Should Investors Position for “Late Cycle” or “Recession”?

By Aline Wealth Management on May 28, 2019

“Late Cycle” More Likely Than “Recession”
While the economy is showing some signs of slowing, recession does not seem imminent. Recession anxiety is fueled by declines in economic indicators, such as industrial production and business credit. During the first quarter of 2019, industrial production fell from an annualized rate of 3.5 percent to 2.8 percent – certainly not a recession, but not headed in the right direction, either. Optimistically, the decline was substantially driven by data in motor vehicles and parts, and an offsetting hope may be found in retail sales: U.S. retail sales jumped in March, driven by a 3.1 percent increase in motor vehicle sales and parts, which could lead to a subsequent pick-up in industrial production. Likely related to trade uncertainty, business credit applications also slowed in the first quarter; this uncertainty could shift with a resolution of NAFTA, a trade pact with China, and clarity on EU auto tariffs, but the slowdown can be disconcerting until then. In the meantime, consecutive monthly improvements in U.S. small-business optimism offers hope that credit growth can improve regardless of trade issues.

In contrast to the above potential reasons for caution, some other indicators argue against recession. For instance, weekly jobless claims are down to the lowest level since the 1960s, and mortgage applications for home purchases have also improved. Economic fundamentals, driven by strong employment, continued wage growth, corporate earnings, and a pause in tighter monetary policy suggest a recession is not poised to unfold in the near future.

Although a recession may not be imminent, a more challenging environment than we have enjoyed over much of the last 10 years should be expected, with the main differentiator stemming from less stimulus. The Fed has pivoted to pause rates, but rate reductions do not seem necessary. From a fiscal standpoint, another round of tax-cuts is unlikely – thus removing the likelihood of government stimulus – and slow global growth is of little help to the U.S. economy. In the absence of domestic stimulus, and with little help from the global economy, investors should plan for a late-cycle environment.

An Atypical Late Cycle?

The atypical nature of this cycle may not permit formulaic investing that worked in previous cycles. Late cycles are typically characterized by high inflation and often by a sense of investor euphoria – especially if the economy is showing signs of overheating. Typically, stocks perform relatively well, as do assets that benefit from inflation, including commodities and real estate. However, this 2019 late-cycle environment has so-far been characterized more by skepticism than euphoria and relatively low inflation (not high inflation).  Inflation, though, could yet reveal itself. With only the unemployable left unemployed, wages could rise relatively quickly, as companies compete for qualified labor, and resulting wage growth would contribute to higher inflation. A delay in the Fed’s response – a classic mistake made in past cycles – would allow inflation to gain some foothold before eventual tighter monetary policy is pursued. In this scenario, inflation-protected investments such as commodities or real estate could perform relatively well. But, again, without investor euphoria, stocks seem less likely to follow their historic late-cycle pattern.

Keeping an open mind, a more unusual scenario could also develop to bring about the demise of the current cycle. Low levels of inflation and a stable Fed policy suggest that this late cycle could evolve with continued stable rates – not higher ones. If this stable-rate scenario unfolds, interest-rate sensitive sectors such as housing and autos may struggle to improve, since: a) higher home prices and stable rates translate into reduced affordability and, therefore, slower home sales; and b) strong auto sales over the past several years should translate into little pent-up need for new cars, and this low demand could combine with potential EU tariffs to further restrict auto sales. Late-cycle growth could, therefore, plod along, or deteriorate slowly, until a catalyst other than the usual suspects of higher inflation and higher interest rates emerges to bring about its end.

That cycle-ending catalyst could be lack of earnings growth, which may pressure U.S. equity prices lower; in turn, lower equity prices could impact the U.S. wealth-effect, potentially contributing to a decline in economic growth. Another possibility is that the catalyst could emerge as rising concerns about excessive U.S. Government and corporate debt produce redemptions of debt holdings; the resulting higher interest rates could be especially punishing to lower quality credits, leading to increased bankruptcies and an economic slowdown. Yet another catalyst could come in the form of a more socialist political agenda. Managed care stocks have recently underperformed, as the probability of Bernie Sanders winning the Democratic nomination has increased. Such a reaction suggests investors might respond quickly to fears of increased regulation and new corporate taxes that could reduce profits or provide incentive for companies to expand outside the United States; U.S. equities would likely decline as a general de-risking of portfolios unfolds.

In any scenario, late-cycle behavior still seems likely before recession. However, unlike past cycles, recession could come without high inflation or the investor euphoria that pushes stock prices higher.

Portfolio Considerations:
1). For investors who feel that economic growth will plod along close to potential of 1.8 percent, a gradual tilt away from risk may be appropriate. Such investors can opt to emphasize large high-quality growth stocks. This sector should perform relatively well, as investors favor large well-managed companies that can sustain a downturn yet continue to perform well in a slow-growth environment.

2). Investors who expect the economy to follow a more typical late-cycle path of rising inflation, delayed Fed response, and an eventual slowdown might consider increasing holdings of commodities or real estate. Funding for such investments could come from lower-quality sectors, including loans, in anticipation that higher Fed funds will push loan rates higher, restrict credit, and increase the possibility of distress.

3). Those who fear that high investor anxiety will compress late-cycle opportunities may want to forgo any strategies distinct to late-cycle investing and pre-position for recession. Such investors may want to reduce lower-quality securities, including high-yield debt, and position toward higher-quality debt. Non-agency mortgage-backed securities may be a fixed-income opportunity that provides high-quality protection without giving up as much yield as a move to pure U.S. treasuries.

HighTower Wealth Management is a team of investment professionals registered with HighTower Securities, LLC, member FINRA/SIPC, & HighTower Advisors, LLC a registered investment advisor with the SEC.  All securities are offered through HighTower Securities, LLC and advisory services are offered through HighTower Advisors, LLC. This is not an offer to buy or sell securities.  No investment process is free of risk and there is no guarantee that the investment process described herein will be profitable.  Investors may lose all of their investments. Past performance is not indicative of current or future performance and is not a guarantee. 

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