Recession – Maybe This Time is Different

August 1, 2019  | by Ryan Driscoll

Industry Knowledge | Investment Strategy | Market Commentary

The July Federal Open Markets Committee (FOMC) meeting signaled the end of central bank rate normalization with the first rate cut in more than a decade. The last time the FOMC cut rates was in December 2008 and it was done in dramatic fashion as then Chairman Ben Bernanke announced a surprise 75 basis point rate cut after fears of a looming U.S. recession sent the equity markets into a tailspin. It wasn’t until seven years later that Chairman Yellen (5 hikes) and then Chairman Powell (4 hikes) embarked on a series of nine 25 basis point increases believing domestic growth was on sound footing.

This isn’t the first salvo in the growth reflation war. At the conclusion of the March 2019 FOMC meeting, the Federal Reserve issued updated guidance regarding its plans for the size of its securities holdings and the transition to the longer-run operating regime. The Committee stated its intent to slow the reduction of its holdings of U.S. Treasury securities by reducing the cap on monthly redemptions. However, in what came as a surprise to many, it was also announced that the balance sheet drawdown will end on August 1st.

Perhaps the preemptive easing of monetary policy is a necessary consequence of trade-related uncertainty and weaker than expected economic dataflow. The recent rally in global bonds pushed aggregate negative yielding sovereign debt above $11 trillion as of mid-June, a level not seen since October 2016. The figure was primarily driven by Eurozone countries, accounting for more than half the change, with the rest coming from Japan. This rate suppression has also brought more curve inversions and speculation that the “clock is ticking” on the traditional 12- to 18-month lag between curve inversion and recession. It remains to be seen, but there is precedent to support the case that a recession is not imminent given the current economic backdrop. Like the 1990’s, when the yield curve inverted three times (1995, 1998 & 2000) before a recession unfolded in 2001.

The table below compares the prevailing economic fundamentals prior to the last two recessions with the current state of the market across four categories – Valuations, Growth and Inflation, Interest Rates and Policy, and Consumer Health.

CH_01_What_Will_Cause_the_Next_Recession

The historical pre-recession periods each had unique attributes that signaled potential issues. In 2000, equity valuations were extremely high and GDP growth averaged 4.85 percent over the preceding two years. Attempting to cool the economy, the FOMC undertook a very aggressive tightening path and increased the Fed Funds rate 200 basis points between June 1999 and May of 2000. This effectively stopped economic growth and the FOMC was forced to reverse its actions in January 2001 but by that point the recession was already baked in. In 2006, equity valuations were very close to current levels, but debt levels were sky high and there was an enormous amount of consumer leverage due to loose lending standards and unconventional debt and derivative instruments. This ultimately led to the Great Financial Crisis and the FOMC actions referenced earlier.

All of this begs the question of where the risks lie in today’s environment. As seen in the table, equity valuations are reasonable, corporate profits have grown and the current business environment incentivizes domestic investment. The current low rate environment makes equities and credit attractive from a potential return perspective (as seen in the Equity Risk Premium). Inflation is contained, and households aren’t over-levered by historical standards, so a consumer debt crisis probably isn’t lurking. It should be remembered that the current benign environment is in part due to the government’s willingness to shoulder the debt burden vis-à-vis a massive expansion of its balance sheet, a factor that doesn’t seem to be reversing anytime soon given the recent debt ceiling and budget deal that is projected to boost spending by $320 billion over the next two years.

Perhaps, while not immediately obvious, the prudent course of action is a near-term rate cut to stabilize growth. Ultimately, it may prevent the FOMC from having to reflexively change its interest rate policy in the face of crisis as has been all too common in the past. On the other hand, the FOMC may regret using one of the few tools they have in the kit if and when a recession does happen.

Authors

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Ryan Driscoll is responsible for trading, investment analysis. He is a member of the Treasury Solutions team since its inception. Ryan is an active participant in the investment and rebalancing process, manages the quarterly reporting process and is actively engaged with Treasury clients. Prior to joining Commonfund, Ryan worked at Sailfish Capital Partners, a multi-strategy fixed income fund, where he served on the Emerging Markets team. Prior to that, he was on the fixed income team at Grantham, Mayo, Van Otterloo & Co. and was an equity/fixed income trader at Loring, Wolcott and Coolidge, in Boston. Ryan received his B.S. in Finance and M.S. in Global Financial Analysis (with Distinction) from Bentley College. He is a CFA Charterholder and is a member of the Boston Securities Analyst Society and CFA Institute.
Ryan Driscoll
Director, CFA
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Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.