Financial Insights

Looking Beyond the Horizon

The S&P 500 closed at a new record high on Friday and is now trading at 18 times forward earnings. While this multiple exceeds the 25-year average (of 16), it remains below the market average for periods of low inflation (20). Despite this, our discussions with advisors and clients reveal a growing level of discomfort stemming from our extended bull market and the length of the current economic recovery.  Many are looking for signs of the next recession. The unfortunate fact about recessions is the difficulty (or impossibility) in forecasting their arrival. We can look to the past for guidance, but the data is unhelpfully thin, with only 12 recessions in the post-war period. So we will make do with the data we have.

First, though, let’s recognize that the latest market appreciation appears to have been driven by higher than usual expected corporate earnings growth.  This year, earnings are forecast to rise nearly 10% for S&P 500 companies, and next year, another 12%. Since investors value companies for what they can deliver in the future, it is reasonable to compare those figures to the market’s appreciation since the beginning of 2016. Since then, stocks have returned 29%, so just 7% more than the growth in expected profits. If the S&P 500’s performance returns to its historical average next year (a roughly 6% increase) and if earnings growth delivers to expectations, we should see that market multiple start to come down by the difference between earnings growth (12%) and appreciation (6%). Such a contraction would go a long way in reassuring investors that stock valuations still remain tethered to fundamentals and would be consistent with a decline in earnings growth in future years.   (No one should expect earnings to continue to grow at their current pace indefinitely.)  The market could experience a year with a 6% level of appreciation, but where the P/E of the market contracts from 18 to under 17. That outlook assumes nothing disturbs market fundamentals in the meantime, and that brings us back to the question of the chances of a recession.

Sorry, but we aren’t going to come up with a recession probability in this commentary. But we can look at a few of the likely recession drivers of the past to get an indication of whether the U.S. economy appears vulnerable from the usual suspects. First on the list are oil price shocks. Of the 12 post-war recessions, 10 of them have been preceded by or were coincident with a sharp increase in oil prices. Higher energy costs make everything else in the economy more expensive to produce and have led to broad-based slowdowns. How about now? Given the relatively recent arrival of fracking and horizontal drilling technologies, the U.S. is no longer as vulnerable to price fixing attempts by OPEC since we can turn on the spigot ourselves to keep supply flowing at or near current prices. So recession from an oil price shock seems unlikely over the next several years, despite OPEC’s efforts to reduce its own supply into world markets.

Another likely source of recession is higher costs of another type – labor compensation.  Higher wages can disrupt profits when firms have a hard time raising prices to keep pace. Wages can rise because inflation surges or when labor shortages force firms to bid more to fill job openings.  This one bears watching. Wages are indeed moving higher, though modestly so far. And inflation is still hovering just below 2%, but is at risk of breaking over the Fed target as pressure builds in labor markets. As labor costs rise (and as revenue growth slows), firms across the U.S. will look for new ways to economize, and this, too, could lead to a broad-based slowdown as firms “clean house” in an attempt to trim operating costs. With wage growth of 2.3-3.3%, this threat does not seem imminent, but we should follow it closely.

There is another source of rising costs that could trigger a recession – higher imported goods prices. The Smoot-Hawley Tariff Act of 1930 raised tariffs on dutiable imports to the U.S. from 40% to 59% and has been credited with lengthening and deepening the Great Depression.  While trade amounts to only 28% of U.S. GDP, its value would be more accurately measured by the replacement cost of those imports, not their cost when available for purchase from other countries.  Take T-shirts, for example. The cost of T-shirts made in Bangladesh was $3.72 back in 2013, while in the U.S. the cost topped $15. That’s a whopping difference. If the US were to replace all imported T-shirts with those made at home, they’d be more than three times as costly (and a lot fewer would be purchased). The renegotiation of NAFTA brings front and center the risk of higher import prices and a shift towards domestic production. Moreover, it would take years for industries reliant on international supply chains to realign in the face of a new set of tariffs on imports of car parts, textiles, agricultural, and a myriad of other products. While abandoning NAFTA would not come close to the massive impact Smoot-Hawley had, it nevertheless could trigger a slowdown for a U.S. economy currently growing at a moderate rate.

Finally, some point to higher interest rates as a possible cause of past recessions, and as we are in the midst of rising rates, we must consider this risk as well. But interest rates are tricky since they are prices (of future goods) and so are ultimately the result themselves of the forces of economy-wide supply and demand. In the second half of the 1990s, for example, interest rates were much higher than they are today, but so was GDP growth – higher interest rates can be a result of a strong economy.   Moreover, the Fed is raising rates very slowly and the market does not even believe the Fed will raises rates as much as it has projected.

For now, the U.S. economy appears well supported by strong fundamentals – modestly rising GDP and wages, below-target inflation, falling unemployment, and strong job openings and hires. But these goods signs—and the possible threat of disruptions to trade agreements—bear vigilant attention. In addition, the U.S. economy also relies on strength in global demand and a stable geopolitical environment, so a disruption to growth in China or a breakout of war in the Middle East or Asia (North Korea) present further possible recession triggers.  Investing strategy in such an environment calls for appropriate attention to the risk of recession, but equally important is finding a mix of equity and fixed income exposure that balances risk and return over the long haul.  Don’t worry if you are unable to forecast the next recession and get out before the next bear market.  Trying to time the market is exceedingly difficult, and recessions tend to be short and so are bear markets (even if 2008 was the exception).

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.


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