Separating Fear from Reality

By: Richard A. Anderson

Over the past few months, market participants have focused on the yield curve and its history of predicting an economic recession. As the chart below shows, the yield curve has inverted prior to every recession dating back to 1962. With predictive power like this, it’s no wonder investors have been vigilantly monitoring its movement in an attempt to gauge when a recession may occur.

01142019_US Yield Curve Steepness.png

Last week I highlighted an important distinction between the stock market and the economy, noting that we can have a bear market in stocks not accompanied by an economic recession. But it certainly feels like investors have resigned themselves to the fact that a recession is imminent.

Most of these fears are based on the time from yield curve inversion to recession. But focusing on one measurement or data point is not a prudent strategy. Below are some thoughts on data points that support this economic expansion should continue.

The December jobs report released earlier this month showed nonfarm jobs grew by 312,000, far exceeding the median consensus estimate of a 184,000 increase. This was a record 99th consecutive month with positive jobs growth. Though the unemployment rate ticked up to 3.9%, the first monthly increase since June, it increased for the right reason. 419,000 new workers entered the workforce and the labor force participation rate increased.

In addition, average hourly earnings grew 3.2% year over year in December. This is the fastest pace since the economic expansion began in 2009 and the third straight month average hourly earnings have grown by more than 3.0%.

The markets responded positively to this jobs report, along with favorable comments about the pace of rate hikes made by Federal Reserve Chair Jerome Powell. But like all news, there can always be a negative spin. Some pessimistic economists fear strong wage growth may lead the Fed to continue hiking rates to fight a possible inflationary environment. After all, wages represent about 70% of business costs so if wages rise, costs of goods and services should rise as well.

Investor sentiment seems to be shifting every day. When there’s positive news, the economic expansion is going to continue forever. When there’s negative news, a recession is imminent. Recently, it seems like there is more negativity than positivity.

We believe current wage growth is healthy and below excessive levels that have historically preceded economic recessions. As the chart below shows, wage growth has reached an average of 4.1% before each of the last three recessions. Furthermore, since 1970, wage growth has exceeded 4.0% prior to all recessions. 1

01142019_Wage Growth.png

In addition to wage growth, we can also monitor the actions of the Federal Reserve. The real federal funds rate, or the Federal Reserve’s target short-term interest rate less inflation, can be used as a benchmark to gauge the economy. The real federal funds rate today is around 0.3%. Dating back to 1970, the real interest rate has averaged a high of 4.2% before the U.S. economy headed for a recession.2

01142019_Real Fed Funds Rate.png

Investor sentiment seems to be shifting every day. When there’s positive news, the economic expansion is going to continue forever. When there’s negative news, a recession is imminent. Recently, it seems like there is more negativity than positivity.

This highlights the problems with focusing on one sign or data point to signal what the future holds. Without context, data is meaningless. Every recession and every bear market in history have been different. They have different causes and different effects.

I wish I had the ability to predict when the next stock bear market or next economic recession will happen. But it’s not that simple. If it was everyone would be rich.

Just because we can’t predict the future doesn’t mean we can’t prepare for it. Markets and economies move in cycles. But it’s impossible to consistently pinpoint when the cycle will turn. That is why we stay informed on what’s going on in the markets and economy and invest in diversified portfolios.

1“Wage Growth and Recession Fears.” LPL Research, 4 Jan. 2019, www.lplresearch.com/2019/01/04/wage-growth-and-recession-fears/.

2“Market Fears and Economic Realities.” LPL Research, 2 Jan. 2019, www.lplresearch.com/2019/01/02/market-fears-and-economic-realities/.