The global economic and investment outlook reversed in just six months. Prior to October, stocks in the United States and elsewhere were leaping. The U.S. Federal Reserve and the Bank of Canada were raising their benchmark interest rates in anticipation of economic overheating while the European Central Bank had ended its bond-buying stimulus program and was considering raising rates. The Federal Reserve also worried about tight labour markets rekindling serious inflation even though none was evident.
But then the S&P 500 Index peaked on Oct. 3 before plummeting almost 20 per cent to its Christmas Eve low as evidence of worldwide economic slowdown mounted. Still, the U.S. central bank raised its interest rate again on Dec. 19 and continued the run-off of its massive portfolio.
In late January, however, the scales fell from the Fed’s eyes and it announced a pause. Fed chairman Jerome Powell in late February said, “With our policy rate in the range of neutral, with muted inflation pressures and with some downside risks we’ve talked about, this is a good time to be patient.”
With the Fed’s pause, equity investors yelled, “All clear!” and jumped back into equities, but their recent rise is probably a bear-market rally. Obviously, to make such a dramatic and sudden policy shift, the Fed must be very worried about the downside.
Another clue: The yield on the 10-year Treasury note has dropped from 3.2 per cent in early November to 2.5 per cent. Maybe part of that decline is investor relief spawned by the Fed’s pause, but it also suggests even lower inflation ahead, weak credit demand and a recession. Even more so for the yield on the 30-year Treasury bond, which fell from 3.5 per cent to 2.9 per cent.
The Fed recently cut its inflation forecast, and Mr. Powell said, “It’s one of the major challenges of our time to have downward pressure on inflation globally. Ten years in this expansion and inflation is still not clearly meeting our [2 per cent] target.”
Contrary to the Fed, I’ve been warning of a recession and possible deflation since March, 2018, when I first discussed the growing evidence in our monthly Insight report. I see a two-thirds possibility of a U.S. business downturn, starting this year and which will probably be global. It may have already started in the first quarter, but given the long lags in data reporting and revisions, it will be several quarters before the situation is clear.
The forerunners of a recession are legion beyond the earlier weakness in stocks. With the Fed on hold, the decline in the 10-year Treasury note yield pushed it, in late March, to below that of three-month Treasury bills. This yield-curve inversion – the reverse of the normal spread – has consistently signalled past recessions.
Also, dampening business and consumer spending is uncertainty over the not-yet-finalized new trade deal between Canada, the United States and Mexico, and the trade war between the United States and China.
The International Monetary Fund and World Bank continue to cut their forecasts for economic growth in major countries and for the total world. The combined leading indicators for the 33 major economies, including Canada, continue to slide, with the year-over-year decline in December the biggest since July, 2009, during the global Great Recession.
I see a one-third likelihood of a soft landing in which the Fed shifts from credit tightening to easing without a business downturn. By my count, that happened only once, in the mid-1990s, out of 13 attempts by the U.S. central bank to cool off what it saw as an overheating economy. Further reducing the odds of a soft landing: the Fed’s liquidation of its massive assets.
If economic growth revives later this year, the recession will probably only be postponed until 2020. The Fed would resume raising interest rates since it wants more room to cut them in the next recession.
Weak economic growth for the first quarter is widely expected, but if it continues, that spells recession. As usual in a business downturn, stock prices will fall much more than the economy. Also, equities are expensive in relation to earnings, and props such as big stock buybacks will dry up.
Still, I don’t see big imbalances that just beg for huge corrections that will devastate stocks. Nothing like the subprime mortgage debacle in the 2000s that spawned the deepest recession since the 1930 and a 57-per-cent peak-to-trough plunge in the S&P 500. Nothing like the 2000 busting of the dot-com bubble that took the tech-heavy Nasdaq index down a whopping 78 per cent. And nothing like the severe 1973-75 recession that resulted from the collapse in inflation hedge-buying of excess inventories and deflated the S&P 500 by 48 per cent.
An average recessionary decline in equities is more likely, which would take the S&P 500 down 21 per cent from its Oct. 3 peak to 2,340, not much below its Christmas Eve low of 2,351 but still a decline of 17 per cent from its recent level.:
Still, the risks are on the downside. In portfolios I manage, we are emphasizing:
1. Long the U.S. dollar, which is a global refuge and benefits from trade war uncertainties.
2. Long U.S. Treasury bonds, also a safe haven in a sea of global trouble that gain in price because of the declines in credit demand and inflation in a recession as well as lower interest rates abroad.
3. We aren’t yet suggesting shorting stocks in general, but believe investors should be defensive in long stock positions. These include health care, consumer staples and utilities stocks.
4. Short commodities such as copper as the dollar rises and demand weakens as the Chinese and other economies sag.
5. In the current uncertain investment atmosphere, we suggest heavy cash positions.
A. Gary Shilling is the president of A. Gary Shilling & Co. Inc. and will be the keynote speaker at The Globe Advisor Forum held at The Globe and Mail Centre in Toronto on Thursday, April 11 starting at 1 p.m. For more information and to register click this link.