The primary risk to most investors’ portfolios are large stock market declines, and most large stock market declines of 20% or more are associated with recessions. During a recession, corporate revenues and earnings contract, and stock prices generally follow the earnings decline. Therefore, it is very important for investors to understand the causes of a U.S. recession.
While the U.S. Federal Reserve (Fed) has been successful over the long-term in aiding an environment for growth in the U.S., history teaches us how their long-term focus and dual mandate can translate into risks for investors. As their dual mandate dictates, the Fed is charged with controlling inflation and balancing unemployment. Recently, the Fed has begun a tightening cycle, which has implications for market success and investors. Therefore, we continue to believe this tightening cycle and Fed policy is a key risk consideration for equity investors.
FOLLOWING THE FED
As we have shown in previous work, “The 100 Year Learning Curve: Fed Policy and Recessions,” nearly every recession, and large equity market decline by extension, was caused by a U.S. Federal Reserve (Fed) policy error in our opinion. For example, each recession that has occurred during the last 50 years was preceded by the Fed over-tightening monetary policy and causing the Treasury yield curve (the difference in yield between long-term and short-term bonds) to invert.
Equity prices then suffer subsequent declines on the back of the inversion as noted in exhibit 2.
Judging by that metric, Fed policy is far more influential to the economy than any other program. Importantly, the Fed can tip the economy into a recession without necessarily inverting the yield curve. For example, the last time long-term U.S. interest rates were as low as they are now was in the 1930s. During that period, the U.S. suffered multiple recessions without an inverted yield curve
WHERE DO WE STAND NOW
In general, we think the global economy is in good shape and the current business cycle can continue for years on the condition that the Fed does not make a significant policy error. Up to this point, we have been comfortable with their policy moves since the spring of 2016 when the Fed put further rate hikes on hold until this past December.
Other global central banks, including the European Central Bank and the Bank of Japan, continue to support the global economy through monetary stimulus, such as quantitative easing. This stimulus is warranted since many other regions are lagging the U.S. recovery and their central banks rightly continue to support growth. We think that this additional global stimulus creates more room for the U.S. Federal Reserve to tighten their policy.
As we manage risk in real-time, we are watching our dashboard of indicators to alert us if the Fed goes too far in tightening monetary policy. Our indicators include weekly jobless claims (e.g. layoffs) and the growth rate of the amount of cash moving through the economy, which can be an early indicator of panic and cash hording by consumers, banks, and other institutions. Collectively, these data points can act as an early warning system to a U.S. Federal Reserve induced recession and equity market decline.
Until these signals suggest otherwise, we think that the current business cycle and bull market can continue to run for years.
This article was written by Gary Stringer, CIO, Kim Escue, Senior Portfolio Manager, and Chad Keller, COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.
DISCLOSURES
Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management, LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not be taken as an advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested.
Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.
The securities identified and described may not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.
Data is provided by various sources and prepared by Stringer Asset Management, LLC and has not been verified or audited by an independent accountant.
Index Definitions:
S&P 500 Index – This Index is a capitalization-weighted index of 500 stocks. The Index is designed to measure performance of a broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.