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Are we headed toward recession?

SIMA Financial Group > Retirement  > Are we headed toward recession?

Are we headed toward recession?

Last week the yield on 2-year Treasurys eclipsed the yield on 10-year Treasurys for the first time since 2007. This ‘inversion’ of the yield curve is widely-followed because it has preceded every recession post-WWII. That’s not to say that it causes recessions, but it is considered a harbinger of slower growth.

(recessions are shaded in gray)

Lots of ink was spilled last week debating whether a yield curve inversion is as relevant today as it once was in light of the Federal Reserve’s policy over the last decade. That debate is not important. What’s important is to remember that everything is cyclical, including the U.S. economy. So to the question, “Are we heading for a recession?” the answer is yes, eventually.

Recessions tend to follow a yield curve inversion by about 22 months. Some come sooner, some later. But an inversion is not universally bad for stocks. The S&P 500 has returned 12% on average in the year following an inversion. After the yield curve inverted in the summer of 1998, stocks climbed another 40% before the recession began in late 2000.

Some of you may be thinking “What should we do with my portfolio?” To answer that, we always start with your personal financial plan. Your time horizon, risk tolerance and liquidity needs are the predominant factors in determining how much of your portfolio should be in stocks, bonds, cash or other alternatives. Once that has been carefully decided, it does not change unless and until there is a change in your life that warrants a revision to your financial plan and the portfolio designed to fund it.

What we will change, however, is the composition within your overall asset allocation in order to position ourselves more or less defensively, depending on the opportunity set at hand.

At this time, our stock and bond exposure has two main focuses: quality and income, in that order. The excesses that concern us are the growing amount of low-quality corporate debt, massive amounts of foreign government debt in countries with low growth and high taxes, and lofty valuations for private equity “unicorns” that have no profits. While we are currently avoiding these corners of the market, we may not be immune to “spillover”-type effects if problems were to occur.

QUALITY

When the next recession hits, we don’t want to own over-leveraged, unprofitable companies. We also don’t want to be lenders to these companies. That stands in sharp contrast to many on Wall Street who are happy to provide cash to profit-less ventures in the form of equity funding or debt financing. In tough economic times, we would prefer a broadly diversified mix of companies with stable cash flows, healthy balance sheets, and management teams that make rational capital allocation decisions. At the present time, we see that opportunity set primarily coming from U.S.-based companies.

We are slightly underweight international and emerging market stocks, as many European, Asian and Latin American economies are struggling with too much debt, high tax rates, and little growth. That isn’t to say that companies domiciled in those regions can’t grow their earnings, but the climate in which they must do so is challenging. Still, the valuations are low compared to the U.S., and there remain valuable benefits to global diversification.

And as we mentioned in the most recent quarterly memo, we have upgraded the quality of our fixed income holdings, eliminating exposure to high-yield bonds which we believe are not compensating investors for the myriad risks. We continually monitor our investment-grade holdings as well.

INCOME

For the long-term investor, the power of equity dividends cannot be understated, especially during times of slower growth. Dividend income (especially rising dividend income) adds appreciation in the form of total returns and can also lessen the effects of market declines and inflation. Studies have shown that over a typical 20-year holding period, dividends can account for more than 50% of total return. So if stock prices go nowhere for a year or two (or more), it’s comforting to know that reinvested dividends are working hard all the same.

CONCLUSION

If fears of a recession have you worried, step back and consider where we have been. 50 years ago the entire U.S. economy produced $1 trillion of goods and services per year. Today it’s over $21 trillion! And in those 50 years we had seven recessions. Looking at the chart below, you’ll see that our economy spends far more time expanding than contracting.

 

 

Furthermore, fifty years ago the S&P 500 was priced at around 100 and paid a dividend of about $20. The same index recently traded above 3,000 with a dividend of more than $55.

Recessions are a normal part of the economic cycle. But we acknowledge that just because something is normal doesn’t mean that we become immune to the anxieties that it may cause. That’s exactly why we hold diversified index funds that give us exposure to multiple asset classes and why we rebalance regularly.

Patience, diversification and a strong investment discipline are the best antidotes to economic gyrations and market volatility. Keep working your financial plan and reach out to us if you have questions or concerns. We look forward to discussing all of this with you at your next update meeting.