Stock markets continue to break records, the economy has finally achieved 3% growth, and deregulation and tax reform are likely to spur continued economic growth in the coming months.
So what do we have to be worried about?
For one thing, the current recovery is now 103 months old. That’s more than eight and a half years, making it the third longest in U.S. history. It’s creeping up on number two (106 months from February 1961 to December 1969) and isn’t too far from number one (120 months from March 1991 to March 2001).
If a recession hits, today’s bloated asset prices are likely to fall along with the economy. Ned Davis Research found that, post-World War II, the average decline in the S&P 500 Index from its pre-recession peak to the recession low is nearly 28%. During the Great Recession, it declined 50%.
Signs of Trouble
No one knows when the next recession will begin – only that it’s bound to begin someday. However, James T. Swanson, chief investment strategist at MFS, sees several troubling signs that could indicate that a recession is coming:
- Too much borrowing
- Frothy M&A and margin debt
- Profit share of GDP
Each of these are on Swanson’s recession checklist, which he uses regularly.
Too Much Borrowing
Corporate borrowing has been on pace for a record year in 2017. U.S. investment-grade corporate debt issuance surpassed $1 trillion on Oct. 1, 2017, a pace that was three weeks ahead of 2016.
Meanwhile, consumer debt rose to a record $12.96 trillion in the third quarter, an amount that’s $280 billion above the previous high from the third quarter of 2008, according to the Center for Microeconomic Data’s Quarterly Report on Household Debt and Credit.
“In my experience, too much borrowing is a sign of too much confidence, and excessive confidence is never a good thing,” Swanson wrote.
While servicing the debt is currently manageable, it will be less so as interest rates rise.
The Federal Reserve Board announced its third rate hike of the year on Wednesday. While the quarter point hike brings the benchmark rate to a range of 1.25% to 1.5%, two more increases are expected to take place in 2018.
In addition, the expanding economy and the Fed’s decision to “normalize” its $4.5 trillion bond portfolio will put additional upward pressure on interest rates. Interest rates tend to rise late in business cycles.
Frothy M&A and Margin Debt
Swanson also noted that the excessive increase in mergers & acquisitions that’s taking place and an accompanying increase in prices paid are “classic late-cycle phenomena.”
“Often, late in the cycle, companies doubt their ability to grow earnings and sales fast enough to please investors,” Swanson explained, “so they buy another company in order to create savings and to juice earnings per share. Often they’ll pay too much in the process. In my opinion, takeover activity is on the rise and the premia being paid are growing toward peaks seen in previous cycles.”
Similarly, Swanson is worried that increasing margin debt may be a recessionary red flag. Margin debt on the New York Stock Exchange hit a new high of $561 billion at the end of October.
“Some investors borrow against their portfolios in order to buy more shares, which can amplify profits if stocks continue to rise or magnify losses if stocks fall,” Swanson wrote. “Other investors use margin debt as a cheap source of short-term funding for other priorities. That could be worrisome if investors begin to use margin debt the way they used home equity loans in the run-up to the global financial crisis.”
Investors who borrow against their portfolio may be adding to downside risk, especially if they are forced to sell shares to meet margin requirements.
Profit Share of GDP
Using national income and product accounts (NIPA) data from the U.S. Bureau of Economic Analysis, Swanson divides all profits produced by the U.S. economy by gross domestic product (GDP), then he compares the resulting profit share of GDP with previous numbers.
“When that profit share (of GDP) is rising,” he wrote, “it usually suggests that better times lay ahead for stock prices, based on the assumption that businesses are more likely to invest and hire when profits are rising than when they’re falling. When profits are falling, they tend to rein in hiring and investment. … Historically, when profit share of GDP falls for a year or more, it suggests trouble lies ahead.”
Although the overall profit share percentage remains relatively high, it’s been dropping slowly for nearly a year. It typically falls 12 to 18 months before the onset of a recession.
Prepare, Just in Case
Maybe the economy will continue to grow and the stock market will continue to set new records throughout 2018. And maybe they won’t.
It’s best to be prepared. Don’t go all in with Bitcoin or other risky assets. Consider capital preservations strategies, because there are signs that a recession may be coming.