Recessions Can Be Unsettling,but Their Long-Term Impact Has Been Modest | Capital Group

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Recessions Can Be Unsettling,but Their Long-Term Impact Has Been Modest

By Jared Franz
Capital Group Economist

 

Is a recession coming? After a bull market that just eclipsed 10 years, and an economic expansion that’s lasted nearly as long, it’s no surprise that I’m asked this question a lot nowadays.

The short answer is, yes, a recession is expected — but not right away. Downturns strike for a variety of reasons, most often because of imbalances that build over time and must be corrected. Though stresses are developing in some areas, they don’t appear to be substantial enough to derail growth in the immediate future.

That said, recessions are a natural and necessary part of every business cycle. Despite its current vigor, the U.S. economy is late-cycle. Weakness in China and Europe, and a global tide of corporate and governmental debt, are all potential hazards. At the moment, economic indicators suggest the economy could soften in the next two years and a recession could begin sometime in 2020 or 2021.

Of course, history has shown how difficult recessions are to predict, and the U.S. economy has been remarkably resilient in recent years. The most recent example of this came late last year, when concerns about slackening global growth triggered a bruising stock market decline. Equities rebounded in the first quarter as fear subsided. As famed economist Paul Samuelson once noted wryly, “The stock market has predicted nine of the last five recessions.”

The long-term impact of recessions is small.

Regardless of timing, it’s important to keep a few truths in mind. The first is that economic contractions generally don’t last long. A Capital Group analysis of 10 cycles since 1950 shows that downturns have ranged from eight to 18 months, with the average lasting about 11 months.

Recessions also are relatively small blips in economic history. Over the past 65 years, the U.S. has officially been in recession less than 15% of all months. And the net economic impact of most downturns is fairly small. The economy shrank less than 2% in the average downturn, compared with a 24% surge in the typical expansion. Beyond that, equity returns can actually be positive over the full length of a contraction, with some of the most powerful stock rallies occurring during the late stages of a recession.

Bear markets and recessions usually overlap at times, with equities tending to peak about seven months before the economic cycle. By the time a recession has been officially declared, equities already may have been declining for months. But just as stocks often lead on the way down, they also have led on the way up. The S&P 500 typically bottoms about six months after the start of a recession — and usually begins to rally before the economy starts humming again. This means that aggressive market timing, such as shifting an entire portfolio to cash, often can backfire. Some of the strongest returns can occur during the late stages of an economic cycle or immediately after a market bottom. Though many factors can contribute to recessions, here’s a quick look at three signals I am watching closely: corporate profits, unemployment and the yield curve of Treasury securities.

Company profits as a share of GDP usually peak midcycle for the overall economy and start decelerating long before the start of a recession. In this cycle, earnings are still at high levels from a historical perspective, but there is reason to believe they have peaked. And they are likely to come under more pressure from rising wages and inflation, the ebbing benefits of tax reform and higher costs amid global trade uncertainty. The most recent peak in corporate profits as a percentage of GDP was in 2012, meaning we already are past the average lead time of 26 months.

The U.S. unemployment rate is near a historical low and has been declining throughout the expansion. Wage growth has been well below average compared with past expansionary periods, but it has started to pick up recently — a positive for consumer spending but a potential drag on profits. The labor market is past the level that many economists consider full employment and has been for years, so there may be little room for joblessness to decline further. This is such a powerful economic driver that even moderate increases in unemployment can be a disturbing signal.

An inverted yield curve may sound esoteric, but it’s a simple concept and one of the more accurate recession signals. The yield curve measures the relationship between short-term and long-term Treasury yields, and an inversion occurs when short-term rates exceed long-term rates. This can happen when short rates rise during Fed tightening cycles and long rates fall amid high demand for bonds. An inversion is bearish because it indicates that investors favor the perceived safety of long-term government bonds over riskier assets.

In December, the yield curve between two-year and five-year Treasury notes inverted for the first time since 2007. Other parts of the curve — such as the more commonly referenced two-year/10-year yields — have not inverted. However, even an inverted curve in that range is not cause for immediate panic, as there typically has been an average lag of 16 months between an inversion and the start of a recession. Moreover, there is debate about whether central bank interventions in the bond market have distorted the yield curve and made it a less reliable indicator.

These factors are just some of the ways to take the temperature of the U.S. economy. One or two negative readings can be meaningless. But several key indicators flashing red for a sustained period can foreshadow a gloomier outlook. In my view, that time has not yet arrived.

Regardless of economic conditions, it’s wise to regularly review your asset allocation with your Investment Counselor to ensure that your portfolio is broadly diversified and tailored to your personal needs.

JASF

Jared Franz is an economist based in our Los Angeles office. He has 13 years of investment experience and has been with Capital Group since 2015.

The above article originally appeared in the Spring 2019 issue of Quarterly Insights magazine.