Is a Recession Imminent? Why Investors Should Not Fear For Now.

Transcription

1 Is a Recession Imminent? Why Investors Should Not Fear For Now Contents Overview 1 Are We Close to a Recession Now? How Can We Tell? Indicator 1: Real Income 4 Indicator 2: Employment 8 Indicator 3: Wholesale Retail Sales 10 Indicator 4: Industrial Production 11 4 Author: Ryan Hanna, CFA, CAIA Title: Senior Vice President Author: Catherine Hickey Title: Vice President Author: T.J Kistner, CFA, CAIA Title: Director Company: Segal Marco Advisors Website: Indicator 5: Real GDP 12 Conclusion 15 This report was prepared by The Marco Consulting Group prior to its acquisition by Segal Rogerscasey. The combined firm is called Segal Marco Advisors.

2 2 Overview US stock investors have become accustomed to steady, strong returns over the last few years, but a recent bout of lackluster performance has caused many to worry. After seven years of a bull market that began in 2009, the S&P 500 was down -5.1% in the first two months of this year. Since then, a robust rally for stocks in March 2016 has eased investors pain somewhat. However, such sudden declines for stocks may conjure memories of the 2008 financial crisis and the ensuing severe downturn for stocks back then. It was not just the performance declines that sparked investor nervousness recently. The volatility associated with these performance chang- FIGURE 1: Performance Figure 1 depicts the performance of the S&P 500 index from The current bull market for stocks began in March 2009 and has continued ever since.

3 3 es has also taken investors on a bumpier ride than they have grown used to in recent years. Volatility was relatively low between 2012 and 2014, as news about the economy improved steadily and investor optimism grew. However, choppiness has returned in 2015 and early 2016 and comes on the heels of a disappointing 2015 for stocks, commodities, and many bond categories. Volatility, which is indicated in Figure 2, is back in part because investor nervousness about the economy has grown recently. As concern has grown regarding the health of the U.S. economy, chatter on financial news outlets has turned to the possibility that a recession could be imminent. An economic recession has direct impact on the performance of the assets in your FIGURE 2: Volatility Figure 2 depicts the level of volatility of S&P 500 stocks. Volatility was relatively high during and in the years after 2008, but it dropped significantly from 2013 to It picked up again in late 2015 and early 2016, as worries about the global economy made investors nervous.

4 4 portfolio. In a recession, investment assets typically perform poorly as conditions make it more difficult for businesses to grow, workers to find jobs, and consumers to spend. Thus, while recession is an economic phenomenon, it has real consequences for markets and for portfolios. As typically defined by mainstream media, a recession is identified by two consecutive quarters of negative Gross Domestic Product (GDP) growth. However, there is a more granular definition which is defined by the National Bureau of Economic Research (NBER), which states a recession is a significant decline in economic activity spread across the economy, lasting more than a few months. The NBER says that in a recession, declines are normally visible in five primary indicators including: Real Income Employment Wholesale-Retail Sales Industrial Production Real GDP Three of the five indicators (real income, employment, and wholesale-retail sales) are directly related to the health of the consumer, which accounts for 2/3 of the U.S. economy. This paper will examine the state of each of these economic indicators and how that relates to prior economic cycles. So, Are We Close to a Recession Now? How Can We Tell? Indicator 1: Real Income Real income, or real disposable income, is a proxy for consumers ability to spend money. It is an inflation-adjusted metric for how much money consumers have to spend on things other than essentials such as food and utilities. The more disposable income consumers have, the more likely they are to buy cars, houses, boats, etc., which in turn stimulates the economy. Figure 3 shows real disposable income (in $) over time, as well as the rate of growth. As mentioned previously, consumption (the consumer) accounts for 2/3 of GDP in the U.S. Figure 3 indicates that sharp drops in disposable income often precede a recessionary period as consumers are less likely to spend. In examining the current environment, real disposable income looks strong (up 3.4% in 2015) likely due to the sharp drop in oil prices. In essence, this translates into savings at the pump for consumers and more money that can be spent on other discretionary items. While the US experienced a sharp drop

5 5 FIGURE 3: Real Disposable Income Figure 3 depicts the past two recessions have been preceded by a decline in Real Disposable Income. Real Disposable Income has continued to show strength over the last few years. in disposable income in 2013, the economy was able to avoid recession and rebound the following year. The outlook for income growth is still very strong, though there was a leveling off in real disposable income late in Another important data point that impacts real income for consumers is the unemployment rate and wage growth. Simply put, as more people work and their pay increases, they have more discretionary income that can be spent to stimulate the economy.

6 6 FIGURE 4: US Unemployment and Hourly Earnings Growth Figure 4 depicts recessionary periods are typically accompanied by increasing unemployment and declining wage growth. Unemployment rates have been declining for the past five years while wages are improving. Figure 4 shows unemployment continues to drop steadily and currently sits at 4.9% as of the end of February, roughly in-line with pre- Financial Crisis numbers. Wage growth is also starting to increase, an indication that disposable income is increasing as well. Another encouraging sign for income growth is the quit rate in the U.S. Quit rates and wage growth are positively correlated, meaning as quit rates increase, wage growth increases as well. People typically quit their job in order to pursue a higherpaying job, so a higher quit rate could translate to more higher-paying jobs.

7 7 You will notice in Figure 5 that leading into and throughout a recession, employees are less likely to quit their job since as there are fewer jobs to find as many workers have been laid off. The current level of quits in the U.S. is strong and may indicate further income growth for the consumer. Indicator Rate: Real Income An improving labor market should lead to improving wage growth. FIGURE 5: Quits and Wage Increases Figure 5 depicts quit rates and wages generally decrease during recessionary periods. Currently, quit rates and wages are increasing.

8 8 FIGURE 6: Weekly Job Claims and Hires Figure 6 depicts hires decrease and jobless claims increase during recessions. Currently, hires are increasing while jobless claims are decreasing. Indicator 2: Employment Employment is another key metric for the consumer. The more people employed in an economy, the higher the output and the more money that can be spent within the economy. Figure 4 showed the strength in the unemployment number, which currently sits at 4.9%. Another indicator for strength in the job market is the Weekly Jobless Claims. Figure 6 shows that jobless claims are at the lowest level in 16 years, indicating that fewer and fewer people are filing for unemployment benefits. Meanwhile, the number of nonfarm hires in the U.S. is back to pre-financial Crisis levels. Both of these metrics indicate a healthy labor market. Figure 5 highlighted the relationship between quit rates and wage growth. Figure 7 shows that while the number of quits in the U.S. is increasing, the

9 9 FIGURE 7: Quits and Job Openings Figure 7 depicts job openings and quits decrease during recessions. Currently, job openings and quits are increasing. number of job openings is also increasing and at a greater rate. This indicates that as people search for higher-paying opportunities, there are more jobs available for them to find. Typically, in prerecessionary periods you would see the job market dry up and the number of job openings fall as companies cut work forces to prepare for earnings Indicator Rate: Employment Unemployment rate is steadily declining while job openings remain plentiful. slumps. This is not happening within the current job market environment.

10 10 FIGURE 8 Retail and Auto Sales Figure 8 depicts retail sales have decreased during the past two recessions. Currently, retail sales are increasing which proves contrary to past trends. Indicator 3: Wholesale Retail Sales Retail sales growth, another measure of the strength of the consumer, has been strong since This metric is tied very closely to income growth. As mentioned previously, the more disposable income a consumer has, the more likely that consumer is to buy things such as cars, appliances, homes, etc. Weakness in retail sales can often be a sign of bad things to come for the economy, as Figure 8 highlights. If consumers lose their job or are becoming worried they might lose their job, the likelihood they are going to spend money on big ticket items is low. You will notice the sharp drop in both retail sales and vehicle sales during the Financial Crisis. Compare that to today s environment, and the economy has been experiencing strong (albeit slowing) retail sales growth and even stronger growth in larger purchases such as vehicles. Vehicle sales are back to or above pre-financial Crisis

11 11 levels, indicating consumer confidence in the job market and a willingness to spend money. Indicator 4: Industrial Production Industrial Production has been the weakest component of GDP over the past couple of years. While there are many factors at play here, two prevailing themes have impacted this component Indicator Rate: Wholesale Retail Sales Retail sales growing though at a slower pace. more than anything else since Those themes are the strong U.S. dollar and energy. Net exports/imports is the proxy for Industrial Production within the GDP components. When this FIGURE 9 Purchasing Managers Index Figure 9 depicts manufacturing and services both slow materially during recessionary periods. Manufacturing is in correction territory while services is still in expansion, though weakening

12 12 number is negative, the U.S. is importing (buying) more goods than it is exporting (selling). Over the last couple of years, the U.S. dollar has significantly appreciated relative to virtually every other major currency in the world. This makes U.S. goods more expensive to foreign buyers, therefore encouraging those buyers to purchase from another country. This dynamic is hurting exports, and as a result, the companies and all other related businesses and financiers. In turn, these oil and energy companies have been slashing capital expenditure budgets and postponing (or cancelling altogether) investments in new projects. This reduction in investment also flows through to the Gross Private Domestic Investment component of GDP and is a large reason for the weakness. industrial sector as a whole. Figure 9 shows the Institute for Supply Management s Purchasing Managers Index both for the manufacturing and non-manufacturing (services) sectors. A reading above 50 indicates expansion within that industry and a reading below 50 indi- Indicator Rate: Industrial Production Strong dollar and weakness in energy is hurting industrial production. cates contraction. As shown in the chart, manufacturing has recently entered into contraction territory. While this may be cause for concern, the manufacturing sector only accounts for roughly 12% of the U.S. economy.* The services sector, which accounts for two-thirds of the economy s production, is still in expansion territory. Another theme impacting Industrial Production is energy. Oil prices have fallen from around $110/ barrel in 2013 to as low as $26/barrel in 2016 on the back of dramatic supply increases and concerns over slowing global growth. This prolonged price correction has inflicted extreme stress on oil Indicator 5: Real GDP GDP in the U.S. is comprised of four primary components: Gross Private Domestic Investment, Personal Consumption Expenditures, Government Consumption Expenditures & Gross Investment, and Net Exports of Goods and Services. By far, the largest component of GDP is Personal Consumption Expenditures (the consumer) which accounts for nearly 2/3 of GDP. Figure 9 highlights GDP growth over time along with each individual component s contribution to GDP growth. A couple of observations can be *source:

13 13 FIGURE 10: Components of GCP Growth Figure 10 depicts personal consumption and business investment weaken or turn negative during recessions. Currently personal consumption is positive, but shrinking while business investment is flat to negative. made leading up to and entering into a recessionary period (the dark shaded area). First, strength in the consumer (yellow bar), the largest component of GDP, begins to weaken and may even turn negative. Often times this will be the result of a weakening labor market or general loss of confidence consumers have in the Gross Private Domestic Investment (green bar). This too will often weaken or turn negative leading up to a recession. This is a reflection of business growth and corporate strength within the economy. When corporate investment dries up, companies begin to lay off people and earnings typically suffer. economy. The second observation has to do with

14 14 Leading into the recession of 2001, consumption and domestic investment numbers were strong. In mid to late 2000, these numbers began to weaken or drop off altogether. This coincided with the infamous Tech Bubble, a period when dot com or other tech stocks were trading at valuations never seen before and certainly not warranted by the cash flows these businesses were generating. Once the market crashed and many of these tech companies went bankrupt, business investment dropped off, workers were laid off, and the consumer stopped spending money on discretionary items. A similar dynamic played out leading up to the Financial Crisis in This time around, the bubble resided in the housing market. Sub-prime mortgages, or mortgages given to less creditworthy borrowers, were growing at an alarming rate as more and more Americans wanted to own a home amid the rapid increase in home values in the mid-2000s. Banks were happy to lend to these borrowers, package the mortgages in a collateralized pool, and sell those packages as investment products to the general public. All of this activity was additive to business investment and consumption in the early to mid-2000s. Once home prices began to fall and these sub-prime borrowers defaulted on their mortgage payments, the wheels were set in motion for a broad collapse in the economy. Banks took large losses on the mortgages they owned and would no longer lend money to businesses, who in turn laid off millions of Americans, who in turn curtailed spending. In comparing these two periods to the current economic backdrop in the U.S., the largest component of the economy (the consumer) appears to be very strong. More importantly, the data supports the notion that the consumer continues to remain relatively healthy. Disposable income is rising while unemployment is falling, job openings are plentiful while the number of people filing for unemployment is at multidecade lows, and consumers are spending the money they are saving at the pump due to lower oil prices. The one blemish in growth continues to be in the Manufacturing sector due to the strength of the U.S. Dollar and the impact low oil prices have had on investment within the energy sector. Indicator Rate: Real GDP GDP growth positive but still low.

15 15 Conclusion: This analysis of economic data is not meant to be exhaustive. It is nearly impossible to be able to pinpoint the time when an economy enters recession, and just because these indicators do not demonstrate one now does not mean that a recession is not here or is not coming. Some spots in the economy are still stronger than the best way to weather the storm. Different assets perform well at different times, and when stocks sink, assets such as high-quality bonds can perform better. It is always important to reconfirm your financial road map for achieving your investment objectives, especially during times of volatility. However, investors would do well to sit tight and ride out any market uncertainty knowing investment objectives are generally achieved over long periods of time. others, while some, like industrial production, have shown continued weakness. For instance, factory orders, an indicator of industrial production which tracks output in the economy, was negative in This has, at times, led to the economy entering into recession in prior economic cycles. Nevertheless, the data in this analysis of NBER recession indicators does not appear to show that the Indicator Rate: Real Income Indicator Rate: Employment U.S. is currently in a recession or imminently heading Indicator Rate: Wholesale Retail Sales into a recession. Instead, the economy seems relatively healthy enough to continue to grow, albeit at a lower rate than in the past. Indicator Rate: Industrial Production Given all this information, what should investors do? Though it s tempting to make changes based on the economic tea leaves, for the most part investors should stay the course. It is important to stick with your asset allocation through times of uncertainty. During volatile times, a diversified asset mix can be Indicator Rate: Real GDP The views contained in this report are those of The Marco Consulting Group (MCG) and are based on information obtained by MCG from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations, or projected returns for any particular investment product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from The Marco Consulting Group.