US recession a possibility
The most important issue for US investors in the near term is determining where we are in the business cycle.
The reason why this is important is that different industry sectors lead the stockmarket during the various phases of the business cycle – early, mid, late or recession – both in terms of how often they outperform and by how much.
Expansions and contractions vary from one cycle to the next in both magnitude and duration. However, each set of expansions and contractions shares certain attributes. These contribute to patterns in terms of which sectors lead the rest of the stockmarket. Industry sectors lead the stockmarket at different moments because of characteristics that exert a heavy influence on their activities. These include the sensitivity of financial firms to interest rate movements or the stability of the healthcare and consumer staples sectors.
Our analysis indicates that, in spite of the absence of restrictive monetary policy, the signs of an economic slowdown in the US are becoming more dominant. It therefore seems prudent to rotate portfolios into more defensively oriented sectors, such as consumer staples and healthcare, where profits are less sensitive to the economy. This said, we don’t foresee a major broad correction in the markets from these levels. Regardless of the economic backdrop, we have an eye to invest more aggressively on a tactical basis, potentially as the outcome from the US presidential election in November becomes clearer.
After 34 months of economic expansion, we expect to see economic figures in the US confirm what we’re seeing from our bottom-up research into individual stocks: a contraction in activity over the coming months, with a distinct potential for outright recession by the end of the year.
This is in spite of concerted global action over monetary policy, which has been the principal catalyst for the business cycle since the 1950s. A typical business cycle unfolds as follows:
- early phase – the economy emerges from recession and the rate of growth accelerates from negative levels;
- mid/late phases – expansion becomes firmly entrenched and the Federal Reserve begins to raise rates to temper growth and the rate of inflation;
- late/recession phases – the pace of growth slows, turns negative and enters recession, leading to cuts in interest rates that help move the economy toward recovery.
Like economic data points, monetary policy is not a definitive indicator of the direction of the economy, however, as the turbulence of 2008 proved. The correlation that has existed for the past 60-plus years may be breaking down.
Unless it adopts a policy of targeting high inflation, the Federal Reserve is effectively removed from the battlefield in trying to combat the current contraction and massaging the business cycle. For now, a bias to defensive sectors seems warranted.