession. But the good news is that while global growth is indeed slowing, fears of a global recession are largely overblown.
…Are Greatly Overblown
First, it should be pointed out that the very risks we’re worried about, primarily the trade war slowing growth, likely makes that risk self-limiting. For example, thanks to China’s economic growth rate, which was already falling due to the government’s attempts to wean it off excessive reliance on debt as well as a labor force that’s been shrinking since 2014 (due to the one-child policy that is now suspended but too late to help) China is making strong overtures in trade negotiations including announcing plans to:
- postpone higher tariffs on $126 billion in US imports scheduled to go into effect January 1st
- buying as much as 3 million tons of US corn as early as January
- Lowering tariffs on US cars from 40% to 15% (a retaliatory tariff imposed in July)
Now it’s important to realize that due to the complex nature of these negotiations, which involve many important trade policies that need to be addressed (such as Chinese IP theft) we’re NOT likely to get a trade deal by March 1st (the current deadline). Rather economists expect that steady progress will merely cause the US and China to extend their “truce” on new tariffs.
Current tariffs will remain in place (unless the US reciprocates with pulling back on some of its enacted tariffs) and an actual definitive trade deal is likely to take six to 12 months. The US/Canada/Mexico NAFTA negotiations took 15 months to complete and there was far less animosity between America and those trade partners.
The good news is that President Trump is now listening to something other than his gut on trade policy. While short-term share prices are actually a terrible economic indicator the market fear that has tipped us into the second correction of the year also means that Trump is likely to remain at the negotiating table. That’s especially true now that solid progress is being made and he feels rising pressure from the one thing he cares about other than his gut instinct.
What about that other weak global economic growth data? Well, Japan’s economic weakness is also not as bad as it seems. According to Takashi Miwa, a Research Analyst at Nomura:
“A breakdown by demand category shows declines of 0.1% q-q for real consumer spending and 1.8% for real exports, with such factors working to push down overall real GDP growth. We think this turn to negative GDP growth is a temporary downturn caused by natural disasters. In fact, monthly indicators released since October point to a recovery in real exports and real consumer spending, which had also turned downward q-q in Jul-Sep.”
Meanwhile, the growth rate of global manufacturing, while certainly slowing from late 2017’s high, actually appears to be bottoming at a level that makes a global recession unlikely.
(Source: Bloomberg) – above 50 indicates positive growth
What about slowing global growth forecasts? Well, slower growth is not the same as negative growth. The IMF estimates that the world economy will grow 3.7% next year, down from 3.9% this year.
(Source: Forexlive) – November estimates
The OECD also expects slower but solid growth in the future, including in all major economies.
The point is that when you see scary headlines in the financial media realize that these serve two main purposes. They are meant to explain short-term market volatility (basically a guess at why stocks fall on any given day). But more importantly, they are designed to maximize page views and ad revenue. They are NOT generated with your best interest in mind. All investing decisions need to be made with a long-term focus, keeping in mind your personal risk tolerances, long-term plan, and what asset allocation is best for your financial goals.
Current Economic Growth
- Q3: 3.5% (second estimate)
- Q4: About 2.4% to 2.5%
- Full Year 2018: 2.9% to 3.1%
- 2019: 2.4% to 2.7%
(Source: Atlanta Federal Reserve)
Every major GDP model uses slightly different combinations and weightings on leading indicators to estimate the current growth rate of the economy. Thus, the actual weekly figure is far less important than the trend of the estimate.
The Atlanta Fed’s model is the most volatile one I track and is once more being far more bullish (3% growth) than the overall economist consensus (2.5%).
(Source: New York Federal Reserve)
The New York Fed’s GDP model, which tends to err on the conservative side, is siding with the consensus estimate with a 2.4% growth forecast. That’s not just for Q4 but also for Q1.
Nowcasting remains the most bullish forecast, with 3.5% growth expected this quarter, though that’s down from earlier estimates as high as 3.9%. Personally, I tend to side with the New York Fed on this one and estimate we’re currently growing 2.4% to 2.5%.
That would mean 2018 GDP Growth of:
- Q1: 2.2%
- Q2: 4.2%
- Q3: 3.5%
- Q4: 2.4% to 2.5%
- Full Year: 2.9% to 3.1%
While it’s certainly disappointing that US growth is slowing going into 2019 I must remind you that this was entirely expected.
(Source: Federal Reserve)
2.4% to 2.5% is at the low end of what the Fed is expecting for next year, and in 2020 and 2021 growth is expected to slow even more. But slower growth does not a recession make.
Recession Risk: Very Low
- The probability that we’re in a recession right now: 0.58%
- The probability of a recession starting in the next three months: 1.63%
- The probability of a recession starting in the next nine months: 22%
I use eight key meta-analyses to track the health of the economy. That includes those which have historically proven to be good predictors of recessions:
- The 10y-2y yield curve;
- The 10y-3m yield curve (most accurate)
- The Base Line and Rate of Change or BaR economic graph;
- Jeff Miller’s meta-analysis of leading economic indicators;
- The St. Louis Fed’s smoothed-out recession risk indicator; and
- The New York, Atlanta Fed’s and now-casting.com‘s real-time GDP growth trackers.
(Source: Business Insider)
The yield curve has proven the single most accurate predictor of recessions over the past 80 years. Specifically, when the curve inverts or goes below 0 (because short-term rates rise above long-term rates), then a recession becomes highly likely. It usually begins within 12-18 months.
Yield Curve Inversion Date
Recession Start Date
Months To Recession Once Curve Inverts
(Source: St. Louis Federal Reserve, Ben Carlson)
According to a March 2018 report from the San Francisco Fed, an inverted yield curve has “correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession.”
In other words, if the yield curve goes negative, there is probably a 90% chance of a recession starting within the next 17 months or so.
Unfortunately, investors hoping to use the yield curve to time market tops are out of luck. While a yield curve inversion is very accurate at predicting recessions with long lead times, its track record on predicting bear markets is far less impressive.
10y-2y Yield Curve Inversion Vs. Bear Market Starts
(Source: Wealth Of Common Sense)
The lag time between market tops and yield curve inversions is all over the map, ranging from just 2 months in 2000 to nearly 2 years in 2005.
And if we go back to 1956 (using the 10y-1y yield curve), we can also see that yield curve inversions are largely useless for timing bear market starts. In fact, on three occasions, the forward-looking market has actually peaked before the curve inverted. This means that the yield curve should not be used as a market timing mechanism but rather purely as a good recession risk indicator.
Current 10y-2y Yield Curve: 0.16% (down from 0.24% two weeks ago)
On December 3rd the 5y-3y warning curve (its inversion has heralded the 10y-2y inversion by a few months for 40 years) inverted but on December 14th it uninverted (currently 0.01%). This shows why it’s important not to panic about a warning curve inversion because yield curves can go up as well as down.
But more important than the 10y-2y curve is the 10y-3m curve.
(Source: San Francisco Federal Reserve)
According to an August 2018 study by the San Fran Fed, “The best summary measure is the spread between the ten-year and three-month yields.”
10y-3m yield curve: 0.47%
According to a Dallas Fed bank survey, banks are closely watching the 10y-3m curve and plan to pull back on lending (and thus cause the recession they fear) when this curve inverts. Fortunately, that curve, the most accurate recession predictor of all, has been flattening at a highly predictable rate. If that trend continues then it will take 14.5 months for the 10y-3m curve to invert.
At which point we’re likely about a year away from recession. That means that my best estimate of the next recession start date is 23.5 to 30.5 months (December 2020 to July 2021).
But it’s important to remember that you shouldn’t fear a flat yield curve as a sign of poor short- to medium-term stock performance.
During the strongest bond market in US history (tech boom), the yield curve was as low or even lower than it is now. Of course, that was also an epic bubble, but the point is that a flat, but positive yield curve is not a sign of poor returns ahead.
Average Monthly Stock Market Returns By 10y-2y Yield Curve Slope (Since 1976)
In fact, over the past 42 years, the period when monthly stock returns were at their highest and volatility was at its lowest was when the yield curve was flat but positive. This means that we’re likely in the sweet spot right now, and investors should avoid using fears of yield curve inversion as a reason for market timing.
That’s because even after an inversion occurs, stocks tend to continue rising for quite some time and tend to generate strong returns before the next bear market begins.
Basically, the yield curve is a totally binary indicator.
- positive = very low recession risk (carry on with long-term investing plans)
- negative = 90% chance recession is coming within 6 to 24 months (most likely 18 months) – consider getting more defensive
The second economic indicator I watch is David Rice’s (aka Economic PI) baseline and rate of change, or BaR economic analysis grid. This is another meta-analysis incorporating 19 leading indicators that track every aspect of the US economy. That includes the yield curve, though a different version of it. I consider it the best overall indicator of fundamental economic health (because it’s so granular).
(Source: Economic PI)
The BaR grid has shown to be a reliable indicator, predicting the 1980, 1990, 2001, and 2007 recessions.
(Source: David Rice)
Currently, 11 out of 19 economic indicators are pointing to positive economic growth with eight indicating negative growth. That number of negative indicators is up from three two weeks ago.
(Source: David Rice)
Note that over the past 35 weeks, the number of leading indicators in the decline quadrant has ranged from three to 10. There is a lot of volatility between the number of indicators showing decelerating or accelerating growth. This is just statistical noise, and only long-term trends should be used as recession risk warning signs.
(Source: David Rice)
Both the three-month and 12-month trends remain highly positive and currently moving in the right direction (continued growth). Most important of all, the mean of coordinates or MOC continues to remain high, though it is now down from 35.3% three weeks ago. The average of the leading indicators is now below the MoC though indicating that growth has likely peaked and will be trending lower (confirming what other models are expecting and forecasting).
(Source: David Rice)
According to Mr. Rice, the peaking of the MoC usually happens about two years from the start of a recession, which backs up what the yield curve (and other models) are saying.
Next, there’s Jeff Miller’s excellent economic indicator snapshot, a rich source of numerous useful market/economic data. It also provides an actual percentage probability estimate for how likely a recession is to start in the next few months.
(Source: Jeff Miller)
What I’m looking at here is the quantitative estimates of short-term recession risks. In this case, the four-month recession risk is about 1.63%, while the probability of a recession starting within nine months is down from 24% to 22%. The short-term recession risk is highly volatile, ranging from 0.24% to 3.32% since I began tracking the economy over that past eight months. Thus, the more important thing to focus on isn’t the absolute figure but the trends in both short-term and medium-term recession risks.
Both have shown low risks, with the 9-month recession risk being highly stable at 24% all year, and now falling to 22%. The falling inflation expectations are due to lower inflation expectations. The high equity risk premium (earnings yield minus 10-year yield) is good news. That indicates that stocks are now attractively priced, and we’re likely close to a bottom right now.
For a final look at recession risk, I like to use the St. Louis Fed’s smoothed-out recession risk indicator. This looks at the risk of a recession beginning in the current month (it’s actually delayed two months). It uses a four-month running average of leading economic indicators.
(Source: St. Louis Federal Reserve)
Since 1967, this smoothed out recession probability estimator has predicted five of the last seven recessions before they have started. The key is that as long as the recession risk is at 3.9% or below, the economy is very unlikely to be in a recession. At 0.58% risk right now, this confirms that the US economy is likely to keep expanding for the foreseeable future.
Bottom Line: Next Year Is Likely To Bring Slower Global Growth But No Worldwide Recession Is Likely
Again, I’m not a market timer, just a macroeconomics nerd (my major in college) who wants to ensure I and my readers see the big picture. Any estimates of when recessions and bear markets are likely to begin are purely based on historical averages, and the most time-tested models we have. They are probabilistic and not definition predictions that should be used for market timing purposes.
Basically, these weekly economic updates are not meant for market timing purposes, but rather to allow you to prepare yourself emotionally and financially for when a recession does inevitably happen. It’s also meant to give you around a year’s warning (hopefully longer) to adapt your portfolio’s capital allocation strategy.
That might mean:
- Stockpiling some cash (to take advantage of future bargains during a bear market);
- Putting new capital to work in more defensive companies (utilities, healthcare, telecom, consumer staples); or
- For the most risk-averse investors, potentially moving some money into bonds or cash equivalents (asset allocation changes).
Personally, I’m now in recession prep mode, which means I’m focused on paying off all margin ($129,000 worth) ahead of the next bear market which is still a long way off (but it will take me about 15 months to pay off that much margin which is why I’m starting now).
- next recession start date: around late 2020 to mid-2021 (most likely early 2021)
- next bear market start date: around mid-2020 to late 2020
I’m not actually being defensive since I’m still 100% in stocks and have no plans to sell before the next market downturn starts. Nor do I recommend most investors switch from their current long-term investment plans, which should already have you in the right asset allocation that best meets your personal needs and risk profile.
Rest assured that if the macro trends (both economic and earnings) shift and point to a recession (and bear market) coming within the next 12 to 18 months, you’ll read about it here. But for now, investors can cheer:
- the more dovish Fed they’ve been hoping for
- good progress on trade negotiations with China
- that global economic (and earnings) growth remains positive
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.