The outbreak of the coronavirus proved to be a reality check for investors who were uber-bullish about the prospects of the American economy and capital markets. Most of the indexes, including the S&P 500, crashed in the last couple of weeks in January. Travel and aviation stocks took an especially brutal beating over fears of reduced travel activities on a global scale. While markets have partially recovered in February, investors are more alert than ever to the possibility of a recession or a significant decline in stock prices. While it is impossible to determine when the next downturn will hit the American economy, paying close attention to the available indicators could prove to be beneficial in allocating assets correctly and generating attractive returns in all market conditions.
Bloomberg says there’s a 28% chance of a recession within the next 12 months
Bloomberg has developed one of the most famous trackers of the U.S. economy, which many analysts follow to gauge a measure of where the country is headed. According to data compiled at the end of 2019, the chance of a recession within the next 12 months stood at 28%, a slight increase from 25% in November.
Source: Bloomberg.
The index reached a high at the start of 2019 with a probability of more than 47% for a recession within the year, but the risk did not materialize and the markets had one of the greatest years on record. As illustrated in the chart above, the probability index is nowhere near its historical highs and remains well below the numbers reported just before the dotcom bubble and the financial crisis. This is a clear sign that the American economy has more legs in this late-cycle and it would be irrational for investors to abandon equity market investments in fear that the outbreak of the coronavirus will lead to a burst of the bubble.
Goldman Sachs economists share the same view and believe that the likelihood of a severe downturn is very slim within the next 12 months. The investment bank’s chief economist, Jan Hatzius, wrote in November:
“We see several reasons why standard models – and thus forecasters – may be overestimating recession risk at present. The 24% chance for a recession within 12 months remains below the probability estimates of the median forecaster and reinforces our view that the risk of recession remains moderate.”
A slowdown in manufacturing activities can be expected in China in the first half of the year as many facilities in Wuhan remain in lockdown following the outbreak of the virus. However, the economic impact will likely be short term in nature and Bloomberg projects things to be better in the second half of this year, which is good news for the global economy.
The trend in corporate profit margins remains the bigger concern
As long as American companies generate sufficient profits, there will not be a real risk of a recession. The economy is closely tied to the success of corporations. Therefore, the after-tax profit margin on a national scale is considered one of the most reliable indicators of an upcoming turbulent period. Narrowing corporate profit margins could lead to a significant decline in capital spending, which would eventually weaken the economic growth of a country. Historically, the profitability of American corporations has declined drastically leading up to a recession.
Source: Federal Bank of St. Louis.
Even though profit margins have been declining over the last decade, they still remain above the historical average, suggesting that companies generate sufficient earnings to facilitate shareholder distributions and execute capital investments. However, if the trend remains negative for a few more years, companies will eventually have to cut back on spending and dividends, which could officially mark the end of this business cycle.
The low interest rate environment will help many companies keep their financing costs at a manageable level, but those gains will likely be offset by paying higher salaries for skilled employees. According to data from the U.S. Bureau of Labor Statistics, the unemployment rate in January was 3.6%, which is close to the 50-year low of 3.5%. Tight labor markets will make it difficult for companies to hire talented professionals, which will lead to companies offering higher-than-average salaries to retain and attract such employees.
The best way forward for investors is to monitor macroeconomic and geopolitical developments that could further contract profit margins, which would serve as a leading indicator of an upcoming recession or a difficult time period for the economy.
The Fed’s hands are tied
Whenever the American economy failed to deliver and entered a downward spiral, the Federal Reserve was there to provide a boost to economic activities through monetary policy easing. However, this could change dramatically during the next recession. Historically, the policymakers have had a lot of room to deal with and interest rates were cut multiple times as seen necessary to attract borrowers. The interest rates, however, are near record lows at present, which provides authorities with very little wiggle room.
Source: Bloomberg.
This is not good news for investors as there will be no external support to revive economic growth when America enters the next downturn. This highlights the importance of diversifying into global markets. Even though many developed countries have historically low rates, things are different in emerging countries that are continuing to grow at high single-digit rates. Many of these countries still have significantly higher policy rates than the U.S. and many European nations, which provides them with ample room to boost economic activities by cutting rates during a slowdown.
Source: Global-rates.com.
Investing through an exchange-traded fund could be the best option to gain exposure to international markets as this simplifies the investment process.
A leaf out of Buffett’s book
Legendary investor Warren Buffett (Trades, Portfolio) has consistently been bullish on the long-term prospects of the American economy. However, the guru highlighted the importance of investing internationally in his annual shareholder letter in 2019.
“There are also many other countries around the world that have bright futures. About that, we should rejoice: Americans will be both more prosperous and safer if all nations thrive. At Berkshire, we hope to invest significant sums across borders.”
In the same letter, Buffett went on to say that good businesses are trading at sky-high valuations, prompting the conglomerate to park most of its assets in cash.
According to data from GuruFocus, the ratio of total market capitalization to U.S. gross domestic product has reached a record high, which is an ominous sign.
A ratio of 150% was previously reported only before the dotcom bubble crashed, and at the current level of 158%, it is flashing warning signs for investors. However, investors can still find value in unloved sectors such as financials, utilities and energy. Considering the overvalued nature of the broad market, it would be a good idea to invest in these cheap sectors to avoid a hard fall in the next downturn.
Takeaways
The U.S. economy is showing mature signs with unemployment at record lows and corporate profit margins declining. While the breakout of the coronavirus proved to be a good wake-up call for unassuming investors, the long-term economic impact of this phenomenon will be negligible. However, now is a good time for investors to consider diversifying their portfolios to gain exposure to international equities and to take profits from overvalued tech stocks. Even though there are no warning signs at present to indicate an upcoming market downturn, the cyclical nature of business activities cannot be ignored altogether. Closely monitoring the housing starts, unemployment levels, corporate profitability and the yield curve will provide many early warning signs for investors to get ready for the next market crash.
Disclosure: I do not own any stocks mentioned in this article.
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