The Good News
While 2016 has had its volatile moments—Chinese stocks plummeting in January and the “Brexit” shock in June—the US stock market has nonetheless made a very respectable showing, returning 8% for the first nine months of the year. As we noted last quarter, those exogenous shocks were noise that temporarily masked the signal the US economy was sending, which was one of steady improvement.
Since January we’ve maintained a positive outlook for the US economy and stock market in 2016, which was a rather contrarian view ten months ago. We think this good weather holds for a bit longer, but only for a bit.
We’ve also been saying that we see clouds gathering on the horizon for 2017 and that we anticipate reducing sail (equity exposure) as year-end 2016 draws near. We still do. This, too, is a contrarian call.
And the Bad
The happy fact is that we haven’t seen a recession in the US economy or a bear market in US stocks (20%+ decline) since 2008. That does, however, make the current bull market in stocks and the ongoing economic expansion rather long in the tooth by historical standards. That said, it’s also true that old age doesn’t kill bull markets or economic expansions. Generally speaking, rising trends in interest rates and inflation do.
And, indeed, interest-rate and inflation trends are the threats we see for US stocks and the economy. For those who follow such things, this may seem odd given that interest rates remain quite low and inflation fairly quiescent. But the drivers of the ebb and flow of the US economy are the trends in these factors more than their levels. The point here is that the trends in interest rates and inflation have flattened out, that is, they’ve stopped declining. In the current global economic climate, that may be enough to turn the tide.
Imagine you’re flying a plane into a very strong headwind. Maintaining altitude is a constant challenge and very minor changes in throttle can make the difference between ascending and descending. That’s the condition the US economy finds itself in.
The roaring expansion in China and the emerging markets during the 2000s created a powerful tailwind for the global economy. Now, that tailwind has turned into a headwind as China’s boom goes bust. Combine that with decades-old weakness in Japan and the political and debt-burdened struggles of the Eurozone and you have a powerful, long-term headwind for the global economy. The US economy is like a plane flying into that headwind. What would have been minor, even negligible changes in economic conditions a few years ago can, today, make the difference between ascending and descending.
In decades past, you needed rising interest rates and inflation to push the US economy into recession and, anticipating that, US stocks into a bear market. Today, simply flattening out these trends could cause altitude loss.
Remember that falling interest rates create—with a time lag—a wave of stimulus to the economy by making borrowing and thus spending incrementally easier. Similarly, falling inflation, generally oil prices, means consumers spend incrementally less at the gas pump and incrementally more on discretionary items. In both cases, it’s the incrementally greater domestic spending that stimulates the economy.
Over the past two years, global interest rates fell and oil prices plummeted. That set off a wave of stimulus that landed on US shores in 2016. But those declines have ended. They’re no longer providing that incremental boost in domestic spending. And that, in effect, is a loss of throttle speed.
With the stimulative effects of falling rates and oil prices having peaked, the US economy is more at the mercy of global headwinds. And that likely spells a loss of altitude—that is, a slowing economy and a declining pace of corporate revenue and profit growth. As corporate profitability drives employment in the US, slowing profits spell slower job growth. This, in turn, slows revenue and profit growth and a vicious cycle is engaged.
When facing such a situation in the past, the Federal Reserve would lower interest rates, thereby making borrowing and spending easier, which would stimulate the economy and break the cycle. The problem now is that the Federal Reserve has had the interest rate it controls at or near 0% for going on eight years—since the Great Recession. So, one of the key tools for combatting recession is effectively no longer available.
A further compounding risk factor is that the pick-up in the US economy in 2016 helped other economies around the globe—including those of China and other emerging countries. The US is, after all, the largest buyer/importer of goods and services on the planet. If we perk up, every country that sells to us gets a boost. Conversely, if we slow, so does every country that sells to us, which is virtually all of them.
Here we should remember Warren Buffett’s famous saying that you don’t know who is swimming naked until the tide goes out. By this he meant that the weak links in the global economy aren’t evident until growth slows. We’ve made this point before, that when global growth slows the risk of financial crisis somewhere in the world goes up.
What We’re Doing
In sum, we see the odds of a recession in the US rising as we enter 2017. We also see that some of the traditional tools for combatting recession are no longer in the toolkit. For both reasons, we also see the odds of a bear market in stocks rising. Compounding this stock market risk is the rising risk of a foreign financial crisis we know not where.
For these reasons we are moving our portfolios’ equity exposure from a neutral to a defensive weighting. Our equity exposure will emphasize less volatile stocks of companies with stable growth, strong balance sheets, safe dividends, and less sensitivity to the ebb and flow of the global business cycle.
After reviewing the risks we see ahead for 2017, some may ask “Why be in stocks at all?” Our answer is probabilistic: We believe the odds of a bear market have risen substantially. That doesn’t mean there will be one. So we hedge our bets, reducing but not eliminating our portfolios’ equity exposure. For the baseline fact investors must always keep in mind is that the long-term trend of the US stock market is up.
Good News Again
If the US stock market suffers a bear market as the US enters recession, the seeds of recovery will thereby be sown. A recession by definition means declining demand. That declining demand will cause interest rates to fall substantially—even from current low levels—as will inflation. These will then send a wave of stimulus to our shores, eventually boosting the stock market and the economy. This is the cyclical nature of markets and economies. It’s just how they work.
One intriguing possibility is posed by the upcoming elections. Should Clinton win big, as it appears she will, and Democrats sweep both houses of Congress, you could well see substantial fiscal spending legislation enacted, focusing on repairing and expanding our domestic infrastructure. This is long overdue regardless of where we are in the economic cycle. But if made in response to a US recession, such spending would provide a much-needed boost to employment and to the economy as a whole. Indeed, it’s possible this could happen even with the House remaining in (chastened) Republican hands.
This could be the silver lining to a US recession: a concerted reinvestment in our domestic infrastructure by a federal government committed to actually governing.
Farnum Brown, Chief Strategist
The opinions expressed herein are those of Arjuna Capital, LLC (“Arjuna Capital”) and are subject to change without notice. This material is not financial advice or an offer to sell any product. Arjuna Capital reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. Arjuna Capital is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Arjuna Capital including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request. AJC 16-08