Is a U.S. recession lurking around the corner?

On the latest edition of Market Week in Review, Senior Quantitative Investment Strategy Analyst Dr. Kara Ng and Rob Cittadini, director, Americas institutional, discussed U.S. recession risks, the potential benefits of portfolio diversification in an economic downturn and the latest developments in the ongoing Brexit saga.

Recession worries on the rise as stock market slump continues

The ongoing slide in U.S. equities (as of market close Dec. 14, the S&P 500® Index is down 2.75% on the year, while the Dow Jones Industrial Average is off 2.5% for 2018), coupled with the pronounced recent flattening of the U.S. Treasury yield curve, has led to increased speculation about the potential timing and severity of the next U.S. recession. Ng and the team of Russell Investments strategists believe that late 2019 into 2020 is the most likely timeframe for an economic downturn to set in. Why?

"U.S. GDP (gross domestic product) growth, the labor market and consumer spending are still very strong--implying that near-term recessions risks remain relatively low," she said. However, Ng expects that the risks of a recession will become elevated later in 2019 as the impacts of fiscal stimulus--which helped boost U.S. GDP growth and corporate earnings in 2018--fade around the midpoint of next year. In addition, accelerating wage growth and a tight job market likely mean that the U.S. Federal Reserve will continue raising interest rates into 2019, she said. "This could lead to an inversion of the yield curve--and historically, once the yield curve inverts, a U.S. recession follows within 12 months," Ng noted.

However, she emphasized that the next recession in the U.S. is likely to be fairly mild--probably more on par with the economic downturn of 2001 than the Great Recession.

Weathering the storm: Potential benefits of diversification in a bear market

Generally speaking, a broadly diversified, multi-asset portfolio may help investors better weather the next bear market, Ng said. "Within equities, defensive sectors like consumer staples and healthcare tend to fare better during market downturns," she noted. In addition, analysis by Ng and the team of Russell Investments strategists of the last several market cycles indicates that adopting a defensive portfolio strategy earlier on is generally less painful than waiting until after a bear market sets in.

"Another interesting tidbit we uncovered in our research is that having cheap valuations heading into a downturn tends to be associated with a smaller overall portfolio drawdown," she stated. What this likely means is that, although the next recession may be mild, U.S. equities are at heightened risk for a steeper pullback, due to their expensive valuations, Ng concluded.

More market volatility likely in UK as Brexit drama continues

Turning to Brexit, Ng noted that the political rollercoaster over the UK's divorce from the European Union continued the week of Dec. 10, punctuated by Prime Minister Theresa's May survival of a no-confidence vote. "Because the revolt against May failed, she's free from another challenge to her leadership for 12 months," Ng noted, "but make no mistake, her position of authority has been severely weakened."

So, what might happen next? "We think the majority of Parliament still wants to avoid a no-deal Brexit," Ng said, "but it just so happens that at the moment, they can't decide what they alternatively want." As a result, UK bond yields and sterling will probably remain volatile as the saga continues, she said.

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