Recessions are Unavoidable. WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS December 19, 2017 Recession Indicators Agree the Expansion Continues

Transcription

1 Austin Pickle, CFA Investment Strategy Analyst WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS December 19, 2017 Recession Indicators Agree the Expansion Continues Key Takeaways» There are several economic indicators that investors can track to gain a sense of recession risks. We monitor these indicators, and many others, on an ongoing basis.» The stock market, the ratio of copper prices to gold prices, the yield curve, and The Conference Board s Leading Economic Index (LEI) are some of the most popular. Currently, they are all in agreement, with data signaling that another U.S. recession is not imminent. What It May Mean for Investors» With the economic expansion expected to continue in the near term, Wells Fargo Investment Institute (WFII) favors most cyclical sectors (Consumer Discretionary, Financials, and Industrials). WFII also believes that investors should have less exposure to defensive sectors (Energy, Utilities and Consumer Staples).» We expect real estate investment trusts (REITs) to continue performing well. We also believe that the yield curve remains modestly attractive through the intermediate-bond area. While we favor broadly diversified debt holdings, the flattening Treasury yield curve diminishes the benefit from moving into longermaturity U.S. issues. We all remember the panic and devastation of the great financial crisis of Now, on the 10th anniversary of one of the worst recessions in history, some investors have asked, Is another one just around the corner? While we do not expect a recession in the U.S. this year or next, in today s report, we highlight some of the indicators that investors can track to help determine the next turn in the domestic economy. We also share our assessment of the U.S. economic outlook. Recessions are Unavoidable As painful as they are, recessions are a normal part of economic cycles. During a period of economic prosperity, household and business confidence rises until it tips over into overconfidence. This generally leads to excesses in certain parts of an economy, such as when firms and individuals take on more debt than they can truly afford or when market bubbles develop. Yet, there often is a specific event that triggers the start of a recession, such as the subprime mortgage crisis of 2007, or the oil crisis of the 1970s. When this happens, consumer confidence drops, credit tightens, spending falls, unemployment rises, defaults increase, and economic growth recedes into recession Wells Fargo Investment Institute. All rights reserved. Page 1 of 8

2 Are there any readily available recession predictors? The National Bureau of Economic Research (NBER) is a private, nonprofit research organization that is tasked with determining the official beginning and end of U.S. recessions. But, the NBER has declared the existence of a recession on average eight months after the recession has started. Are there simple indicators that a casual observer could monitor to get a sense of recession risks before a recession develops? The short answer is yes the stock market, the copper-to-gold price ratio, the yield curve, and The Conference Board s LEI have been some of the most useful recession predictors, in our view. We review each of these below and share our perspectives on them today. Stocks as a recession predictor Negative stock-market returns can be a sign that consumer spending, business spending, manufacturing activity, and/or sentiment are weakening. Any of these could signify poor economic health ahead. Chart 1 shows how successful the stock market has been at predicting recessions. The shaded areas show official U.S. recessions. The green area is the year-over-year return of the stock market. Notice how the green drops below zero prior to, or coincident with, nearly all recessions. Yet, it is important to be wary of false alarms as stock returns have turned negative many times without a subsequent recession. These false alarms happen for numerous reasons, such as overly optimistic investor expectations that do not play out or a decline in company earnings like we saw earlier in this economic cycle. We believe that strong recent stock-market returns indicate that U.S. economic growth will continue in the near term Wells Fargo Investment Institute. All rights reserved. Page 2 of 8

3 Chart 1. Stocks as a recession predictor 60 Dow Jones Industrial Average (YoY %) Dow Jones Industrial Average (Year-over-Year %) Gray shaded bars indicate U.S. recessions Sources: Bloomberg, Federal Reserve Bank of St. Louis Economic Research (FRED), Wells Fargo Investment Institute. Monthly data: January 31, 1900 through November 30, Past performance is no guarantee of future results. You cannot invest directly in an index. Real Assets as a recession predictor (copper-to-gold price ratio) The copper-to-gold price ratio is monitored by some as a gauge of economic health. Copper, or Dr. Copper, as it sometimes is called, can be useful in ascertaining the health of the economy because it is used in a wide range of industries. When the economy is booming, many industries are expanding, and construction and manufacturing typically are thriving. As a result, the demand for copper rises, causing its price to increase (and the opposite is true when economic growth is falling). Gold, on the other hand, is thought of as a safe-haven asset. As such, gold prices typically increase when investors are worried about future conditions. The ratio of these two metals prices (the price of copper divided by the price of gold) can act as an early warning system for an economy. If the ratio decreases, the economy could be expected to slow. Chart 2 reviews how well this ratio has performed, and the results are similar to stocks. Yes, the ratio declined immediately prior to most recessions, but there also were plenty of false alarms. Today, the copper-to-gold price ratio is firmly within expansion territory as the indicator recently increased by more than 40% on a year-over-year basis Wells Fargo Investment Institute. All rights reserved. Page 3 of 8

4 Chart 2. Copper-to-gold price ratio as a recession predictor 100 Copper/Gold Ratio (YoY %) Copper/Gold Ratio (Year-over-Year %) Gray shaded bars indicate U.S. recessions Sources: Bloomberg, Federal Reserve Bank of St. Louis Economic Research (FRED), Wells Fargo Investment Institute. Monthly data: January 31, 1968 through November 30, Past performance is no guarantee of future results. Bond yields as a recession predictor (an inverted yield curve) We have come to what may be the most well-known recession predictor: the yield curve. The yield curve is determined by a series of yields along the maturity range of fixedincome issues from short-term yields to long-term yields. A recession may be imminent when the yield curve inverts (short-term yields move higher than the longterm yields shown in Chart 3 when the red area is below zero). This indicator has been especially accurate since the 1957 recession (it was not particularly useful before that time), with very few false alarms. Out of the single factor predictors, this one has been, by far, the most reliable in modern history. Notice how the difference between long- and short-term yields is declining (a flattening yield curve) but remains in positive territory today. This signals that a recession is not imminent, and, in fact, that it is unlikely in the near term (based on this indicator). Keep in mind that yield-curve flattening is normal and results from growth expectations tapering later in the economic cycle. In other words, a flattening yield curve does not necessarily mean that an inverted yield curve is imminent Wells Fargo Investment Institute. All rights reserved. Page 4 of 8

5 Chart 3. Yield curve as a recession predictor 4 Long-Term Treasury Yields minus Short-Term Yields Long-Term minus Short-Term Treasury Yields Gray shaded bars indicate U.S. recessions Sources: Bloomberg, Federal Reserve Bank of St. Louis Economic Research (FRED), Wells Fargo Investment Institute. Monthly data: January 30, 1920 through November 30, Long-term yields shown are a composite of FRED data, including U.S. long-term Treasury yields and the 10-year U.S. Treasury yield. Short-term yields are a composite of FRED data, including U.S. 3-6 month Treasury yields and the 3-month U.S. Treasury yield. Past performance is no guarantee of future results. The Conference Board s Leading Economic Index as a recession predictor The Conference Board created the LEI, which is a weighted average of 10 indicators, in an attempt to blend multiple single factors into a reliable recession predictor. Chart 4 shows that The Conference Board has largely succeeded the LEI historically has been quite good at warning of a recession prior to its start. Notice how the blue bars dip below zero prior to the start of the past 7 (of 8) recessions, with few false alarms. Yet, there have been a number of near misses as the index returns have approached zero multiple times in the 1990s and 2000s. Again, this indicator is far from recession territory today and, in fact, is increasing. Chart 4. The Conference Board s LEI as a recession predictor 15 Leading Economic Index (YoY %) 10 Leading Index (Year-over-Year %) Gray shaded bars indicate U.S. recessions Sources: Bloomberg, The Conference Board, Federal Reserve Bank of St. Louis Economic Research (FRED), Wells Fargo Investment Institute. Monthly data: January 31, 1960 through October 31, Past performance is no guarantee of future results Wells Fargo Investment Institute. All rights reserved. Page 5 of 8

6 We believe the U.S. economic expansion will continue The economic indicators that we have analyzed in today s report can provide useful warning signs for investors. Stocks, the copper-to-gold price ratio, the yield curve, and the LEI all have had success in predicting past recessions. Currently, all four are providing the same signal; that the U.S. economic expansion is poised to continue. Investment implications Ten years is a long period of time between (the start of) recessions, and it is natural for investors to get nervous that another one is quietly approaching. Yet, economic expansions don t die of old age; they typically die from excessive optimism concentrated in specific sectors of an economy. With little sign of domestic economic excesses and growth expected to continue (and accelerate) in 2018, we recommend that most investors resist the urge to become overly conservative. Rather, investors should ensure that allocations to cash alternatives, stocks, bonds, and real assets are in line with their goals and risk profile. Within equities, cyclical sectors tend to benefit most from an accelerating economy, while defensive stocks typically are less impacted. With the signs pointing to continued growth, WFII continues to favor most cyclical sectors (including Consumer Discretionary, Financials, and Industrials) and believes that investors should have less exposure to defensive sectors (including Energy, Utilities and Consumer Staples). Real estate and the companies that invest in real estate, such as real estate investment trusts (REITs), should benefit from continued economic growth, and we continue to have a favorable view of REITs as we enter While we recommend broadly diversified global fixed-income holdings (including exposure to all major U.S. and international fixed-income classes and all domestic maturity categories), the flattening U.S. yield curve decreases the yield pickup from moving into longer maturities and also diminishes the potential benefit from doing so. We favor a neutral duration 1 positioning, and we recommend that investors raise average credit quality as we continue to move through the latter part of the U.S. economic cycle. 1 Duration measures a bond s price sensitivity to interest-rate changes. Bonds with shorter duration tend to be less sensitive to changes in interest rates (assuming a parallel shift in the yield curve) Wells Fargo Investment Institute. All rights reserved. Page 6 of 8

7 Economic Calendar Date Report Estimate Previous 12/19/2017 Housing Starts 1245k 1290k 12/19/2017 Housing Starts MoM -3.50% 13.70% 12/19/2017 Building Permits 1277k 1297k 12/19/2017 Building Permits MoM -3.00% 5.90% 12/19/2017 Current Account Balance -$116.0b -$123.1b 12/20/2017 MBA Mortgage Applications % 12/20/2017 Existing Home Sales 5.52m 5.48m 12/20/2017 Existing Home Sales MoM 0.70% 2.00% 12/21/2017 GDP Annualized QoQ 3.30% 3.30% 12/21/2017 Initial Jobless Claims 235k 225k 12/21/2017 Personal Consumption % 12/21/2017 Continuing Claims k 12/21/2017 GDP Price Index 2.10% 2.10% 12/21/2017 Philadelphia Fed Business Outlook /21/2017 Core PCE QoQ % 12/21/2017 Chicago Fed Nat Activity Index /21/2017 FHFA House Price Index MoM % 12/21/2017 Bloomberg Consumer Comfort /21/2017 Bloomberg Economic Expectations /21/2017 Leading Index 0.30% 1.20% 12/22/2017 Personal Income 0.40% 0.40% 12/22/2017 Personal Spending 0.40% 0.30% 12/22/2017 Real Personal Spending 0.20% 0.10% 12/22/2017 PCE Deflator MoM 0.30% 0.10% 12/22/2017 PCE Deflator YoY 1.80% 1.60% 12/22/2017 PCE Core MoM 0.10% 0.20% 12/22/2017 PCE Core YoY 1.50% 1.40% 12/22/2017 Durable Goods Orders 2.00% -0.80% 12/22/2017 Durables Ex Transportation 0.50% 0.90% 12/22/2017 Cap Goods Orders Nondef Ex Air 0.40% 0.30% 12/22/2017 Cap Goods Ship Nondef Ex Air % 12/22/2017 New Home Sales 650k 685k 12/22/2017 New Home Sales MoM -5.10% 6.20% 12/22/2017 U. of Mich. Sentiment /22/2017 U. of Mich. Current Conditions /22/2017 U. of Mich. Expectations /22/2017 U. of Mich. 1 Yr Inflation % 12/22/2017 U. of Mich Yr Inflation % 12/22/2017 Kansas City Fed Manf. Activity /26/2017 S&P CoreLogic CS 20-City MoM SA % 12/26/2017 S&P CoreLogic CS 20-City YoY NSA % 12/26/2017 S&P CoreLogic CS 20-City NSA Index /26/2017 S&P CoreLogic CS US HPI YoY NSA % 12/26/2017 S&P CoreLogic CS US HPI NSA Index /26/2017 Richmond Fed Manufact. Index /26/2017 Dallas Fed Manf. Activity Source: Bloomberg as of 12/15/ Wells Fargo Investment Institute. All rights reserved. Page 7 of 8

8 Risk Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities. Investments in fixed-income securities are subject to interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity. There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets. General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR Wells Fargo Investment Institute. All rights reserved. Page 8 of 8