The U.S. is in the second longest economic expansion since the 1800s, and historically the S&P 500 Index has generally peaked six months before the onset of a recession. Given the age of the economic cycle, getting a clear read on recession risk is crucial. The Business Cycle Index (BCI) model uses a range of economic and financial variables to estimate the strength of the U.S. economy and to forecast the probability of recession. The BCI index as at the 23rd of November 2018, estimates the probability of recession in the next 12 months is around 25% - a level which signals caution, but not an outright warning.

Short-term (three month) recession risks are very low, given the strong labour market, still-easy financial conditions, and strong economic growth. At the 12-month horizon, the model recommends that investors remain alert but not alarmed. We are closely monitoring the data, but until recession risk is especially elevated (i.e. probabilities are in the warning zone), we believe leaning out of risky assets at this point is premature. A key watch point for longer horizons is the slope of the yield curve, which is an input into the BCI model and a reliable leading indicator. The 10-year U.S. Treasury yield is determined by the term premium and the average expected short rate over the 10-year period. When the 10-year yield falls below short-term yields, the market is pricing a growth slowdown in the future where the Fed is forced to cut rates. The yield curve hasn’t inverted yet, but it has uncomfortably flattened. Continued flattening will put upward pressure on the model’s recession probabilities.

There can be a significant negative impact in being defensive in your portfolio too late, but also a cost in being defensive too early. We conclude that we’re late in the cycle but not at the end of the cycle, and the risk of a near-term U.S. recession is still relatively low.

A cause for pause

Equity markets experienced a solid amount of negative return in the fourth quarter, but the U.S. market remains expensive in late 2018. This has put our measures of momentum close to zero and our signal for equity versus fixed income at a level resembling 2007. However, while this is a scary place for models to be, the macroeconomic backdrop is much different in 2018. In 2007 the yield curve was inverted, and our business cycle index was signaling recession.

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

  • Business cycle: The business cycle remains strong, though the risk of a recession is gradually increasing as we near the end the cycle.
  • Valuation: Equities seem to be fairly valued, according to our Fed model that compares U.S. treasury yields to the equity earnings yield.
  • Sentiment: Momentum has decreased significantly, which puts it to near zero as of the end of October 2018.

While a possible market correction needs to be respected, we believe as of November 30, 2018, it is not something to go overboard about, given broader context. But—given the end of cycle payout is low and some warning signs are there—we believe a cautious stance is prudent. That said, if the equity market rebounds, then the caution could be waved. This would take a few months to confirm so in the meantime this is simply a cause for pause while we wait and see.

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.

The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested.

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