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Strategist: Recession is on deck

Expert says current U.S. economic expansion is in ‘bottom of the eighth with two outs.’

August 30, 2019
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Although economic expansions have no built-in timer, enough “stresses and strains” are piling up that a market analyst believes the likelihood of a mild recession is around 30% next year and 50% in 2021.

Jeff Korzenik, chief investment strategist with Fifth Third Bank, spoke to the Business Journal on Aug. 22 to expand on an analysis of the current market and U.S. economy he shared with Fifth Third investors Aug. 19.

His remarks came as the two-year/10-year yield curve inverted for the first time since 2007. Since then, the yield curve has “bounced around,” Korzenik said.

According to an Aug. 22 article in The Balance, “an inverted yield curve is when the yields on bonds with a shorter duration are higher than the yields on bonds that have a longer duration,” and it’s often an indicator of a recession on the horizon.

Korzenik said long-term yields, or long-term interest rates, typically are linked to government bonds, corporate bonds, long-term investments and mortgage interest rates. They “traditionally reflect long-term expectations for growth and inflation” and are “truly a market rate,” he said.

Short-term interest rates, on the other hand, are largely controlled by the Federal Reserve, which sets the “very short-term” Fed funds rate and also influences “shorter-term instruments” including the two-year Treasury notes, he said.

When a yield curve is normal, short-term bond yields are lower than long-term bond yields.

When the yield curve inverts, it’s because investors have low confidence in the short term and “prefer to buy long-term bonds and tie up their money for years even though they receive lower yields. They would only do this if they think the economy is getting worse in the near term,” according to The Balance.

So, what are some of the factors causing investors to spook?

Korzenik said one concern businesses have is the state of the labor market.

“We’re pushing up against the limits of the growth of our labor force. Economies grow when you can grow your labor force and when you can grow the productivity of your labor force, and our ability to grow our labor force is hampered by our very low unemployment rate and the inability to get more people off the sidelines,” he said.

“We’re having some success there but not a big enough success. It’s becoming very difficult for employers to get the workers they need, and if you can’t get the workers you need, you can’t service your customers; you can’t grow your business. Those are the kind of things that are challenges.”

Paradoxically, he said U.S. employers have had some success growing productivity on the backs of their existing labor pool, mostly thanks to capital expenditures in newer equipment in 2017 and 2018.

“The problem we have going forward is that businesses only make that kind of long-term, capital-intensive commitment when they are confident,” Korzenik said. 

He added that trade tensions and our political environment have undermined that confidence.

Korzenik said hitting a growth wall could have a couple of outcomes.

“Either some surprising event comes along and you grow even slower than your potential growth and then suddenly you stop growing or are barely growing, then you start getting negative feedback loops, so the growth gets really low, access to credit gets harder, which makes growth go even lower, and next thing you know, you’re in a recession,” he said.

“On the flip side, if you’re pushing up against the limits of the labor force and you try to hire and hire and hire and the workers aren’t there, you tend to increase wages, which is good to a degree, but at some point, it becomes inflationary, then that is the kind of thing that can push us into that ninth inning.”

Korzenik said most regions in the U.S. need to get better about getting workers off the sidelines and into the labor pool.

“Grand Rapids is one of the areas in the country that has done a really good job, particularly with people who need a second chance for employment, whether because of a history of addiction or especially a history of incarceration. The Grand Rapids business community is one of the standout leaders in the U.S. for this,” he said.

Most economists — including Korzenik — agree that economic expansions have no set time limit. Australia’s economy has been in growth mode for around 25 years, and The Netherlands saw uninterrupted growth at one point for around 20 to 25 years, Korzenik said.

He said President Donald Trump’s push for the Fed to lower interest rates is unlikely to provide the hoped-for stimulus, given the causes of the current economic conditions.

“The issues in the economy are not really issues that can be resolved by monetary policy,” he said.

Korzenik shared these additional insights about the economy:

  • The U.S. economic expansion, to use a baseball metaphor, is in the bottom of the eighth inning with two outs — late in the game but not quite in the final inning.

  • In the ninth inning, inflation will force the Fed to raise rates, even if it increases the risk of a recession. Firmness in the consumer price index for the past two months might influence the Fed, but the influence will be confined to limiting the speed and duration of future easing, not to setting renewed monetary tightening. The Fed’s preferred inflation measure, the personal consumption expenditures deflator, runs below CPI, and central bankers have said they would be comfortable with PCE inflation running above 2% for some time. The point at which the Fed will be forced to raise interest rates still is far ahead.

  • The decay in business confidence may hold back capital expenditures (CAPEX), the key to driving productivity. With continued tight labor markets and solid wage gains, productivity will be needed to keep inflation in check. But there still is some productivity momentum from the pickup in CAPEX from 2017-18, though that will fade.

  • The two-year/10-year yield curve inversion is a warning signal. Investors historically have benefited by maintaining a risk posture for a while after inversion — the period between the initial inversion and the stock market peak can take many quarters and offer superior returns.

  • It’s possible the yield curve inverted earlier than it otherwise might have since the 10-year yield is influenced by negative yields abroad. If so, (August’s) inversion might be a false or premature recession signal. If so, the economic expansion might have more room to run.

  • Although the Fed easing rates will not address the core issues of trade tensions and a labor shortage, easing will benefit consumers through mortgage refinancing and lower interest costs on floating rate debt. Corporate debt burdens also might lessen. There will be some good that comes out of the Fed’s actions, at least until the point when inflation becomes more of an issue. Whether this is worth the Fed expending some of its limited number of rate adjustments will be something only known in hindsight.

  • Portfolios should have an equity bias until a recession becomes visible on the horizon. Signs of a prospective recession include negative forward earnings growth, sharply lower nonfarm payroll gains, net job losses in manufacturing, inflation to the degree it forces the Fed’s hand and significantly wider credit spreads.

  • After such a long bull market, it is fairly natural for equity positions to become overweight on the backs of strong returns. Often, there are valid reasons not to reduce such excess equity positions: tax liabilities, for example. However, in the final inning of this economic cycle, today is the day to start to bring these portfolios in line.

  • Never underestimate the resiliency of the American economy. Returning to a baseball metaphor, 10% of all Major League Baseball games go into extra innings, and the longest game in MLB history went a full 26 innings. For the economy, extra innings would be based on rising labor force participation rates. So far, the evidence is mixed — female labor force participation is rising, while social problems are holding back other demographics, including young men.

  • Long-term success as an investor is based on patience and a disciplined portfolio approach.

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