November 28, 2017
As I travel around the world visiting clients, I’m often asked, “What keeps you awake at night?” The answer: trying to time the next recession. While global economic growth continues its synchronized expansion, there are some worrisome signs that’ve cost me a few winks.
Why do I find recessions so worrisome? Because they wreak havoc on risky asset prices. According to Ned Davis Research, the average decline in the S&P 500 Index during the post–World War II era, from pre-recession peak to the recession low, is nearly 28%. Sure, risky assets like stocks and high-yield bonds have tended to provide positive returns in excess of the rate of economic growth over the long term, but typical investors often fail to reap those long-term rewards. Why? Because owing to the vagaries of human nature, recessions can be ruinous to your portfolio. Investors often dump their investments once markets have already declined — the worst possible time — and are slow to return, only jumping back in long after markets have begun to heal. In my experience, once investors are scared, they tend to stay scared. In other words, it can take investors far longer to heal psychologically than it does for markets to heal from a price perspective. So clearly, being mindful of the potential for recession is useful to investors positioning portfolios.
Since no one has a crystal ball, it’s important to have a framework within which to view risks that may lay ahead. Mine is the recession checklist that I’ve used for years. While the checklist is not forecasting an imminent recession, there are three worrisome signs that I think are worth exploring in greater detail.
Too much borrowing
Markets are at record highs. Investors are confident. Financial conditions are loose. Interest rates are low. Why shouldn’t business and consumers ramp up their borrowing? Servicing debt should be easy against this benign backdrop, right? It should not come as a surprise that the amount of debt on both corporate and household balance sheets has risen to levels that exceed the past two cycle peaks.
In my experience, too much borrowing is a sign of too much confidence, and excessive confidence is never a good thing. And while debt service is quite manageable at the moment, the US Federal Reserve is poised to raise rates again in December, and in my view probably hike more than markets expect in 2018. Late in business cycles, interest rates tend to rise, and this business cycle is one of the longest on record.
Frothy M&A and margin debt
A pickup in deal flow and higher prices paid for mergers and acquisitions are classic late-cycle phenomena, and we’re seeing excesses in this arena, in my opinion. Often, late in the cycle, companies doubt their ability to grow earnings and sales fast enough to please investors, so they buy another company in order to create savings and to juice earnings per share. Often they’ll pay too much in the process. In my opinion, takeover activity is on the rise and the premia being paid are growing toward peaks seen in previous cycles.
Margin borrowing is a similar concern. To many, surging margin debt is a sign of confidence. Some might call it a sign of overconfidence. So against that backdrop it’s worth noting that as the end of October NYSE margin debt hit a new high of $561 billion. Some investors borrow against their portfolios in order to buy more shares, which can amplify profits if stocks continue to rise or magnify losses if stocks fall. Other investors use margin debt as a cheap source of short-term funding for other priorities. That could be worrisome if investors begin to use margin debt the way they used home equity loans in the run-up to the global financial crisis. Borrowing against your portfolio can take away a downside cushion if markets move lower and borrowers are forced to sell shares in order to meet margin requirements.
Profit share of GDP
In my view, one of the best indicators of where the US economy is within the business cycle is the profit share of GDP. Using the national income and product accounts (NIPA) data produced by the US Bureau of Economic Analysis, it’s possible to compare all the profits produced by the US economy — from the local pizza parlor and beauty salon to Apple and Netflix — and divide those profits by gross domestic product, which measures the value of all goods and services produced in the economy. That quotient is the profit share of GDP. When that profit share is rising it usually suggests that better times lay ahead for stock prices, based on the assumption that businesses are more likely to invest and hire when profits are rising than when they’re falling. When profits are falling, they tend to rein in hiring and investment. Historically, when profit share of GDP falls for a year or more, it suggests trouble lies ahead. During this cycle, profits as a percentage of GDP hit all-time highs. But at the moment, profit share of GDP is lower than it was a year ago. It tends to fall 12–18 months before the onset of a recession, and we’re now approaching a year of slowly sinking profit share of GDP — though the overall percentage remains relatively high, historically.
Tap the brakes
While the economy and markets appear to be firing on all cylinders, to me these indicators are like the warning lights on a car’s dashboard. Some see the “check engine” light flashing but think hey, it seems to be running just fine. But I think warning lights are there for a reason. They’re meant to keep you out of major trouble. So I believe investors may want to consider capital preservation strategies as an option to putting their foot to the floor at this point in the cycle.
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