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What recession?

The investment industry is obsessed with forecasting the next down cycle, particularly given the pain of being caught on the wrong side of the trade by a recession. But are we right to worry when being too cautious too early could lead us to miss remaining upside from the current bull market?

Our analysis reveals that this market cycle has more room to run before investors need to overhaul portfolios.

When Is the Next Recession?

Term spread -- the difference between long- and short-term interest rates -- has been a strong predictor of future economic health for decades. In fact, all recessions since the 1970s have been preceded by term spread turning negative (an inverted yield curve).

As we enter the 108th month of the current expansion, the second longest in U.S. history, and the yield curve flattens to levels not seen since 2007, it's logical for investors to fear a recession may be on the horizon. Using the last five recessions as our guide, we calculated the average time-span between term spreads falling below 50 basis points and inverting, and the average time-span between inversion and the start of a recession. The results imply a relatively limited chance of a recession in the near term.

With term spreads having recently declined below 40 basis points, we might expect around seven months (the data set median) before inversion, and a further 17 months to a recession. An inverted yield curve has been a reliable recession indicator in the past, but lead times tend to be very long.

How Serious Will It Be?

Data suggests a relationship between the depth of a recession and the strength of the subsequent recovery, and the strength of a recovery and the severity of the subsequent recession.

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Our analysis of changes in output surrounding the previous ten market cycles shows a positive correlation between recession depth and the pace of the subsequent recovery (severe recessions tend to precede rapid expansions). The most recent recovery, however, has been an exception to this historical trend. The 2007-2009 recession was severe, but real GDP growth has been slow to recover. A restrained rebound in employment and personal consumption expenditure growth in the quarters immediately following the start of the recovery are likely contributors to this phenomenon.

Our findings also show that expansions that last longer (in this case, measured in months from start to finish) are typically followed by relatively mild recessions, regardless of the actual increase in output. The reason could be that longer recoveries may demonstrate a more measured degree of growth, necessitating a less severe correction in the period that follows.

Given the length of the current expansion (the second longest in history, and still going), historical evidence suggests the next recession may be relatively mild.

Is Now the Time to Act?

Financial markets are forward-looking in nature, and trading levels are likely to react in advance of the start of a recession, which could be at least 24 months away. But, what is the typical lead time?

Using S&P 500 Index undefined and three-year Treasury trailing three-month returns as proxies for risk, we find that the latter begins to outperform the former around five to nine months prior to the start of a recession, using the previous three recessions as a guide. This suggests a near-term move to risk-off positions would be premature.

What to Do When It Comes

The current expansion will inevitably come to an end, and investors don't want to be hung out to dry. Potential triggers may be an overly rapid tightening of monetary policy or a large shock to global growth. While we remain positive on near-term earnings growth, the pace of improvement could diminish late next year.

As we move through 2019 investors may want to think about transitioning their portfolios in preparation for a down cycle. In U.S. high yield, for us that means shifting weightings towards higher quality issuers, whose bonds tend to have longer durations and therefore more interest rate sensitivity, but are less vulnerable to the risk of default.

By: Michael Salice, Director of Research, SKY Harbor Capital Management.