Rollover in the US, NOT a Recession

This week’s revenue forecast downgrades from Apple and Delta Air Lines and Thursday’s steep dive in the ISM manufacturing PMI only appeared to confirm what market participants already knew: US growth is rolling over. After accelerating to a punchy 4% rate in mid-2018 thanks in large part to last January’s tax cuts, it now looks as if US GDP growth slowed to around 2.6% in 4Q18. All the macro evidence points to a further slowdown in 2019, with the US entering another soft patch for growth. Yet despite the recent sell-off in equities and the further flattening of the US yield curve—the three-month to 10-year spread is now just 15bp—we see no recession on the horizon.

It seems the number of market participants who agree with us is fast diminishing, especially after the ISM manufacturing PMI recorded its steepest fall since October 2008, slumping from an extremely high 59.3 in November to 54.1 in December (see the chart in the web version). Incorporating that fall, the Atlanta Fed’s GDPNow compilation of high-frequency data indicates that 4Q18 growth is likely to come in at just 2.6%, down from a quarter-on-quarter annualized rate of 4.2% in 2Q18.

Like most, we have been expecting a slowdown. With the structural growth rate of the US somewhere around 2%, there was no way GDP could keep growing at 3-4% for long—especially not with a relatively tight labor market. Moreover, the US housing sector, which is a good leading indicator of the overall economy, was weak throughout 2018.

But a soft patch does not mean recession (see Don’t Sweat About The Yield Curve). History suggests that for a recession to occur there will probably need to be a significant contraction in either residential investment or business investment, or both. Neither appears to be in the cards.

Admittedly, residential investment has been weak. In the first three quarters of 2018 it averaged an annualized contraction of -2.8%, and the figure for the fourth quarter is also likely to be negative. But this is a modest contraction for a sector that commonly shrinks by -10-20% before and during recessions.

After last year’s contraction, the housing sector may find its footing in 2019. The current cycle has not seen the above-trend building binge common to earlier cycles, nor have vacancy rates risen. So there is no supply overhang to correct. The reason the sector stopped growing last year was that rising house prices and rising mortgage rates made financing the purchase of new builds less affordable, and relatively unattractive relative to renting (see The Drag Of US Housing). But this headwind has abated over the past month as mortgage rates have come down. As a result, our affordability indicators have gone from negative for most of last year to neutral today.

Meanwhile, we expect business investment to remain positive. This is primarily because our Wicksellian spreads—the gap between the apparent rate of return on invested capital and the real cost of borrowed capital—remain positive. And with interest rates no longer rising, we could see yet another year of positive spreads. As long as companies can borrow at rates lower than the returns they expect to make on new investments, growth in business investment is likely to remain positive. Of course, ROIC could collapse, or corporate interest rates could spike. But while we expect ROIC to fall and borrowing costs to rise, we expect these developments to be gradual. Recent developments in the bond market support this view. For now, the facts on the ground suggest growth will remain at least modestly positive.

Where does this leave investors? Assuming that the US economy is going to avoid recession this year, investors should steer clear of long bonds (10 years and over). These currently yield little more than cash, and so do not reward investors for taking duration risk. After the recent decline in equity prices, earnings yields on US equities look more attractive. At the beginning of December our growth and valuation models led us to recommend 70% equity exposure and 30% cash. After the sell-off, our models suggest using this dip to increase equity exposure to 80%, with the remainder still in cash or short-term credit.

To be sure, risks abound. US-China negotiations could fail to bear fruit, the US government shutdown could drag on, and Brexit could get ugly, any of which could tip the balance towards a recession. But any or all of these troubling issues could also recede, and a recession could be avoided. For now, then, our assessment is that equities still offer the best risk-reward proposition, followed by cash. Long bonds continue to come in last. If Warren Buffett is right that one should “be fearful when others are greedy, and greedy when others are fearful,” this is a good time to get greedy.

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