We’re now in the longest economic expansion in US history. July marked the 121st month of consistent growth, a situation dating back to June 2009, surpassing the previous record of 120 months set between March 1991 and March 2001. This environment has been great for many investors’ portfolios, but it raises a natural question: When will the party end, or—in light of recent equity market weakness—has it already ended?
Economic expansions don’t die of old age. In other words, they don’t have a natural life expectancy. Look no further than Australia, which has now gone 27 years—27 years!—without a recession. There is, however, always the chance mismanagement can cause a downturn. To paraphrase economist Rüdiger Dornbusch, the Fed can murder an expansion. What investors want to know is whether a recession is imminent and, if so, what they can do about it. Let’s consider these two questions separately.
Is a recession imminent?
Predicting recessions for a broad and diversified economy like that of the United States is incredibly challenging for one simple reason: There haven’t been that many of them. According to the National Bureau of Economic Research, the US has experienced just 11 recessions since the end of World War II.
One of the most widely followed predictors of a recession is the yield curve—more specifically, the spread between 10-year and three-month US Treasuries. Usually the yield curve is upward sloping, with yields increasing as maturity extends. So we’d expect the yield for the 10-year Treasury to be higher than that of the three-month Treasury. When the reverse is true, as it is now, the spread inverts, or turns negative. When this phenomenon persists for at least three months, or one full quarter, it’s seen as a recession warning sign. The chart below reports the yield spread through time, with recessions shaded.
10-year Treasury constant maturity minus 3-month Treasury constant maturity
Source: Federal Reserve Bank of St. Louis, 8/13/2018
Why is the yield curve good at predicting economic activity? First, it’s heavily influenced on the front end by monetary policy. Thus the curve is more likely to be inverted when the Fed is raising rates in an attempt to cool down economic activity. However, an inverted curve also tells us that the market is expecting lower rates in the future, which likewise indicates a slowdown in economic activity. By the end of August, the curve will have been inverted for more than three months.
Beyond the yield curve, other factors are causing investors to think a recession may be imminent. Trade tensions with China are increasing. Job growth in the US is showing signs of slowing. And the effects of the 2017 tax cuts are weakening. All of these represent potential impediments to future growth.
That said, the 2020 elections are just around the corner. The good news is that it’s rare for a recession to occur in a presidential election year. The bad news is that eight of the past 11 recessions began in the first year of a presidential term. If the trend holds, 2021 may be a good bet for the timing of the next recession.
What you can do about recession warning signs
If you’re in the camp that believes a recession is on the way, the next question is what you can do about it. First, it’s always prudent to monitor your portfolio and determine whether it’s adequately diversified. Until recently equities have been on a nice run. Through the end of July, the S&P 500® Index was up more than 20% year to date, while most intermediate bond indexes were up just 6%. If recent market moves have caused equities to move beyond your investment policy threshold or your upper level of comfort, consider rebalancing before the market does it for you. Every investor should have a disciplined rebalancing process in place to manage risk across their portfolio.
Alternative strategies may be worth considering if you’re worried about signs of a recession. Since the 2008 global financial crisis, liquid alternatives have grown as a collective market segment. These strategies seek to deliver competitive returns while exhibiting low correlation to traditional assets. (Note, however, that low correlation means these vehicles act as a diversifier and not a hedge.) Many readers will recognize that competitive returns and low correlations to traditional assets are the promises hedge funds seek to deliver. Unlike hedge funds, however, liquid alternative strategies attempt to add diversification benefits in a transparent manner—and without draining the investor’s wallet in the process.
A final consideration for investors: incremental strategies that offer the potential for added return in more challenging equity environments. One example of such a strategy is covered call selling. A typical call-selling strategy is expected to add incremental return over a market cycle while reducing risk. However, return expectations for these strategies increase if equity markets are flat or down. In these scenarios a call-selling strategy may add meaningful positive cash flow to the portfolio and reduce the risk that the investor has to sell a security at a depressed price to meet ongoing obligations.
The bottom line
Talk of a recession may be premature at this point, although warning signs in the market are making investors skittish. If you believe a recession may be imminent, now’s the time to tune up your portfolio and confirm it’s ready to navigate the potentially more challenging environment that may lie ahead.
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Tom Lee, CFA, Chief Investment Officer, Equities and Derivatives
Tom leads Parametric’s Research, Strategy, Portfolio Management, and Trading teams, coordinating resources, aligning priorities, and establishing processes for achieving clients' investment objectives. Tom has coauthored articles on topics ranging from liability-driven investing to the volatility risk premium. He is a voting member of all the firm's investment committees. Prior to joining Parametric in 1994 (originally as an employee of the Clifton Group, which was acquired by Parametric in 2012), Tom spent two years working for the Board of Governors of the Federal Reserve in Washington, DC. He earned a BS in economics and an MBA in finance from the University of Minnesota. A CFA charterholder, Tom is a member of the CFA Society of Minnesota.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.