Is the Market Presaging a Recession?

I have been writing on Real Money for over 10 years, and I genuinely think the site offers a unique opportunity for our readers. In the media generally, there is an incentive to make big calls to attract eyeballs and/or clicks. However real investors can't (profitably) operate that way. We need to live in a world of possibilities and probabilities. This is why when I write, I try to convey not just how I'm positioning, but what could go wrong and how I'm trying to mitigate losses should that adverse scenario come to pass. For readers looking for how professional investors really think about positioning, this is it. For those looking for gurus who have it all figured out, be prepared to eventually lose a lot of money. With that preamble, let's consider the possibility that the market is presaging a recession. To be clear, I'm not making a call at all. There is no way to know a recession is coming until we are already in one, and anyone who says otherwise is either ignorant or dishonest. Rather we'll think about what will probably happen and what might happen. From that we can think about what does it means for interest rates, risk assets, and what positioning gives us the best chance of making some money through a tough market. The Fed still kills expansions If a recession is about to begin, it is very likely because monetary policy has already gotten too tight, we just didn't realize it. Specifically, it could be that the fiscal boost from tax cuts last year may have offset tighter monetary policy in the beginning part of the 2018. That boost now seems to be wearing off, and it could be that the combined thrust of fiscal and monetary policy may be going from accomodative to tight without any change in the Fed's target rate. In addition, rate hikes effect the economy with a lag, so the effect of the last couple rate hikes may now be filtering into the real economy exactly as the fiscal boost is waning. I don't know for sure this is happening, but the evidence is piling up. Toll Brothers earnings report on Tuesday, warning that new orders were the lowest in four years, is but the most recent example. Interest-rate sensitive sectors are showing signs of strain. Business investment seems to be flagging. Both of these are classic early signs of a economic slowdown. What would a 2019 recession look like? Probably pretty mild. There isn't enough excesses in the economy to produce a deep recession. Corporate leverage is high, but interest coverage remains pretty good. Multi-family residential has probably been overbuilt in some city centers, but building activity has already slowed and rents are coming down mildly to accommodate the supply. Auto sales were probably unsustainable a couple years ago but they've come off their highs. A recession will cause some pain for sure, but each of these problems is pretty solvable. Banks are in good shape and aren't especially exposed to problem sectors so the opportunity for contagion is mild. What would the Fed do? It would take time for it to be clear we were actually in a recession. Ahead of the 2007 recession, the Fed didn't make its first cut until just three months before the recession officially began. By that time job growth had slowed from +173,000/mo in 2006 to just 104,000 to that point in 2007. We'd only get 3 more positive prints before the bottom fell out of the economy in early 2008. The 2001 recession was similar. The Fed cut two months before the recession officially began (cutting in January 2001). At that point we already had four negative job prints and again, and just like 2007, the bottom was about to fall out. Starting in April 2001 we had a streak where 10 out of 11 months saw job losses of over 100,000 jobs. I think the same would happen this time. The Fed isn't going to start cutting until the recession is pretty obvious, and I suspect by that time it will be too late to actually avoid the recession. However once they start cutting, expect them to cut aggressively. They really don't want to have to resort to non-traditional tools like QE, so cutting aggressively at the outset gives them the best chance at arresting the downturn before it gets too ugly. What would that mean for the bond market? The fact that the Fed is going to keep rates high until it is too late will keep the yield curve extremely flat and probably inverted. Long-term rates should continue to fall if additional evidence of a slowdown emerges. However once the Fed starts cutting, expect the curve to steepen substantially. As a result of this, I think it is time to modify the flattener trade I've had on for nearly two years now. I had been overweight 20-30 year bonds vs. short 3-7 year bonds. I am moving that to be over weight 10-20 year bonds and neutral vs. 30-years. This is mainly because that steepener could happen suddenly and the long bond will get hurt the most. I still think the curve flattens before it eventually steepens, but risk/reward in the 30-year isn't great. Besides, after the huge flattening Monday and Tuesday, it is deeply overbought. Is it worth owning high-yield bonds at all? It is nearly a guarantee if there's a recession in 2019, junk bonds will post negative returns. However I don't mind remaining long corporate bonds selectively. Valuations remain tight, but as I said above, the ingredients for a big default spike just aren't there. I think you need to be very selective, not just buy high quality, but buy stories that have some company-specific upside scenario and hence could buck the trend of the general market. I wouldn't buy or here. Even if we don't get a recession in 2019, odds are very high that sometime between 2019-2021 a recession comes. That will make it hard for credit spreads to broadly tighten. I.e., investors will be hesitant to bid up junk bond prices until we are completely through this cycle. As I mentioned last week, I do like energy bonds here. Make sure you do your homework on any given company, but overall, balance sheets in this space are much stronger than they were in 2015. The bonds (and preferreds) of many of these companies are trading like it will be 2015 all over again. It won't. This is the space within credit where valuation is most attractive. What about stocks? I'm a bond guy by trade, but it strikes me that the broad stock market is in a tough spot. There are a number of risks to company earnings that aren't necessarily risks to the general U.S. economy: rising wage costs, weakness in emerging markets, Brexit, tariffs, etc. Stocks are also facing the same problem I mentioned above about high yield. If we don't get a recession in 2019, we very well might in 2020-2021. The market is going to know that and value stocks accordingly. Plus we know that if the economy keeps growing, the Fed is going to keep hiking, which is another source of pressure on stock valuations. I'm pretty cautious on stocks broadly here

Is the Market Presaging a Recession?

There really is no way to know a recession is coming until we are already in one,

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