Is the U.S. economy peaking?
The current economic expansion is already the third longest on record—about three times longer than the average—and Dan Roberts, chief investment officer for investment management firm MacKay Shields, says there are several signs it’s nearing a top. Among the most significant: The Federal Reserve is raising short-term interest rates, which it’s done shortly before every recession since World War II, and the yield curve is flattening—another phenomenon that’s preceded every recession since WWII.
Roberts, who also serves as executive managing director and head of global fixed income for MacKay Shields, cautioned attendees at the 2018 SVIA Spring Seminar that the warning signals aren’t fully synchronized yet, and a recession doesn’t appear imminent. He noted that beyond flattening, the yield curve actually turns negative before most recessions, and then starts to steepen again right before the recession starts. But, he cautioned, if the Fed raises short-term rates another 75 basis points between now and the end of the year, as many Fed watchers are expecting, the curve could become inverted by the year’s close. After all, the spread between 2-year and 10-year Treasuries was only about 50 basis points at the end of April.
Meanwhile, spreads between Treasuries and high-yield bonds also tend to turn higher two to six quarters before a recession, Roberts said. Right now, those spreads are low by historical standards—in the range of 320 to 350 basis points—and haven’t started to climb.
Unemployment rates also tend to turn up about two to six quarters ahead of a recession, Roberts said, following a sustained decline. In the wake of the Great Recession of 2008-2009, the unemployment rate has been falling for nearly nine years, and by April had hit 3.9 percent. That represents its lowest level since December 2000.
Every economic cycle is different, of course, and Roberts pinpointed a few characteristics unique to this one, starting with the Fed’s balance sheet, which has ballooned from about $750 billion in 2008 to about $4.2 trillion today. That increase was attributable to the Fed’s massive efforts to stimulate the economy by buying fixed-income securities to help keep interest rates down. All that buying did, in fact, keep downward pressure on interest rates for the past several years, but the bond market no longer has that headwind at its back now that the Fed has ended its bond-buying program.
Meanwhile, workers’ wages in the U.S. haven’t gone up as much as one might have expected during the long contraction of the unemployment rate, a phenomenon Roberts attributed in part to demographics. As high-earning baby boomers begin to retire, he said, they’re being replaced by lower-earning younger workers.
While demographics—and technological disruptions—are skewing wage growth and inflation lower than in the past, Roberts said he does expect inflation to pick up, which could prompt the Fed to raise short-term interest rates even faster than people have been expecting.
In terms of how all these developments are impacting his firm’s investment portfolios, Roberts said he and his colleagues have been trimming marginal risk as prices for risk assets continue to rise and economic risks continue to increase, and are focusing on high-conviction ideas.
