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Signs Of Economic Headwinds

One of my favorite pastimes is golf. While playing golf over the years, I have had the pleasure of meeting a number of people who have become close, life-long friends. I have also had the opportunity to play with a few people who should probably consider quitting the game.

I can think of one person in particular whose golf game has a tendency to go in and out of streaks in which he plays poorly for an extended period of time. This poor play ultimately leads to pent up frustration, which typically ends with a significant club toss.

Economic Cycles

A similar type of buildup to a negative reaction occurs repeatedly over time with the U.S. Economy. At the moment, some variables that are consistent with late economic cycle conditions appear to exist. An economic cycle consists of four consistent themes that repeat themselves over time. Each economic cycle has a peak, contraction, trough and expansion.

The peak is the economy’s high point, right before the club toss, when a number of underlying variables ultimately culminates in a sudden contraction of the economy. Contractions in the economy are sometimes referred to as recessions. Eventually, recessions bottom out at their low point, which is called the trough. Finally, the economy begins another expansion mode, which starts the cycle over again.

Source: Capital Group, National Bureau of Economic Research, Thomson Reuters. As of 9/30/2018. Month-end values used for S&P 500 returns. Nearest quarter-end values used for GDP growth rates. GDP growth shown on a logarithmic scale.

Chart Source: Capital Group, Outlook January 2019. https://www.americanfunds.com/advisor/pdf/shareholder/MFCPBR-073-621331.pdf

As the above chart illustrates, economies do not grow in straight line. Rather, they tend to have an upward trend over time. There are many intelligent people who have embarrassed themselves trying to predict contractions/recessions. I could share hundreds of failed predictions with you from prominent economists, but due to lack of room in this newsletter, I am just going to share one of my favorites.

This particular quote came from Ben Bernanke, who is a highly regarded economist. Mr. Bernanke has Undergraduate and Master’s degrees from Harvard, where he graduated summa cum laude, as well as a PhD in Economics from MIT. At the time of this quote, he was the U.S. Federal Reserve Chairman.

In July 2007, right before one of the largest economic recessions in our country’s history, Ben Bernanke stated his feelings on the prospects of the U.S. economy. Bernanke said, “Overall, the U.S. economy seems likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying trend.” This prediction proved to be embarassingly inaccurate when, instead of seeing growth, the U.S. economy experienced a complete meltdown that started in 2007 and continued into 2009.

Why Is This Relevant?

The reason this topic is relevant now is that the United States has been in its current economic expansion since the 2007-2009 economic crisis. While the average expansion lasts a little longer than 5 years, the current expansion has now exceeded the ten-year mark1. Keeping this in mind, it is easy to see why many are wondering how long this can last. While some argue that this expansion still has room to grow, others are arguing that a contraction is just around the corner.

There are some late-cycle economic headwinds that are beginning to show on the horizon. In my opinion, the Capital Group recently did a good job of summarizing one of these headwinds in a piece on U.S. economic outlook . Presently, we have a low unemployment rate (3.6%), which is translating to higher wages. Higher wages tend to encourage stronger consumer spending and rising labor costs. These rising labor costs put pressure on corporate profits, which ultimately can lead to the start of a recession as corporations have to increase costs and reduce hiring to compensate for paying their employees higher wages.

Other Considerations

One thing to keep in mind is that the average expansion lasts 67 months, while the average recession lasts only 11 months. It also may be comforting to know that the S&P 500 index has historically averaged  +117% over the course of an expansion, versus just +3% over the course of a recession. As a result of the aforementioned considerations, and given the fact that it is nearly impossible to predict the timing of a recession, it historically has been prudent to avoid being reactionary during times like these.

One tactic that could be beneficial when it comes to protecting your investments from a recession is broad diversification. We also favor investments that are more likely to deliver singles or doubles rather than swinging for home runs, as home runs could be more likely to cause a strike out. Some recent adjustments to client portfolios echo this sentiment.

We will continue to monitor this situation in an attempt to avoid any large impacts resulting from a recession. While we know we can’t time the next downturn, we have taken measures that aim to cushion the blow that will be delivered from the next recession. Please contact us with any questions, concerns or comments.

Definitions

S&P 500®: The S&P 500® is a market capitalization-weighted index of large-cap U.S. equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.

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