A Cautious U.S. Economic Outlook

Our Economic Composite (TEC^TM) gave us a U.S. business cycle peak alert in March 2019, the first warning since the U.S. economic expansion began in 2009. Comprised of several economic variables, we developed the TEC^TM to monitor global business cycles and forewarn of potential business cycle peaks. Our research has shown that since 1965 each occurrence of a two-year rolling loss of 20% or more has been preceded by a business cycle peak.

As we wrote to clients in our Q2 2019 newsletter, we opted to not initiate any material hedges after the March TEC^TM alert as strong market gains are typically seen as the economic cycle is peaking. With the S&P 500 up over 15% from our alert to the end of 2019, we are pleased to have held off.

Since the alert, several key economic data points have weakened. Table 1 shows that unemployment is the only major economic data point that has improved since March.

Table 1. Change in Key U.S. Economic Data Points Since March 2019

A few months after our TEC^TM alert, the New York Fed’s recession probability model—based on the Treasury spread—breached 30%. Since 1970, this model has never crossed 30% without a recession commencing in the subsequent months. As of November, that model’s recession odds have fallen to 25%.

The Federal Reserve responded to these weaker numbers by cutting rates three times in 2019, citing efforts to sustain the economic expansion. Balance sheet expansion has resumed; $400 billion has been added to the Fed’s balance sheet in the last few months. However, the Fed insists this current balance sheet operation is for “reserve management purposes” and not a large-scale asset purchase program (i.e., quantitative easing) intended to boost the economy.

The U.S. is not alone in looking for ways to shore up economic activity. In Japan, Prime Minister Abe announced a $240 billion fiscal program aimed at disaster repair, infrastructure, and counteracting consumption tax hikes and weakening economic data. China, rattled by the ongoing trade dispute, announced that the People’s Bank of China would follow September’s stimulus with another injection of $115 billion into the economy. The European Central Bank has recently urged governments in the Eurozone to boost public spending or cut taxes to combat faltering growth. The ECB itself starting buying €20 billion worth of bonds a month in November 2019 and reduced its deposit rate to -0.5%.

With global equities hitting new all-time highs, investors are clearly not worried about an economic slowdown in the near term. The consensus view appears to be that re-invigorated central banks have successfully stabilized the global economy through this soft patch, setting the stage for a resumption of global growth following the anticipated Phase 1 of the U.S.-China trade deal to be signed on January 15, 2020.

The current cycle has already seen two soft stretches in 2013 and 2016. Will 2019—buffeted by the U.S-China trade dispute, grounding of the 737 MAX 8, Hong Kong protests, and Brexit—go down as another soft patch in the post Great Recession expansion? Or is the yield curve inversion suggestive of something more ominous ahead for the U.S. economy?

For the first time since this cycle began, our firm now has a cautious economic outlook. With the S&P 500 trading at a healthy 14x EV/EBITDA, a resumption of economic growth is baked into the market. Our view is that this is far from certain and the high current valuations pose a risk of a correction if the economy fails to get back in gear.