Positioning for a US recession
Since the end of last year we have been worried about an “unexpected” slow-down, or even recession, in the world’s developed economies. In order to monitor the situation on a daily basis, we built a new indicator of US economic activity which contains 17 components ranging from lumber prices and high-yield bond spreads to the inventory-to-sales ratio. It was necessary to construct such an indicator because six years of extreme monetary policy in the US (and other developed markets) has stripped economic data of any real meaning.
Understanding this diffusion index is straightforward. When the reading is positive, investors have little to worry about and should treat “dips” as a buying opportunity. When the reading is negative a US recession is a possibility. Should the reading fall below -5 then it is time to get worried — on each occasion since 1981 that the indicator recorded such a level a US recession followed in fairly short order. At this point, our advice would generally be to buy the defensive
cyclical team with a focus on long-dated US bonds as a hedge. This is certainly not a time to buy equities on dips.
Today, the indicator reads -5 which points to a contraction in the US, and more generally the OECD. Such an outcome contrasts sharply with official US GDP data, which remains fairly strong. This discrepancy is best explained by offering specific portfolio construction advice in the event of a developed market contraction. The assumption is simply that the US economy continues to slow. Hence, the aim is to outline an “anti-fragile” portfolio which will resist whatever brickbats are hurled at it.
During periods when the US economy has slowed, especially if it was “unexpected” by official economists, then equities have usually taken a beating while bonds have done well. For this reason, the chart shows the S&P 500 divided by the price of a 30-year zero-coupon treasury. A few results are immediately clear: - Equities should be owned when the indicator is positive. - Bonds should be held when the indicator is negative. - The ratio of equities to bonds (blue line) has since 1981 bottomed at about 50 on at least six occasions. Hence, even in periods when fundamentals were not favourable to equities (2003 and 2012) the indicator identified stock market investment as a decent bet.
Today, the ratio between the S&P 500 and long-dated US zeros stands at 75. This suggests that shares will become a buy in the coming months if they underperform bonds by a chunky 33%. The condition could also be met if US equities remain unchanged, but 30-year treasury yields decline from their current 3% to about 2%. Alternatively, shares could fall sharply, or some combination in between.
Notwithstanding the continued relative strength of headline US economic data, note that the OECD leading indicator for the US is negative on a YoY basis, while regional indicators continue to crater. The key investment conclusion from the recession indicator is that equity positions, which face risks from worsening economic fundamentals, should be hedged using bonds or upping the cash component.