Caution, not warning (yet)


The U.S. equity bull market celebrated its 10-year anniversary on March 9, and the U.S. economic expansion could become the longest in history by June 2019. The natural question around such milestones is to ask, “How much longer?” The Business Cycle Index (BCI) model, which uses a range of economic and financial variables to estimate the strength of the U.S. economy and to forecast the probability of recession, is on the cusp of risk-on versus risk-off. Short-term risks are still low, but the BCI model estimates the probability of recession in the next 12 months is around 30%—right on top of the warning threshold for leaning out of risky assets. 

Some weakness in U.S. consumer spending and the labour market since December 2018 raised BCI recession risk in the last couple of months. However, the weaker data was likely driven by transitory factors such as the partial U.S. federal government shutdown, unusually cold weather and uncertainty with trade-war negotiations. Going forward, the tight labour market with rising wages should support a healthy consumer. Offsetting the weaker economic data was the dovish shift in Fed forward guidance since January 2019. With the Fed no longer raising interest rates at a quarterly pace, financial conditions loosened, and the rate of yield curve flattening slowed, which eased some BCI recession risk.

How long the economic expansion can continue, from the point of view of the model, depends on sustaining a Goldilocks level of growth—hot enough to avoid a negative confidence spiral, but cold enough for accommodative monetary policy. If consumers and businesses become pessimistic, spending and hiring could slow, raising BCI recession risk. If the Fed fears overheating, then restrictive monetary policy could tighten financial conditions and invert the yield curve, also raising BCI recession risk. The elevated 12-month recession risk reflects the late-cycle balancing act, where there’s less room for error.

Thinking positive (barely)

After a drop in December, equity markets bounced back in early 2019. For a few months at the end of 2018 our Equity-Fixed model dipped below zero in response to the market’s momentum. The model shows an improvement since then along with the general market trend.  It is time to go back to thinking positively about equities but there are still some macroeconomic concerns in the background.

Within our cycle, value and sentiment investment framework we make the following overarching assessments based on our quantitative models.

  • Business cycle: We see signs of late-cycle woes, but otherwise the model indicates low probability of recession in the very near term.

  • Valuation: After the year-end 2018 market selloff, the Fed model, which compares the equity yield to the 10-year U.S. Treasury yield, signaled equities as more attractive, but that preference has since faded.

  • Sentiment: The Momentum model’s signal has stabilised to neutral after the late-2018 selloff.

Moving into the second quarter of 2019, the Equity-Fixed model’s signal is slightly above-neutral for equities, which suggests a mid-single-digit return on equities for 2019. 

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