The stock market is considered one of several leading economic indicators. Since 1949 markets have turned lower on average seven months prior to recessions, with a median pullback of about 9%. However, this includes a wide range of numbers and in six out of the last nine recessions stocks were actually positive for the preceding twelve month period. Recently, investors’ recession fears have jumped in light of increased market volatility. While these concerns are understandable, we prefer to take a broader view when gauging the health of the U.S. economy. Doing so suggests more factors are working in favor of the current expansion than against it, and we could have more room to run.
As of March 1st, the United States entered its 105th month of economic expansion – the third longest on record. If gross domestic product (GDP) remains positive through May, the current expansion will become the second longest in U.S. history. While subpar growth has helped extend the length of this economic cycle, it’s important to acknowledge that we are likely in the later innings of the expansion that started in 2009.
Despite its unusual length, our economy has several factors working in its favor. These include strong corporate earnings growth, a healthy consumer, and improving business spending. Corporate earnings have improved significantly following a decline in 2015 that was tied to lower oil prices and an appreciating U.S. dollar. Likewise, the recently passed tax law — which reduced the U.S. corporate tax rate from 35% to 21% — should provide a significant boost to corporate spending in the months and years ahead. In fact, we’ve already seen a pick-up in capital expenditures from businesses as they’ve been able to return more cash held abroad at lower tax levels.
Although business spending has been notably weak for most of this economic cycle, the consumer has been a major contributor to GDP growth since 2009 and remains healthy. Strong jobs growth and recent gains in wage growth should continue to support household spending. While markets are concerned that the recent gains in wage growth suggest inflation may be heating up, it’s important to remember that for the last nine years investors were more worried about deflation. We would suggest the recent increases in wage growth reflect a healthy development, one that indicates a return to more normal conditions.
To that point, U.S. inflation has been persistently below the Federal Reserve’s 2% target since the Financial Crisis. With the recent uptick in wage growth, the Personal Consumption Expenditure Index (PCE) – what the Fed uses to track inflation – is now up only 1.7% on a year-over-year basis. Contrary to investor concerns, this would not suggest an over-heating price environment but a return to healthy inflation levels. Gradually rising inflation will also allow the Federal Reserve Open Markets Committee (FOMC) to continue to normalize interest rates, which have been at unusually low levels. Higher yields will help support millions of retirees on fixed incomes, stabilize many pension funds, and most importantly give the FOMC wiggle room to lower rates when the next downturn occurs.
As the FOMC continues to raise rates this year, investors and economists will be closely monitoring the yield curve. The yield curve is a line that plots the interest rates of bonds with the same credit ratings but different maturities. During economic expansions, the yield curve is usually upward sloping as bonds with longer maturities typically have higher yields. However, since 1901 there have been seventeen inverted yield curves (when the yields on shorter maturity bonds exceed those on longer maturity bonds) that have persisted four months or longer, all of which have been followed by a recession. Thus, an inverted yield curve that stays inverted for at least four months has never produced a “false positive” recession reading. This stands in contrast with the stock market, which as the late Nobel laureate Paul Samuelson once said, “has accurately predicted 9 of the last 5 recessions”.
Towards the end of 2017 the yield curve began to flatten. This caused some investors to worry it would invert, indicating a recession was around the corner. Starting in late January stock market volatility and bond yields jumped, amplifying investors’ recession fears. Ironically, the stock market turbulence and higher interest rates helped push the yield curve higher. Although the recent market swings and decline in bond prices (resulting from higher yields) were unpleasant, they are helping to avoid an inverted yield curve – one of our most reliable recession predictors.
In short, we see more positives than negatives regarding the economy. At the same time, it’s evident that we are in the later innings of the current expansion and risks such as high corporate debt levels, rising interest rates, and above-average asset valuations could trigger the next recession. Accurately predicting when that will happen, however, is a difficult job for even the most astute economists and investors. Fortunately when looking at the prior nine recessions since 1957, stocks have declined just 1.5% on average and market returns one-, three-, and five-years following past recessions have been significantly positive. Granted, the stock market during any individual recession may be significantly negative, but in four out of the last nine recessions, stocks actually rose. These statistics support our belief in long-term investing and using market pullbacks as opportunities to add to positions at lower prices.