Why coronavirus’s impact on local business isn’t a predictor for recession
The past 18 months has been a roller coaster for recession risk. Last summer, headlines and talking heads screamed of a looming recession, pointing to factors like the inverted yield curve. Those screams are ringing out again as investors are fleeing to safety and bond yields have plunged around concerns of a coronavirus-driven global economic slowdown.
An inverted yield curve occurs when short-term Treasury bonds yield more than long-term Treasury bonds; and has historically been a predictor of recessions. But you should never look at one metric in isolation; rather you should look at metrics in the context of the greater economic data. And some signals, including the unemployment rate, the quit rate and residential building permits do not point to a major slowdown ahead.
The other prevailing concern is that consumer sentiment won’t hold up with slumps in the industrial and manufacturing sectors. Yet consumer confidence remains relatively high. It has dropped slightly since last year, falling eight percent from last December, but when entering a recession, it tends to drop closer to 15%. The U.S. service sector represents some 70% of our economy and so far has been very resilient in the face of troublesome news overseas.
The U.S. economy has been growing for the past decade now, the longest run on record. As the market rises, investors have become increasingly concerned. Should you fear all-time highs? Market highs give many investors flashbacks to the dot-com bubble or the financial crisis of the last decade, because they recall how quickly gains can evaporate. But it is hard to be a successful investor if you always interpret all-time highs as a breaking point.
There is a cliché uttered around stocks: “What goes up, must come down.” And while this phrase makes sense if you’re throwing a baseball, it’s an oversimplification of the market and assumes that it operates around a flat trend line. Long-term investors know that isn’t the case.
Over the past 60 years, the average one-year return for the market has been 10.2%. The average 12-month forward performance following an all-time high has been around 12%. So, rather, highs generally bring about further highs.
This does not mean a recession won’t strike in the future, but exactly when the next economic downturn will come is extremely uncertain and is not a guarantee just because the market reaches new highs. Markets don’t die of old age — investors typically need to anticipate a significant fundamental shift in earnings, profit margins, inflation or interest rates to sustainably change their speculative appetites.
Recessions are notoriously hard to predict, as there are typically lag times of varying lengths between economic indicators turning cautionary and the manifesting of recessionary data. And, the stock market cycle rarely lines up perfectly with the economic cycle. In fact, the stock market tends to perform well during the start of the recession. In five of the past eleven recessions, markets saw double-digit gains while the recession was underway.
Many people don’t even recognize we’re in a recession when it’s unfolding. The recession during the summer of 1990 wasn’t declared by the National Bureau of Economic Statistics (NBER) until April 1991, a month after it was over. And in late 2008, NBER didn’t announce it was a recession until December, a year after it began and just six months before it was over.
If you are trying to predict the economy just by reading headlines, chances are you will be off on how the market reacts. It’s not just the news that moves stocks, it’s the news relative to expectations that moves stocks. Good or bad matters a lot less than better or worse and it’s entirely possible that the markets will discount economic contraction before it’s actually captured in those headlines.
For example, earnings reports late last year were not as bad as what was feared and markets were able to rally despite flattish overall growth versus 2018. However, they sold off in 2018 despite double-digit growth. Forces such as monetary and fiscal policy can influence stock prices in ways that one might miss by just focusing on economic data.
While risks are still elevated in light of the world’s second-largest economy effectively shuttered due to the virus outbreak, that should not dissuade you from having balance in your portfolio and looking towards reasonable valuations on companies that have good, long-term value. As an investor, it’s important to remember that staying invested has historically been a sound strategy.
Simon Hamilton is a portfolio manager with Reston-based The Wise Investor Group at Robert W. Baird & Co. Incorporated