QUANTITATIVE MODELING
INSIGHTS

Our models suggest caution, but not alarm. The yield curve is flattening, but remains far from inverted. The 12 - month recession probability is only 25%.

 

Aging gracefully

The U.S. is in the second-longest economic expansion since the 1800s, but we still see some runway left. On the bright side, the pace of job growth is still strong and corporate credit spreads are still low.

However, the Business Cycle Index (BCI) model, which uses a range of economic and financial variables to estimate the strength of the U.S. economy, recommends caution, though not alarm. The caution is partially driven by the slope of the yield curve, a historically reliable predictor of recessions and an input into the BCI model. In the last five cycles, an inverted yield preceded a recession by 10 to 32 months. The current yield curve is far from inverted, but its flattening puts upward pressure on the model’s recession probability.

Another point of caution is the Treasury-Euro/Dollar (TED) rate spread, or the difference between 3-month London Interbank Offered Rate (LIBOR) and U.S. Treasury bills. This model input is historically an indicator for financial institution health. With no manual override, the rise in TED spreads would’ve triggered a 12-month recession warning in the BCI model. However, the current increase in the TED spread is driven by supply and demand shifts in the money markets and not default risk. Adjusting for the TED spread distortion, the BCI model’s 12-month recession probability is only 25%.

A positive outlook, but on the lookout

Throughout this market expansion our equity-fixed income model has been slightly bullish. Following momentum as the market goes higher yet cautious of high valuations. The past few months have seen a small increase in the preference for equity over fixed income but at mid-year 2018 this overall pattern of cautious optimism holds. 

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

  • Business cycle: The cycle remains strong, though the risk of a recession rises as we near the end the of cycle.
  • Valuation: We see equities as fairly valued relative to fixed income measured by our “Fed” model, which focusses on earnings yield versus U.S. Treasury yield.  Our “Discounted Future Cash” model sees equities as more attractive.
  • Sentiment: This currently favors equity. It may fluctuate between mild and strong but the signal has been consistently positive from a momentum perspective.

Given that we still see both positive momentum and expensive valuations, we face a tough call between equity and fixed income. We continue to have a positive outlook, yet look for any sign that the market may flinch and reverse our momentum score. This leaves us in a mildly positive spot but on the lookout as we get further and further into this cycle.

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